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PLD > SEC Filings for PLD > Form 10-Q on 5-Nov-2013All Recent SEC Filings

Show all filings for PROLOGIS, INC.

Form 10-Q for PROLOGIS, INC.


Quarterly Report

ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Consolidated Financial Statements and the related notes included in Item 1 of this report and our 2012 Annual Report on Form 10-K.

Certain statements contained in this discussion or elsewhere in this report may be deemed "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Words and phrases such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," "designed to achieve," variations of such words and similar expressions are intended to identify such forward-looking statements, which generally are not historical in nature. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future - including statements relating to rent and occupancy growth, development activity and sales or contribution volume or profitability on such sales and contributions, economic and market conditions in the geographic areas where we operate and the availability of capital in existing or new co-investment ventures - are forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Although we believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be attained and therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Many of the factors that may affect outcomes and results are beyond our ability to control. For further discussion of these factors see "Part II, Item 1A. Risk Factors" in our 2012 Annual Report on Form 10-K. References to "we," "us" and "our" refer to Prologis, Inc. and its consolidated subsidiaries.

Management's Overview

We are the leading global owner, operator and developer of industrial real estate, focused on global and regional markets across the Americas, Europe and Asia. As of September 30, 2013, on an owned and managed basis, we had properties and development projects totaling 562 million square feet (52.2 million square meters) in 21 countries. These properties are leased to approximately 4,500 customers, including third-party logistics providers, manufacturers, retailers, transportation companies, and other enterprises.

Of the approximately 562 million square feet of our owned and managed portfolio as of September 30, 2013:

• 523 million square feet were in our operating portfolio with a gross book value of $40.7 billion that were 93.9% occupied;

• 28 million square feet were in our development portfolio with a total expected investment of $2.3 billion that were 50.3% leased;

• 11 million square feet consisted of properties in which we have an ownership interest but do not manage and other properties we own, including assets held for sale; and

• the largest customer and 25 largest customers accounted for 1.9% and 17.5%, respectively, of our annualized base rent.

Prologis, Inc. is a self-administered and self-managed real estate investment trust ("REIT"), and is the sole general partner of Prologis, L.P. (the "Operating Partnership"). We operate Prologis, Inc. and the Operating Partnership as one enterprise, and, therefore, our discussion and analysis refers to Prologis, Inc. and its consolidated subsidiaries, including the Operating Partnership, collectively.

Our business strategy includes two operating segments: Real Estate Operations and Investment Management. We generate revenues, earnings, net operating income (calculated as rental income less rental expenses), funds from operations ("FFO" as described below) and cash flows through our segments primarily through three lines of business, as follows:

Real Estate Operations Segment

Rental Operations-This represents the primary source of our core revenue, earnings and FFO. We collect rent from our customers under operating leases, including reimbursements for the vast majority of our operating costs. We seek to generate long-term internal growth in rental income by maintaining a high occupancy rate at our properties, by controlling expenses and through contractual rent increases on existing space and renewals on rollover space, thus capitalizing on the economies of scale inherent in owning, operating and growing a large global portfolio. Our rental income is diversified due to both our global presence and our broad customer base. We expect to generate long-term internal growth in rents by increasing our occupancy rate and through rent increases on existing space and renewals on rollovers. We believe that our property management and leasing teams, regular maintenance programs, capital expenditure programs, energy management and sustainability programs create cost efficiencies, allowing us to leverage our global platform and provide flexible solutions for our customers as well as for us.

Capital Deployment Activities-Our development and re-development activities support our rental operations and are therefore included with that line of business for segment reporting. We develop and re-develop industrial properties primarily in global and regional markets to meet our customers' needs. Within this line of business, we capitalize on: (i) the land that we currently own in global and regional markets; (ii) the development expertise of our local personnel; (iii) our global customer relationships; and (iv) the demand for high quality distribution facilities in key markets. We seek to increase our rental income and the net asset value of the Company through the leasing of newly developed space, as well as through the acquisition of new properties. Depending on several factors, we may develop properties for long-term hold, for contribution into one of our co-investment ventures, or for sale to third parties. During 2013, we recognized gains in continuing operations of $402.3 million from the disposition of properties - primarily properties we developed. We develop directly as well as with certain of our partners in a variety of co-investment ventures.

Investment Management Segment-We invest with partners and investors through our co-investment ventures, both private and public. We tailor industrial portfolios to investors' specific needs and deploy capital with a focus on larger, long duration ventures and open ended funds with leading global institutions. We also access alternative sources of public equity such as the Nippon Prologis REIT, Inc. ("NPR"). These private and public vehicles source strategic capital for distinct geographies across our global platform.

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We typically hold an ownership interest in these ventures between 15-50%. We generate investment management revenues from our unconsolidated co-investment ventures by providing asset management and property management services. We may earn revenues through additional services provided such as leasing, acquisition, construction, development, disposition, legal and tax services. Depending on the structure of the venture and the returns provided to our partners, we may also earn revenues through incentive returns or promotes. We believe our co-investments with investors will continue to serve as a source of capital for new investments and provide revenues for our stockholders, as well as mitigate risk associated with our foreign currency exposure. We expect to grow this business with the formation of new ventures, such as the two ventures formed in the first quarter of 2013 and discussed below, and through the growth in existing ventures with new third-party capital and additional investments by us. As of September 30, 2013, we had 14 co-investment ventures (consolidated and unconsolidated) and approximately 90% of these ventures are long-life or perpetual vehicles (based on the gross book value of the buildings in these ventures).

Our Priorities

We believe the scale and quality of our operating platform, the skill set of our team and the strength of our balance sheet will provide us with unique competitive advantages going forward. We intend to focus on the following three key priorities to grow our company in the coming years:

• Capitalize on rental recovery-As noted earlier, during the first nine months of 2013 in our owned and managed portfolio, we had rent increases on rollovers ranging from 2% to 6%. We are seeing increasing rents across most of our markets and expect that this will continue. We believe the demand for logistics facilities continues to be strong globally and will support increased rents. As we are able to recover the majority of our rental expenses from customers, this increase in rent translates into increased net operating income and earnings.

• Create value from development, by utilizing our land bank, development expertise and customer relationships-We believe one of the keys to a successful development program is having strategic land control and, in this regard, we believe we are well-positioned. Our land bank is increasingly undervalued allowing us to realize this value going forward through development at high incremental returns. We believe our current land bank has the potential to build nearly 200 million of additional square feet. During the third quarter of 2013, we stabilized properties that we developed with a total expected investment of $500 million. We estimate that after our development and leasing activities, these buildings have a value that is 38% more than our invested cost.

• Scale our business to grow earnings-We believe we have the infrastructure in place to allow us to increase our investments in real estate either directly through acquisitions of properties or by increased investment in our co-investment ventures. We are beginning to see our acquisition pipeline grow through both third party real estate transactions and opportunities to increase our ownership interest in our co-investment ventures. We completed an equity offering in April 2013 in order to take advantage of some of these investment opportunities and made investments in real estate and in our co-investment ventures as detailed below. In the third quarter, we increased our owned and managed portfolio by more than $1 billion, while keeping our expenses relatively flat.

We believe these three strategies will enable us to generate growth in revenue, earnings, net operating income and Core FFO (each as described below) for our shareholders in the coming years.

Merger Priorities

At the time of our merger on June 3, 2011 (the "Merger"), we established five key strategic priorities to guide our path through the end of 2013. Over the last two years, we have been focused on these priorities and we believe we achieved these objectives as of June 30, 2013, six months ahead of schedule as detailed below:

• Align our Portfolio with our Investment Strategy. We have categorized our portfolio into three main market categories - global, regional and other markets. At the time of Merger, 79% of the total owned and managed portfolio was in global markets and our goal was to have 90% of the portfolio in global markets. We have substantially met this goal; as of September 30, 2013, global markets represented 86% of the owned and managed platform.

• Strengthen our Financial Position. Our intent was to further strengthen our financial position by lowering our financial risk and currency exposure and building one of the strongest balance sheets in the REIT industry. We have lowered our financial risk by reducing leverage and maintaining staggered debt maturities, to increase our financial flexibility and provide for continued access to capital markets in order to capitalize on market opportunities across the entire business cycle as they arise. As of June 30, 2013, we reduced our debt by $3.7 billion since the Merger and improved all of our debt metrics significantly. Although our debt may increase temporarily due to acquisitions and other growth initiatives (as it did in third quarter), we expect debt as a percentage of assets to continue to decrease over time.

We have reduced our exposure to foreign currency exchange fluctuations by borrowing in local currency where appropriate, utilizing derivative contracts to hedge our foreign denominated equity and by holding assets outside the United States primarily in co-investment ventures in which we maintain an ownership interest and provide services generating investment management income. As of September 30, 2013, we improved our share of net equity denominated in U.S. dollars to 73% from 45% at the time of the Merger. We expect our U.S. dollar denominated net equity to increase further in the fourth quarter.

• Streamline Investment Management Business. We have worked and continue to work with our partners to rationalize certain of our co-investment ventures. Some of our legacy co-investment ventures contained fee structures that did not adequately compensate us for the services we provide. Therefore, we have terminated or restructured certain of these co-investment ventures. In other cases, we may combine some co-investment ventures to gain operational efficiencies. In every case, however, we have worked and will continue to work very closely with our partners and venture investors who have been and will be active participants in these decisions. We have made tremendous progress in repositioning this business to focus on larger, long duration ventures, open end funds and geographically focused public entities and expect to continue with these activities during 2013 and 2014. We plan to continually grow our investment management

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business with the deployment of the capital commitments we have already raised, formation of new co-investment ventures and raising incremental capital in both our private and public formats across our global platform. Since the Merger, we have raised a significant amount of new third-party strategic equity. We have reduced the number of our co-investment ventures from 22 at Merger to 14 at September 30, 2013, with approximately 90% being in long-life or perpetual vehicles.

• Improve the Utilization of Our Low Yielding Assets. We expected to increase the value of our low yielding assets by stabilizing our operating portfolio to 95% leased, completing the build-out and lease-up of our development projects, as well as monetizing our land through development or sale to third parties. As of September 30, 2013, we increased occupancy 320 basis points from the Merger to 93.9% as of September 30, 2013, and expect to further increase occupancy by year-end. In this current environment, our leasing personnel are focused on increasing rents on lease turnover and we may sacrifice the occupancy gain, temporarily, in order to obtain the higher rent. In our owned and managed portfolio, we experienced increased rents on turnover in 2013 ranging from 2.0% to 6.1% (2.0% in the first quarter, 4.0% in the second quarter, and 6.1% in the third quarter). Since the Merger through September 30, 2013, we monetized approximately $1.0 billion of our land bank, principally through development starts. A significant part of our business is our development platform and we have continued to experience strong development returns with an average yield of 7.7% on the developments since Merger.

• Build the most effective and efficient organization in the REIT industry and become the employer of choice among top professionals interested in real estate as a career. We realized more than $115 million of cost synergies on an annualized basis, compared to the combined expenses of AMB Property Corporation and ProLogis on a pre-Merger basis. These synergies included gross general and administrative savings, reduced global line of credit facility fees and lower amortization of non real estate assets. In addition, we implemented a new enterprise wide system that includes a property management/billing system (implemented in April 2012), a human resources system (implemented in July 2012), a general ledger and accounting system and a data warehouse (both implemented in January 2013). In connection with this implementation, we strive to utilize the most effective global business processes with the enhanced system functionality, and have also implemented several analytical management tools to further empower and assist our regional and local teams. In early 2012, we implemented two new compensation plans that we believe will better align employees' compensation with our company performance. We are focused on building a culture of accountability and empowerment. With these tools, we believe our people are equipped to manage their divisional profitability, overhead efficiency and business risk.

Summary of 2013

During the nine months ended September 30, 2013, and through the date of this report, we completed the following activities in support of our strategic priorities:

• In the first quarter of 2013, we formed two new ventures, one in Japan and one in Europe:

• In early 2013, we launched the initial public offering for NPR. NPR will serve as the long-term investment vehicle for our stabilized properties in Japan. On February 14, 2013, NPR was listed on the Japan Stock Exchange and commenced trading. At that time, NPR acquired a portfolio of 12 properties from us for an aggregate purchase price of ¥173 billion ($1.9 billion). This resulted in ¥158 billion ($1.7 billion) in net cash proceeds and a gain of $337.9 million after the deferral of 15%, which represents our ongoing ownership interest in NPR.

• On March 19, 2013, we closed on a euro-denominated co-investment venture, Prologis European Logistics Partners Sàrl ("PELP"). PELP is structured as a 50/50 joint venture and has an initial term of 15 years, which may be extended for an additional 15-year period. At closing, the venture acquired a portfolio of 195 properties from us for an aggregate purchase price of €2.3 billion ($3.0 billion). This resulted in €1.0 billion ($1.3 billion) in net cash proceeds and a gain of $1.8 million after the deferral of 50%, which represents our ongoing ownership interest in PELP. In the fourth quarter of 2012, we recognized an impairment charge of $135.3 million to adjust the carrying value of the portfolio of assets to the expected proceeds upon contribution.

• We concluded four ventures, one in Japan, two in the United States and one in Mexico:

• In connection with the wind down of Prologis Japan Fund I in June 2013, we purchased 14 properties from the venture and the venture sold the remaining 6 properties to NPR. In addition, we contributed one development building to NPR for $232.6 million. As a result of the combined transactions, we recorded a net gain of $56.9 million.

• In June 2013, we acquired our partners' interest in Prologis Institutional Alliance Fund II, a consolidated co-investment venture. In connection with this transaction, we paid $243.0 million and issued 804,734 limited partnership units worth $31.3 million in one of our limited partnerships. These units are exchangeable into an equal number of shares of our common stock. Based on the venture's cumulative returns to the investors over the life of the venture, we earned a promote payment of approximately $18.8 million from the venture. Of that amount, approximately $13.5 million represents the third party investors' portion and is reflected as a component of noncontrolling interest in the Consolidated Statements of Operations in Item 1. We also recognized approximately $3.0 million of investment management expenses representing the estimated cash bonus to be paid out to certain employees under the Prologis Promote Plan, previously referred to as the Private Capital Plan. As a result, the assets and liabilities associated with this venture are now wholly owned.

• On August 6, 2013, Prologis North American Industrial Fund III ("NAIF III") sold 73 properties to a third party for $427.5 million and we acquired our partners 80% interest in the venture. All debt of the venture was paid in full at closing. As a result of the combined transactions, we recorded a net gain of $43.7 million.

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• On October 2, 2013, we acquired our partner's interest in Prologis SGP Mexico ("SGP Mexico"), one of our co-investment ventures.

• Excluding the transactions discussed above where we bought out our partners' interests, we invested an additional $488.4 million, in some cases over and above our existing equity commitments, in three ventures:

• We invested €137.3 million ($178.9 million) in Prologis European Properties Fund II, and increased our ownership interest to 33.9%.

• We invested €160.0 million ($209.5 million) in Prologis Targeted Europe Logistics Fund, and increased our ownership interest to 49.2%.

• We invested $100.0 million in Prologis Targeted U.S. Logistics Fund, and increased our ownership interest to 27.0%.

• Excluding the NPR, PELP and NAIF III transactions discussed above, we generated aggregate proceeds of $815.6 million from the disposition of land and 39 operating buildings to third parties and the contribution of 13 operating buildings and 1 pre-stabilized development building to three unconsolidated co-investment ventures during the nine months ended September 30, 2013. We recognized a net gain of $62.5 million in continuing operations and a net gain of $59.6 million in discontinued operations as a result of these transactions.

• In April 2013, we issued 35.65 million shares of common stock in a public offering at a price of $41.60 per share, generating approximately $1.4 billion in net proceeds ("Equity Offering").

• As a result and in combination with our significant contribution and disposition activity, along with the Equity Offering, we decreased our total debt to $9.1 billion at September 30, 2013, from $11.8 billion at December 31, 2012, and we increased our U.S. dollar net equity to 73%. Through this activity:

• We repaid $1.4 billion of outstanding secured mortgage debt with the proceeds from contributions of properties to PELP and NPR and we transferred $353.2 million of debt to PELP in connection with the contributions during the first quarter 2013. In addition, we repaid $552.3 million in senior notes and $342.2 million in exchangeable senior notes.

• In April 2013, we redeemed $482.5 million of our preferred stock.

• We entered into several cross currency derivative contracts to hedge our net equity investment in euro ($800 million at an average economic exchange rate of 1.33 and terms ranging from 4 to 5 years); and yen ($250 million at an average economic exchange rate of 96.54 and a term of 5 years).

• We commenced construction of 42 projects on an owned and managed basis during the nine months ended September 30, 2013, aggregating 15.7 million square feet with a total expected investment of $1.2 billion (our share was $982.0 million), including 18 projects (42% of the total expected investment) that were 100% leased prior to the start of development. We used $298.2 million of land we already owned for these projects. We expect these developments to be completed by February 2015 or earlier.

• During the nine months ended September 30, 2013, we leased a total of 108.2 million square feet in our owned and managed portfolio and incurred average turnover costs (tenant improvements and leasing costs) of $1.42 per square foot. This compares to the nine months ended September 30, 2012, when we leased 104.8 million square feet in our owned and managed portfolio with turnover costs of $1.39 per square foot. The increase in turnover costs is due to the longer term and higher value on the leases signed. As of September 30, 2013, our owned and managed operating portfolio was 93.9% occupied and 94.3% leased as compared to 94.0% occupied and 94.5% leased at December 31, 2012, and 93.1% occupied and 93.6% leased at September 30, 2012

• Our effective rental rates increased 6.1% over in place rents on leases signed for our owned and managed portfolio during the third quarter of 2013. Rent change is continuing its upward trend in our portfolio and we expect to continue to see increases in our rents on rollover. During the nine months ended September 30, 2013, we retained 81.1% of customers whose leases were expiring, as compared to 82.9% during the nine months ended September 30, 2012.

Operational Outlook

The recovery of logistics real estate markets is strengthening around the globe and net effective rents are growing in most of our markets in our view. Operating fundamentals improved during the quarter and we believe this trend will continue as the leading indicators of industrial real estate demand are strong. Global trade is expected to grow 2.9% in 2013 and accelerate into 2014 with growth of 4.9%, according to the International Monetary Fund. Based on our own internal surveys, space utilization in our facilities continues to trend higher, setting another record in the quarter. This means that our customers are short on space to handle their current needs and their future growth.

Market conditions in the U.S. further improved during the third quarter. Rental rates are increasing and growth has broadened to more markets in our view. The industrial market absorbed 221 million square feet during the last four quarters; significantly above the 68 million square feet of completions during the same period per data from CB Richard Ellis ("CBRE"). The excess of demand of 153 million square feet is the highest in the 33 years of data. Market occupancy was 92.6% for the quarter ended September 30, 2013, up 90 basis points from the prior year based upon data from CBRE. Occupied space stands only 1% above its 2007 level per CBRE, while imports are 9% higher and Gross Domestic Product, consumption and population are all 5-6% higher (per the Bureau of Economic Analysis and census data). Reflecting the improvement in the operating environment, we are increasing our internal 2013 net absorption forecast for the U.S. to 200 million square feet, up from 180 million square feet.

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We believe the recovery in Europe is becoming more firmly established. Despite economic recession during portions of 2012 and 2013, net absorption for logistics facilities has been positive throughout, tightening vacancy rates based on data from CBRE, Jones Lang LaSalle and DTZ. For the first time in four years, sentiment among our customers is positive. We see net effective rents growing and the recovery broadening to more of our markets. We believe rent growth, combined with our view of declining capitalization rates, will lead to a strong recovery in European values.

The availability of Class-A distribution space remains highly constrained in our Asian markets in our view. In Japan, supply chain reconfiguration remains an ongoing positive driver in the marketplace. In addition, cyclical conditions remain positive. With the 2020 Olympics and elevated economic growth, we believe market conditions will remain favorable, which puts upward pressure on rents. Demand in China is accelerating and we see new requirements from retailers and e-commerce customers. Low vacancy conditions continue to lead to outsized rental rate growth in our view.

Operating fundamentals in our Latin American markets are outperforming modest macroeconomic momentum. In Mexico, demand has continued to recover and market occupancy rate across the six largest logistics markets (Mexico City, Monterrey, Guadalajara, Juarez, Reynosa and Tijuana) was 91.4% for the quarter ended September 30, 2013, up 100 basis points from the prior year, based on internally generated data. Brazil continues to be an underserved logistics market in our . . .

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