Earnings Call Transcript - REXR Q2 2021

David Lanzer, General Counsel

We thank you for joining us for Rexford Industrial Second Quarter 2021 Earnings Conference Call. In addition to the press release distributed yesterday after market close, we posted a supplemental package in the Investor Relations section on our website.

Michael Frankel, CEO

Thank you, and welcome to Rexford Industrial's Second Quarter 2021 Earnings Call. Today, I'll begin with a brief overview, Howard will then cover our markets and transaction activity and Laura will discuss our financial results. We will then open the call for your questions. Our team continued to deliver exceptional results through the second quarter. We closed $257 million in new acquisitions. And from an operational perspective, a robust 2.2 million square feet of leasing produced 98.2% occupancy in our stabilized portfolio. Re-leasing spreads continued at extraordinary levels, averaging 21% on a cash basis and 34% on a GAAP basis. As a result, our strong internal and external growth produced year-over-year core FFO growth of 36% and 22% on a per share basis. As we enter the second half of the year, the California economy shows robust growth and continued reopening. Industrial tenant demand remains at historically high levels, driven by strong secular growth across a wide range of industry sectors. In addition, the acceleration in e-commerce is driving shifts in supply chain and last mile distribution strategies. Further, emerging e-commerce and technology-enabled new businesses are intensifying the growing need for infill locations. From our vantage point, we believe that we are still in the early stages of these long-term market shifts, which are expected to drive ongoing growth. Our portfolio is particularly well positioned as our properties generally represent mission-critical locations for our tenants. And as rent typically represents a very small share of our customers' economics, we continue to see a favorable degree of price elasticity in terms of our ability to drive rent growth.

Howard Schwimmer, CFO

Thank you, Michael, and thank you, everyone, for joining us today. For the second quarter, Rexford's leasing performance was outstanding, reflecting the high quality of our portfolio and the strength of our infill markets. Across the nearly 2.2 million square feet of leases signed in the quarter, we achieved cash and GAAP spreads on new leases of 25% and 39%, respectively, and 19% and 31%, respectively on renewal leases. We continue to see rental rates accelerating at unprecedented levels. Based on our internal portfolio metrics, market rents within our portfolio increased by 16.8% over the prior year. Looking forward, the company is well positioned from an internal growth perspective. Our consolidated portfolio weighted average mark-to-market for cash rents is estimated at 19%. Mark-to-market for the 1.8 million square feet of leases expiring through the end of the year is estimated at 24%.

Laura Clark, CFO

Thank you, Howard. I'll begin today with details around our strong operating and financial results. Second quarter stabilized same-property NOI growth was ahead of our expectations at 10.1% on a GAAP basis and 22% on a cash basis, driven by strong portfolio performance. Compared to prior year, average occupancy is up 100 basis points to 98.5%. Leasing spreads are up 35% on a GAAP basis over the trailing 12-months and bad debt as a percent of revenue in the same-property pool was a positive 40 basis points compared to a negative 130 basis points in the second quarter of last year. As a reminder, the bulk of our short-term deferral agreement, although nominal, were granted in the second quarter of last year, positively impacting this quarter's cash same-property NOI year-over-year comparison. Adjusting for these impacts, cash same-property NOI growth was a robust 11.3% in the quarter and 9.4% year-to-date. Our tenant base continues to perform extraordinarily well. Rent collections continue at pre-pandemic levels with second quarter and year-to-date collections of contractual billings at 98.6% and 98.7%, respectively. Bad debt reserves as a percent of revenue for the quarter were a nominal 10 basis points of revenue and 30 basis points year-to-date. These strong results collectively enabled us to grow core FFO per share by 22% to $0.39 per share. Turning now to our balance sheet and financing activities. We continue to maintain a best-in-class low leverage balance sheet, which supports our opportunistic internal and external investment activities. As of June 30, net debt to EBITDA was 3.8x, below our target leverage of 4x to 4.5x, with net debt to enterprise value at 12%. During the quarter, we executed a number of accretive capital markets transactions. In May, we completed a forward equity offering for expected gross proceeds of $500.4 million. We also issued $15.6 million of equity on a forward basis through the ATM program. In June, we repriced our $150 million unsecured term loan, reducing the spread by 50 basis points over LIBOR, equating to annual interest savings of approximately $900,000.

Blaine Heck, Analyst

One probably for Laura to start out. You guys were pretty conservative in the way you accounted for deferred cash rents and their effect on same-store cash NOI in 2020. But as we look at this year's results, obviously that headwind of missed cash collections has turned into a tailwind as you recover those deferred rents. We appreciate the added disclosure around this quarter's results and the benefit from those repayments, but can you also quantify how much those repayments might be contributing to full year 2021 cash same-store NOI guidance?

Laura Clark, CFO

Yes, Blaine, thank you for being here today. Regarding our cash same-property NOI, for both the current quarter and year-to-date, COVID-related deferrals affected our reported figures. In the second quarter, these deferrals influenced our 22% reported number. If we factor out the COVID-related deferrals, cash same-property NOI would have shown a solid 11.3% growth, compared to the 22% reported and 9.4% year-to-date, which contrasts with the 14.8% we previously noted. Over the full year, COVID-related deferrals account for approximately 150 basis points of the 325 basis point difference between our cash and same-property NOI growth guidance. Thus, when excluding the COVID-related deferrals, our guidance for same-property cash NOI falls within the 7.5% to 8.5% range.

Blaine Heck, Analyst

Great. That is very helpful. And then second question for me, maybe a little bit more of a big picture question for either Howard or Michael. Can you guys talk about the regulatory environment, especially in light of the newly proposed emissions rules in the Inland Empire that require operators to offset their trucking pollution? Number one, do you see those types of rules and added operator expenses hampering any of the future rent growth you guys are expecting in your markets? And number two, do you think this is just a one-off type of regulation or kind of a foreshadowing of what's to come in markets across the country?

Michael Frankel, CEO

Hey Blaine, it's Michael. Great to hear you today. Thanks for joining. So numerous embedded questions in there. But number one, the emissions, it's an indirect tax basically targeting trucking use and trying to minimize emissions from trucking use into warehouses, and it's indirect in the sense that they're taxing operators inside the warehouses, by the way, not landlords. It's actually the tenants. And furthermore, to qualify for the tax, you have to be operating in at least 50,000 square feet within a building that is at least 100,000 square feet. Incidentally, for Rexford, our tenants, we have about 90 tenants out of our 1,500-plus tenant base that would be potentially impacted. So for the record, there's really no impact to Rexford. That having been said, we think the maximum tax for those tenants could be about $1 a square foot. However, there are many ways that tenants can mitigate the costs. For instance, by instituting various energy efficiency programs within the property and within their operations. And so that we expect the tenants themselves will be able to substantially mitigate the potential of the $1 per square foot per year tax. So we don't see the absolute cost to tenants as being material, and we don't really see an impact to our forward rental rate growth within our markets, certainly given the extreme scarcity of product.

Manny Korchman, Analyst

Just looking at the redevelopment schedule you have in the sub, there are bunch of projects where yields jumped up significantly. I assume that's driven by rental rate growth. Was just hoping that you could confirm that, that's the reason they've gone up. And also just give us an idea of how you think about rental rates when you put out those pro forma yields? Is that in place now or are those based on where the yields or where the rents could be once those projects deliver or stabilize? Thanks.

Howard Schwimmer, CFO

Hi, Manny, it's Howard. Yes, we adjust our yields on a quarterly basis based on current market rents. Once they're on the repo page, we don't make forward-looking adjustments. Interestingly, our repositioning page shows about 3 million square feet in current and future projects, with around 750,000 square feet already pre-leased or leased. Many of these will be stabilized and reported next quarter, with some even happening in the third quarter. I believe I covered all your questions. Did I miss anything?

Manny Korchman, Analyst

No, I think that was that. And then just looking at the pipeline of deals you have coming, you guys have been buying a lot of covered land plays or maybe they're better than covered, given the rents you're getting on them. But how much of the pipeline is made up of those types of deals versus more of your traditional warehouse or logistics stuff?

Howard Schwimmer, CFO

Without getting into too much detail because some of these transactions may or may not close, we do probably see a little bit of an uptick in some of the covered land plays. We've identified some opportunities that are providing substantial cash flow. The one thing I might also point out is, in our markets there's been a lot of development in previous years of some of these low-rise office structures on industrial zone land, and we're starting to put a little bit of focus into buying a few of those, one deal we closed after quarter end in San Diego. That deal has some improvements on it that we're going to be basically waiting for the burn off, but we bought it at a 5.5% yield. And so those are pretty attractive opportunities we're buying them basically at land value. And so you'll see us starting to report a few of those as well.

Dave Rogers, Analyst

Maybe I'll start with Howard. On the lease diversity front, in the past you've given some color on kind of where the leasing is coming from. Curious more on the changes that you're seeing into the second quarter, if any, versus where you were in the first quarter and how you finished 2020?

Howard Schwimmer, CFO

Well, I'd say if anything, we're seeing even more diversity of uses that are coming into the properties. Obviously, e-commerce type leases are abundant in that. But just in the last quarter, I mean, looking at sort of our leasing, we did some food and beverage type transactions, restaurant supply. There was an entertainment lease, home improvement, construction materials, furniture, medical, biotech, 3PLs. You name it, it's showing up in our product. And we're just lucky to be in one of the most diversified markets in the country and not reliant really on any one industry that's supporting a lot of the leasing activity.

Dave Rogers, Analyst

Thanks for that, Howard. I think, Michael, you made the comment in your prepared remarks regarding tenants and doing more with existing customers and existing tenants. I guess, I was curious on one front, is that doing more leasing with existing customers? And I guess, what's the percentage of return visits with your customers or was that with regard to maybe doing more sale-leaseback or purchase transactions with some of the customers you have, and I was curious around that front as well?

Michael Frankel, CEO

Dave, thank you for the question. We're seeing an increase in expansions from our current tenants, which is very positive. This is also tied to our growing presence in the market. As we expand our reach and market share, we expect this trend to continue. Additionally, Rexford is taking a more proactive approach given our scale, exemplified by the creation of our customer solutions division last year during the pandemic. This division's goal is to identify emerging tenant demand through our own research, including existing tenants and companies that aren't yet with us. We're engaging more proactively in the market, which is an exciting development for the company. We're already experiencing significant results; rather than just discussing individual spaces or lease expansions with tenants, we're now in strategic conversations with tenants who need multiple spaces in infill Southern California. This is an exciting time for us. Regarding where that demand is coming from, it is extensive. For instance, in the building industry, local municipalities in California are mandated to increase housing stock by 20%, which is a long-term endeavor that will take years to achieve. They're providing incentives to encourage development. Historically, this was seen as more cyclical, but now we're looking at sustained demand growth in that sector. The electric vehicle market is another area of growth. Additionally, there are various emerging businesses and technologies that are helping traditional retailers compete with Amazon and enabling new businesses that weren't even on our radar a few years ago, all looking for significant space in our markets. The infill distribution market for last-mile delivery is incredibly dynamic right now. As I mentioned, we are in the very early stages of these shifts, and it's exciting for the company as it enhances the value of our spaces and portfolio.

Howard Schwimmer, CFO

And Dave, I'll add just a little bit more to that. We did 1.2 million square feet of new leasing and 1/3 of that were expansions of existing tenants, about 400,000 square feet. So we're really doing, I think, a really superb job of working with our existing tenants and identifying their needs, and it really smooths the transaction process where we already know a tenant. We're not trying to bring somebody new into the portfolio as well. So it's really a benefit to both sides of these lease transactions.

Michael Frankel, CEO

And related to that, I think what we're seeing are probably one of the drivers of our kind of outsized NOI growth, if you will, has been literally a little lack of downtime, when we need to renew a tenant or rather than we need to re-tenant the space. And also, we have a range of spaces that were slated to go into redevelopment or repositioning but the existing tenant was able to pay such a high rent, just so they could stay in the market and stay in our space that the yields on those extensions of the leases compelled us to keep the tenant and not go into repositioning. So that just gives you a sense for just how dramatic the demand is, both from in-place tenants and new tenants.

Jamie Feldman, Analyst

I guess, the first question is just maybe if you could provide a little bit more color on just how things have changed with the reopening so far. I know we may see mass coming back. Just as we think about kind of the fluctuations in the return, how has your business changed? How has demand changed? And how do you think we should be thinking about what's ahead?

Michael Frankel, CEO

Well, I think it's a very important point. Go ahead, Howard.

Howard Schwimmer, CFO

I'll start by discussing the demand and then turn it back over to Michael. What I hope came through in our earnings and some of the commentary is that we are truly in uncharted territory in terms of demand. Demand is exceptional. Tenants are competing for every space we list. The COVID situation has only increased the demand in the marketplace, and that trend continues. Regarding the current discussions about new mask requirements, we are not seeing any impact on demand. Just today, I spoke with one of our leasing agents in Orange County. We decided to bring a space to market a bit early with a tenant planning to vacate, and we already have three offers on it. There is competition, and it's likely to lease well above our initial projected rents. There is hardly any space available, and incremental demand persists in the market. That’s why, for the project I mentioned earlier, we are not even pricing assets in the leasing process because rent growth is so dynamic and the demand is so strong that each deal is setting new market highs in rents.

Laura Clark, CFO

One thing I want to add, which is definitely reflected in our financial results and lower bad debt, is that this was driven by a couple of factors, including the decrease in watch list tenants and reserves. This clearly indicates the health of our tenant base, which is performing well as shown by our strong collections. Our collections are now nearly at 99% of pre-COVID levels, and we are also maintaining incredibly high occupancy levels. All of this has led to lower reserves and fewer watch list tenants. Additionally, we are observing that tenants from industries more affected by COVID are now performing well with the reopening and are repaying amounts that were due even before the moratoriums were in place.

Michael Frankel, CEO

I think I’ll briefly add that we are observing employers who have been testing return-to-office strategies. A significant number of them are choosing a flexible approach that allows employees to work from home for part or all of the time. We are facing considerable pressure in recruiting new talent, with flexibility and the ability to work from home often being their top priority, even more important than compensation. The market appears to be recognizing this shift, and as we move past COVID, it seems likely that the distribution of goods directly to homes will continue at substantial levels.

Jamie Feldman, Analyst

That's an interesting point. Are there new submarkets that you are considering now that you might not have in the past?

Michael Frankel, CEO

Our market represents the largest regional population in the country, along with being the largest area of consumption and the biggest industrial market as well. We primarily focus on Greater LA and Orange County, which account for approximately 70% of our activities, in addition to the Ontario market. Therefore, you can expect us to continue our focus in these areas as we deepen our efforts and improve our operations within these markets.

Jamie Feldman, Analyst

Okay. And then, Michael, you had commented that rent's a very small share of customer economics, which provides good price elasticity. Can you talk a little bit more about, from a percentage basis, what does that really look like, the small share?

Michael Frankel, CEO

Yes. We do not provide specific percentages because they can vary greatly depending on the type of business. For instance, in a pure distribution company that primarily handles cargo and boxes, rent might represent a higher percentage of overall expenses. However, typically, in that scenario, transportation costs for the goods are considerably higher. Conversely, in a branded company that distributes its own products, distribution and warehousing costs are minimal, often less than 5% of their total expenses on average. This variation is why we are cautious about sharing specific percentages. Moreover, the rate at which rental rates are increasing is remarkable. Historically, over the past 40 years, our markets have seen average rental rate growth of about 3%, with some years below and some slightly above that figure. Currently, we are playing catch-up due to a severe supply shortage, which cannot be quickly remedied. We have motivated institutional owners, like Rexford, who are driving prices higher, and tenants show no signs of fatigue at this time. Given our empirical experiences and understanding of tenants' expense structures, it appears there is a strong growth potential ahead.

Jamie Feldman, Analyst

Okay. And then just following up to the prior conversation you were having, you talked about electric vehicles as an avenue of growth. As you think about your portfolio and what your tenants might be doing on that front? Do you think there'll be material CapEx to prepare for that or how should we be thinking about that? Or maybe that's a strategic advantage that you can have within your portfolio, how do you think about that transition and what it means?

Michael Frankel, CEO

Rexford's business model focuses on low finish generic industrial space. We typically don't invest in or develop heavy manufacturing or high capital expenditure uses. Our CapEx numbers have consistently been low on a per square foot basis over the years, so that aspect is not a significant part of our business model. The electric vehicle sector encompasses everything from vehicle storage and distribution to component assembly, including battery assembly. It's a whole ecosystem linked to the electric vehicle industry, which is still in its early growth stages. In short, we don't anticipate this being driven by heavy capital expenditures or what you would classify as auto manufacturing uses.

Howard Schwimmer, CFO

I think also in terms of how we prepare our buildings, Jamie, for market, and back to the original question a while back about the ATM deal rules and how tenants can mitigate some of those incremental costs that they're being subjected to, part of that is electrifying their fleets. And so today, when we renovate existing buildings or we're going to construct some new buildings, we're adding heavier power components to those buildings. We're providing conduits that bring that electricity to the exterior of the buildings and to points in those yard areas that they are further away from the buildings, just allowing for the future functionality that people are going to need as they need more electric in different places on the exterior of the building to supply power for charging those vehicles.

Michael Frankel, CEO

And that's a great point that Howard makes, because remember, we're the largest distribution market in the country. We have more truck miles per year than any other market in the country by far. So you'd expect that this market to benefit like no other market in terms of the emerging demand for space for the electric vehicle industry.

Vince Tibone, Analyst

I have a follow-up for Laura on the bad debt side. You mentioned bad debt was about 30 basis points of revenue year-to-date, but you're expecting it to be probably closer to 70 basis points full year or applying more than 100 basis points in the second half. Just was hoping you could provide a little color on the reason for the jump in the back half? And maybe what's the best way to think about normalized bad debt for the portfolio once all the COVID-related noise passes?

Laura Clark, CFO

Hey Vince, great question. Thanks for joining us today. Yes, as you mentioned, our forecast for the full year bad debt and the total consolidated portfolio is 70 basis points of revenue, and that does imply a bad debt expense in the second half of the year at about 100 basis points. So our second half assumption of bad debt assumes reserves that are to similar levels of what we experienced in the second quarter, but what we've excluded from that assumption is any recoveries that could come through in the second half of the year. It's difficult to predict recoveries quarter-to-quarter, especially with the ongoing pandemic and the moratoriums that are in place. So that 100 basis points is in line with the reserves ex those recoveries that I talked about earlier.

Vince Tibone, Analyst

Got it. That's really helpful. As we start to consider 2022 and beyond, is 100 basis points of revenue a reasonable estimate for bad debt? Just some of the cadence.

Laura Clark, CFO

Yes, pre-COVID, we were bad debt expenses in the 50 basis point area. So kind of getting through this year and as we move through COVID, we would expect that we should tick back down to levels that are more in line with historical averages.

Vince Tibone, Analyst

Got it. That's helpful. One more for me, switching gears. Can you just discuss your thought process and rationale for doing forward equity offerings versus just issuing equity through the ATM when you need it?

Laura Clark, CFO

Yes, we are issuing equity on a forward basis to the ATM as well. It really depends on our capital needs and their timing. I appreciate the flexibility of issuing on a forward basis, as it helps us better align our funding with our capital use, particularly in our acquisition pipeline. We adopt an opportunistic approach to capital raises, seizing attractive debt and equity options to support our near-term pipeline, which currently stands at $650 million. We are committed to maintaining a low leverage, investment-grade balance sheet, and this method is another tool to help us achieve that.

Vince Tibone, Analyst

So it sounds like you're just trying to basically lock in your cost of capital, is that fair? Like you're under contract for 650 of acquisitions, and you just want to lock in that basic funding cost of capital now, is that fair?

Laura Clark, CFO

Yes. When we consider purchasing an asset, we envision holding it indefinitely. Our main focus is not on the price at any given moment but on the long-term value we can create. These assets are expected to contribute to our growth and enhance our net asset value over the years. Therefore, we concentrate less on pricing and more on financing the near-term projects that we have lined up. Thank you. Our first question comes from the line of Mike Mueller with JPMorgan.

Mike Mueller, Analyst

I have a quick question about the decision to choose Series A. What was the reason for selecting Series A instead of considering B or C, or are those options reserved for later?

Laura Clark, CFO

Yes, Mike, it's Laura. Thank you for joining us today. The Series A is callable on August 16, which is the first available date. This Series A has a relatively high coupon compared to our current cost of capital, set at 5.875%. Therefore, we believe it is advantageous to redeem the Series A at this time considering the cost of capital. Regarding our other preferred shares, they are not callable at this moment but will become callable over the next few years.

David Lanzer, General Counsel

On behalf of the entire team at Rexford, we want to thank everybody for joining us today and for your support and interest in the company, and we look forward to reconnecting next quarter. Thank you all, and wish you and your families well.

Operator, Operator

This concludes today's conference. You may disconnect your lines at this time. We thank you for your participation.