First Industrial Realty Trust Inc (FR) 2006 Q3 法說會逐字稿

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  • Operator

  • Good afternoon, ladies and gentlemen. My name is Mia and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. [OPERATOR INSTRUCTIONS] Thank you. It is now my pleasure to turn the floor over to First Industrial Realty Trust. You may begin your conference.

  • Sean O'Neill - SVP IR

  • Good morning, everyone. This is Sean O'Neill, Senior Vice President of Investor Relations and Corporate Communications. Before we discuss our results for the quarter, let me remind everyone this call contains forward-looking statements about First Industrial. A number of factors may cause the Company's actual results to differ materially from those anticipated. These factors can be found in our earnings release that is available on our website at www.firstindustrial.com. Now let me turn the call over to Mike Brennan, President and CEO.

  • Mike Brennan - Pres, CEO, Dir

  • Okay. Thank you very much, Sean, and welcome, everybody, to our third quarter 2006 earnings conference call. With me here today is Jojo Yap, our Chief Investment Officer, who will discuss our investment performance and our pipeline, David Draft, Executive Vice President of Operations, who will cover our portfolio results, Mike Havala, Chief Financial Officer, who will go through our capital markets activity and financial results for the quarter, and you've just heard from Sean O'Neill.

  • Let me start by thanking everyone who had the opportunity to come down and visit us for our Investor Day in Phoenix and also everyone who listened in on the web cast. For those that did not have the opportunity to participate, at that conference, we initiated our guidance for 2007 with FFO per share projected to increase about 9% and that is on top of the 14% FFO per share that we expect for 2006, using the midpoints of our guidance range.

  • At Investor Day, we discussed three important things. First, the growth drivers that we see for our business, second, the benefits of our strategy, and third, the strength of the franchise that we have built at First Industrial, all of which were evident in our third quarter results.

  • Getting into the specifics of the quarter, funds from operations were a dollar per share, up from $0.95 last year and FFO year to date has increased 18%, so we are very much on track in terms of our annual FFO guidance. For the quarter, net operating income grew 13% versus a year-ago's quarter. Joint Venture Income was up more than 61%, and net economic gains increased 35%, so we were able to produce solid growth across all of our revenue streams.

  • When we look at the drivers of our business, while some areas of the economy may grow more slowly than others, business spending, a very important part of industrial space absorption, is projected to increase 8% for 2006 and capacity utilization has risen to 82% and we haven't seen that since mid 2000. And these key indicators point to continued positive industrial space absorption.

  • Our corporate customers continue to tell us that they need more industrial space to accommodate an increasing flow of goods rising from international trade, and in many cases, this also requires them to reconfigure their supply chains as manufacturing shifts to lower cost regions and import volumes rise in both major coastal and inland ports. This year alone, containerized cargo is projected to be up about 9%, which in turn increases the demand for industrial space and drives higher rent growth, all of which we are seeing today. In addition, as we saw in our Phoenix market tour during Investor Day, companies also need more industrial space in high-growth cities to fill the needs of rising populations. And since our strategy and franchise have been built around the comprehensive supply chain needs of our customers, all of which are growing, we continue to see many opportunities to grow our business. And we've made significant investment in our business over the past several years and we're seeing the benefits of those, having grown our capital sources and our markets and our talent base and our bottom-line financial results.

  • Along with shareholders, our joint venture partners, who invest with us every day, are also the beneficiaries of the value that we've created through our franchise. And we're very pleased that during the quarter, we formed our third joint venture with the California State Teachers Retirement System since the beginning of 2005. And some of you know this $950 million venture we'll invest in strategic land and developments across North America, particularly in the high growth coastal and inland markets, as well as the large population centers that are experiencing high rates of growth in the number of new residents.

  • So overall I'm very pleased with the third quarter results. I'm pleased with the progress that we've made in further strengthening the franchise, and I'm optimistic about the remainder of this year, as well as next year. And so with that, I'd like to turn the discussion over to Jojo

  • Jojo Yap - CIO

  • Thank you, Mike. Let me just start by saying that we had strong investment results for the quarter and we remain on track toward our overall investment guidance for the full year. As we noted at Investor Day, we had significant capital capacity through our JVs and we have a growing pipeline of investment opportunities to put this capital to work. Let move on to the details of the quarter. First I will discuss our on-balance-sheet activities. Then I'll provide you with an update on our joint venture activities. And I'll close by reviewing our investment pipeline.

  • For our balance sheet, we acquired 24 properties in 15 separate transactions for a total of $212 million. On the development side, we placed in service eight developments totaling $110 million, including build-to-suits for Solo Cup, Libbey Glass, and Hunter fans, as well as two developments in the Port of Houston for logistics providers Ozburn-Hessey and Jacobson, who are also repeat customers for our real estate solutions. This is the largest quarterly total for Developments Placed in Service for our balance sheet in First Industrial's history. In total, balance sheet Investment during the quarter was $322 million.

  • As we continue to highlight, our focus on corporate customers drives our investment strategy. 38% of our acquisitions in the third quarter and 46% year to date were within this target segment. Fourth quarter, our investment yield exceeded the yield of dispositions by 172 basis points, as we continue to create value and strong margins.

  • With regards to balance sheet sales during the quarter, we sold 26 properties in 22 separate transactions for a total of $261 million with a weighted average cap rate of 7%.

  • I'd like to move on to our joint venture activities right now. In our JVs we invested $222 million during the quarter, the majority of which was in our Development/Repositioning venture. During the quarter, we also sold $123 million from our JVs, primarily from our [core portfolio venture] as we continue to unlock value from that portfolio. As in prior quarters, we exceeded the leveraged returns we projected at the time of acquisition.

  • I will now turn to a discussion of net economic gain. In the quarter, net economic gain was 33 million. On our sales, we achieved an unlevered IRR of 15%. A key indicator of our ability to create value quickly through our active investment process is the average holding period for all properties sold in the first three quarters, and that was 2.1 years. Net economic gains, as a percentage of cost, was 16% in the quarter and also year to date. It's important to remember that these margins are from a wide range of investments, including build-to-suit, spec development, single asset sales from prior portfolio acquisitions, and net leased properties, all of which have varying risk characteristics. Our goal is to maximize the risk adjusted returns on each investment. We underwrite this wide range of investments because our strategy is to serve the comprehensive real estate needs of our customers, and we believe that the outlook for our future margins is favorable because our franchise has grown and we're seeing an increasing volume of submissions from customers and brokers, that stands at $19 billion year to date. Our higher volume of investment opportunity means we can be more selective, which increases our margins.

  • Now I just want to point out a few examples of our investment strategy enacted during the quarter. The first is an acquisition of three vacant buildings in Phoenix, totaling 385,000 square feet. Our strategy was to stabilize the properties and them market them for sale. We leased the properties and sold it to an investor in a deed for a 1031 exchange and we achieved an unlevered IRR of 65% on this transaction.

  • In the second example we sold three recent build-to-suit developments for our corporate customers Solo Cup, Pier 1 and Hunter Fan. Solo Cup was the largest build to suit in Georgia last year at 1.3 million feet. Pier 1 was a 450,000-square-foot distribution center in the Port of Tacoma market, built as an alternative to this additional West Coast ports for receiving increasing containerized cargo from the Pacific rim. And Hunter Fan was a 935,000-square-foot facility in the Memphis market.

  • As I mentioned, we executed a similar strategy with build-to-suits we completed for Ozburn-Hessey and Jacobson in the Port of Houston. We sold these projects to a public real estate company and achieved an unlevered IRR of 49%.

  • Now to our investment pipeline. We define our pipeline as all acquisitions and developments under agreement and Letter of Intent, as well as acquisitions already closed since the end of the last quarter. Our overall pipeline for balance sheet and JVs is about 1.5 billion. Of the amount, acquisitions currently under agreement and LOI totaled 772 million, and we've closed 84 million of new investments since September 30th.

  • Developments currently under construction and under agreement and LOI totaled $603 million. As in the past, let me now break down the pipeline by entity, which you can also find in our press release. Of the $603 million of development, 273 is for our JVs and the remainder for our balance sheet. Of the 856 million dollar acquisition pipeline, 575 million is for our JVs and the rest is for our balance sheet. Additionally, if you look at our land holdings, which will be important for future development pipelines, they total approximately 1,900 acres. 1,300 of which has been acquired through our JV since the beginning of 2005. And much of it is in the key markets of Southern California, Florida, and Phoenix. These land holdings can accommodate approximately 37 million square feet for more than $1.5 [billion] of additional development.

  • Our core investment discipline is centered around being a spread investor in all our markets. And as we discussed at Investor Day, much of our future investment will also be driven by top-down consideration, as we increase the capital allocation to major growth markets benefiting from international trade, supply chain reconfiguration, and demographic change. We continue to identify opportunities in seaports like Southern California, hub markets like Chicago, inland ports such as Atlanta, as well as demographically driven markets, namely Phoenix and Florida, where we believe our customers will be demanding additional space in the future.

  • So in closing, we continue to deliver strong profits and our pipeline of investment opportunities remains strong as we look to meet the current and of course the future demands of our corporate customers. And with that, I'd like to turn over to David Draft.

  • David Draft - EVP Operations

  • OK, well, thank you very much, Jojo. As I usually do, I'd like to just start with some brief comments on the market fundamentals for the industrial real estate sector overall, and after that, I'll review our own portfolio results for the quarter. Nationwide occupancy for the quarter was 90.4% and that's up 20 basis points from the last quarter. Year-to-date national occupancy is up 30 basis points. Many of the key macroeconomic statistics were strong in the third quarter. Industrial production rose at an annual rate of 3.6%, somewhat of a decline from the rapid gains of the previous three quarters, but a solid improvement versus the year-ago quarter. Industrial capacity utilization remained high at 82% for the quarter. And demand for industrial space was solid, as net absorption in the quarter was approximately 58 million square feet. And that compares to 53 million in the second quarter. In terms of supply, new deliveries were approximately 37 million square feet, which was a modest decline from the 40 million square feet delivered in the second quarter.

  • So business activity remains strong, and as we've highlighted thus far today and at our Investor Day as well, there are strong fundamental macroeconomic and demographic factors that are expected to continue to drive the long-term demand for industrial space. So I'd like to, at this point, turn to First Industrial's On Balance Sheet portfolio results, beginning with occupancy. Occupancy increased to 93.1% in the quarter. That's a 90 basis point increase over the second quarter and the strongest occupancy level for us in over five years. This increase resulted from a solid level of a new leasing, as well as an exceptionally high level of retention, which I'll comment on in a few minutes.

  • We've also placed a number of fully leased new developments in service during the quarter. Now, as reported at Investor Day, in 2006 we were, once again, the industry leader in customer service. And that's measured by the respected Kingsley Index. We're very proud of that, as we've substantially increased the size of our owned managed portfolio over the past few years, the satisfaction level of our customers has continued to increase, as well. Now this bodes well for the overall strength of our portfolio in terms of both renewals and new leasing opportunities. And we see this reflected in our retention levels. In the third quarter, we renewed an impressive 86% of our expiring square footage. We're also seeing solid performance in many of our markets. Markets that have remained especially strong include the East Coast markets, as well as central PA, southern and northern New Jersey, and Philadelphia. Houston continues to see strong demand due to solid fundamentals in the petroleum industry, as well as increased port activity due to customers seeking alternatives to the ports of LA and Long Beach. Active industries in the quarter included the food-service industry, logistics firms, medical equipment suppliers, packaging companies, and distributors of consumer products.

  • Now our projection for average occupancy for the full year 2006 remains at about 92%. We reiterate our expectation that occupancy levels next year will continue to improve, with the 2007 full-year average being in the range of 92 to 93%.

  • Turning now to NOI, total NOI in the quarter was $67.1 million, and that's an increase of 13% from the 59.3 million posted in the third quarter of last year. This increase was driven by higher occupancy and the very good news that rental rates turned positive in the quarter, something I'll provide detail on in a few moments. Now for the same store pool, on a cash basis, excluding lease termination fees, same store was 3.1% positive in the quarter. On a GAAP basis same-store was 0.8% positive. Based on improving same-store results for the fourth quarter, we maintain our projection that same-store will be approximately even for the year and that's on a GAAP basis.

  • Turning now to rental rate changes, I am pleased to report that the rental rate change was a positive 1.5% in the quarter. That compares to a decline of 0.5% in the second quarter and a -4.4% reported for the full year 2005. Looking forward, we expect rental rates to be positive in the fourth quarter and into 2007. And as I mentioned last quarter and again at Investor Day, a key contributor to this outlook is the opportunity that we have going forward to renegotiate leases originated in the soft market conditions of '02, '03, and '04, and to do so in what is now a much improved environment.

  • Turning to lease coats. Lease costs in the quarter were $1.86 per square foot. That's down from $2.35 in the previous quarter. The decline there is the result of the high level of retention that I spoke about a few moments ago in a number of larger spaces that were leased in as-is condition. Also I might just add that the higher occupancy level nationwide is causing tenant incentive packages to moderate, so that's helping, as well. So we had a solid set of operating results in the quarter. And we're also confident that more good results are in store over the remainder of this year and throughout 2007, as we continue to operate in a sound environment and as customer service remains the primary focus of the First Industrial franchise.

  • So at this point, I'd like to turn the call over to Mike Havala.

  • Mike Havala - CFO

  • Well thanks, David. First, let me provide you with an update on our capital markets activities during the quarter. We had one private capital raised and two public capital raises during the quarter, all of which lowered our cost of capital. So let me touch briefly on these three capital raises.

  • First, as we previously announced, we entered into a significant new joint venture with CalSTRS. This new joint venture is a $950 million venture focused on investments in strategic land positions and the associated development.

  • Second, in August, we raised $50 million in preferred stock at a coupon of seven and a quarter. And the reason that we issued this preferred stock is that in 2007, we can call for redemption our series C preferred stock, which has a much higher coupon at eight and five-eighths. So we should see savings from this refinancing starting in 2007.

  • Third, we raised $200 million of convertible bonds at a coupon of four and five-eighths. The purpose of this capital was to line up capital for replacing $150 million of notes which mature in December of this year and carry a higher coupons at 7%. So we'll see significant savings here, replacing 7% debt with four and five-eighths percent debt. Note also that when we issue the convertible bonds, we did so such that the bonds effectively carry a 40% premium -- convert premium. This means that our stock price must hit nearly $60 per share before there's any effect of the convert premium.

  • Then next area that I'd like to talk about is private capital. As most of you are aware, we raised a significant amount, nearly $4 billion, of private capital capacity since March of last year. I've spent time discussing our joint ventures at our Investor Day earlier this month, so I won't repeat the details here, but the main point is that we have a significant amount of capital capacity already in place to fuel substantial growth in the future.

  • Regarding our third quarter numbers, our FFO came in at a dollar per share, which is right in the middle of our guidance range. And then note that we had in the third quarter a $0.06 per share charge, which reduced FFO and this resulted from an interest rate protection agreement that we entered into earlier in the year and settled during the quarter. This had hedged the interest rate of a future bond offering, but because we issued the debt earlier than originally projected, we recognized the full charge in the third quarter.

  • Next, let me mention that we provided more information in our supplemental on G&A expense. What we did is we separately should the directed G&A associated with economic gains and also the direct G&A associated with our joint ventures. Note that this breaks out the G&A directly connected with those activities, but that there's other overhead costs that are associated with these activities that are more indirect in nature, so we hope this additional information or this additional disclosure is hopeful.

  • The last area that wanted to discuss is our FFO guidance. For 2006, we increased the midpoint of our guidance range by $0.02 and we narrowed the range to $4.07 to $4.17. We increased our 2006 FFO guidance due primarily to higher expected JV FFO in the fourth quarter, as well as what we had in the third quarter, and this was offset by several other items, including the interest rate protection agreement charge, which I referred to before. At our Investor Day earlier this month, we initiated our FFO guidance for 2007 and we're reaffirming that FFO guidance here.

  • So with that, we're very pleased with how we're finishing 2006 and we look forward to another strong year in 2007. With that, I'll turn it back over to Mike Brennan.

  • Mike Brennan - Pres, CEO, Dir

  • Okay, thank you, Mike. I'd just like to make a few summary comments and then we'll open it up for questions. First of all, I want to complement our employees. We have been improving and increasing our human resource capacity and they've done a very solid job of executing and a solid job of delivering the result. They've also done a great job and being able to help us take advantage of the great opportunities that we've seen in the corporate real estate business. We mentioned international trade, we mentioned supply chain reconfiguration work, the opportunities we have in the demographically blessed areas of the country, and also the day-to-day individual building requirements that we get from our corporate real estate customers. And the result is a very healthy pipeline, as Jojo mentioned.

  • Great employees and the great opportunities has helped us build a strong franchise. Whether it's with our customers, the brokers, the capital sources, our brand, our people, all of that is really helping us deliver on the solid opportunities for growth. So we're extremely excited about the future and quite pleased with the results of the quarter. So with that, Moderator, I would like to open it up for any questions we may have.

  • Operator

  • [ OPERATOR INSTRUCTIONS ] Your first question is coming from Paul Adornato of BMO Capital Markets.

  • Paul Adornato - Analyst

  • Hi, good morning. Given your guys’ exposure to corporate America, I was wondering if you could comment on corporate America's reaction to the real estate market. How sensitive are they to what's happening in real estate, in terms of their real estate activities?

  • Mike Brennan - Pres, CEO, Dir

  • Paul, this is Michael Brennan. Maybe I can start and then Jojo can maybe add a little color. But I would say that a couple of years ago, corporate America began to say that we have maybe some significantly undervalued assets that sit on our balance sheet. Saw it in Toys "R" Us, saw it in McDonald's, and so CFOs have been saying that this is an asset that wed better take a look at and better decide whether or not it's appropriate for us to have that type of investment. And so we think that increasingly, they're going to make the decision that they earn more in their corporate business than they do in the real estate business. So I think you've certainly seen more attention focused on it.

  • The other area of focus is by Chief Operating Officers. They're wondering whether or not the configuration of their buildings due to changing labor patterns or distribution patterns is optimal. So they'd given greater attention, along with the Senior Vice Presidents of Logistics, to not only how much real estate they had, but where it ought to be and what it ought to look like. So you're getting much more attention at the C-Suite in corporate real estate than you have before and you can see some of that in some of the transactions we've done, like Rockwell. But I think that's an area of attention and focus that we hoped that corporate America would begin to focus on because we have a franchise that we think can help them in many of those endeavors, whether they're operational driven or financially driven.

  • Paul Adornato - Analyst

  • Okay, thanks for the color.

  • Operator

  • Thank you. Your next question is coming from Ross Nussbaum of Banc of America Securities.

  • Ross Nussbaum - Analyst

  • Hi guys, good morning. Couple of questions. First, I may have missed this, but what was the occupancy rate on the 110 million of development that you placed in service in the third quarter?

  • Jojo Yap - CIO

  • Ross, hi, this is Jojo. It's in the mid-90s.

  • Ross Nussbaum - Analyst

  • And Jojo, I don't remember if it was you who gave this number, but the average holding period on the assets disposed year to date is now 2.1 years?

  • Jojo Yap - CIO

  • 2.1, you're correct, Ross.

  • Ross Nussbaum - Analyst

  • And I thought I had saw at your Investor Day that that number, at least through June 30th, was 2.7 years.

  • Jojo Yap - CIO

  • You're correct.

  • Ross Nussbaum - Analyst

  • OK, so that would imply that in the third quarter, the average holding period was remarkably small.

  • Jojo Yap - CIO

  • Yes, you're correct, and primarily led through the holding period of joint venture.

  • Ross Nussbaum - Analyst

  • So if I'm reading this right, that would imply almost that the average holding period was one year or less in a lot of the stuff you sold in the third quarter?

  • Mike Havala - CFO

  • Ross, we also sold a number of development projects, build-to-suits, during the third quarter, as well, so that impacted that.

  • Jojo Yap - CIO

  • Yes, but it's much shorter than the 2.7. You're correct, Ross.

  • Ross Nussbaum - Analyst

  • Okay. Next question, on the same-store numbers, maybe you can just help me out on the math a little bit, your same-store revenues were up 1.2%? And if I read correctly, same-store occupancy was up 80 basis points and you talked about 1.5% rental rate change. I assume that's releasing spreads. To me, that would lead to something higher than 1.2% same-store revenue growth. Am I missing anything there?

  • Mike Havala - CFO

  • With respect to that, I think we had 0.8% same-store growth in the quarter and part of that depends on GAAP numbers like straight-line rent and FAS 141 and so forth.

  • Ross Nussbaum - Analyst

  • I guess I'll have to follow up with you, because it just seems empirically to me that an 80-basis-point occupancy gain would drive more than 1.2% rent growth. It would almost imply that there's something else going on there offsetting the occupancy gain. That's what I'm trying to figure out.

  • Mike Havala - CFO

  • Well, you did have an increase in both expenses and in revenues in the same-store pool.

  • Ross Nussbaum - Analyst

  • Right, but I'm talking about your same-store revenue number, your subliminal was up 1.2%. I can follow up with you after the call, but it just seems to me I'm missing something here.

  • Mike Havala - CFO

  • OK.

  • Ross Nussbaum - Analyst

  • OK, thank you.

  • Operator

  • Thank you. Your next question is coming from Michael Gorman of Credit Suisse.

  • Michael Gorman - Analyst

  • Hi, guys, just a few quick questions here. Could you maybe help reconcile some of the new guidance for me? I understand that the range narrows 4.07, 4.17, but if I run through the primary changes as I see them, the midpoint on your gains goes up 2.5 million, which is $0.05. The JV income goes up by 7.5 million, which is $0.15. So I understand that there's some offset from the charge and maybe some other costs, but why so little change to the bottom line? And why does the top end specifically come down?

  • Mike Havala - CFO

  • Sure, let me walk through that with you. Basically, as you saw, we raised the guidance for the line item of JV FFO and we raised the bottom line FFO, as well, but not as much. The reason for that is a couple. First of all, in producing that joint venture income, we also have cost of production, and so that's in a different line item, if you will. That's in our overhead, our G&A line item, so that's some part of that. Also remember we had the $0.06 interest rate protection agreement. That is a factor, as well. Also, we had just -- in fine-tuning our numbers as we get closer to year-end and looking at the timing of acquisitions and sales during the quarter, as well as what we sold at the end of the third quarter, that impacts the numbers, as well. And then note on the gains on the range there, we tightened that range from 110 to 120 to 115 to 120 just because we have better visibility as we go out closer to the year. And we had expected to be towards the top end of that range and now as we get closer to year-end, we have more certainty with respect to where we expect to come in to the range. So again, bottom-line, we did raise our FFO guidance for 2006. Again, remember we did it earlier in the year, and we're very pleased about where we see 2007 coming out, given the opportunities that we have.

  • Michael Gorman - Analyst

  • Okay, and just quickly. I'm sorry if I missed it when you went over it, that $0.06 charge on the market to market, that was not expected? That was an unexpected charge?

  • Mike Havala - CFO

  • Yes, that pertained to our issuance on the convertible notes, and so yes, that charge was a not-factored-in charge back when we gave third quarter guidance a number of months ago.

  • Michael Gorman - Analyst

  • Okay. And then for Jojo, if I just look at some of the investment activity for the quarter, or even year to date, your acquisitions are at like an 8.6 cap rate in the supplemental. That's a 30-basis-point premium, a premium said spread to what you do on your development side, an 8.3. I just want to -- if you're doing developments for 30 basis points less than what you can buy them for, why take on the development risk at al? Why even build it?

  • Jojo Yap - CIO

  • Well, a couple of things. There are opportunities in both. Just to try to address your first question, on the yields, why are there higher acquisitions this quarter? They go up and down. There's really no long-term trend of acquisitions going to be a heavier yield that's much higher than the development, but I just wanted to mention that in this quarter, we had quite a bit of corporate deals. And corporations need complex solutions. Usually our yields go up. so if it gives you another view, we price our services with a premium, as opposed to development.

  • In terms of development, there are opportunities, like we told you about all the customer needs coming from international trade, supply chain reconfiguration, so that's a big business. So our goal here, really overall, again, is to serve corporate America and when you do that, you'll find both development opportunities like build-to-suit, speculative development, and in acquisitions, you'll find redevelopment and sale leasebacks. So again, we're looking at -- we're trained and our craft is to really be an owner, builder, redeveloper, all types of industrial real estate impersonation. That's our strategy and we're going to stick to that.

  • Michael Gorman - Analyst

  • Okay. And then just one last one for David, I think. Just looking at the Los Angeles market, started the year same-store occupancy of 98%, you fell to 59% in the second quarter, which I understand, but given that it's one of the stronger markets in the country, why no improvement? Why no positive leasing activity in the third quarter on the market? Is there anything specific going on there?

  • David Draft - EVP Operations

  • No, our portfolio in Los Angeles is less than a million square feet, so we do a lot of capital recycling year, a lot of value-add and selling back out again and creating value. And so what happens when you've got one or two buildings for whatever reason in a particular quarter, occupancy levels significantly [technical difficulty.] That's a very healthy market for us and we've done really well in Los Angeles over the long term, but you're going to see some volatility from quarter to quarter. And our investment in JVs is higher there, as well, so you don't see everything come through on the occupancy level for any one particular quarter. It's a great market. As you know, I'm sure.

  • Michael Gorman - Analyst

  • Absolutely, that's why I was just a little bit surprised not to see an uptick in Q3. OK, thanks, guys.

  • Operator

  • Thank you. Your next question comes from Jonathan Litt of CitiGroup.

  • Craig Melcher - Analyst

  • Hi, it's Craig Melcher here with John. On the development pipeline, you discussed at the Investor Day that you were looking to become a top three developer in the U.S. Is this stuff you're currently working on, as well as in the shadow pipeline? Would that get you to be a top three development or do you have to ramp the development pipeline further?

  • Mike Brennan - Pres, CEO, Dir

  • This is Mike Brennan. Jojo can help me on the exact statistics that would put us in that position, but it would be approximately 700 million would put you one, two, or three every single year. So I think we're a year or year and a half away from doing that. Now, obviously, volume's not our goal; profitable volume is our goal. So those are two of our missions. So with the pipeline that we currently have, the land that we currently own -- again, I'm repeating myself -- I'd say about a year, year and half. I think we could do that.

  • Craig Melcher - Analyst

  • Okay. How do you expect the development yields beyond these assets in the shadow pipeline relative to the developments that are currently in process?

  • Jojo Yap - CIO

  • Hi, this is Jojo. It's going to be in a similar range. We would say at about 8- 8.5% range.

  • Craig Melcher - Analyst

  • Okay. And then the economic gains for 2007, how do you expect that to break out, relative to the breakout you've been experiencing so far? This year and '06?

  • Jojo Yap - CIO

  • It would be about 65 to 75% [merchant] economic gains which includes land sales, and the rest would be existing property.

  • Craig Melcher - Analyst

  • And the last question is just on the G&A. How much G&A are you capitalizing at this point? And if your development pipeline grows, will that give you the opportunity to capitalize more G&A?

  • Mike Havala - CFO

  • Yes, to the extent that we do have development overhead and we have projects that we do capitalize G&A under GAAP, and to the extent that we have more development activity, the capitalized G&A would go up a little, but not a lot, because remember, you're spending a hundred dollars of G&A, whether your development is twice as much as it is now, you still have a hundred dollars of G&A for development. You're still only capitalizing a hundred.

  • Craig Melcher - Analyst

  • What about the cost of the guys that are active in the acquisition disposition of real estate? They're compensated with any kind of a commission or bonus structure. Is that capitalized into the cost?

  • Mike Havala - CFO

  • No, that's all expensed through the G&A expense line. And we try and break out that for you a little bit more in detail to give you, say, the G&A that's associated with our net economic gains. So that's exactly what are some of the costs that are in that number, John.

  • Craig Melcher - Analyst

  • Okay, thank you.

  • Mike Havala - CFO

  • You're welcome.

  • Operator

  • Thank you. Your next question comes from David Taylor of David T. Taylor and Company.

  • David Taylor - Analyst

  • Thank you. I have just one question and it's a big-picture question based on your guidance. You're talking about a 14% gain in FFO this year and a 9% gain next year, however, as we look at the Company, at this moment, your occupancy rate is the highest it's been in years, you're experiencing rent increases year over year for the first time in years, the economy is still ticking along at a fairly good rate. Just from the standpoint of an outsider, it seems to me that your earnings gains should be accelerating, not decelerating, into next year, as your guidance suggests. Would you comment?

  • Mike Brennan - Pres, CEO, Dir

  • David, this is Mike Brennan. Well, it's certainly right that our revenues are hitting. We will see what '07 brings. We think our guidance is prudently and conservatively formulated, but yes, the wind is at our back. As David mentioned, the net operating income that will benefit from increasing fundamentals, plus the opportunity to renegotiate those leases. There's no question there. The investment capacity that we have with our joint ventures is probably, what, Mike, I would say three or four times higher than the current level, so we have opportunities there. We'll see how '07 plays out, David. I'm all for exceeding our estimates, but these were prudently and conservatively put together at this point in time.

  • David Taylor - Analyst

  • Well, I have no need to be prudent or conservative. [laughter] If I were to forecast an acceleration, rather than a deceleration, of your earnings growth, is there any reason to assume that I'd be incorrect?

  • Mike Brennan - Pres, CEO, Dir

  • We've given an FFO range, David, so people that have one view or another can look at the range that we've provided. So hopefully that helps you.

  • David Taylor - Analyst

  • I have to really hit you over the head, don't I, Mike?

  • Mike Brennan - Pres, CEO, Dir

  • Yes, you do. [laughter] Thanks, sir.

  • Operator

  • Thank you. Your next question comes from Cedrik [Lachance] of Green Street Advisors.

  • Cedrik Lachance - Analyst

  • Thank you. Looking at your gains on sales, in this quarter you seem to have had profit margins of about 10.9%, yet you expect about 14% in '07. Can you explain to me what you see in terms of market conditions that might be changing that will explain this increase in profit margins?

  • Jojo Yap - CIO

  • Cedrik, market conditions on pricing levels has not changed. It is because -- we just no and we have more visibility on the properties that we're about to sell. So we have much, much clearer visibility and that's where -- when we have visibility, that's where we base our guidance on. And pricing levels and valuations really have not changed.

  • What continues to change are growth and opportunity because again, like we mentioned to you all at Investor Days, these are really our source of capital, increase source of private capital, and increasing opportunity through some long-term trends that we've indicated to you all. So that's where we see the big change. It's really the dynamics of international trade supplies chain reconfiguration.

  • Does that answer your question?

  • Cedrik Lachance - Analyst

  • What I find difficult to understand is that you increase your proportion of merchant building gain verses other sources of gains, and you expect merchant building or merchant gains to be about 75% in '07, yet while you increase your merchant building gains in '06, your profit margins have declined, perhaps as a result of the type of projects you've found. So are you going to take more risks in your developments or -- where are you going to find projects that are essentially going to yield much higher levels than you have right now?

  • Jojo Yap - CIO

  • Yes, see, the profit margins, again for '07, you're right on in terms -- First of all, in the third quarter, we have significant margin development. Our merchant development -- after-tax margins really have ranged in development anywhere from 15 to 20%. Of course, there might be times where we sell an existing property and again, the after-tax margins range from quarter to quarter. And so in the third corner we had some less than profitable, that’s less than the historical average, existing asset sales.

  • Cedrik Lachance - Analyst

  • In regards to taxes, your gross gains on sales are up about 70% so far this year, however, your taxes are up about 300% versus the first nine months last year. Can you help me bridge the gap there?

  • Mike Havala - CFO

  • Sure, Cedrik. It just is a matter of the mix on what you sell and what the tax implications are. When we own properties in the taxable REIT-subsidiary and sell those at a profit, those are subject to tax. When those assets are owned in the operating partnership, they generally are not. So it just really depends on the entity that owns the asset, as far as what the tax level is going to be. But again, just as you know, everything that we look at and talk about with respect to returns and margins is on an after-tax basis and that's how we view the merits of an investment. So is that helpful to you?

  • Cedrik Lachance - Analyst

  • Yes, it is. Looking at your land acquisitions, you've acquired a few parcels this quarter. My understanding is that one of your JVs with CalSTRS has a right of first refusal on land acquisitions. What would explain the acquisition of land on the balance sheet this quarter instead of putting it into JVs with CalSTRS?

  • Jojo Yap - CIO

  • Okay, Cedrik, the number one reason that we would acquire land on balance sheet, and not JV, is because our venture with our partner CalSTRS does not have exclusivity in build-to-suits. So when we acquire property in conjunction with build-to-suits, you can expect us absolutely to buy that. And there are, over time, over the long term, there will be some land acquisitions where we just plainly don't see eye to eye, where we would want to buy those properties and our partner might not. And we potentially would elect to buy this.

  • Cedrik Lachance - Analyst

  • Okay. And last question, on the page four of your supplemental, you list your land and the number of square feet that you might be able to develop on those parcels. In one particular instance in Philadelphia, your development potential has gone from 5.4 million square feet to about 1.8 on one parcel, however, the land acreage hasn't changed. Can you tell me what happened to that project?

  • Jojo Yap - CIO

  • Yes, Cedrik, what happened was that when we continued to do more due diligence on that side, our initial plan actually expanded because we thought we could build more. But at time of acquisition, we actually didn't think we could build as much. Now after further due diligence, we had found that there were some portions of the site that were not buildable; i.e., wetlands. There were wetlands there that we couldn't build on, so we appropriately reduced the buildable area.

  • Cedrik Lachance - Analyst

  • Does that [impair] the value of the land on your balance sheet?

  • Jojo Yap - CIO

  • No. Like I initially said, when we acquired that site, we did not factor in any value. On a subsequent supplemental, that was the time when we started [sidelining] the site and thought that we could build more, but down the road, at the end of the day, we found out that we couldn't so we went back to our original projections.

  • Cedrik Lachance - Analyst

  • Did you acquire the land with a portfolio acquisition? That's why you wouldn't have put a basis to it? I'm not sure I understand that.

  • Jojo Yap - CIO

  • No, that was straight land acquisition.

  • Cedrik Lachance - Analyst

  • Okay, so you would have included the basis on your balance sheet for the land, correct?

  • Jojo Yap - CIO

  • Actually, yes, but we did not -- in the initial acquisition -- we factored, in our underwriting, a smaller amount of buildable area.

  • Cedrik Lachance - Analyst

  • I see. OK, thank you.

  • Operator

  • Thank you. Your next question is coming from Srikanth Nagarajan of RBC Capital Markets.

  • Srikanth Nagarajan - Analyst

  • Thank you. Most of my questions have been answered, but just one for David Draft. You mentioned Houston and some other markets, but what's curious is that some of the Midwest markets like Chicago, Columbus, Cincinnati, even Texas, like Dallas/Ft. Worth showed both same-store occupancy as well as same-store rent increases. In particular, Chicago's occupancies went up quite a bit. Some color on all of these and was it just a temporary thing or are you seeing trends here that are positive?

  • David Draft - EVP Operations

  • We're seeing some positive trends in virtually all of the markets that you just mentioned. I mean, I could go property by property in terms of what we'd leased up in the quarter, I guess to answer your question at that level of detail, but we're definitely seeing stronger market conditions, more leasing activity, more RFPs, more prospective activity, and more actual activity, as well. I think in terms of the rental rate improvement that we've seen in most of these markets -- and by the way, well over half of our markets went up in terms of the rental rate change quarter to quarter, so it's quite broad based. And it's a product of not only our own portfolio leasing roll-over schedule in terms of the older higher rents that we're coming off from, but we're also seeing just nationwide rental rate positive trends across the market. So we're getting market growth and we've got inside-the-portfolio dynamics that are helping, as well. So it's a combination of factors, I would say.

  • Srikanth Nagarajan - Analyst

  • That's very helpful. Thanks.

  • David Draft - EVP Operations

  • You bet.

  • Operator

  • Thank you. We have a follow-up question coming from Michael Gorman of Credit Suisse.

  • Michael Gorman - Analyst

  • Yeah, hi guys. Just a quick follow-up on the technical side. Jojo, you mentioned the return on cost for net economic gains averaging about 16%. Given the earlier discussion that you don't capitalize the G&A associated with that, what would those returns look like if you calculated them including the G&A, including the personnel cost that's needed to generate those?

  • Jojo Yap - CIO

  • I don't really have those numbers in front of me, and in addition, those are already factored in the G&A that Mike Havala discussed.

  • Michael Gorman - Analyst

  • So it's already accounted for in the 16% on coast?

  • Jojo Yap - CIO

  • Not in the 16% of cost, but Mike Havala --

  • Mike Havala - CFO

  • It's in the G&A line item, but we don't have that detail with us.

  • Michael Gorman - Analyst

  • Okay, thanks.

  • Operator

  • Thank you. Your next question comes from Bill Crow of Raymond James.

  • Bill Crow - Analyst

  • Good morning, guys. Mike Brennan, as you think about net economic gains in '07, what is the sensitivity to the activity based on the economy? In other words, if we're running a 2% GDP growth or if we're running a 3% GDP growth, how do you think those metrics would change the magnitude and maybe the source of the net economic gains next year?

  • Mike Brennan - Pres, CEO, Dir

  • I don't think it would much effect on it. Just step back a second and think about the levels of business and the number of opportunities that we have today and the capabilities that we have versus several years ago, when the economy was slow and our franchise earned its mark of distinction, really, in that slow period. So I guess I would say let's look at the opportunities today. International trade, supply chain reconfiguration work, still some pretty good population increase in household growth formation in this demographically blessed, like California, Phoenix and Florida, and our normal corporate real estate block and tackling that Jojo discussed at Investor Day. Now let's look at the increased amount of resources that we have to take advantage of those. Greater capital, greater market coverage, improved compensation plans, greater amount of transactional officers and specialties in our particular company. And that's given us the unique capability of serving our corporate customers.

  • So what we've done, really, is we've taken that great track record of spread investing that we've had over the last 12 years -- and this is very important to understand -- that for 12 years we've maintained at least an average spread over buying and selling cap rates by about 150 basis points, in good markets and bad. So now what's happened over the past couple of years is we've just put coefficients in front of every great aspect that we have. So look at what we've been able to do this quarter; grow the pipeline, and instead of cap rates going backwards on buys, they're going forward. So I would say that while a soft market isn't good for certain aspects of our business, remember that we've got a unique capability of finding opportunities and creating value for our corporate customers that allows us to maybe benefit in markets where others might find it a bit more problematic.

  • Bill Crow - Analyst

  • Yeah, I was just thinking in terms of things like user sales, sales back to users, that they may become more reluctant to make commitments in a slow-growth environment and that might slow down that aspect.

  • Mike Brennan - Pres, CEO, Dir

  • Yeah, Bill, that's exactly what happened. In '02 through '04, we didn't do too many users sales. But we did a lot of deeply discounted surplus purchasing. So yes, things will change. We didn't do as many build-to-suits, didn't do as many users sales, but again, we did more of other types of business, as well.

  • Bill Crow - Analyst

  • Okay. Fair enough. Thanks.

  • Mike Brennan - Pres, CEO, Dir

  • All right.

  • Operator

  • Thank you. [ OPERATOR INSTRUCTIONS ] Your next question is coming from Mike Baron of European Capital.

  • Mike Baron - Analyst

  • Good afternoon, gentlemen. On the merchant sales line item in the quarter, I think it was 31 million, can you segregate that between redevelopment activity and development?

  • Jojo Yap - CIO

  • Segregate that from redevelopment and development?

  • Mike Baron - Analyst

  • No, redevelopment activity and ground up development.

  • Jojo Yap - CIO

  • I don't have that broken down right now.

  • Mike Baron - Analyst

  • Is it still predominately redevelopment that's generating that line item?

  • Jojo Yap - CIO

  • No. It's merchant development, it's build-to-suit, and then resale , and then speculative development sale.

  • Mike Baron - Analyst

  • Right. It would be helpful to see the break-out on that, because it certainly, what it looks like in '07, since the redevelopment category only has a 20% threshold on costs to qualify a redevelopment, so maybe I can follow up and get that from you offline.

  • Jojo Yap - CIO

  • Yes.

  • Mike Baron - Analyst

  • Okay, thanks.

  • Operator

  • Thank you. There appears to be no further questions. I would now like to turn the floor over to Michael Brennan for any closing remarks.

  • Mike Brennan - Pres, CEO, Dir

  • Okay, well thank you, everybody, for your interest, for calling in, and the questions. And we look forward to catching up with many of you next month. Thank you.

  • Operator

  • Thank you. This does conclude today's conference call. You may now disconnect your lines at this time.