First Industrial Realty Trust Inc Q1 FY2021 Earnings Call

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the First Industrial First Quarter 2021 Results Conference Call. At this time, I would like to turn the conference over to Mr. Art Harmon. Thank you. Sir, please begin.

Thank you, Howard. Hello, everybody, and welcome to our call. Before we discuss our first quarter 2021 results as well as updated guidance, let me remind everyone that our call may include forward-looking statements as defined by federal securities laws. These statements are based on management's expectations, plans and estimates of our prospects. Today's statements may be time-sensitive and accurate only as of today's date, Thursday, April 22, 2021. We assume no obligation to update our statements or the other information we provide. Actual results may differ materially from our forward-looking statements and factors which could cause this are described in our 10-K and other SEC filings. You can find a reconciliation of non-GAAP financial measures discussed in today's call in our supplemental report and our earnings release. The supplemental report, earnings release and our SEC filings are available at firstindustrial.com under the Investors tab. Our call will begin with remarks by Peter Baccile, our President and Chief Executive Officer, and Scott Musil, our Chief Financial Officer, after which we will open it up for your questions. Also on the call today are Jojo Yap, Chief Investment Officer; Peter Schultz, Executive Vice President; Chris Schneider, Senior Vice President of Operations; and Bob Walter, Senior Vice President of Capital Markets and Asset Management. Now let me turn the call over to Peter.

Thanks, Art, and thank you all for joining us. We were very pleased with our first quarter performance, and we are encouraged by the continuing strong economic growth supported by improving consumer confidence and significant government economic stimulus. Similar to our fourth quarter call, we continue to see exceptionally strong fundamentals in the industrial market. Per the recent CBRE flash report, U.S. industrial net absorption totaled 100 million square feet in the first quarter. This marks the first time ever that demand has exceeded 100 million square feet in consecutive quarters. Net absorption also significantly exceeded first quarter completions of 57 million square feet. As you would expect, in response to this demand, high occupancy levels and strong rent growth, we are continuing to invest in new development projects, which I will discuss shortly. Before I recap first quarter results and activity, let me start by updating you on a couple of items since our last call. As we announced earlier this month, David Harker will be retiring as Executive Vice President of our Central Region effective June 30. David has been a valued member of the FR team since 1998 when he joined the company as our Regional Director in Nashville. He has served our company and our shareholders as Head of our Central Region since 2009, helping to shape and grow our portfolio. We will miss Dave's enthusiasm, tenacity and energy and wish him well in his retirement.

Thanks, Peter. Let me recap our results for the quarter. NAREIT funds from operations were $0.46 per fully diluted share, compared to $0.45 per share in 1Q 2020. And our cash same-store NOI growth for the quarter, excluding termination fees and a gain from an insurance settlement, was 2.2%, primarily due to an increase in rental rates on new and renewal leasing and rental rate bumps embedded in our leases, partially offset by lower average occupancy. Summarizing our outstanding leasing activity during the quarter, we commenced approximately 3.3 million square feet of leases. Of these, 600,000 were new, 2.3 million were renewals and 500,000 were for developments and acquisitions with lease-up. Tenant retention by square footage was 76.5%. Cash rental rates for the quarter were up 10.4% overall, with renewals up 8.3% and new leasing 17.8%. And on a straight-line basis, overall rental rates were up 21.4%, with renewals increasing 17.6% and new leasing up 35.5%.

Thanks, Scott. We're off to an excellent start in 2021. Our team is focused on capitalizing on the positive momentum generated by the recovering economy and the continuing evolution and growth in the supply chain. And with that, operator, would you please open it up for questions?

Our first question or comment comes from the line of Michael Carroll from RBC Capital Markets.

Can you guys talk a little bit about your near-term, I guess, development starts? You've been pretty aggressive at the beginning of this year and you just mentioned that you're increasing your speculative development cap. I mean can we assume that FR will continue to break ground on, I mean, the $80 million to $100 million of development starts as we move into the back half of this year to kind of continue this pace you started at the beginning of the year?

So, the cap is now $625 million, and we've got about $225 million of capacity under the cap. So that's $400 million underway. About $318 million is currently under construction and the rest has been completed. So we've got some room there. We're evaluating new opportunities, and you can expect us to announce some additional starts in the second and third quarter.

Okay. And are there specific markets you're willing to pursue spec projects? I mean, are you really focused on the Tier 1 markets to do spec projects or are you willing to go to some of the smaller markets too?

Well, as you know, we're pretty focused on the higher barrier markets now with not only our new development projects but also any acquisitions. And so that's where we'll continue to focus our new investment dollars. That's not really size-related. It's really more growth opportunity related.

Okay. Great. And then last one for me. Can you talk a little bit about the activity you're seeing at the former Pier 1 space? Is there interest in that site right now? And I guess, what's the timing of being able to release that block?

Sure, Mike. It's Peter Schultz. Activity in that market continues to be very good. A number of large lease signings in the first quarter. We've had some interest in our building. Nothing to report on today. Our assumption is that it releases on October 1. And given the high level of demand and the few choices that tenants have, we're optimistic about outperforming on our rental rate there.

Our next question comes from the line of Craig Mailman from KeyBanc Capital Markets.

Peter, just a clarification to the previous question. You said there was $225 million of capacity left under the cap or used under the new cap?

We have $225 million of the $625 million available. Of the $400 million that is used, $318 million is underway. And the difference are 3 projects that we have completed but not yet leased.

And that already includes the projects that we just announced that is going to start Q2.

Got you.

So that $225 million is pure capacity for new starts for the rest of the year unless we lease things quicker.

And then one of your larger peers was talking about replacement costs going higher and the difficulty getting materials. Kind of where are you guys on purchasing, buying new projects? You backfilled the land bank a little bit here. But as we look out to the balance of the year, I mean do you have the steel and other materials to continue to keep pace with starts? Or is that going to be a little bit of a hindrance as we move to the balance of the year unless supply chains ease up a bit here on the material side?

Steel prices have certainly risen compared to before, and this issue has been developing over the last 9 months to a year. We have been proactive in monitoring this situation, expecting longer lead times for steel. However, we are not experiencing any difficulties in obtaining steel, and it is not causing delays in our new projects. While the projects are a bit more costly, a significant portion of the expense increase can be attributed to land appreciation. Jojo, would you like to discuss the details of this expense increase?

Certainly. The rise in construction costs, particularly with steel, has led to an overall increase in total investment by approximately 5% to 7%, assuming the land costs remain unchanged. When you also consider the increase in land prices, that adds another estimated 5% to 7%. In summary, the rise in costs is roughly split between land appreciation and construction expenses.

All right. That's helpful. And then just, Scott, one quick one. It seems like the sales this quarter kind of really helped to boost some of the occupancy and same-store lift, and did it also drag enough on earnings and that's why you guys kind of kept guidance here flat?

Yes. So I'll walk through the math, Craig, with you. You're going to love this stack because I know you love bad debt expense. But our bad debt expense was 0 for the first quarter compared to our guidance of $500,000. So that obviously is a benefit to FFO. And then you're correct, some of the sales in the first quarter caused some dilution that offset that, which is the reason why we kept our FFO guidance the same, the midpoint. Keep in mind those sales proceeds will be part of the funding source that we used to fund the two new starts that we discussed in the script. And when those are completed and leased up, obviously, we'll see an increase in NOI from that activity.

Our next question or comment comes from the line of Rob Stevenson from Janney.

Scott, what drove the 15% same-store expense growth in the quarter? And is any of that carrying over in the back half of the year?

Sure. If anyone on the call lived north during this winter, it was snow removal costs. Being in Chicago, we definitely felt there, and I'm sure many of the folks in the North felt it. So it was an increase in snow removal cost was the primary driver. And again, the vast, vast majority of our leases are net leases. So that's recoverable. And again, with our high occupancy rate, we're recovering most of that and the leakage is pretty small. So that said, as far as whether or not we'll experience that later in the year, I guess you'd have to look at the Farmers' Almanac and see whether we're going to have a bad fourth quarter winter or not. But again, I think the main point is, is when we see expenses increase in the portfolio with a high net lease exposure and a high occupancy rate, the vast majority of it is going to be recoverable.

Okay. And then any known move-outs of size over the remainder of 2021 and into the 2022 leases? And where are you guys expecting the retention rate to sort of fall out for the year? It was low this quarter relative to previous quarters, but I don't know whether or not this just got some of the move-outs out of the way.

Yes, this is Chris. So far this year, we've managed to address 72% of the remaining rollovers. The average size of the rollovers left is about 27,000 square feet, which puts us in a good position. For our retention rate by the end of the year, we expect it to be between 70% and 80%. Looking ahead to 2022, the situation appears to be quite detailed across all markets, so we don't anticipate any major surprises.

Okay. And then last one for me. The three land sites you bought in the quarter supporting 275,000 square feet, is there anything, in particular, I assume that Oakland is probably a smaller asset, but the average of that is all 3 assets over 275,000 square feet, sub 100,000 square foot. Are you combining that with additional land sites to build bigger? Or are these all going to be relatively small developments once you get to them?

Yes, you are right. Regarding the three assets, the Oakland land features a lower coverage building because we have been experiencing significantly higher rents and rent growth from surface parking and surface use. Currently, the design is slightly lower in terms of floor area ratio. It will be a standalone project. Peter?

And then, Rob, in the Lehigh Valley, that site is adjacent to one of our existing properties and is going to share some infrastructure, and we're excited about that size given the difficulty in finding sites and serving demand for that size and that submarket.

Our next question comes from the line of Caitlin Burrows from Goldman Sachs.

Maybe just following up on that land acquisition topic. I think this is the first time in recent history that you acquired lands in Northern California and the cost was pretty high versus 2020 land acquisition. So could you just go through what drove the decision to acquire the land given the economics? And how quickly do you expect to build there? And what kind of yields you could expect?

Thank you for your question. We are very focused on the 880 Corridor in East Bay and anticipate considerable rent growth in this area. It is one of the most densely populated markets in the U.S., and development in the peninsula that the East Bay industrial market serves continues to expand. Our strategy involves acquiring and developing properties throughout the corridor, particularly from Richmond down to San Jose, with a focus on Oakland and Hayward. We recently acquired a site in Hayward, which is at the heart of the East Bay industrial market, and we expect to continue developments there. Regarding our acquisition of First Avenue, we anticipate a significant yield from that property. If the market stabilizes, this property could yield returns below 4%. We expect notable rental rate growth, with rents in East Bay aligning with those in South Bay, Los Angeles, and the Inland Empire.

Got it. Okay. And then maybe just more broadly on acquisitions of land. Can you talk about the competition that you're seeing in the target market? I imagine it's high, but just how often you're being priced at or what the opportunity is there?

Well, most of our efforts involve our teams on the ground making unsolicited offers and persistently contacting the owners of these land sites until they agree to sell. Typically, when we succeed, it’s one of the reasons we can achieve high margins, as we face limited competition. While the owners will consider offers from more than just us, these opportunities are generally not extensively marketed by brokers. We pursue this strategy by sending out hundreds of unsolicited offers each week across the country, and while some of the land sites are smaller, we occasionally secure larger parcels of 80 or 90 acres. We are focused on high barrier markets, which naturally makes large land sites harder to find.

And just to add to what Peter said, we have been very successful in land assemblages, which are among the most complex land acquisitions because they require coordinating multiple sellers and closing simultaneously. We have managed to do this effectively, resulting in a lower basis.

Got it. And then maybe just a last one on the maintenance CapEx, the non-incremental building improvements and non-incremental leasing costs were higher again in the first quarter year-over-year or if you look over the trailing 4 quarters, pressuring the AFFO. So I know last year, you had talked about pulling forward some CapEx. Just wondering how long that's going to continue for? And is that still what's causing the higher maintenance CapEx?

Yes. Caitlin, it's Scott. I believe that's mainly a timing difference from quarter to quarter. When considering capital expenditures, it's important to look at them annually. We anticipate our capital expenditures this year will be around $38 million, which represents a savings compared to our 2020 spending. Additionally, if we maintain the same portfolio size, we expect that figure to decrease by a couple of million dollars over the next few years.

Our next question or comment comes from the line of Dave Rodgers from Baird.

Dave Harker, congratulations on the retirement. Well deserved. Peter Schultz and Jojo, congratulations on the added work.

Ask them how much they got paid.

Going back to the comments, I looked at your development pipeline, and what's under construction today is about 20% larger than what you delivered last year. Some of that can be attributed to changes in mix. However, if we examine the two weakest areas of occupancy in the portfolio, they are Seattle and South Florida, which are typically smaller tenant markets. Could you discuss whether you have a preference for building larger assets, despite your recent comments? Additionally, can you provide insight into the activity in smaller spaces and how that segment of the portfolio is recovering?

Sure. Let me start with that, and then Jojo and Peter can jump in. The weakening or weaker occupancy that you referred to in some of these markets is really one property. So for example, in South Florida, we've got a 96,000 square foot vacancy in Broward County. In Seattle, we've got a 62,000 square foot vacancy there. We don't have a huge portfolio. We're working on it, but it's still not large in Seattle. So that factors into that vacancy that you referred to. Grand Parkway in Houston. Other than Grand Parkway, we're pretty full in Houston. So there's really no issue there. And in terms of demand, the largest rent increases are coming from the tenants in the building sizes of 100,000 to 200,000 square feet. Peter and Jojo, I don't know if you want to add to that?

Sure, Dave. It's Peter. I would say in terms of building size, we're building to what we view as the strength of demand on a submarket basis. So in Pennsylvania, as an example, bigger is better and demand is strongest for larger buildings. In some of the other submarkets, it might be a mid-sized building. But remember, we're always focused on the flexibility to accommodate single tenant or multi tenants in these buildings. And we've been surprised in a couple of cases where buildings that we built for multiple tenants, we've ended up with a single tenant. Jojo?

Yes. To illustrate Peter's point, we have already leased the First Redwood Logistics I Building B, which is a 44,000 square foot property in the Inland Empire and has performed exceptionally well, leasing very quickly after completion. Another example is our build-to-suit project, First Nandina, which is 221,000 square feet in the East Inland Empire. While considered a smaller building, there is strong demand in that area, leading to a tenant wanting to acquire it before we could move forward with the speculative development. Additionally, we are planning to start a project called First Wilson, which will be 303,000 square feet in the Inland Empire. This showcases the diverse demand in the marketplace. As Peter mentioned, we will continue to adapt our development to fit market demands. Regarding the East Bay, many of our assets there will be smaller in size due to demand patterns, but if we encounter opportunities for larger developments, we will pursue those as well. I hope this addresses your question, Dave.

It does. I appreciate all the added color. I think in there, I heard rent increases are biggest among the 100,000 to 200,000 square foot boxes. I guess, as you rank maybe the smaller and the larger component against that range, so below 100,000 and above 200,000, how do those compare? Are they meaningfully different?

So the 50,000 to 100,000 are pretty strong as well. The growth is a little bit lower over 200,000 and under 150,000. So that's a broad generalization, but that's what we're seeing.

No, that's helpful. Last for me, Scott, maybe for you. As you increase the development cap and it makes sense, thanks for running through the numbers. I guess, how do you think about the financing part of that, right? So now maybe you've got more speculative assets that you can add to the pool, but do you think about then having to kind of keep lower leverage using equity more aggressively or selling more assets as the year progresses?

Yes, Dave, I believe we are following the same approach we have in the past. We will use your sales proceeds and excess cash flow after paying a dividend. We do have some capacity to increase our leverage a bit since it is currently low at 4.8 times. As we have mentioned previously, if we encounter great investment opportunities and the equity price is attractive, we will consider issuing equity. That option is certainly available. We have also reviewed our past equity issuances from 2020, 2018, 2017, and 2016, and we allocated most of that capital towards speculative development. As we noted during our Investor Day call last November, the margins from those investments were quite strong, and we felt it was a wise use of our capital. While equity is a part of our strategy, we need to be comfortable with the stock price and ensure we have a solid investment pipeline.

Our question comes from the line of Vince Tibone from Green Street.

Given how land and overall replacement costs are trending, how much longer do you believe development profit margins can stay at the impressive levels they are now? At what point does just competitive market forces push these down some in your mind?

Sure. This is Jojo. In terms of margins, they have remained relatively stable due to increased investment costs alongside rising rents. Additionally, cap rates have decreased, which I believe is justified because many investors did not anticipate the significant rental growth rates we are witnessing. Most initially expected growth between 3% and 5%, but this year may see growth of 5% to 10%, with some submarkets exceeding that range. We are currently in a position where I think margins will persist. There is more competition entering the market, but overall, rents have increased substantially. One final point I want to make is regarding our discussions with customers about rental costs relative to total logistics costs, which still remain low, under 7%. The main expenses for any logistics company are transportation, labor, and inventory management, with the rest being minimal. We actually have the lowest cost structure in the market. While we cannot simply increase prices without consideration, there is potential for growth since rental costs comprise a smaller portion of overall logistics expenses.

Got it. That's helpful. I want to follow-up on one of the comments you made, you saw kind of growing competition. Are you seeing a lot of new players enter the space who traditionally haven't done industrial development or it's more kind of existing players just growing their risk appetite and maybe development pipelines?

We are observing both trends. What you mentioned is indeed a source of new competition. We are seeing increased funding from current investors along with new entrants, and there is significant activity from other product types, particularly in the industrial sector where conditions are notably favorable.

Does that worry you at all for some of the lower barrier markets just kind of ramping supply over the next 2 years? As more and more capital wants to come into the space, how do you think about overall supply risk in your various markets?

We monitor it very closely, but we're not concerned. We adjust our investments based on the demand and supply in each submarket. That's why we have a platform—we consistently track supply and demand. So far, we’ve been quite pleased, and a little surprised, by the over 100 million square feet of net absorption in the entire market just in Q1, despite a constrained supply. This is positive news for everyone in the industrial sector.

Yes, there are lots of new entrants, as Jojo mentioned, where investment managers or investors in traditional assets, apartments, retail, etc., want to get involved in industrial. And they're extremely aggressive, and they actually become really good buyers of some of the stuff that we're selling. So from that standpoint, that's a plus for us.

The only other thing I would add to what Peter said is that we have a platform in our construction, development, asset management, and property management leasing that not all the new entrants possess. This provides us with an embedded advantage in terms of relationships, identifying new deals, and securing deals at low basis value.

And market knowledge.

Our next question comes from the line of Mike Mueller from JPMorgan.

You talked a lot about new development starts, but can you talk a little bit about what you're seeing in terms of the opportunity for buying vacant buildings?

There's not a whole lot on the market to start with. So we track. We'll call it deals done away. That's an old banking term. We track all the transactions that happen. We see most of them. And over the past few years, that analysis has thinned out considerably. So first of all, there's not a lot being sold. Then you break it down to where we want or would consider buying, and that's higher barrier markets, and that shrinks the available pool even more. We would certainly acquire a vacant building if it met all of our criteria. We do evaluate those opportunities from time to time, but it's not a high volume.

Our next question comes from the line of Rich Anderson from SMBC.

I want to add to Mike's question. I'm curious if there's much distress in the industrial sector right now. Is there a creative way to expand your land position, maybe by acquiring a poorly located strip center that you could redevelop into a moderately sized industrial building? Would you consider the risks and time involved in re-entitling? Is that something you are looking into? Are you currently pursuing that, or is it not necessary at this time?

Well, we absolutely take entitlement risk. It's what we do on a regular basis.

Let me rephrase the question. Of course you do that, but I mean more in an opportunistic sense, in the way I'm trying to describe.

Sure, we are definitely considering those opportunities. However, there are some challenges to address. Retail rents are typically higher per square foot compared to industrial rents, creating an economic hurdle. Additionally, many retail centers are in residential areas, and local communities are often not in favor of large trucks operating in their neighborhoods. These factors present challenges, but we are exploring some current opportunities. Like others, we aim to find ways to generate value for our shareholders, and in some instances, this might involve repurposing or redeveloping a retail site.

Okay. My follow-up question is about how the markets reacted today. I don’t want to focus too much on a single day of trading. You reiterated your guidance from last quarter, and in the industrial space, redo rate is seen as a cut, reflecting your past success. What I am asking is, in 2020, e-commerce demand increased in that environment, which hopefully is gradually changing. In 2021, do you believe that your perspective on future growth is somewhat lower as we approach a more typical operating environment? Does this mean we might have a clearer idea of what 2021 guidance will look like in the future? Or are you just as excited, or even more excited this year, despite not having the same surge in demand you experienced last year?

Well, nobody knows exactly how e-commerce growth will unfold, but we did see millions of new customers adopt online shopping last year, which tends to stick. We experienced significant growth in online sales, and while that pace may not continue, we have seen an upward trend. We expect e-commerce to perform at least as well as it did before COVID, which was already strong. We believe e-commerce will maintain a robust growth trajectory, although it may not reach the peak we saw in 2020. Additionally, there is considerable competition as everyone tries to expand their market presence and optimize their supply chains. This competition includes not just e-commerce businesses, but also traditional retailers, and we view it positively as it benefits us and supports growth in rental rates.

Our next question comes from the line of Nick Yulico from Scotiabank.

So maybe just focus on the Inland Empire for a minute. At the Investor Day, you did give some forecasted yields on the future land pipeline there as well as construction starts. And we just came off, I think some people were saying it was a record first quarter in the first quarter for Inland Empire. I guess I'm just wondering there, you cited the cash yield there on that pipeline of 5.6% and construction starts that were starting sort of besides what you've already announced later this year and into 2022, 2023. And I guess I'm just wondering, based on the market dynamics since then, whether there's any increase in yield that you're seeing in that market and as well for some of the future starts, do you speed up some of the development in the Inland Empire?

This is Jojo. When I mentioned a 5% to 7% increase, I was referring to the rise in construction costs as a percentage of total project costs, which remains stable with land costs, largely due to steel prices. Regarding your question about rents increasing, yes, the Inland Empire is a market where rents have grown at a rate surpassing the combined increases in construction costs and land prices. Thus, we expect to see rising yields in the Inland Empire, driven by these rising rents. That aligns with your question about trends. Additionally, I would like to note that there are several factors making this market one of the tightest in the U.S. In both the West and East sides of the Inland Empire, vacancy rates are below 3%, and in the South Bay, they are below 2%. This year, year-to-date Q1 port activity has been significant, with March likely breaking records over the past decade. The top 13 ports in the U.S. have shown increased container throughput, specifically inbound. For instance, comparing Q1 of 2021 to Q1 of 2020, the ports of Los Angeles and Long Beach experienced a 47% increase in throughput. I mention this because it affects absorption rates, rental rates, and continues to contribute to the tight market in the Inland Empire, which serves as a major hub for goods arriving from these ports.

Okay. That's helpful. Just one other question is on the asset sales, you mentioned this quarter that there were some above-market rents that drove that cap rate higher on the sale. How should we think about, going forward, some of the other property sales you may be doing and lining up in terms of that, if there's also an above-market rent impact we need to think about or should cap rates on sales be more normalized going forward?

Well, just to give you a reference point, the tenants in those buildings are moving out in one building and moving out next month. When you take a look at where market rents are there, we project stabilized cap rate on those deals is closer to the low 5s. So obviously, it is what it is today with the tenant in the building and that's why we reported the 8.4%. But the opportunity set going forward, both from a lease-up risk standpoint and a growth opportunity, is just not there and that's why we sold those buildings. On a stabilized basis, so getting back to that, stabilized basis, we think the sales for the balance of the year are going to be more like high 6, low 7 cap rate.

I'm showing no additional questions in the queue at this time. I'd like to turn the conference back over to Mr. Peter Baccile for any closing remarks.

Thank you, operator, and thanks to everyone for participating on the call today. As always, please feel free to reach out to me, Scott or Art with any follow-up questions, and we look forward to connecting with many of you at some point, either virtually or in person, this year. Take care.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day.