Prologis Inc (PLD) — Q3 2022 Earnings Call Transcript

Thanks, Darryl, and good morning, everyone. Welcome to our third quarter 2022 earnings conference call. The supplemental document is available on our website at prologis.com under Investor Relations. I'd like to state that this conference call will contain forward-looking statements under federal securities laws. These statements are based on current expectations, estimates, and projections about the market and the industry in which Prologis operates, as well as management's beliefs and assumptions. Forward-looking statements are not guarantees of performance, and actual operating results may be affected by a variety of factors. For a list of those factors, please refer to the forward-looking statement notice in our 10-K or other SEC filings. Additionally, our third quarter results, press release, and supplemental do contain financial measures such as FFO and EBITDA that are non-GAAP measures. And in accordance with Reg G, we have provided a reconciliation for those measures. On October 3rd, we closed on the acquisition of Duke Realty. As a reminder, Duke's results are not contained in our third quarter earnings release. However, within our supplemental, we included a summary of the portfolio integrated as of quarter end. Please refer to our website for details on the transaction. I'd like to welcome Tim Arndt, our CFO, who will cover results, real-time market conditions, and guidance. Hamid Moghadam, our CEO, and our entire executive team are also with us today. With that, I'll hand the call over to Tim.

Thanks, Jill. Good morning, everybody, and thank you for joining our call. We are clearly in a volatile macro environment where ongoing inflation, steeply rising interest rates, and the war and energy crisis in Europe are pressuring the global economy. And while we're closely monitoring each element, the fundamentals in our business are very strong, and our read of supply and demand in our markets remains out of sync with the headlines. This morning, we reported excellent third quarter results, which generated many new records in the quarter. Yet, we will spend less time on these results and more time describing our view of the market and how we're navigating the environment. Before doing so, I'd like to thank our teams across the entire organization who did an exceptional job keeping focus on the business, especially while working through the Duke acquisition, which closed on October 3. We fully integrated the portfolio, achieved our day 1 synergies, and look forward to the next phase, which is to build AFFO accretion through incremental property cash flows and Essentials income. We move forward with a better portfolio, a larger and stronger balance sheet, talented new employees, and new customers to whom we can introduce to our Essentials business. Turning to results. Core FFO was $1.73 per share, including $0.57 of net promote income earned principally from our PELP venture in Europe. Our annual guidance for promotes was $0.60, with most of the revenue to be earned in the third quarter. The amount came in below expectations due to a nearly 5% write-down of European asset values in the quarter, partially offset by an increase in NAV from debt mark-to-market. In the end, the promote was a record high, while the fund enjoyed a high teens annualized IRR across the 3-year performance period despite the recent markdown. I'll note a few operating stats from the quarter, all of which were records for the company. Ending occupancy increased 10 basis points over the quarter to 97.8%. Same-store growth was 8.3% on a net effective basis and 9.3% on a cash basis. Both were driven primarily by rent change, which was 60% on a net effective basis. Separately, the Duke portfolio ended the quarter with 99% occupancy and net effective rent change of 54%. While these markets are outstanding, they are also backward looking. So we've kept focus on more contemporaneous data, namely rent change on signings, which was 84% during the quarter, and our lease mark-to-market, which now stands at nearly 62%. Finally, we had a very active quarter on the balance sheet, raising over $3 billion of debt in a variety of markets and currencies given our broad access, including a $650 million green bond issued in late September. We ended the quarter with debt-to-EBITDA of 4.3x, excluding gains, providing us significant investment capacity. Turning to our observations of current conditions. We continue to see scarcity of available space across our markets. Vacancy rates are at historic lows, and our own occupancy sits at a record high. Market rent growth in the third quarter remained robust in response to this scarcity and continued strong demand. Color across the markets remains generally upbeat in terms of customer inquiries, and our proprietary metrics also reveal healthy activity even if they've softened from the peak demand generated during COVID to levels still above long-term averages. Transaction gestation was stable during the third quarter at 62 days, proposals via available units slowed during the third quarter to levels more in line with the pace of 2019 and indicative of less urgency to renew space far ahead of exploration. Inside our properties are metrics point to activity that is increasing with our IBI index at 63.8%, the 80th percentile, and utilization up to 86.6%, the 95th percentile. Our certain customers have publicly announced a pause in CapEx spending, particularly those with more mature supply chains. But active dialogue with the majority of our customers confirms an overarching need to increase space as supply chain resiliency remains a top concern. Shifting to supply. We're seeing initial signs of a deceleration in development activity across our markets as construction and capital costs continue to increase. We believe we could see a gap in deliveries emerge in late '23 or early '24. As for today, our true months of supply metrics sit at a healthy 22 months, up from 18 months last quarter. We've previously explained that we expect to see this metric climb into a low 30 months range, still at a level reflecting a strong operating environment. It's important to acknowledge where supply is being delivered as our submarket location strategies minimize our exposure to new supply. For example, in our coastal U.S. markets where we generate over 50% of our global NOI, vacancies are just 1.7%. Geographically, we have an increased level of focus on Europe given the ongoing war and growing energy crisis. While we're reporting record results, including occupancy at 98.6% in a market with 2.4% vacancy, we are closely monitoring conditions. Customers are exercising caution in response to rising energy costs, which may create headwinds to near-term demand. That said, we also believe that new supply will now decline around 15% in 2023, which should support occupancy. The U.S. remains strong, where we now generate 87% of our NOI with the addition of Duke. Our teams continue to see solid activity, although acknowledging a reduced number of prospects for space compared to what we saw during the frenzy of COVID. Rent change on signings during the quarter was 93%, demonstrating a continuation of favorable pricing dynamics. In Latin America, both Mexico and Brazil are performing well, with very high occupancy over 98% and rent change across the region of 24%. And in Asia, construction costs in Japan are rising most acutely from the weakness in the yen, as well as from competition for key materials to complete construction. Market vacancies have increased, but this constraint on new supply, particularly out to '23 and '24, should provide an offset. The combined picture was positive for third quarter market rent growth, exceeding our expectations and driving a 300 basis point increase of our '22 global forecast to 26%, with the U.S. at 28%, significantly up from the 10% and 11%, respectively, in our initial guidance. It's difficult to fully know the impact of this market rent growth on values given the limited transaction volume in the market. But our view is that the increase in return requirements is more than offsetting rent growth and indeed pressuring values. Based on prior cycles, we can safely assume it will take a few quarters for full price discovery to be made as markets stabilize and transaction volumes build. With all this in mind, we're carefully managing the business and approaching our markets with a sense of caution much as we did at the onset of the pandemic. In leasing, despite the very strong spot environment, we are carefully watching for softening demand and will assume that there will be further macro deterioration. In some markets, this will have us managing more for occupancy than rent growth, but in many others, we believe pricing will remain favorable given very low availability. This is an environment where our revenue management capabilities will be the most useful and allow us to manage such decisions lease-by-lease. With deployment, we are reducing our starts guidance to a range of $4.2 billion to $4.6 billion, and we expect our fourth quarter starts will be 60% build-to-suit, reflecting a more cautious approach to deployment in the coming months, aiming to be very selective in new projects. And in terms of strategic capital, we previously mentioned that we expect to see an increase in redemption activity. While we did have inflows from numerous investors, redemptions grew by $1.3 billion, which, for context, is just 3% of our open-end third-party AUM. Our funds have sufficient equity queues to address this activity. In combination with equity called during the quarter, we now sit at net neutral queues. The open-ended funds have ample investment capacity based on overall low leverage, and we are optimistic about the long-term growth of the business. In the near term, we will be prudent as we evaluate further capital deployment, including a pause on contributions in the short term. Turning to guidance, which includes Duke portfolio for the fourth quarter. We are maintaining our guidance for average occupancy while increasing our net effective same-store guidance to 7.5% to 7.75%, and our cash same-store guidance to 8.5% to 8.75%. We expect to see our lease mark-to-market around 65% at the end of the year. We now expect acquisitions to range between $1.9 billion to $2.1 billion, which increased due to our acquisition activity in Europe during the quarter, and contributions and dispositions to range between $2.1 billion to $2.3 billion. Finally, we are increasing core FFO, excluding Promotes, to $4.60 to $4.62 per share, which includes approximately $0.05 of accretion related to the acquisition of Duke. We are guiding core FFO with Promotes to be $5.12 to $5.14 per share, which incorporates a lower Promote guidance of $0.52, reflective of the higher share count resulting from the Duke transaction. I'd like to point out that our earnings have been unimpacted by FX over this extremely volatile year due to our capital strategy and approach to hedging. The same is true for our equity base, which has very minimal exposure outside of the U.S. dollar despite our global footprint. We will continue to protect both proactively and programmatically. To close, we're proud of how we've positioned the business and are optimistic about the organic growth ahead. We own hard assets with contractual revenues, significant embedded mark-to-market, and have meaningful secular drivers that continue to play out. As an organization, we have long had an entrepreneurial and growth mindset. Today, adding new business lines and cash flow streams that are synergistic with our already unique model. We have built the company to thrive across cycles, including uncertain environments like today, where we can seize opportunities and continue to set our business and portfolio apart. We'll now turn the call over to the operator for your questions.

I don't know, Tim or Hamid, I guess what I'm trying to sort of circle up here is that, I understand why development starts would come down in light of what's going on globally, but yet stabilizations are up but the contributions are down. And I guess what I'm trying to really square up is if the funds still have capacity and they're still interested in deploying money, I'm trying to just really circle up why contributions into funds would be down, which is also impacting development gains? So is it a pricing issue? Is it a lack of leasing on the assets? I guess, I'm just trying to get a little more color on why that contributions number is down. And I guess I can understand why dispositions would be down in this uncertain capital markets environment, but I'm just trying to get a little bit better handle on the contribution side.

Yes, Steve, good question. It's actually none of those reasons. The reason the contributions are down is that I made a decision that we are going to pause contributions until we have much better clarity on valuations, because one of the lessons that we and the former Prologis learned in the last cycle is that it's really, really important not to force any issues when there is the least bit of hesitancy around values. And as much as we have ideas about what values are and where they're going, we don't have absolute certainty about that. So it was completely a voluntary decision. Our leasing of our development business is actually ahead of what we underwrote for the properties, and there is no external constraint on us, including capacity, of which the funds continue to have some. They're getting some redemptions, but they have plenty of leverage capacity, and we continue to raise money even in the same environment, not as much as we did before, but we continue to do that.

I would just add, Steve, in relation to your comment on gains in next year, I would just point out that the value creation is occurring regardless of that monetization event. If we hold the development assets on our balance sheet, it's still there at a very attractive yield. And we believe many of those assets will still find their way to the fund. It's just a time, a pause right now.

I just want to go back, Tim, to your commentary. There was, I think, an overarching message that fundamentals are still very strong. And the way it looks to me, you could still have accelerating core growth into next year. But at the same time, you clearly mentioned that some markets you guys would have to be kind of revenue managers here. I just kind of would like a little bit of color on maybe the percentage of those markets or how we should think about what's really at risk from a fundamental perspective? And then also, just as it relates to Duke, clearly, debt rates have moved against you a little bit. And so relative to your initial accretion, there's probably a little bit of a headwind there. And I'm just curious, too, as you guys kind of start to bid and kind of come down a bit this year, where is your updated accretion number for Duke for the first 12 months?

There were a few questions along with one major question. I’ll break it down, and I expect Tim and Dan will provide additional insights. Regarding fundamentals, we believe that a typical range of market outcomes is between 0 to 10. Over the past 18 months, we’ve been operating in an environment possibly around 12, but now it's decreasing to about 9 or 9.5. This is why we’ve shared data on utilization, occupancy, and business activity from our customer surveys. Generally, apart from the last 18 months, the market conditions remain robust. During these periods with a score of 9 or 9.5, some markets are weaker than others, but the key markets remain exceptionally strong. For instance, Los Angeles and the Inland Empire are experiencing no vacancies, and likewise in New Jersey. However, there are regions where vacancy rates hover around 5% to 6%, which is historically quite low. Overall, I would describe the fundamentals as very strong, though not unprecedented compared to the last 18 months. Regarding the Duke portfolio and margins, Dan will provide more details, but we have consistently maintained that our exit cap rates were never estimated at recent peaks from the last year and a half. We accounted for extra premiums due to forward risks given the extraordinary circumstances. Many of the margins reported in previous quarters reflected this conservatism. Rents continue to rise; we projected an 11% increase for 2022, yet they have increased by 28%. Although cap rates have risen, the rents being capped are much higher. In summary, if we stress test everything—considering scenarios where rental growth halts, cap rates rise, and construction costs increase—our development pipeline would see margins drop from the mid-40s to the high 20s. This still exceeds our underwriting expectations, which usually sit in the mid-teens range. We are in a very strong operating environment, but we remain cautious about the capital market situation, as it would be unwise not to be.

And Craig, I'll just pick up your question on the debt in Duke. You're right. Since we announced the transaction in June, depending where you're on the curve, we're 100 to 200 basis points higher in interest rates. So that does hit the debt mark-to-market piece of things. I think if we were redoing the entire accretion on the year, we'd be still in the range, but at the lower end of that original $0.20 to $0.25 today.

Yes. But I would also say on the fundamentals of the real estate, we're ahead of where we underwrote. So I think that far outweighs a mark-to-market on the debt. I mean, both Duke and us were at very low levels of leverage. So the mark-to-market is just not a big deal in our calculus.

Just touching on European occupancy. You certainly had a positive bump to 98.6% and clearly pushed NOI. But can you expand on which geographies led really the sustainability of EU demand, what you guys are seeing on the ground, and any additional leasing comments?

Some of the weaker markets in Europe have strengthened, like Spain would come to mind or France would come to mind. The perennial strong markets in Europe were the U.K. and Germany, historically, Northern Europe. And they remain strong, but we wouldn't be surprised if Germany weakened a bit and the U.K. weakened a bit. In terms of weak markets in Europe, I would say, if you really force me to name one, I would say it's Hungary, which is a very, very small part of our overall business. Poland is actually, too much to our surprise, pretty strong. It must be because of the in-migration of a lot of Ukrainians into Poland and the additional consumption that they drive. But markets in Europe are tighter than they are in the U.S. in aggregate, and that's why vacancy rates are lower. But there's no question that Europe will have lower growth or more if we go into a recession, a bigger recession than the U.S., but by no means is it weak. Quite the contrary, pretty strong.

I just wanted to touch on sort of thinking about as we are heading into a weaker economic environment, most people think there's a global recession coming. If you could give us some context of how to think about potential occupancy impact to the portfolio. I mean, I think most of the third-party brokerage firms are citing something like 100 basis points of U.S. vacancy increase next year because of slowing absorption, some supply picking up. I guess, I'm curious what you thought about that. And then also from a credit loss standpoint, how we should think about the portfolio in sort of a historical context, kind of framing out where you have sort of a credit watch list today and potential occupancy impact on top of just an overall market occupancy impact from a credit loss standpoint in the portfolio if we are heading into a recession.

On credit loss, the average over the past 10 to 15 years has been around 15 basis points. We underwrite at a much higher level than that, but that has been our average during the most challenging periods of COVID, particularly in the first couple of quarters when job losses were significant and uncertainty was high. During that time, the figure rose to 55 basis points. However, we were able to collect on all the credit reserves we established since most eventually made their payments. I’m unsure of the exact ending figure, but we likely concluded around 0, or at least in line with the historical average of 15 basis points. I don’t expect to see those numbers return. Currently, there is considerable demand that is not being met due to a lack of supply. Our vacancy rate is about 4%, and even if it were to rise by 100 basis points—though I don’t believe that will happen—it would still be at 5%, which we would be quite pleased with based on our 42 years in this industry. If we assume the development pipeline has zero leasing—not just for Prologis, but for the market as a whole—and demand decreases considerably, that scenario could lead to the 100 basis points. However, I don’t think it will be that extreme based on the customer interest we’re observing in our spaces in real time.

My question is on the Promotes. I think heading into the year, we talked about 2020 to 2023 Promote being similar or higher than where it was going to be in 2022 just given where valuations have changed and the different dynamics at play. How should we be thinking about the dynamics at play for next year on the Promote side?

Promote levels are very sensitive to exit cap rates that you assumed. So that's a pretty tough question to answer. But if we stress test our numbers from the last time we spoke, the Promote for USLF next year is going to be on par with what it is this year for PELF. But that number can move in either direction by a significant amount, depending to what happens to exit cap rates. And by the way, both of those years, '22 and '23, will be record Promotes by a factor of two or three.

I just want to go back to the question about contributions and your fund business. Can you remind us what the pricing mechanism is for your funds for you to contribute assets? If I remember correctly, that was a broker pref, but obviously, you don't want to force anything into your fund investors. So I'm just curious, what is causing the pause or temporary pause in contributions? Is it just an agreement or agreed-upon price that you can't come to or is it something different? And second question, Hamid, if I think about the business bigger picture, if we didn't have this market volatility, I would have expected your company to contribute an increasing level of assets to your fund business because you have to kind of keep up with the development pipeline. But given that that's probably not going to happen, how should we think about the company taking on more assets on the balance sheet, better for our earnings but also higher leverage? I'm just trying to better understand that dynamic going forward.

Yes. Regarding the fund contribution question, we are willing to contribute deals, but we prioritize managing the long-term value of our private capital business. We haven't initiated and will not initiate contributions of these completed assets because we believe it's not the right course of action. This decision isn't related to appraised values or capacity; it's about waiting for real clarity, which will take time and require some comparisons and transactions. Once clarity is achieved, we'll resume contributions. Unlike the last cycle, contributions today are not mandatory; they are entirely voluntary on our part to offer those properties to investors or not. We won't push this issue. It's not about investors declining or values being too low; the values are strong, and we would still achieve substantial margins if we contributed. This choice is purely voluntary and aligns with our long-term strategy for the company. In terms of leverage, if we choose to retain more assets, our leverage will increase. We built this balance sheet specifically for scenarios like this, to hold more assets for future contributions and to seize investment opportunities. It’s still early, as I believe valuations will adjust to lower levels than what appraisers currently think. I can’t be certain of that. By the way, don’t take my comments as definitive on valuations because for five years, we expected cap rates to rise, and they finally did, which shows we were incorrect and had been overly optimistic on cap rates for some time. One important point I should have made clear is that we never inflated our portfolios to the peak cap rates, nor did we underwrite our developments to those peak levels. We always considered exit cap rates with a built-in premium, which was around 500 to 750 basis points. Therefore, much of what you are observing and may continue to see in values is already accounted for in the way we assessed our margins, and we conducted further stress tests on those figures. I believe I shared those results with you previously.

Hamid, you mentioned tenants with more mature supply chains have slowed their CapEx spending. Obviously, we've seen that in the headlines as well. Are you seeing, though, any givebacks or nonrenewals from those tenants, whether it's FedEx or Amazon or others? And specifically, what are the tenants or industries that are backfilling this gap in demand?

I'm going to let Mike give you a broader view of demand other than the customers you asked about. But let me hit those 2. We have 0 givebacks on Amazon. Zero. We thought we were going to have 2 out of like 160, we have 0. And they continue to take new space from us. So I don't know what all this excitement is all about, but we haven't seen it in the marketplace. They were on a tear in 2020 and '21, and they probably overcommitted to space, and they just reeled that back a bit. But they talked about 30 million feet coming online. We don't think it's even going to be 10 million feet and none of it is in the spaces that we have. So that's Amazon. FedEx is consolidating some of its ground operations with airport operations. We're going to be a beneficiary of that. And we're not going to lose any FedEx business as a result of that. And we're in regular conversation with these people. So those 2 customers specifically, no issue, and we have vetted this about as best as anybody can. With respect to the broader customer picture, Mike?

I would like to emphasize a key point. We can expect more headlines in the future, and I encourage you to carefully consider the context behind those headlines. To add to Hamid's comments, FedEx indicated that they are pausing around 100 projects, which is small compared to the 15,000 spaces they already have. In contrast, Amazon has a portfolio of 550 million square feet. This means we’re seeing about a 1% churn, which is quite standard for our larger customers who operate thousands of spaces. It's crucial to look beyond the headlines for a clearer understanding. As for other activities, Chris can elaborate, but e-commerce remains a significant driver. In our portfolio, e-commerce levels are slightly ahead of where we were before COVID. However, Amazon is temporarily pausing this quarter, while 122 other customers, excluding Amazon, are leasing at levels we experienced pre-pandemic. This is a major factor and an important takeaway regarding the segments that are supporting this backfill.

You increased your market rent growth forecast in the U.S. to 28% this year. How much of that growth has already been achieved through the end of the third quarter? I'd like to hear just how much you think market rents can continue to grow in the current environment.

Vince, yes, the increase is exclusively based on the outperformance in the third quarter. We thought in the present landscape, it would not be appropriate to make an increase. But as we look into next year, I think it's appropriate to expect mid- to high single digits. As Hamid mentioned, we opened this year with a similar level of caution and have seen subsequent increases. We monitor this on a real-time basis let alone reporting out on a quarterly basis. And some of the things that go into that is the ongoing significant momentum, right? So rents were up 6% in the quarter against ultra-low vacancies, healthy demand, healthy leading indicators but set against the macro uncertainty that we've described.

So 75% to 80% of the 28% has already occurred, and we expect the balance to occur in the balance of the year. And by the way, we're only a couple of weeks into the quarter. But again, every time we make a deal, we know what the effective rent is compared to the way we underwrote it. And we call it spear, I won't get into the details of it here. But those indications are up, both in terms of comparison to underwriting or the way we had pro forma those spaces. And also in terms of duration of leases, they're slightly longer than we thought.

I wanted to follow up on Duke. Tim, thanks for the update around the $0.20 to $0.25 of year 1 core FFO accretion. But I'm curious, Hamid, your comments suggest that Duke is running ahead of your initial underwriting. So I'm curious if there's been any change to your underwriting such that the year AFFO impacts changed at all relative to your initial expectations. And then just secondly, regarding the core FFO guidance, excluding net promote income, can you just help us bridge that 1.1% increase at the midpoint from the prior guidance now that Duke's closed and just discuss the drivers of that increase a little bit? It sounded like the quarter came in ahead of budget or plan, which I suspect contributed, but the increase of $0.05 at the midpoint, I think you attributed solely to Duke. Was there anything else that was an offset in the quarter to the stronger growth?

I remember that Duke's leases tend to be longer than ours, leading to an average turnover of about 10% to 12% per year. I’m not sure of the exact figure for the next 12 months, which is what you were asking about. We believe we're performing a couple of points better than that. However, a couple of points on a turnover rate of 10% to 12% across an average duration of 6 months indicates a minimal impact for the upcoming year. The more significant effect will likely come from effectively managing the remaining portfolio as it rolls over, which we estimate could yield an increase of 2% to 3% beyond our projections. Additionally, we expect a couple of hundred basis points improvement from enhancing essential sales, but establishing connections with those customers in those locations will take some time. As for the second part of your question, Tim will provide more details.

Yes, you're right that the quarter was strong. We're probably $0.01 ahead there, and that would be reflected really in the same-store guidance overall that we took up. We would see an uptick on the year from that uplift as well as we would get a little bit out of this slowdown in contributions in the short term. Offsetting each of those, putting the group to about 0 would be a little bit higher interest expense. We've got short-term rates that have really picked up. And then the write-down of asset values in the funds does hit asset management fees. So that would be another take. So that's all coming up to about 0, leaving really the entirety of the accretion to the Duke transaction.

Hamid, can you expand on your thoughts on the broader economy? I think your remarks in the earnings release indicated that you're preparing for an economic slowdown. Does that include a U.S. and/or a global recession? And how should we think about your development starts in 2023 given that you've now added capacity through the Duke transaction but seem to be more cautious here today given macro concerns?

My perspective on the economy is that the Federal Reserve has been slow to respond and is now making aggressive moves to catch up, which may lead to overshooting their intended targets. While many expect immediate effects from these actions, I believe there is typically a two-year lag. This could cause fluctuations in the economy. I don't think a recession is warranted aside from the goal of addressing inflation. Personally, I observe that much of the inflation we're experiencing is not the same wage-price push seen in previous inflationary periods. I remember when I began my career, the 10-year bond yield was 14% and the prime rate was 22%, creating a certain psychological environment in the market. It took significant measures back then to resolve those conditions, which had been established over several years. Currently, we saw inflation at 2% just a year ago before it surged, and I expect that much of it will fade as we return to normal conditions in trade and supply chains. I am concerned about inflation and believe the Fed may overreact. Whether we technically enter a recession is less important to me; I see a low GDP growth rate, especially when the potential is higher. Our industry is certainly not operating at full capacity, even though consumers and their financial situations appear strong, providing reasons for optimism. Just look at the discussions we were having last quarter—the outlook has shifted significantly due to the Fed's actions. If you had asked me last quarter about the likelihood of a recession in the next year, I would have estimated it at 90% chance. Today, I would say it’s more like 60-40 or possibly 50-50. The U.S. appears closer to a recession, while Europe may face a mild downturn. Regarding development starts, I believe there is an undersupply in the market. Each decision will be made on a case-by-case basis, and we will have access to real-time information from potential clients. If we believe there’s demand for new space, we will proceed with construction, regardless of guidance. We make decisions based on the market, and I anticipate we might exceed expectations. However, we can take our time with these choices.

Just going back to the lease signing of 84% during the quarter. It sort of suggests that the commenced leases should be accelerating as well. But how do I marry that with the full-year same-store NOI guidance where you're guiding for $8.625 for the year, but year-to-date, it's 8.7, suggesting a little bit of deceleration? Just trying to understand what could be driving that? Is it occupancy of the comp versus the lease signing that's accelerating?

Yes, Ron. Look, this is a good opportunity actually to distinguish the 2 metrics. So the commencements were 62%, and that's why we're actually calling out the 84% on signings because of the lag that sits between the two. The lease signings on what started this quarter, generating the 62% were probably done in the first quarter. So all that means that the 84% we're signing today, we're really not going to see those commence until '23 outside of the same-store period in our guidance. So that's why we're actually focusing on signings. You'll probably hear a bit more of that going forward.

We've seen the spread between market rent growth and lease escalations widen over the past 2 years. Can you talk to what percent of your leases have a fixed structure? What are the escalators you're achieving on new leases? And how sustainable these are throughout the duration of the lease?

Most leases have escalators, and I would estimate the average is around 3.5%, possibly nearing 4%. I'm definitely seeing a lot of 4s.

I would just clarify that the installed base is probably the 3.5% you mentioned and then more recently 4%.

Yes. And I think that was it. Did you have a third part to your question?

Just wondering how sustainable these increases are throughout the duration of the lease.

They are contractually required to increase, so it’s not influenced by CPI or anything similar. Therefore, unless the tenant defaults, there is no risk involved.

I realize that the markets are very fluid, but I did want to ask about the 4.1% cap rate that you have stabilized on your development starts. I guess, industrial would be the 1 asset class that you could argue the most for negative leverage given the strong mark-to-market that you have, but new developments are signed basically at market. So it doesn't have its same mark-to-market potential. So can you make the argument or couldn't you make the argument that new development should be at a higher cap rate, which I know was counterintuitive to how it's been recently, but it's reflective of that market today?

Yes. I don't believe there's any negative leverage currently. To break it down, interest rates are rising due to inflation, which is creating upward pressure on real rents. In an inflationary setting with higher rates, we are likely to see increased rental growth, primarily because vacancy rates are very low. In terms of internal rate of return (IRR), we are experiencing positive inflation and positive leverage. This has been the case throughout much of my career. While leverage on IRR may be positive, it might not be the same for the initial cap rate or cash yield compared to interest rates. The total return in a high-interest, high-inflation environment will heavily depend on growth. Unless vacancy rates hit 10% to 15%, inflation won't impact pricing power. However, we anticipate maintaining pricing power in the foreseeable future, even under a conservative absorption scenario. I mentioned earlier that I can't foresee vacancy rates dropping to 5% anytime soon, so I believe we will retain pricing power and experience positive leverage on an IRR basis. Additionally, short-term rates have increased significantly more than long-term rates, and real estate is an asset that can last indefinitely. Therefore, returns should be compared to 10-year or longer debt. Tim?

I just want to clarify, John, maybe you see this, but I want to be sure you note that we have in the supplemental, both the exit cap and estimate on it and the development yield, and I think you're quoting the exit cap. The development yields are 6%, 6.5% in the portfolio. So I want to be sure you understand that distinction.

Hence, the huge margins.

I was looking at the sort of the Promote opportunity next year for the targeted U.S. logistics fund. I realize it's volatile and there's a ton of assumptions that go into this. So maybe you could help us and remind us what the hurdle rates are that you have to hit each year to be eligible for a Promote? Just kind of how that structure works, once you hit the hurdle, like what percent of the NOI you get, so we can all be dangerous and make our own assumptions. And then another question I have is on the land portfolio. I think you have it on the books at $2.7 billion. Any estimate on how we should think about the market value of that land portfolio today?

Yes, I believe the market value of our land is currently double our book value. Although no land has traded in significant quantities, I estimate that land values may decrease by 30% before this process is complete, yet they would still remain well above our book value. Regarding the Promote hurdles, we have a total of 7, and the percentage is 20%. We actually have two sets of hurdle promotes at 7 and 10, and then 15 and 20 for participation in the upside, which are based on leveraged hurdle rates. So, it’s 15 over 7 and 20 over 10.

A question on acquisitions. Can you talk more about the Crossbay deal, what brought you to that transaction? I think you talked before about maybe more portfolio deals happening in Europe. Are there more news out there? And what's your, I guess, willingness to do more deals on the balance sheet given kind of the overall macro environment?

This is Dan. I'll address that question. The Crossbay deal was finalized last quarter, and we initially introduced this deal around February. When we first discussed it, the difference between the offer and asking price was significant. However, we managed to secure this deal at a very attractive price, benefiting from a couple of price reductions, and we are very pleased with the real estate, which is a great fit for PELF. The team is enthusiastic about integrating this into our portfolio. Regarding our approach to deploying capital, I focus on being disciplined, patient, and identifying opportunities. We have always maintained a careful deployment strategy, and our team on the ground is well-prepared and eager to capitalize on this. We are currently exercising patience as we anticipate new opportunities, as we have already seen positive results from decisions made during the financial crisis. We are genuinely excited about the potential opportunities on the horizon.

I wanted to touch on an earlier question to see if we can get a little bit more information regarding the larger users with more mature supply pipelines. I know you touched on a few examples. But in general, how big is this bucket of these larger users slowing down? I mean, is it mostly Amazon? And I believe you mentioned FedEx, there are like a few other outside of that or is that about it?

Everybody is running to catch up on their e-commerce supply chain because they're starting behind and they need to catch up. So the demand for e-comm space is broadening. But remember, e-com is just maybe 20% of the overall demand. At the same time that, that's going on, people are building resilience in their supply chain. So inventory levels have adjusted upwards like we predicted. We think half of that adjustment has already occurred, and there's another half of it to go. So I think you'll see all customers or virtually all customers building more resilience into their supply chain by taking up more space so that they don't get caught with the wrong inventory in the wrong place at the wrong time. But demand is definitely broadening. Mike, do you want to?

Yes. And I think I could just give you a sense on all customers are being certainly more introspective and cautious these days. That's natural in times of uncertainty. But if you look at our build-to-suit list, for example, it's a narrower list. Amazon is currently pausing. But the customers that are on the list are still following through with long-term supply chain reconfigurations that have been in place for a long time, and they are following through with those with the same effort that we've seen before. So I would say if you look at build-to-suits, it's a smaller, more active list of customers. And our competitive environment looks even better. There's fewer private competitors out there that are direct competition given the current market conditions. So I view that business as smaller but a deeper prospect list with a higher win rate possibility. So that's one perspective.

Is your 65% year-end lease mark-to-market expectation with or without Duke in it?

That's with Duke.

Hamid, thanks for the details on tenant credit that you provided earlier. I wanted to go back, and maybe this is a draconian question, but when you go back to the global financial crisis, I think you lost 600 basis points of occupancy top to bottom. Some of that might have been credit loss, but even though it's not credit loss, then some tenants may leave just due to the same factors that we're talking about. I guess, how does today differ? And I guess, I'm just a little worried about the convexity of non-investment-grade now above 10%, those types of things. I guess how does your portfolio differ? How do you think the market differs? And then maybe a follow-up to Chris. Last quarter, you had suggested a 75 basis point increase in vacancy for '23 for the market as a whole. Has that number changed?

Okay. I'm not sure I understood the second part. But the first part, first of all, I don't know about Prologis, but I think there was 52 million square feet of spec space that they had built at that time. And the company at that time was, I don't know, 400 million square feet or something. It was a huge part of the installed base, and most of it was spec. So you went into the global financial crisis with a collapse in demand and you were starting off with a 7% or 8% vacancy rate even before going into the global financial crisis, so it was different at least in 3 respects. One, level of spec development; two, the starting level of vacancy; and three, the impact of that on a much, much smaller company than today. So very, very different situation. But the numbers for AMB were that we went from mid-95% occupancy to 91% occupancy. And by the way, the exact same thing happened in the dot-com collapse, which was people had overcommitted to space. The difference is that the shadow space in this market is very low. That's why we look track utilization. We have 90th percentile utilization in the buildings in terms of history. So occupancies are high, utilization is high, there's a lot of ongoing demand and we're starting off at the 98% occupancy. Even if the global financial crisis were going to repeat itself, we'll be at 94% occupancy. That's just fine. There's no problem with that. We can get rent growth at those kinds of numbers. So I don't even think of those draconian scenarios. Of course, somebody launches a nuclear war somewhere, all bets are off, but I'm not capable of making those.

Dave, as it relates to the forecast we shared, you remember correctly but got the units wrong. So we had said we could see a supply-demand gap of 50 million to 100 million square feet next year, which would only be 30 basis points of occupancy increase. Our latest view probably has it at the higher end of that range, say, 100 million square foot gap, which would lead to high 3s or a 4% market vacancy, which again is below the low that prevailed during the decade before. And then also call out in Tim's script that based on the capital market landscape, we could have a gap in development starts that would ultimately translate to a gap in deliveries late next year and early '24.

Two questions. First of all, any change in the lease-up time on new deliveries? And the second question is, you talked a lot about cap rates and cap rate increases over the last 6 or 7 months. I'm just wondering if you were to underwrite an acquisition today, how would that change from where you were early this year? Let's say, how much do you think cap rates have gapped out on a like-for-like deal?

I can start on the lease-up times, and I think Hamid made reference to this just that compared to underwriting. We've consistently beat underwriting, and that would remain the case today. Maybe there's a month lower there, but we're continuing to beat underwriting in new development leasing.

I would say on the cap rate side, you see it in our development portfolio in the supplemental. We moved our exit cap rates from 4.1 to 4.7. So that's demonstrative of the change that we're looking at across the board going forward. For the last couple of years, we encountered approximately a 6% unleveraged internal rate of return on acquisitions, based on an average rent growth rate of 3%, resulting in a 300 basis point gap. This figure is crucial to consider, along with replacement costs. If you anticipate inflation rising to 4%, rents should increase at least in line with inflation due to the rising replacement costs and the market's tight conditions. Therefore, with a 4% growth rate, you could expect internal rates of return to reach 7% to 7.5% moving forward. My main point is that when assessing the discount rate of cash flows, you must also think about the growth rate of those cash flows. While these two factors do not always move perfectly together, they typically align in a market where vacancy rates are below equilibrium.

We were just thinking about how should we think about FX and how that goes into your calculus when you're thinking about investment activity given how strong the U.S. dollar is and your unique global platform? And then secondly, if you could just give us some thoughts on when you think the mark-to-market stops expanding. I think it's been surprising to us how it just keeps going quarter-after-quarter. I'd love to get some thoughts on when that might moderate.

Yes. So let me provide you with an overview of our approach to foreign exchange management. We operate on three levels. First, our goal is to establish a global platform to serve our international customers. However, as a U.S. dollar dividend payer, we don’t distribute our capital evenly across all markets. This means we allocate a greater percentage of private capital in foreign markets compared to the U.S. Second, we maintain a significantly higher amount of debt in foreign currencies that corresponds with our equity in those assets. This strategy helps us remain neutral regarding fluctuations in asset and liability values as interest rates change. For instance, we have $100 of equity matched with $100 of debt against it, and it's important to note that our U.S. operations are much less leveraged, contributing to our favorable overall leverage. This approach effectively addresses the primary risk associated with real estate asset values, making us perfectly hedged—not overhedged or underhedged. Finally, we also manage earnings related to foreign exchange through purchasing hedges that extend protection for approximately two years.

Yes. And I would say even longer, we ladder into that strategy where the next few years are quite fully hedged, but we have hedges out to '26, '27 and we dollar cost average into it. I also think, Jamie, it sounded like underneath your question is how do we feel about sending dollars to Europe or to Japan. And frankly, that's not really how it works. In these other jurisdictions, we're typically recycling capital. That's when we're running the contribution model even at a time like this when the contributions at least in Europe are at a pause, we're funding that with debt in-country. So we don't really have the kind of issue, as I think you're trying to highlight there. Your second question was on the lease mark-to-market, I think, and how does it fall down over time. And I know you appreciate that's going to be purely a function of what is market rent growth from here. If there are no market rent growth, it will come down more precipitously. And if there's a reasonable level, say, high single digits, that's probably going to be paired with our same-store growth. And that would say the lease mark-to-market is going to be pretty constant for a while. So you have to make a bet on market rent growth to really answer that question, and we're not doing that today over the long term, but it's got a very long tail to it, I think, is our view.

I would like to mention that the favorable FX rates for the dollar present significant opportunities to invest in Europe, allowing for attractive values in local currencies alongside a great exchange rate. While we don't plan to act on this immediately, it is an important consideration as we observe the changes taking place. Additionally, I want to highlight our Groundbreakers Conference next Tuesday at Hudson Yards in New York, which will also be available for online streaming. This annual event will showcase influential figures in logistics, including Dave Clark, the new CEO of Flexport and former CEO of Amazon's Worldwide Consumer division, among others. We will address pressing questions about macro trends, offering a unique experience compared to other conferences. If you're interested in the future of logistics, this is an event you won't want to miss. We have received a fantastic response, and I believe you will find it very valuable. I look forward to seeing many of you there. Take care.