Prologis Inc (PLD) 2006 Q2 法說會逐字稿

Good morning. My name is Brad, and I'll be your conference facilitator today. I would like to welcome everyone to the ProLogis second quarter 2006 financial results conference call.

[OPERATOR INSTRUCTIONS.]

At this time, I would like to turn the conference over to Ms. Melissa Marsten, Senior Vice President of Investor Relations and Corporate Communications of ProLogis. Please go ahead, ma'am.

Thank you, Brad. Good morning, everyone. And welcome to our second quarter call. By now you should have all received an e-mail with a link to our supplemental. But, if not, the documents are available on our web site at prologis.com under Investor Relations.

This morning, we'll first hear from Jeff Schwartz, CEO, to comment on overall market conditions and outlook. Walt Rakowich, President and COO, will cover ProLogis' operating company's performance and global leasing activity. Ted Antenucci, President of Global Development, will discuss investment activities. And Dessa Bokides, CFO, will cover financial performance and guidance.

Before we get underway, 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 noted in our Form 10-K.

I'd also like to add that the second 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.

And, as we've done in the past, to give a broader range of investors and analysts an opportunity to ask their questions, we ask you to please limit your questions to one at a time.

Jeff, would you please begin?

Thank you, Melissa. And good morning, everyone.

We are very pleased to be reporting another strong quarter, with FFO per share growth of 20% highlighted by solid property performance, strong CDFS margins, further growth in our property fund business, and continued expansion of our international platform.

Global market conditions remained strong, characterized by positive net absorption, high occupancy levels, positive rent growth on lease turnovers, something we haven't seen in quite some time. Additionally, new supply remains constrained, supporting brisk leasing and a record pipeline of development completions, repositioned acquisitions and properties under development of more than $4.5 billion.

We are pleased to announce that the strength of our operations around the world allows us to increase our full year FFO guidance from $2.95 to $3.15 per share, to $3.15 to $3.25 per share, with our new [lower] guidance equal to our previous high end. Dessa will have further comments on this.

Our industry continues to be fueled by growth in global trade. Companies around the world are striving to maximize the efficiency of their supply chain, but they can't achieve these objectives without modern distribution facilities located in key global trade portals. The need for space in these key logistics markets supports the acceleration of our global development business, which is becoming increasingly concentrated in these locations.

Of course, strategy requires outstanding execution. You need the right people to make it work. And our success in growing our business is directly related to the talent and expertise of the thousand plus people in our teams around the globe. Their in-depth local market knowledge enable us to closely monitor new supply and absorption and allows us to stay abreast of market trends that may have an impact on our business, as we establish close sustainable relationships with our customers.

As always, we continue to monitor key business indicators, such as GDP growth, sales and inventory ratios, and manufacturing indices very closely so that we can be responsive to changing market conditions.

As you've heard us discuss on recent calls, we have made sustainability and, in particular, sustainable development, a corporate priority. When people hear of the term, they often think about solar panels and other energy harvesting, building design features. And we have established market leading expertise in these areas, evidenced by the awards and governmental recognition we have received in Europe.

But another side of sustainability, Brownfield development, has become a critical success factor in our development business. This has long been important to us in areas such as Japan and the UK, where developable land is scarce. In fact, the Catellus expertise in this area and in North America was a key driver behind the merger.

A great example of this is the [port running business park] in North New Jersey, which began taking shape almost four years ago. Catellus had to overcome environmental, transactional, economic, and political challenges. They worked with multiple sellers, two municipalities, multiple environmental agencies, the county, and the State of New Jersey. Through creative solutions and working closely with the community we now have a project that is widely viewed as a model for smart growth.

This is the project we featured on an investor tour one year ago during the NAREIT Conference in New York. Those of you on that tour may recall the discussion about the extensive environmental cleanup that was required. It has now been successfully completed.

At full buildout port running business park will cover 315 acres and have 3.6 million s.f. of industrial space in eight buildings. It will be the first and largest of New York and New Jersey Port Authorities [ports field] initiative projects, which will help ensure the long-term viability of the port as one of the nation's most important import/export hubs.

The project, along with other redevelopments, such as Elizabeth, New Jersey, LA Air Force Base, Alameda Naval Station, and Austin Airport create a major growth area for our North American business.

We are also excited about our entry into the cities of Chengdu, Hangzhou, and [Ningbo] in China, where a team of 150 plus nationals continues to provide significant growth.

Some of you may have noticed the article in yesterday's Wall Street Journal regarding the Chinese Government's new regulation to design and reduce speculation in real estate.

We believe that these changes, given our existing platform and land bank, will work to our benefit. Our tax and repatriation structure already includes domestic registration of companies, as will now be required. We do not leverage our properties in China more than 50%, the new limit. And we believe this new restriction will greatly reduce competition from highly leveraged developers and buyers.

Additionally, the use of economic development incentives will be curtailed. We have never included any such incentives in our underwriting. We have, however, developed a controlled land bank capable of developing in excess of 40 million s.f. We strongly believe that the new regulations will make our first mover advantage that much more important.

We're equally excited about our first project in Kyoshu Island, the southernmost portion of Japan, closest to China, with major trade ties there. Kyoshu accounts for 10% of Japan's total economy. To put this in perspective, the GDP of Kyoshu is equal to that of the entire country of Australia. We are excited about our growth prospects throughout Japan, given the quality of our team.

Europe and North America, including Mexico, continue to be very strong, as Walt, Ted, and Dessa will note in their comments.

We believe that our development expertise, strong customer relationships, and global platform of people and facilities will help us respond to the growth in global trade.

In addition, our solid earnings growth potential, strong balance sheet, and development pipeline permit us to be very selective and disciplined in pursuing investments of all types, including development, acquisitions, and other opportunities. We believe this ability to pursue only the highest quality projects has and will continue to prove a significant advantage.

Now, let me turn it over to Walt to discuss operations.

Thanks, Jeff.

As Jeff mentioned, overall demand remains very, very strong throughout our global markets, and that's really led to occupancies in our stabilized pool in excess of 95%, as well as consistent demand for new state-of-the-art facilities and in emergence of rental growth, which I'll talk about in a moment.

First, some highlights from our international operations. In Asia leasing in our stabilized pool is over 98% now. In Japan we fully leased our second facility at Tokyo's Narita Airport, and to address additional customer demand we began construction on ProLogis Park Narita III, which is a seven-story facility directly adjacent to the [Cargill] entry.

And, as Jeff mentioned, just yesterday we held a groundbreaking for ProLogis Park [Toshu], our first distribution facility in Kyoshu, which is a major new market in Japan. This 400,000 s.f. building is 100% leased to [Mitsui], a major food and pharmaceutical company in Japan.

Also in Japan our combined property funds are now 100% leased, with over $1.6 billion in properties.

In China, Jeff also mentioned, that we announced our entry into Chengdu, Hanjo, and Ningbo. In Chengdu, our first project will be adjacent to the International Airport, which is an increasingly important air cargo destination. We also have land agreements for two additional parks near the Chengdu seaport which is China's fourth largest container port.

In Hangzhou, the capital of [Dajing] Province, we began three buildings in the Hangzhou economic and technological development area, otherwise known as [Heita]. Heita covers more than 100 square kilometers and is one of China's most successful industrial parks.

And in Ningbo we signed a land reservation agreement for approximately 30 acres near the Ningbo port, which is China's fifth largest port by volume, and Ningbo, itself, saw containerized port traffic grow by about 30% in 2005, significant growth.

Now, these three markets represent just a portion of our recent development activity in China, which also includes several ports in Shanghai, Beijing, [Gungo], all of which total more than 3 million s.f. of new expected development.

Many of you recently joined us, of course, on the tour of our operations in Asia to see firsthand what we've accomplished, and I hope you share our enthusiasm about the significant opportunity we've got to expand our leadership position in our business there.

Now, let me go to Europe. Leasing in our stabilized pool is about 95.4% in Europe, also very, very strong. In the UK market conditions are buoyant, very, very little vacancy. We're having a very, very active year there. We just recently leased 500,000 s.f. during the quarter to [Super Drug]. We leased another 350,000 s.f. to Tesco at two of our parks in the Midlands. And that brings us to more than 2.5 million s.f. of leasing on newly developed space this year.

In southern Europe we also continue to see steady activity in France and Spain, with frankly slower demand in Italy which we believe reflects the uncertainty related to recent elections. One particular note, however, is that cap rates in France have fallen to the mid 6% level, which represents a compression of about 200 basis points in just the last 18 months in France.

Recently, you might – may have seen that we sold roughly 1.2 million s.f. of older assets out of the ProLogis European property fund for approximately $85 million, thereby taking advantage of the strong institutional demand we see today, while really at the same time upgrading the portfolio and recycling capital within the fund.

In Germany, also a strong market. We're underway with our third facility at the port of Hamburg. And the two most recent buildings in Frankfurt and Berlin that were just completed in the second quarter are already 100% leased.

And Poland remains a hot bed of activity, as well, with leases signed in the second quarter totaling more than 925,000 s.f. which includes the significant pre-leasing that you saw in an announcement that we had earlier in the week.

Now, let me turn to North America. Markets continue to be good and strengthening. Our stabilized lease percentage in North America is about 95% at quarter end, which is about 300 basis points above overall market occupancies of 92% in the total 30 U.S. markets that we track.

Net absorption in those markets increased over 43 million s.f. in the quarter, a level that's very, very consistent with the pace that we saw in 2005. For the first half of '06 for the most part supply and demand have been in equilibrium, demand a little bit in excess of supply.

Rental rates are now rising in many of the U.S. markets, as I mentioned earlier, which supports positive rental growth of about 2.8% for us in North America for the quarter. In fact, we polled our market officers, and they report that YOY market rents, in their view, have increased on average 5 to 15% in most markets, with some markets being higher than 15%.

As we've mentioned on prior calls, we expect to see rising rents as markets tighten and construction costs continue to rise, and both are occurring at this time. We talked about the increased occupancies. New development costs are up on average 10 to 20% above levels just 12 to 18 months ago, and we'd expect to see continued rental growth ahead as a result of those two factors.

Overall, we continue to be encouraged by what we've seen throughout our global markets, but the added power in our operating system is really driving repeat business with our customers that operate globally.

Historically, over 50% of our CDFS leases come from repeat customers. A recent example of this is [Adidas], who after having worked with us on facilities in Cincinnati and Indianapolis, recently signed a 650,000 s.f. build-to-suit with us in China, and just became our first customer in our first building in Seoul, South Korea.

In addition, we just signed 116,000 s.f. lease with Amazon in [Sujo], China to go along with their two facilities with us in the U.S. and one in Europe. Transactions like these demonstrate how powerful customer relationships are in driving global growth.

And, now, I'm going to turn it over to Ted, who will talk a little about investment and disposition highlights. Ted.

Thanks, Walt.

The continued strength in global demand, that Walt described, supported total starts for the first half of more than $1.4 billion. This development activity brings us to a record CDFS pipeline of more than 4.5 billion. On average, those properties are 53% leased, which is up from a pipeline of 4 billion that was 49% leased at the end of the first quarter.

Beginning in North America, we started new developments in Juarez, Dallas, eastern Pennsylvania, Columbus, and Chicago. YTD we have 365 million in starts for North America, and are well on-track to meeting or exceeding our annual goal.

In Europe, YTD starts of 466 million are also in line with our guidance. This amount includes over 1 million s.f. of inventory started during the quarter in Poland, as well as new developments in Hungary, Germany, and the Midlands.

In addition, we started our first project in Bucharest, Romania, and have acquired additional land adjacent to our existing site there. Upon full buildout the largest park of Bucharest will be the largest industrial park in that country.

In Asia, second quarter starts in Shanghai and Tokyo drove us to over $560 million in new development in the first half of the year.

We also made progress in our mixed use and redevelopment projects in the quarter. At the Robert Mueller Municipal Airport in Austin we began 225,000 s.f. of retail development, 54% of which is pre-committed, with a total expected investment of $38 million.

And at LA Air Force Base our joint venture completed the exchange with the Air Force and now owns the residential land which is under contract to a homebuilder. The exchange generated an after-tax gain of roughly $15 million.

And on the redevelopment front we leased more than 270,000 s.f. of ProLogis [Port Ready Business Park]. The project, Jeff mentioned earlier, is a focused 500 customer. Currently, we are doing site work for the second facility at the park, which we expect to complete in the summer of 2007.

In addition, we made further progress on the sale of the Catellus non-core properties. We completed the sale of the Embassy Suites Hotel in San Diego, which generated a $32 million non-FFO gain. Also, we completed the sale of the Circle Point Corporate Center, outside Denver, two office and two retail buildings in Anaheim, and the Corona Office Park in Los Angeles, bringing total proceeds to just over 200 million. We have now completed non-core dispositions of $571 million, which is over 80% of our target, and have the majority of the remainder under contract.

As we've discussed in the past, one of our stated goals has been to significantly expand our operation in Mexico and, in particular, Mexico City. To that end, we acquired more than 3.5 million s.f. of newly developed industrial space in Mexico City and Guadalajara for $238 million. This is the best portfolio we have ever seen in Mexico. It has an average age of four years with over 90% of the square footage in [in fill] locations.

Importantly, more than a quarter of the total space is leased to companies included in our focus 500. Also included in the transaction is 140 acres of land that will support another 2.9 million s.f. of future development. This acquisition increases our platform in Mexico by more than 40% to almost 11.5 million s.f., and makes us the number two provider of light manufacturing and distribution facilities in Mexico.

In summary, our development business is strong, and we are making great progress in redeploying capital from non-core product into expanding our market share throughout the world.

And, now, I'll turn it over to Dessa.

Thanks, Ted.

As noted earlier, YTD results have been very strong, and we are outperforming our initial guidance in several areas. Improvement in operating performance, continued strong CDFS margins, and the realization of profits from strategic initiatives gives us confidence that we will reach the high end of our earlier guidance of $3.15 of FFO per share.

Therefore, we have adjusted our guidance for the full year to between $3.15 and $3.25 in FFO per share, and $2.20 to $2.45 of EPS. EPS could be as much as $0.50 higher due to the recognition of gains on the disposition of non-FFO property that may occur towards the end of the year.

We now believe that first half FFO will be over 55% of full year FFO per share, and the FFO for the remainder of the year will be more heavily weighted toward the third quarter. The increase in our guidance is driven both by strong property operations and increases in our development management fees and income from CDFS JV.

We are raising our guidance on these latter two line items, combined with the long-term note receivables line item, from a range of $55 to $85 million to $90 to $110 million. These represent ventures where we are realizing profits either earlier or in larger amounts than originally anticipated. The increases are indicative of the synergies that we are recognizing from our merger with Catellus last year, as well as the creation of other long-term projects.

We anticipate that our earnings from redevelopment activities will continue to be strong as we grow that business, capitalizing on Catellus' historical ability to build partnerships with government entities, just as ProLogis has done in Europe and Asia in the past.

Given the strength of our same-store operating pool, we are also raising our guidance for the same-store net operating income growth for the year from 2 to 3% versus our earlier guidance of 1 to 2%. These increases will be offset by a 10 to 15% increase in our guidance for full year G&A, primarily due to increases in the costs of our long-term compensation programs, which we believe are necessary to attract and retain talent in the current market environment. In addition, our taxes will increase in relation to increases in the development related income, that I mentioned earlier.

Turning back to second quarter results. All three business segments performed well. Property operations was strong with occupancies remaining at approximately 95.2%.

In our same-store pool we achieved NOI growth of 3.5% over the first half of last year, with occupancy gains of 3.4% and positive rent growth of .2% YTD. We also saw modest rent growth on lease turnovers in the total portfolio of .1% for the quarter for the first time since the third quarter of 2002.

We believe we have completed much of the cycle in which North American leases completed during peak period in 2001 and 2002 are rolling off, and in the vast majority of our U.S. markets current rental rates are greater than in-place rents. But we are beginning to see in North America, our expectations for same-store growth overall are somewhat tempered, as lease rates in Europe are still decreasing with the turnover of longer term leases which is driven by cap rate compression.

Customer retention remained high at 74% for the YTD, above our expectation of 60 to 70% for the full year. Second quarter FFO also included foreign exchange gains of approximately $8.5 million due to the retainment of an inter-company loan, the timing of which was uncertain. We do not expect this line item to be recurring.

Looking at development activity relative to expectations at $1.4 billion for the YTD our run rate for development starts is ahead of full year guidance of $2.2 to $2.4 billion. The breakdown by region is in line when viewed on a YTD basis.

CDFS dispositions of $860 million for the first half are tracking below our expected pace of $2.2 to $2.4 billion for the full year. In addition, the average YTD post-tax, post-deferral CDFS margin of 21% was stronger than expected due to continued cap rate compression in many parts of the globe.

Given the strength of the pipeline we now believe that the proceeds will be between $1.7 and $1.8 billion for the year, and that CDFS profit will be within our previous range.

FFO from other income, which includes development management fees, income from CDFS joint ventures, and long-term notes receivable were 65 million for the YTD, which annualized is ahead of our new annual guidance of 90 to 110 million.

As Ted mentioned, [inaudible] portion of the second quarter income from CDFS JVs came from the LA Air Force Base land exchange. Remember, the revenue in this area will also be lumpy as some of it will be related to fees from infrastructure, development and land fill for which it is difficult to predict timing. We expect, however, that this will be a sustainable business with continuing gains in the years to come.

Lastly, from a balance sheet perspective we successfully amended our global senior credit facility, expanding capacity to $3.4 billion from $2.6 billion when it was first established in October 2005, and giving us the ability to further expand it up to $4 billion.

Thank you. We look forward to providing you with updates on our performance and opportunities in our next call.

Operator, we are ready to take questions.

[OPERATOR INSTRUCTIONS.]

And we will take our first question from Jonathan Litt of Citigroup.

Hi, it's [inaudible], here with Jon. Just on your CDFS guidance for the full year, can you talk about what the margins you're now expecting for this year, given your new guidance range?

Well, we believe they'll continue to be strong, somewhere in the range they are to date.

Is it 21% for the first half?

It's 21% for the first half.

Okay, so you expect you should be able to get that?

Well, I'm not saying – I'm saying that within that range, we expect them to be on the stronger side.

Yes, 18 to 20%.

18 to 20%.

Type range. Long term we still believe it's the 15 to 18% margin business, but this year – it's a combination of a compression in cap rates, but more importantly it's very, very strong execution everywhere. By our team in North America, by our team in Europe, by our teams in Asia, leased up faster than expected, not spending any budget contingencies. It's just real good execution.

We will take our next question from David Fick with Stifel Nicolaus.

Yes, good morning. Can you talk a little bit more about the amount of, the impact in spread compression and the foreign exchange issues that you're dealing with now?

When you say 'spread compression,' can you define – Operator, if you'd let David come back in to define spread compression?

Mr. Fick is in there.

Okay.

Clearly, it's become more difficult to maintain spreads on your leveraged side of your business, in the funds. And I'm just wondering how you're looking at that going forward? And then the second question is just how you're dealing with the current exchange rate movements?

Well, let me answer the spread compression question. Although, you've got to remember we've got a business that's spread around the world. In Japan interest rates have been raised by 25 basis points, now they're at 25 basis points for short-term rates. You've seen relative stability over the last month or so in the 10-year [JGV].

Interest rates have moved up marginally in China. Interest rates are, you know, are on an upward trend, but still significantly lower in Europe than they are in the U.S. And the U.S., you know, we may or may not see continued increases in the short-term rates. We'll see what Bernanke decides to do at the end of this month.

Nonetheless, we've seen continued, you know, if not compression or downward pressure on cap rates, at a minimum stable cap rates throughout the world. And if anything is still trending downward, the cap rates, but let's call them stable.

So we really haven't seen that the spread compression, and people's return expectations are tempered somewhat by the rising interest rate environment, but they're seeing that everywhere. And, quite frankly, within our funds we're seeing, our investors are seeing performance well beyond that of the overall market, so we have very, very happy investors.

I'll let Dessa answer the question on the exchange.

Yes, regarding foreign exchange, we actually are seeing positive benefits from the foreign exchange rate within the devaluation of the U.S. dollar, our business outside the U.S. actually is strong. And we're seeing gains on that business from foreign exchange. We protect ourselves from the down side by buying options, so we're protected on the down side. But from the up side it actually has been a positive.

And I would add one thing, too, David. As Jeff mentioned before that really we expect long-term, more like 15 to 18% margins. And we've been saying that. I think the pipeline right now is big enough at $4.5 billion that we feel very comfortable moving forward, that, you know, that's how we expect to run the business on a long-term basis. Right now, we're a recipient of higher margins, but frankly the way we think about it in terms of growing our earnings every year is still at a 15 to 18% margin business. That's how we look at the business. We've continued to have nice business.

We've been at it a long time, Walt, Ted, and I. And Dessa has been worried about foreign exchange issues for a long time and doing a lot of other things that are very valuable to us, but we look at it as a 15 to 18% business.

We will take our next question from Lou Taylor from Deutsche Bank.

Thanks. Dessa, you touched a little bit on the CDFS income, the joint ventures and other income, and you had mentioned the LA Air Force Base. It sounded like it was around 15 million. What were some of the other larger items in that line item this quarter?

That really was the largest line item in there, the LA Air Force Base. The other line items in there are all relatively small and in the couple million dollar range. You know, things that are, Toronto Parkway, you know, some of the – Hilton in [Torrance], some of those projects that we've spoken about before and really are projects that we picked up with the Catellus merger.

Also, within that – and that's really in the JVs, and then we also have development management income that has, is having a good affect on the increases, and part of that is driven by a European property, [Dartford], where we're seeing good returns this year.

And, Lou, let me just add to what Dessa said on the operating side. We've really been building a business that, you know, you might have remembered three, four, five years ago we had management fee income or development fee income of, you know, $10, $20 million.

Now, with a couple of things – one, we've really expanded that business in Europe and in particularly in the UK. As mentioned, Dessa mentioned, Dartford is a great example of that. Some of the Catellus operations that we brought onboard were great fee income generators, design, build type fees and other type development fees.

And you're going to see more and more of that, but, you know, today here we are five years later, we're probably doing $30 to $40 million a year. So in that kind of business. And I think you're going to continue to see that business grow over time as we grow our operations throughout the world. And so, you know, it's not a onetime thing. It's just you're repetitive on a quarterly basis. It's our business.

To reiterate what Walt said, I think this is a very sustainable business, a business that we're going to focus more and more on in the future. And I could, you know, while at times it'll be lumpy on a quarter to quarter basis, on an annual basis I would fully expect us to continue to see this business area grow over the years to come.

We will take our next question from Chris Haley with Wachovia Securities.

Good morning. Had a question on the G&A items as a portion, probably in reflecting the new guidance, the relative outperformance of the second quarter and the first half versus your earlier guidance, appears to be greater than that which you are raising guidance.

So the items that you mentioned as negatives would be taxes and an increase in G&A, though CDFS will be in line. So I'm just interested in kind of to get your sense of – maybe if, first, if you could go through those items a little bit again? Definitely that would be helpful. And then comment on the G&A, how much of that is onetime versus recurring?

From a G&A perspective, as we said, the growth is primarily, and I'd say, you know, somewhere over 50 to 75% of it is due, around 50% I guess to long-term comp. We will continue to have long-term comp, but that's partially due also to continued good performance of our stock and our other, the way the business is performing.

We believe that it is in line with the growth of our FFO. We believe it's in line with the growth of our assets. So we're not concerned about the increases in G&A, but that's one piece of it.

The other is where I noted that taxes will increase, and that really is a direct offset to some of the development management income. Some of that is TRS activity, where we will see increases in taxes at the same, at the rate that, at kind of the percentage rate. And just to give you an idea on LA Air Force Base, you're seeing probably a 40% tax rate that we're showing in our net $15 million gain.

Bottom line, Chris, is our taxes will continue to grow as we become more profitable in areas that are taxable, but that's not a bad thing. That's a really good thing.

And, also, G&A, the stock performance has driven the majority of the G&A increase, although some of it, quite frankly, is due to our global expansion, growing our business in China, and we continue to grow business in Japan, growing our business in Europe, and growing our business far beyond what it was a few years ago in North America.

And these are good things and things that will create long-term shareholder value and the results are being seen this year and will continue to be seen in the years to come.

We will take our next question from Jay Habermann with Goldman Sachs.

Good morning. A question for Walt or Jeff. Looking at – in your comments on new supply, and you mentioned it remains constrained. But given the rent growth, occupancy increases, and compression in cap rates, and solid margins, how long should we expect supply to remain constrained? And what's your near-term outlook?

Jay, this is Jeff. I'll let Walt and Ted, who are – I think you're – it sounds like your question is particularly focused on the North American market, where there is sufficient land. And at times in the past people have overbuilt the market, although we're not seeing it this time, as opposed to some of our international markets which are extremely land constrained and we don't expect, even, you know, in the history of us following this market we've never seen an overbuilt market.

Jay, let me, I'll try to put some numbers in the U.S. in perspective for you. And I'll only go back a couple of years, because otherwise you'd be taking down a lot of numbers.

But really in '04 we saw net absorption in our top 30 markets of about 110 million s.f., and we saw new deliveries that year of about 86 million s.f. And if you go back to '05, last year, there was net absorption of about 160 million s.f., and new supply of about 100 million s.f.

We made the comment, I believe it was on the first quarter call, that we thought that you're going to see demand tailing off a little bit this year. We thought it'd be 130 to 150. And we also thought supply would rise to about 120ish type million s.f. And, interestingly enough, that's exactly where we are.

The first quarter absorption in the top 30 markets was about 68 million s.f. And if you take that times two you're really between 130 to 150, i.e., the demand is slightly less than last year but not significantly less, but just the way we thought.

And, also, the supply is looking like it's going to come in at roughly that 120 million s.f. number, i.e., we're still in positive net absorption territory, albeit it not at the same pace as last year, as you would expect in a market that is more mature than it was last year.

So, you know, definitely still the market is still absolutely in equilibrium. Overall, the vacancy is still going down. Interestingly enough, in the U.S. it's 92% leased in the top 30 markets. And the highest its ever been is roughly 92.8, I believe. So, you know, we're almost at a point where we're at call it frictional vacancy or certainly historically, and that's why you're beginning to see rental rates rise.

So, let me turn it over to Ted, and he can talk more about it, as well, and kind of give you the dynamics in the markets.

Well, Walt touched on just about, you know, really all the things that are going on in the market, but I think the key that we're focused on right now is just the overall vacancy rates. And if you look at a trend line in all of the 30, just about all of the 30 markets, occupancies are increasing. And right now the supply and demand is in check, and we're encouraged with how the last 18 months has gone. And I think our current projections for a minimum at the end of this year and the early part of next year look pretty solid.

The one thing I'd also say, Jay, that we kind of see a little bit, interestingly enough, in the second quarter the overall supply actually went down. We think that some of that has to do with the fact that construction costs are up pretty significantly.

And, you know, so developers are kind of looking at it and saying, 'well, jeez, construction costs are up 20%, can I really build into this market today without seeing some rental rate increases.' And we think it's put some people on the sidelines, which is a good thing, net net. We also think it's great for our $10 billion portfolio that's sitting out there that we think has pretty good rental growth prospects.

And we'll take our next question from [Matt Ausbauer] from Morgan Stanley.

Good morning. Could you guys just refresh me on what is exactly in the 90 to 110 million? Specifically, is it all the FFO from the JVs? You talked about the Air Force Base, I think that's in there, and part of that same line item. Is that all, is that whole line item in there? And can you articulate that being sort of the management fees and what else comprises that number?

Yes, there are really three line items that we combined together to get that number. The first is the development management fees and other income, which is one line item on the income statement. In the other income line item there's investment from unconsolidated, I mean consolidated CDFS joint ventures. And then there's also the notes receivable balance, and interest and income from other notes, from notes receivable. So it's those three line items that are combined together.

I think to understand what they are, the notes receivable balance really are notes receivable on development and joint ventures. Different sales, different development opportunities that we've had and we're continuing to receive interest on those notes. And we have about 175 million of notes that we're receiving interest on, and that becomes a fairly steady number.

Within the development management we have the [FOSO] note, we have all of our design build in North America and in Europe and Japan, and then things like the Austin Air Force Base redevelopment, any redevelopments will, for development management fees will go in there.

And then, finally, in the JVs it's all JVs that we have, things like [Chirano Parkway], LA Air Force Base, [vehicle house], the Hilton in Torrance, and some of our Chinese JVs. So it's a variety of JVs that are combined into that. And then in that area we have capital invested but the returns are often skewed towards incentive returns at the end of the day that make up a good amount of the gains there.

For example, our China JVs are within that line item, and that's an area obviously we will expect to grow in the future given our presence in Sujo, our presence in port in Shanghai. It's a high growth area, good returns, and it's an area that we will continue to grow the business as well as our development management business, our development business in North America, Europe, and Asia.

We go next to Ross Nussbaum with Banc of America Securities.

Hi, good morning. Dessa, I think you had alluded to the fact that the contributions to CDFS pipeline had been running below the prior base of 2.2 to 2.4 billion. I think you lowered that to 1.7 to 1.8 billion?

And I guess, I'm sort of confused by that because the development starts are running ahead, the leasing seems like it's running ahead, is it just that you sort of made the numbers this year and don't necessarily need to contribute as much? Because I guess I – where I'm going is you've got a 4.5 billion pipeline now, is this sort of setting the stage for the contributions to be even higher next year?

Ross, I'll start it out, and turn it over to Dessa, if that's okay with you. We raised guidance three times this year. We are continuing to build a very healthy pipeline. There are ways, you know, by holding properties a little bit longer, if we can contribute a property when it's 92% leased or 93% leased to a fund, it will value differently than if we contribute it when it's 100% leased. The appraiser treats it differently, doesn't put a risk, any risk profile on that vacant space, the 7% or 8% vacancy. So we create more value by having it at 100% leased.

So we are very much focused on creating maximum shareholder value and excellent value for investors in our fund and building a very healthy pipeline to accomplish that, while meeting or exceeding our numbers that we gave. Obviously, far exceeding the numbers we gave at the beginning of the year.

I think that answers it. And we also are committed to our partners, and there is a time limit in which we have to contribute property. So we work within that realm.

Right, while maximizing value.

Right.

Our next question will come from David Harris with Lehman Brothers.

Yes, good morning. Have you considered the margins on your Japanese business more or less vulnerable to shrinkage than the margins on your business elsewhere?

That's an interesting question, and it's a good one, David. I was prepared for a lot of political questions you'd ask, that's one that I'm, obviously, well prepared to talk about, you know, given our activity there and the amount of time I spend there, and the amount of time we spend with our people there.

It's interesting, and it's – what's happening is what I think you and I talked about several years ago. We had, there was a point in time where a 10-year JBV was 40 [BPS], you could borrow 70 [year BPS] even with spreads then that were very large, i.e., 60, 70 basis point spreads, which we thought were outrageously large given our credit. We were still borrowing fixed 7-year money at 90 BPS. And cap rates were below 6% which made no sense at all.

And it was because there was an expectation in the economy and in the investor sentiment that there'd be continued deflation. And, in fact, the appraisers were modeling in rental rate decreases over time, which is what drove you to 6% cap rates in a very low interest rate environment.

What's happened now, while interest rates have gone up a little bit, you know, now that the short-term rate is 25 BPS and 10-year JBV hovers between 1.7 and 2%, people now have an expectation of growth in Japan, have the expectation of rising prices.

And there was an interesting article, I don't know if you caught in in the Wall Street Journal, last week or earlier in the week, I think it was on Monday, about the potential for inflation in Japan, given the shortage of labor and the very, very low unemployment rate, i.e., less than 4% today. Their historical low unemployment rates, you don't have great population growth so there's people that are worried that Japan may be entering into an inflationary cycle.

All of this has contributed to cap rates coming down, and we're seeing the lowest cap rates that we've ever seen in Japan. Great assets are now trading in the 4% range. AIG bought some office buildings near Tokyo Station for cap rates that were, a cap rate that we believe to be sub 3%. Now, these are prime office buildings, and we don't expect in the Japan market, at least, our industrial buildings to receive the same cap rate, but we do, we are seeing the mid 4s, the high 4s for assets depending on the quality and the location.

So we've seen cap rate compression while interest rates are going up, which I think is a sign of a healthier Japan economy and good news for our business overall. We're 100% leased in the country.

David, Ted. The other thing about Japan is the entitlement issues, it's the land constraint nature of the area, the buildings are much more complicated than the buildings we're building in other parts of the world. And I think they'll contribute to ongoing higher margins than you would see in the U.S.

And we've got a phenomenal team out there, for which we've got a lot of embedded value, because their skill set and their ability to perform with those type of constraints and complications is something that we think we're going to be able to capitalize on in the future.

And our next question will come from [Cedrick LaChance] with Green Street Advisors.

All right. Thank you. My question is for Walt. Walt, when I'm looking at funds 6 to 10, the funds, the assets that were acquired from Keystone in '04, I know that the occupancy being about 86% right now. I think these assets were acquired at about mid 80s occupancy.

How do I reconcile that with all the positive comments you've been making about the North American markets, the 92% occupancy levels? And all that's been happening for the past three years? Is it a question of market mix? Is there something in regards to these funds that explain the lower occupancy?

Yes, there is. Great question, Cedrick. And if you look back, I think it was the last supplemental, actually we were over 90%, we've fallen back down to 86%.

And I would tell you that one of the markets that is the one that's underperforming is Greenville, SC. And to be honest with you there are a lot of very short-term transactions that are in that city. I mean they tend to have an average lease life of two years, two to three years. And so from a quarter to quarter basis, you know, if we have a big turnover or a big vacancy there it has a big impact in that overall lease percentage. It is completely driven by that.

The market in New Jersey, which is where the preponderance of the properties are, of course, is, has also been slightly softer than the other major markets but not bad. I mean just, you know, and so overall the new Jersey properties and the Eastern Pennsylvania properties I think are performing reasonably well. It's Greenville that has dragged that down. And you might see next quarter it pops up over 90% again if we knock down a big lease in Greenville, and it just sort of goes up and down based on Greenville, SC.

You may remember that when BMW first put their manufacturing plant, where they build the Z4s and the X5s in South Carolina, a lot of developers migrated to Greenville believing that it was going to become a distribution hub driven by BMW. We never participated in the development, we've never built a building in Greenville.

Keystone was one of those that followed that trend into Greenville. It's never panned out to be the kind of distribution market that people hoped or believed it would be with BMWs entry there. But we'll continue to lease up the buildings there, and that's a slight drag on that portfolio. But, overall, as we talked about, our business throughout North America is very strong.

And our next question comes from [Chris Pike] with Merrill Lynch.

Good morning. Perhaps for Ted or Walt. With respect to the Mexican acquisition can you perhaps add a little color on the strategy there? I think despite, I think you guys said you had about 25% of the assets, a solid tenancy. Are you facing any lease-up challenges? And then with respect to the land, you know, what kind of entitlement considerations are there, if any at all?

Okay. Let me start, and then Ted can kind of chime-in. The, first of all, dating back to the analysts meeting we had, Chris, about a year-and-a-half ago, where we said that, 'look, we have a strategy where we're along the border, we absolutely believe in the growth in Mexico, not just the manufacturing growth but, frankly, the growth in GDP per capita which has been startling.' We like where the distribution market is heading. We need to probably move south and penetrate the largest market, Mexico City, Guadalajara. I think we talked about [San Luise, Potece], as well, and a few other markets that we wanted to penetrate. That was a year-and-a-half ago.

We had our eyes set on some things. We were very, very fortunate to buy this portfolio which has an average age, as Ted mentioned, of four years, i.e., these are all new buildings. And for strategic reasons we've been talking to this seller for a long time. Fortunately, this came to fruition.

And if you break-out the overall $238 million purchase price you'll find that we bought the buildings for about $190 million which is about $54 a s.f. We think that's a very reasonable price, and, frankly, pretty close to where we can replace those assets today as a developer and below where we can, if you will, sell or contribute those assets in the future. So we think we're into it at a great price.

In addition to that, the rest of it is land. And to your point, it is all land that is entitled and ready to go. And so you're going to see our development program in Mexico taken to the next level as a result of this transaction.

Yes, one of the other things I would add to that is that the majority of these buildings are in business parks which are secured areas, and really make them somewhat unique to what you could just go out and build in Mexico City right now. There's a lot of value in having several buildings within a project that's all secured.

In addition, and I'm scrambling here looking to confirm this, but if I remember correctly 3.1 million s.f. of the space is in Mexico City, which I did not mention in my comments, but that's significant to us.

I mean, you know, we were really excited about the opportunity to get this type of portfolio, this size of a portfolio in Mexico City which is, well, we were down there not too long ago, an incredibly land constrained area. I mean it's, you know, you don't really think of it that way, but when you go down there and you start looking for sites it's a tough place to get product, especially this type of product.

Operator, we'll take two more questions, and then we're running short on time. There are a lot of calls, a lot of people releasing earnings today.

Sure, no problem, sir. And we will take our next follow-up question from Jonathan Litt with Citigroup.

I wanted to follow-up on the LA Air Force Base. Can you tell me how much income you have? And is that also the reason for the current income tax expense on your income tax line item, and how much is in there [for that], both of those line items are quite a bit off from your usual run rate?

And, also, just to follow-up on Ross' question, is it that the assets that are being sold into CDFS are going to be lower because the assets [are yet to] be contributed?

Well, first of all, LA Air Force Base, as far as Ted noted, it's about $15 million after-tax income. And that means that there's about 27 million in our JV and about 11 to 12 million of tax. So that does affect the current tax number, and that is a big portion of it. The other portion of the current tax number is the normal sales from some of our UK properties. And then other, a few other items.

As far as CDFS goes, as Jeff said, we plan always for the 15 to 18% margin. What we are looking at right now is margins are strong YTD, and we believe there's a possibility we could be on the high side of our expectations for margins going into the rest of the year. But we continue to build and plan for the 15 to 18% margin.

And, John, as Jeff has mentioned, and I know I've mentioned in the past, in many of our funds we have flexibility as to when we can contribute assets. Dessa mentioned that we're in accordance with that in all the funds, but we've got flexibility up to, in many cases six to nine months after buildings are stabilized to make contributions.

So buildings, I think, overall are extremely well leased as you I'm sure have noticed on page 18, our development section. You know, we couldn't be more happy with the progress in leasing really throughout the world.

We're building a [inaudible] pipeline and maximizing the value that we do get when we contribute them, and part of the reason for the increased margins is the building up of these buildings up to 100% before contributing.

And we will take our final question from Michael Mueller with JP Morgan.

Yes, hi. Looking at the other revenues, again, is there anything significant that you see that could skew either Q3 or Q4?

And, also, Jeff, based on your comments, you were talking about this business earlier, should we assume that the '06 increase here is not an anomaly? We should think of that as onetime? And it's more of an expectation for going forward?

Yes, and I think I went through the line items that we felt were the bigger ones for the other income which included a lot of the development management fees. I'd say the one item that probably stands out, other than LA Air Force Base, is the Dartford Project, and in Europe we're seeing design builds strong.

But, as Jeff had mentioned before, this is something that we expect to see on an ongoing basis. We have a number of projects we're working on, and a number which we expect to come to fruition in '07, '08 and for the years to come.

And, Michael, this is something that we continue to focus on. And while we never give any guidance on '07, this early in the year, we expect to continue to grow this business and continue to be a source of revenue, in '07, '08, '09 and forward from there. And it's something that we're, you know, Ted is focused on, our people in Europe are focused on, our people in Asia are focused on, and something that we continue to grow because it's a high return on equity business.

Operator, thank you. And thank you to everyone on the call.

And I'd like to take one moment and thank all of our ProLogis people around the world for a great quarter and for what's shaping up to be a great year. We're very, very pleased to [with the range of] guidance for the year.

And we hope that everyone on this call has a great summer. We look forward to seeing you in the near future, and if not before that, be talking to you in October. And, again, have a great summer. Thank you.

Ladies and gentlemen, a replay of this financial results call will be available today at 12:00 p.m. Central, 1:00 p.m. Eastern Time. If you wish to hear this replay dial 888-203-1112. Again, that is 888-203-1112 in the Continental United States. Or 719-457-0820 for all international callers. Then enter the replay pass code, 4448890. Again, that is 4448890 to listen to the replay.

This does conclude today's conference call. Thank you for your participation. You may disconnect at this time. Have a good day.