Prologis Inc (PLD) 2018 Q1 法說會逐字稿

Welcome to the Prologis Q1 earnings conference call.

My name is Kim, and I will be your operator for today's call.

(Operator Instructions) Also note, this conference is being recorded.

I'd now like to turn the call over to Tracy Ward.

Tracy, you may begin.

Thanks, Kim, and good morning, everyone.

Welcome to our first quarter 2018 conference call.

The supplemental document is available on our website at prologis.com under Investor Relations.

This morning, we'll hear from Tom Olinger, our CFO, who will cover results and guidance; and then Hamid Moghadam, our Chairman and CEO, who will comment on the company strategy and outlook.

Also joining us for today's call are Gary Anderson, Mike Curless, Ed Nekritz, Gene Reilly, Diana Scott and Chris Caton.

Before we begin our prepared remarks, 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 assumptions and beliefs.

Forward-looking statements are not guarantees of performance, and actual operating results may be affected by a variety of factors.

For a list of those factors, please refer to the forward-looking statement notice in our 10-K or SEC filings.

Additionally, our first 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 to those measures.

With that, I'll turn the call over to Tom and we'll get started.

Thanks, Tracy.

Good morning, and thank you for joining our call.

I'll cover the highlights for the quarter, provide updated 2018 guidance and then turn the call over to Hamid.

By now, you've seen our supplemental reporting package, which reflects the harmonization of our operating metrics for the logistics sector we announced last quarter.

As we've previously mentioned, the new definition had an immaterial impact on our operating metrics.

Starting this quarter, we've also taken the opportunity to report our leasing data based on commencement date versus signed date.

This change better aligns our NOI metrics and is consistent with how we manage our real estate internally.

Now let's turn to our results.

We had a strong first quarter and are well-positioned to deliver another year of sector leading earnings growth in 2018.

Core FFO in the quarter was $0.80 per share, which included $0.09 of net promotes.

The net promote we earned was from our China venture and came in higher than forecasted due to increased property values as well as favorable foreign currency.

Core operations also came in better than expected, driven primarily by same-store NOI and lower interest expense.

Our share of net effective rent change on roll was approximately 22%, led by the U.S. at more than 32%.

This marks the fourth consecutive quarter of global rent change above 20%.

Occupancy ticked down sequentially to 96.8%, in line with normal seasonality.

Our share of cash same-store NOI growth in the quarter was 7.9%, led by the U.S. at more than 9%.

While these results reflect the excellent market conditions around the globe, they were favorably impacted by 2 factors: first, we had approximately 150 basis points of free rent burn off in the quarter, which was primarily driven by higher lease commitments in the first quarter of 2017; second, we had approximately 50 basis points of nonrecurring adjustments that also benefited same-store.

For the full year, we expect cash same-store NOI growth to be higher than our initial forecast, and I'll cover this in more detail when I give guidance.

Moving to capital deployment for the quarter.

I'd like to highlight development stabilization, which had an estimated margin of almost 30%.

Margins on starts remain very healthy as well.

This is notable, given that build-to-suits accounted for nearly 2/3 of our start volume in the quarter.

We completed more than $600 million of contributions and dispositions at a weighted average stabilized cap rate of 5.2%.

Buyer interest for our assets remain strong and market cap rates continue to impress, particularly in Europe.

Turning to capital markets.

We continue to have significant liquidity and the internal capacity to self-fund our growth for the foreseeable future.

I'd like to spend a minute on 2 financing transactions we completed in the quarter.

In January, we issued a 2-year EUR 400 million note with an all-in effective interest rate of negative 10 basis points.

This transaction underscores our ability to access capital globally at very attractive rates.

We also realized a gain from the settlement of a swap that reduced interest expense in the quarter.

Looking forward, we expect the quarterly interest expense run rate for the remainder of the year to be approximately $5 million higher.

Now moving to guidance for the year.

I'll cover the significant updates on an our share basis.

So for a complete detail, refer to Page 5 of our supplemental.

Based on the strength of our first quarter results, we're increasing the range of our cash same-store NOI by 50 basis points to between 5.5% and 6.5%.

Given the market rent growth in the first quarter, our in-place rents continue to be below market by more than 14% globally and 18% in the U.S. This continue to position us for strong operating performance for the next several years.

For strategic capital, we now expect net promote income for 2018 to range between $0.11 and $0.13 per share, which is up $0.06 from our previous guidance.

We expect to recognize the remainder of the promote revenue in the fourth quarter.

Given our strong leasing pipeline, we're increasing our development starts guidance by $200 million to range between $2.2 billion and $2.5 billion.

Build-to-suits will comprise about 50% of this volume.

We're also increasing our disposition guidance by $475 million to a range between $1.4 billion and $1.7 billion.

With this volume, we will effectively close out our nonstrategic asset sales.

This initiative began in 2011, and upon completion, will total $14 billion on an owned and managed basis.

As result of our deployment guidance changes, we now expect to generate an additional $300 million of net sources for the full year.

Putting this all together, we're increasing our 2018 core FFO hit plan by $0.08 per share and earning the range to between $2.95 and $3.01 per share.

Our revised guidance represents a year-over-year increase of 6% at the midpoint or 8%, excluding promotes.

This increase is particularly strong as we expect average leverage in 2018 to be approximately 250 basis points lower than 2017.

The capacity we have to normalize leverage will be a catalyst for future earnings growth, as every 100 basis points in additional leverage translates to about 1% core FFO growth.

To sum up, we had a great quarter and are excited about our prospects for the remainder of the year and beyond.

And with that, I'll turn it over to Hamid.

Thanks, Tom, and good morning, everyone.

I don't have a whole lot to add to what Tom talked about because our results speak for themselves.

While we remain vigilant and on the lookout for any signs of market weakness, we feel great about our business and are optimistic about our company's future prospects.

Let me now turn it over to Kim for your questions.

(Operator Instructions) Your first question comes from Manny Korchman from Citi.

Tom, if we think about your increase in starts guidance, how much did the percentage of build-to-suits in that starts guidance change?

And is that what gives you confidence that the supply picture remains healthy as you and others think about starting new projects?

This is Mike, I'll take that one.

As Tom mentioned, our build-to-suit had a great first quarter at almost 2/3.

That should normalize around 45%, 50% over the year, which is a very solid number.

And so that's driven a lot of our confidence in raising our development guidance.

90% of our activities identified, and I should point out the spec that we're doing in our parks in cities that are 97% leased.

So those 2 combined give us a lot of confidence to raise the guidance in the manner that we did.

Your next question comes from John Guinee from Stifel.

Great news on all the build-to-suits.

Somebody told me the other day that Amazon has a new prototype out there, 30 or 40 they're considering throughout the country where it's a multilevel but not multi truck court level elevate or oriented, 6- or 7-story, 100,000 to 200,000 square foot, footprint times 6 or 7 story prototype that they're thinking about, and I'm sure you're in those discussions with them.

Can you elaborate at all?

John, it's Mike again.

We don't get a lot of details about any particular customer's plan but safe to say, we certainly have our hat in the ring on a few of these opportunities and that's very early days on that right now.

More to come on that in the future.

Right, John.

Let me give you also a background without getting specific on Amazon.

Generally, if you want to get closer in, you got to shrink your footprint and go vertical.

So anybody who's trying to get close in to where the population is has to be thinking of that.

And the idea of a multilevel warehouse for Amazon specifically is not a new one.

The number of stories may be at some point but certainly, you've seen 2 mezzanine levels in our building that we've toured with investors.

So shrinking of a footprint and going more vertical would be a logical extension of that without getting to the specifics.

Your next question comes from Tom Catherwood from BTIG.

Hamid, kind of sticking on that point that you mentioned, tenants trying to get closer and closer to population centers.

30% of your portfolio is buildings under 100,000 square feet.

I assume this includes a number of legacy assets in more densely populated areas.

Given the challenge of acquiring land today, how much of an opportunity is available to redevelop some of these older well-located buildings?

Actually, quite a bit, and we're adding to it all the time.

I mean, if you look at what we've done in San Francisco, we bought a lot of parking areas, a lot of older, obsolete buildings.

Interestingly, you don't need to clear heights for rapid in and out distribution.

So some of those buildings work really well and you need to assemble a fairly good sized site before you can put a multistory building on it.

So there are lots of ways you can increase the value of those older assets by just basically cleaning them up and using them for more rapid infill delivery and also eventually, for the larger parcels, knocking them down and building something multistory.

I just want to remind you that the old -- this is not a new strategy deal.

AMB's strategy was very much infill in the larger market.

So -- and that's probably, I don't know, 1/3, maybe 40% of our portfolio.

So people -- you've got to offer product along the entire size of the supply chain.

You have to have 500-mile product, you have to have 50-mile product and you have to have last 5-mile product.

So we're active in all those different segments.

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

It's Jordan Sadler here with Craig.

Regarding same-store, cash same-store was a big driver of the growth the last couple of quarters.

Unconsolidated, in particular, has been a bigger driver, particularly on the revenue side.

Can you talk about the driver of the unconsolidated same-store growth versus the more flattish looking revenue growth you're seeing in the consolidated same-store portfolio?

And then just maybe as a follow-up.

There's a big spread between cash, same-store and, net effective this quarter, almost 260 basis points and I'm wondering if there was anything in particular going on there.

Let me take the latter and you can answer the former.

I think on the issue of cash versus GAAP, I think we have unsuccessfully described our preference for GAAP for several years but everybody asks us about cash.

So we basically said, "Okay, starting 2018, we're just going to report cash because that seems to be what everybody is asking us all the time." We do have the GAAP number in the supplemental, so it's not like we're not providing that but it gets really confusing if you start talking about owned and managed, our share, cash, GAAP and all that.

So we're really going to our share and cash as the relevant number that you guys need to look at or seem to want to look at.

So that was a decision that I made.

Now Tom, do you want to...

Yes.

So Jordan, on your first question, I think -- I'm not sure if you're looking at owned and managed but clearly, when you look at, geographically, the U.S. versus outside, the bulk, obviously, of our share is going to be driven roughly 75% by the U.S. And I don't see anything in performance, difference between on an our-share basis by geographies that are very consistent.

Yes.

It's just mix.

It's just that our fund business is a heavier percentage overseas than it is in the U.S. We own more of our U.S. portfolio but within the U.S. portfolio, consolidated, unconsolidated, we don't even manage our business that way.

We don't even look at the statistics that way.

Your next question comes from Jeremy Metz from BMO.

In terms of -- your cap rate compression has really held back any pickup in rent growth.

At the start of the year, Hamid, you talked about possibly nearing an inflection point on this dynamic.

So I'm wondering if you can just give us an update on what you're seeing on the ground over there in terms of rent growth.

Which markets, perhaps, are seeing rent growth really materialize ahead of expectation, and has your outlook changed at all over there from a few months ago?

I think every -- with every passing quarter, we get more optimistic about rental growth in Europe.

I think I talked about the crossover point being later in 2019 and 2020, back in the 2019 and then 2020.

So we're some distance away from that but Europe continues to accelerate in terms of rental growth.

The best markets?

I would say the highest absolute rental growth in the past has been the U.K., followed by Germany and Northern Europe, and probably the laggard has been Poland and maybe France if you want to put it in that bucket.

So -- but even those markets are picking up in terms of activity and vacancies decreasing.

So I think we're going to get more pricing power in those markets.

And I think rental growth in Europe will be a couple of points this year and will be more than that next year.

Your next question comes from Jamie Feldman from Bank of America.

I'd like to get your team's big picture thoughts on trade war risk, how people should be thinking about what it could mean longer term for the warehouse business.

And then maybe just as you talk to your clients or maybe your clients haven't really talked about it, but what's the sentiment among tenants about what they're seeing in the press and the tweets, and what this all might mean?

Okay.

Let me give you the bad news first and I'll tell you the good news next.

I think the bad news is that any kind of a trade war or -- which we -- I don't think we're quite there yet but any kind of trade war is bad for economic growth generally, and that will affect everything, including our business.

So if the economy grows at 30, 40 basis points slower than it would have otherwise, which is what I see most people talking about, that's not good for anybody's business, including ours.

Now on the mitigating side of this, first of all, it's really early in those discussions.

Those tariffs haven't even kicked in.

And who knows, with the latest pronouncement on TPP, I mean, I don't know what to read into any of that stuff.

So -- and I would say, most of our customers -- all of our customers that I'm aware of have basically had their head down doing their business and not paying too much attention to what comes out in the tweets in the morning until there's something specific they can react to.

The other thing that I would point out to you is that most of the tariffs, at least to date, have been on intermediate material or raw material that goes into production.

And as you know, we're not that active on the production and to the supply chain anyway.

We're at the consumption end of the supply chain.

So it has less of an effect on us than on places that are focused more on production.

So -- and by the way, a lot of these goods don't even go through our warehouse.

Steel doesn't go through warehouses.

Aluminum doesn't go through warehouses.

So I guess, the simplest way of thinking about it is that we're concerned by the talk.

We're not yet concerned by the action, and we'll just see what the action is going to be.

Your next question comes from Blaine Heck from Wells Fargo.

Hamid, can you talk a little bit about what you're seeing with respect to supply in general, and more specifically, on construction financing.

We've heard that the banks and other lenders have recently become a little bit more willing to lend for industrial construction, in particular.

Is that consistent with what you're seeing, and does that give you any concern as you look out into 2018 and 2019?

Yes.

I don't think the banks were hesitant to lend on industrial construction.

They just wanted to lend an equity on the deal which made it more difficult for developers to finance projects, so -- you can get bank financing.

You just have to have 40% equity in the deal, which means that you usually have to bring in a partner and that complicates deals.

And the partner has to get their returns, and the developer has to get its returns.

So it just gets to be a tighter calculus.

Having said that, I think actually, the bigger constraint on industrial development is really land availability and entitlement.

So I mean, these buildings are getting bigger.

The need for a flat ground is getting, in large parcels, is getting to be more intense and the supply constraints are more severe than ever.

So that's what's really constraining the supply, particularly in the markets where a lot of demand is.

So Gene, do you have anything to add to that?

Yes.

I mean, I think our concerns about supply have revolved around the same markets for probably the last 2 years, and that's basically South Dallas, south of Atlanta and Central Pennsylvania.

And what we've seen is these markets will bounce from a temporary oversupply to being imbalanced to oversupply.

Currently, all those 3 are in an oversupply situation but otherwise, supply is pretty well-contained in the U.S.

Your next question comes from Vikram Malhotra from Morgan Stanley.

Just in the last few quarters, you sort of outlined a strategy of willing to sort of push rent at the expense of occupancy to some extent.

Maybe just big picture, if we look out over the next few years, you needed a lot of room in terms of mark-to-market.

So how much would you have to see occupancy adjust to sort of step back and say, maybe we need to tweak it a little bit?

So Vikram, this is Gene, and I'm probably a little unsure of exactly what the question is but we don't really think of it as intentionally dropping the occupancy to achieve a certain result on the rent change side.

We think more so of focusing more on what rent we really ought to be achieving in each case.

And when you're in a dynamic market environment, there is a bias, typically, in the field to manage for occupancy.

If you manage to a budget every year, you're naturally going to do that, and we're trying hard to get away from that.

It's a basic way of doing business.

So we're really looking to push rents and we, frankly, have been pretty successful in doing so but it isn't based on some sort of calculation of dropping occupancy.

As a natural result, you will leak a little bit.

But at these levels of occupancy, we can certainly afford to do that.

Let me make that a little more specific for you.

If you are the person leasing space in X market and you have a vacancy, you have a tenant lease coming over for renewal in the middle of the year, if you don't make that deal, it's likely that, that space will remain vacant for the balance of the year and you'll miss your budget because particularly, you don't have the benefit of diversification of a really large portfolio like we do sort of at the company level.

For that person, that's a big, big miss on the budget.

If you're not careful, the sum of all those individual decisions will bias you towards more conservatism so that you want to increase the probability of renewing that lease to a virtual certainty.

And that makes you leave a lot of money on the table.

So we got to derisk that behavior for the field so that, that individual doesn't have the incentives to just keep renewing at whatever algorithm they can get.

So there are some behavioral stuff that we're working on over here that maximizes the bottom line for the company while individual locations and individual people may underperform and some of their other colleagues will overperform.

So what maximizes the benefit for an individual or performance for an individual is not necessarily the same thing that maximizes the performance for the company.

That's what we're trying to do.

Your next question comes from Vincent Chao from Deutsche Bank.

Just want to go back to the discussion of land, and maybe on the covered land side, if you could provide some additional details around what the size of that portfolio looks like, maybe on a square footage basis or NOI begin rate today.

And how long it might take you to realize that covered land bank?

Vincent, this is Tom.

I just want to put our land in 3 buckets.

You've got land we owned, we've got land under option and then we have covered land plays.

I think the covered plays probably from a total buildout and this could be over the next 5-plus years but that number is probably north of $2 billion of incremental development.

And as Hamid said that we work really hard at continuing to increase that pool but that's the magnitude.

And there's probably more upside over the long term with that number.

Yes, and remember, there is no -- in the short term, it shows up as operating real estate because, by and large, you're getting a yield very close to what you would have gotten had it had a building on it.

So that's why it's called covered.

So in the short term, it's an operating asset.

And in the long term, it's positioned for redevelopment to the tune of the $2 billion that Tom has talked about.

Your next question comes from Dick Schiller from Baird.

Quick question on the loan package you guys took out, $400 million, at a negative interest rate.

Does that give you guys comfort to be more aggressive on the acquisition front?

Or looking at development starts, should we be putting more money capital to use into a development pipeline?

How are construction costs balancing your IRR and your expected return from that development pipeline?

Look, we look at our overall cost of capital -- weighted average cost of capital and that varies by geography.

And just because on a given maturity, in a given day, in a given currency, we can borrow money on a very attractive basis.

We don't run around trying to match that with uneconomic deals.

So our thresholds for what makes sense for us to deploy capital and -- remains pretty much unchanged, other than big changes in cost of capital in different locales.

So no change in that.

And generally, I would say, in terms of the incremental yield that we're looking at for development, it's usually in the order of 100 to 150 basis points of yield above the exit cap rate.

And if you want to translate that to margin, it's about, on the low side, 10% for a really safe and secure build-to-suit, and at market land values, about 15% on spec but we keep exceeding that because of excess rental growth and excess cap rate compression.

So the margins that you've seen have been a lot higher than that.

And some of our land has an older basis so that further boost the margins.

But at market, like I've always said, spec development should be about 15 and build-to-suit should be 10 to 12.

And we're getting better than that now.

Your next question comes from Rob Simone from Evercore.

On the free rent impact on same-store, I guess, with the 150 basis point impact, does that kind of imply that, that impact should -- or that benefit should trail off as the year progresses, just given that you guys have been saying the difference between GAAP and cash will be about 100 basis points plus or minus?

And then I have a really quick follow-up after that, if possible.

Sure, Rob.

This is Tom.

So you're right, the free rent impact, as I mentioned, was about 150 basis points in the quarter and it was driven by the high amount of the above average amount of lease commencements we had in Q1 of '17.

If you look at the rest of 2017 by quarter, the commencements are much more in line with what we did in Q1.

And if you want to just think big picture, cash same-store looking forward, and I do think it's going to moderate the spread between cash and GAAP to about 100 basis points.

And if you think about the components of the cash same-store NOI, you're going to have rent change, we're going roll about 20% of the portfolio of cash.

Rent change is going to be 10%, so call that 200 basis points.

You're going to have bumps on the 80% that's not rolling.

That's about 250 basis points same-store occupancy.

We talked about a year-over-year occupancy impact of about 50 basis points last quarter.

And then you have free rent and indexation, which is another 50 basis points.

So that's a nice high-level way to think about cash same-store going forward.

Great.

That's really helpful.

And just really quickly, on the promote.

So the balance of the revenue is going to be recognized in Q4 but well, you guys, like in past years, also had some amortization in Q2 and Q3 that could drag on those quarters slightly?

That's correct.

About $0.01 of strategic capital expense related to promote just because of the timing difference, revenues all up front and the promote expense comes in over time.

Your next question comes from Eric Frankel from Green Street Advisors.

Can you just identify the markets at which you plan to sell assets this year?

What is the source of the increased disposition guidance?

And then second, I think there are a couple of larger portfolios on the market for purchase, so I wanted to understand what your criteria are for purchasing it.

And whether you're going to enlist some capital partners to join on those purchases given the increased investor interest.

Yes.

Our disposition strategy, Eric, hasn't really changed.

The timing of it may have been accelerated because the market -- we're leasing up some of our -- our nonstrategic assets factor and so they're becoming positioned earlier for sale.

And the market is good, so we're taking advantage of those opportunities.

But they're generally the remaining nonstrategic assets in Europe and the U.S. that we identified a long time ago.

We're not changing that.

It's just that we're getting through it faster than we would have otherwise.

With respect to capital deployment, look, we look at everything and -- I mean, since KTR, we ended really big -- buy a big portfolio and before KTR, we didn't buy a big portfolio either.

It's just that in a lot of these instances, the quality of what's available and our desire for maintaining that portfolio that we have so diligently constructed over the last 5 or 6 years.

I mean, we sold $14 billion of real estate, as Tom has mentioned.

I mean, we really worked hard at perfecting the quality of this portfolio.

And when we look at a portfolio or most of these portfolios, we would have to sell 60%, 70% of them to get down to the 30% or 40% we like.

So obviously, we got to price them so we can sell them and still come out of the good valuation for what we want to keep, and that becomes kind of difficult to do.

So we're, by and large, not a big portfolio buyer because of the fifth issue but in terms of return requirements, again, I go back to my previous answer, we have a cost of capital that is different for each jurisdiction and we need to get an appropriate spread before we deploy capital in those markets.

Your next question comes from Ki Bin Kim from SunTrust.

So I kind of imagine that one of the bigger challenges that you guys have is finding smart ways to deploy development capital in size.

So could you talk about where the next rounds of opportunities are globally?

Sure.

I mean, there -- we have a really great way of

deploying capital, which is in a market that's in the high 4% vacant.

We can deploy capital development, which will not only service the needs of our customers but will also monetize our land bank.

And we control, based on our current land bank, and the option land and even excluding the covered land plays, we have close to $10 billion opportunity to deploy capital.

So that's a couple of years of activity that doesn't depend on anything else or any portfolio acquisitions or the like, and we are -- it's not a static number.

We're always adding to it and growing it.

So I think, primarily the global development platform, which very few people actually attribute any value to, is a driver of our growth and it's a pretty unique and substantial driver of deployment and earnings growth over time.

So that's our primary way.

The acquisition stuff tends to be more value added, tends to covered land plays.

There's got to be an angle.

If we're going toe to toe on just the cost of capital raise with the latest sovereign wealth fund or pension fund that wants to be out there, that's generally not our MO, particularly when you overlay the quality consideration that I talked about earlier.

Your next question comes from Michael Mueller from JPMorgan.

I apologize, I missed some of the intro comments, if this was asked but looking out to '19 to '20, it looks like you have about 13% to 15% of square footage expiring each year.

How much pull forward should we expect on top of those levels?

Michael, this is Tom.

I don't think you should expect a lot of pull forward to those levels.

We're obviously -- I think you're going to see our churn over time naturally come down slowly because of longer lease durations.

So I wouldn't expect...

But I think what he's asking is that in a typical year, we lease about 5% more than the rollover we have.

So I think 15% for the whole year, it's going to be 20% because we're pulling basically 6 months of the next year into the current period so we're always running ahead.

Although we're getting a little smarter about that.

It took us a while to figure it out but by moving things forward, in a rapidly escalating market, you are actually blocking a lease rate at a lower rate than you should have, and that's another behavioral thing that we are working on here.

So I think the answer -- specific answer to your question is about 5% more but there's a rent aspect of that, that you got to keep in mind as well.

Your next question comes from John Guinee from Stifel.

Mike Curless, follow-up call.

When you're looking at development overall, a lot of moving pieces, land and entitlement costs, hard costs, required yield by you and others, as well as rental rates, what do you think are good examples of what's happening to land versus hard costs versus required yield in various markets that you're looking at new development?

Well, we're certainly seeing, as Hamid mentioned, with the scarcity of well-located sites particularly in the markets that are closer to the consumers, scarcity there is going to be driving up and is driving up land prices.

Construction costs are being driven up in select markets as well.

Look at that going on with steel.

But in the places that we're doing business, we're seeing the corresponding run rates being there and we're seeing our margin is still sustainable.

I got to tell you, this construction cost thing is no joke in the Bay Area.

Construction costs are 20%, 25% up over the last year.

That, by the way, affects other parts of California, too.

So -- but they've been stable for many years.

And now, it's the time for the contractors and the subs and suppliers to make some hay while the sun is shining.

So construction costs are really tough and some of that has been mitigated by yield compression on the required return side but it's getting tougher to pencil spec development in some of these markets.

And that's good news, I guess, for rental growth over time because the cost of that marginal product come to market is much higher now.

Your next question comes from Eric Frankel from Green Street Advisors.

I just wanted to address the topic of rent paying abilities among tenants.

Obviously, the rent increases you're pushing through to tenants especially in coastal markets, there doesn't seem to be much of rent fatigue, I guess, is what's been phrased the last few years.

Can you talk about what -- how higher rents fit into your tenant supply chain at this point, especially population dense markets?

And it certainly seems for potential multistory development in the future that you need rent to be in the $15 to $30 range for the economics to work.

Can you talk about which tenant can actually afford those types of prices?

Sure.

First of all, keep in mind that while nominal rate -- rental rates have increased a lot in terms of real rents, we're still way below the high water marks of the late '90s and early 2000, substantially below that.

So real rents is really what matters over time.

Secondly, a lot of this marginal player, marginal not in terms of bad but marginal, meaning in terms of incremental players that need close infill space are really substituting retail space.

So the difference between retail and industrial is blending and they get a lot more throughput in last-touch delivery.

And therefore, by eliminating retail rents and another -- and a lot of other supply chain costs, I think they can afford to pay a lot more -- those particular tenants can certainly pay a lot more for higher cost real estate.

The third consideration is that there are not a lot of these opportunities around to develop.

So it's not like a greenfield situation where you can go and all of a sudden build 10 new buildings and all that.

So -- but probably, the most important factor is that industrial rents are a tiny, tiny, tiny portion of the entire supply chain cost.

I mean, certainly under 5% and in many cases, under 2%.

And in particular categories like parcel delivery, food, construction, municipal items and all that, you got to be there to provide those services close in.

So those tenants tend to be less rent-sensitive.

If you're distributing tires, you're not going to be in those locations because you're very rent-sensitive.

But those are not the kind of tenants you'll end up finding in those infill locations.

Your next question comes from Jon Petersen from Jefferies.

So the promotes this quarter came in well ahead of your guidance.

I just wonder if you can give some color on why it was so much higher than the outlook you gave a couple of months ago.

I think it was all from the China fund.

And then kind of stepping back to the bigger picture, I'm just curious, when you provide guidance, how do you go about underwriting, what the promote potential is?

Do you guys assume a 25 basis point increase in cap rates or slow NOI growth or something conservative like that to drive the number?

Just trying to think about how you guys think about that when you give guidance.

Jon, it's Tom.

Thanks for the question.

So our approach on promotes is we generally provide guidance based on spot valuations and spot FX.

And what we saw in the first quarter was China values increased pretty meaningfully and we had positive tailwind from FX.

The RMB strengthened against the dollar in the quarter and these formal calculations, obviously, will be sensitive to valuations.

So we give you our -- the spot values on promotes.

As I mentioned, the fourth quarter promote is based on the funds in Europe, and we'll recognize all the revenue in that quarter.

Yes.

It's more like an auction price.

I mean, it's an effect that call on appreciation of the portfolio, plus the preferred return.

So it's very sensitive to that exit value when cap rates have been moving around and rents have been moving around.

So we do our best.

We're not trying to step on the scale or anything.

It's just sometimes -- most of the time, in a downward compressing cap rate environment, it's just been so biased to the upside.

Your last question comes from Jamie Feldman from Bank of America.

Sticking with your last statement, just on compressing cap rates.

I mean, what are your thoughts on how much lower cap rates can go or maybe a better way to ask it is just to talk about demand you're seeing out there for industrial assets and what the transaction market looks like and what underwriting assumptions look like for buyers?

I think that's based on what we're seeing, people are paying mid-4 cap rates for sort of very mediocre-ish portfolios.

And in the best markets like L.A., some of the cap rates, at least to that market are in the high 3. So that's -- and that translates into maybe a 5.5 on leveraged IRR on a good day.

So that's what we're seeing in the marketplace.

And what it should be, I don't know.

We're not buying a lot of real estate at the high 3 cap rate, so I don't really know.

What was the first part of your question?

Jamie, could you ask the first part of your question again.

Okay, you're gone.

All right, you can call me privately.

I forgot the first part.

Anyway, thank you.

Thank you very much for your interest in the company and we look forward to communicating with you over the course of the quarter.

This concludes today's conference call.

You may now disconnect.