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PLD > SEC Filings for PLD > Form 10-K on 26-Feb-2014All Recent SEC Filings

Show all filings for PROLOGIS, INC.

Form 10-K for PROLOGIS, INC.


Annual Report

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our Consolidated Financial Statements included in Item 8 of this report and the matters described under Item 1A. Risk Factors.

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Management's Overview

We believe the scale and quality of our operating platform, the skills of our team and the strength of our balance sheet will provide us with unique competitive advantages going forward. We have a straightforward plan for growth that is based on the following three key elements:

• Capitalize on rental recovery. During 2013 in our owned and managed portfolio, we had quarterly rent increases on rollovers of 2%, 4%, 6% and 6%, following 17 quarters of decreases. Market rents are growing across the majority of our markets and we believe they have substantial room to further increase as they remain significantly below replacement-cost-justified rents. We believe demand for logistics facilities is strong across the globe and will support increases in net effective rents as many of our in place leases were originated during low rent periods, following the global financial crisis. As we are able to recover the majority of our rental expenses from customers, the increase in rent translates into increased net operating income, earnings and cash flows.

• 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 are well-positioned. Based on our current estimates, our land bank has the potential to support the development of nearly 200 million additional square feet. During 2013, we stabilized development projects with a total expected investment of $1.4 billion. We estimate that after our development and leasing activities, these buildings will have a value that is approximately 30% more than book value (using estimated yield and capitalization rates from our underwriting models). Based on our view of improving market conditions, we believe that our land bank is carried on the books below the current fair value and expect to realize this value going forward through development and sales.

• Use our scale to grow earnings. We believe we have the infrastructure in place and the acquisition pipeline to allow us to increase our investments in real estate either directly through acquisitions of properties or by investing in our co-investment ventures with minimal increases to gross general and administrative expenses beyond property level expenses. We completed an equity offering in April 2013 in order to capitalize on these opportunities and we made investments in real estate, as well as in our co-investment ventures as detailed below.

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

Since the Merger, we were focused on the following priorities ("The Ten Quarter Plan"), which we completed June 30, 2013:

• Align our Portfolio with our Investment Strategy. We categorized our portfolio into three main market categories - global, regional and other markets. At the time of the 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 substantially met this objective primarily through sales of assets in non-strategic locations, with a portion of the proceeds recycled into new developments. As of December 31, 2013, global markets represented 85% of the owned and managed platform, based on gross book value.

• Strengthen our Financial Position. Our intent was to further strengthen our financial position by lowering our financial risk, reducing our currency exposure and building one of the strongest balance sheets in the REIT industry. By the end of 2013, we reduced our debt, improved our debt metrics, increased our financial flexibility and ensured continued access to capital markets. Although our debt may increase temporarily due to acquisitions and other growth initiatives (as it did during the last half of 2013), 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 currencies where appropriate, utilizing derivative contracts to hedge our foreign denominated equity, as well as through holding assets outside the United States primarily in our co-investment ventures. As of December 31, 2013, we increased our share of net equity denominated in U.S. dollars to 77% from 45% at the time of the Merger. We expect our percentage of U.S. dollar denominated net equity to increase further in 2014.

• Streamline our Investment Management Business. Several of our legacy co-investment ventures contained fee structures that did not adequately compensate us for the services we provide and as a result we terminated or restructured a number of these co-investment ventures. We substantially repositioned this business to focus on large, long duration ventures, open end ventures and geographically focused public entities and expect to continue with these activities in 2014. Since the Merger, we have raised a significant amount in third-party equity and we expect to grow our investment management business going forward. Growth will come from the deployment of the capital commitments we have already raised, as well as new incremental capital in both our private and public formats. We have reduced the number of our co-investment ventures from 22 at the time of the Merger to 13 at December 31, 2013, with approximately 90% 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. We increased occupancy in our owned and managed portfolio 440 basis points from the Merger to 95.1% at December 31, 2013. From the Merger through December 31, 2013, we monetized approximately $890 million of our land bank through development starts and an additional $330 million through third-party sales.

• 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

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combined expenses of AMB and ProLogis on a pre-Merger basis. These synergies included gross general and administrative savings, as well as 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).

Summary of 2013

• We formed two new ventures and announced the formation of two additional ventures:

• 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 Tokyo 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). During 2013, NPR completed two follow on equity offerings and used the proceeds to buy properties from us at appraised value.

• 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 with Norges Bank Investment Management ("NBIM") 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). PELP acquired additional properties from us during 2013.

• In November, we extended the relationship with our partner in China and formed Prologis China Logistics Venture 2. The venture is expected to build, acquire and manage properties in China. The venture has potential investment capacity of over $1 billion, including $588 million of committed equity of which $88 million is our share.

• We announced the formation of Prologis U.S. Logistics Venture ("USLV") with NBIM in December. We closed on the venture in January 2014 with a contribution of 66 operating properties aggregating 12.8 million square feet for an aggregate purchase price $1.0 billion. These properties were acquired by us in June and August through the acquisition of our partners' interests in two previous co-investment ventures (Prologis Institutional Alliance Fund II ("Fund II") and Prologis North American Industrial Fund III ("NAIF III"), which are described below). We own 55% of the equity and the venture will be consolidated for accounting purposes due to the structure and voting rights of the venture.

• 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 six properties to NPR.

• In June 2013, we acquired our partners' interest in Fund II, a consolidated co-investment venture. Based on the venture's cumulative returns to the investors, we earned a promote payment of approximately $18.8 million from the venture. The third party investors' portion of the promote payment was $13.5 million, which is reflected as a component of noncontrolling interest in the Consolidated Statements of Operations in Item 8. The assets and liabilities associated with this venture were wholly owned at December 31, 2013, and were subsequently contributed to USLV in January 2014.

• On August 6, 2013, NAIF III sold 73 properties to a third party for $427.5 million and we acquired our partners 80% interest in the venture, which included 18 properties. All debt of the venture was paid in full at closing. As a result of these combined transactions, we recorded a net gain of $39.5 million. The assets and liabilities associated with this venture were wholly owned at December 31, 2013, and were subsequently contributed to USLV in January 2014.

• On October 2, 2013, we acquired our partner's 78.4% interest in Prologis SGP Mexico ("SGP Mexico") and began consolidating its operating properties with an estimated total fair value of $409.5 million.

• During the year and including the initial formation of the two new ventures discussed above, we contributed a total of 235 development properties to five of our unconsolidated co-investment ventures and generated net proceeds and net gains of $6.2 billion and $416.0 million, respectively. In addition, we contributed a total of 19 properties acquired from third parties to three of our co-investment ventures and generated net proceeds and net gains of $337.4 million and $139.2 million, respectively.

• We generated net proceeds of $785.6 million from the dispositions of land and 89 operating buildings to third parties and recognized a net gain of $125.4 million.

• In addition to the transactions discussed above, we invested a total of $505.7 million of new commitments (with cash and through contributions) in our unconsolidated co-investment ventures, which includes increasing our investment in three ventures:

• We increased our ownership interest in Prologis European Properties Fund II to 32.5%.

• We increased our ownership interest in Prologis Targeted Europe Logistics Fund to 43.1%.

• We increased our ownership interest in Prologis Targeted U.S. Logistics Fund to 25.9%.

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• In April, 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").

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

• We had a significant amount of capital markets activity in 2013. As a result and in combination with our significant contribution and disposition activity, along with the Equity Offering, we decreased our total debt to $9.0 billion at December 31, 2013, from $11.8 billion at December 31, 2012. We extended our maturities and lowered our borrowing costs by issuing several series of new debt and repurchasing existing higher coupon debt. Details of debt activity are as follows:

• We issued senior notes during 2013 as follows (dollars in thousands):

                                Principal         Effective
                                  Amount        Interest Rate          Maturity Date
   Senior Note Issuance Date:
   August 15, 2013              $  850,000                4.25 %        August 15, 2023
   August 15, 2013              $  400,000                2.75 %      February 15, 2019
   November 1, 2013             $  500,000                3.35 %       February 1, 2021
   December 3, 2013             €  700,000                3.00 %       January 18, 2022

• We used the proceeds of the newly issued debt to buy back debt of $1.5 billion through tender offers or private transactions, which resulted in a loss on early extinguishment of $180.7 million.

• We repaid $1.6 billion of outstanding secured mortgage debt (with an average borrowing cost of 2.4%) with the proceeds from the contribution of properties, primarily to PELP and NPR, and we transferred $548.0 million of outstanding mortgage debt in connection with contributions. In addition, we used proceeds generated from property dispositions and the Equity Offering to repay $564.5 million in senior notes and $483.6 million in exchangeable senior notes. As a result of our repayment of debt, we recorded a loss on early extinguishment of $96.3 million.

• All of this activity decreased our borrowing costs to 4.2% at December 31, 2013, from 4.4% at December 31, 2012, and increased the remaining maturity from 43 months to 58 months for the same period. Also, the issuance of the euro denominated debt and derivative contracts increased the percentage of our total equity denominated in U.S. dollar to 77%.

• We commenced construction of 68 development projects on an owned and managed basis, aggregating 23 million square feet with a total expected investment of $1.8 billion (our share was $1.5 billion), including 27 projects (42% of our share of the total expected investment) that were 100% leased prior to the start of development. These projects had an estimated weighted average yield at stabilization of 7.6% and an estimated development margin of 19.1%. We used $445.3 million of land we already owned for these projects. We expect these developments to be completed by June 2015 or earlier.

• We leased a total of 151.9 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. At December 31, 2013, our owned and managed operating portfolio was 95.1% occupied and 95.1% leased as compared to 94.0% occupied and 94.5% leased at December 31, 2012.

• Our rent change on roll over was positive in each quarter in 2013 for our owned and managed portfolio, ranging from 2% to 6%. Rent change in our portfolio is continuing its upward trend and we expect to continue to see increases in our rents on rollover. During 2013, we retained 82.6% of customers whose leases were expiring.

Operational Outlook

The recovery of the logistics real estate market further strengthened and broadened globally during 2013. Operating fundamentals continued to improve and we believe this trend will continue as the leading indicators of industrial real estate are strong. Global trade is expected to grow 4.9% in 2014 and 5.4% in 2015 (a). Based on our own internal surveys, space utilization in our facilities continues to trend higher, which means our customers are short on capacity to handle their current needs and their future growth.

Market conditions in the U.S. are very favorable and an ongoing supply and demand imbalance exists (b). The industrial market absorbed 233 million square feet in 2013, the highest level since 2005 (b). By contrast, development completions amounted to only 67 million square feet resulting in a demand imbalance of 166 million square feet, the highest on record (b). These conditions have driven U.S. market vacancy to a new record low of 7.2% (b). As customer demand remains active and supply pipelines are below historical norm, we expect vacancy to continue to decline and rental rates to continue to increase in 2014.

Operating conditions in our Latin American markets are positive and have outperformed uneven macroeconomic growth in 2013. In Mexico, demand has continued to recover and the market occupancy rate across the six largest logistics markets (Mexico City, Monterrey,

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Guadalajara, Juarez, Reynosa and Tijuana) was 91.6% at the end of 2013, up 100 basis points from the prior year, based on internally generated data. In Brazil, despite a slowing economy, we believe it is an underserved logistics market and there is strong demand for modern logistics facilities as companies serve the growing consumer market.

In Europe, we believe we have seen the end of recessionary conditions in most countries. Customer sentiment continues to improve and broaden, which is translating into meaningful demand. Evidence for this includes pan-European market occupancy of 91.3%, higher than the level achieved in 2007 (c). The occupancy rate rose 1.0% in 2013 and we expect further gains in 2014. Economic momentum turned positive in 2013 and brighter macroeconomic prospects appear to be generating demand for logistics facilities, in our view. Our research indicates new starts for speculative development are near historic low levels. We expect net effective rents to continue to increase and the recovery to broaden to more of our markets. We believe high occupancy and rent growth, combined with declining capitalization rates will lead to a strong recovery in European industrial real estate values.

Expansionary market conditions are evident in our Asian markets. The availability of Class-A distribution space remains highly constrained and net effective rents are rising. In Japan, vacancy rates remain below 3% (a), and there is upward pressure on rents, especially in Tokyo and Osaka, as these markets have absorbed new deliveries. Increasing development costs, driven by higher land and construction pricing, are expected to keep new supply in balance. 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. Land availability has been constrained but appears to be improving. Barriers to supply continue to drive rents ahead of inflation, and we believe that we are well positioned with our development platform to meet this accelerating demand.

We believe elevated occupancy rates across our markets, coupled with the still-gradual pickup in new construction starts, are leading to notable increases in replacement-cost rents and effective rents. We expect to use our strategic land positions to support increased development activity in this environment. Our development business comprises speculative development, build-to-suit development, value-added conversions and redevelopment. We will develop directly and within our co-investment ventures, depending on location, market conditions, submarkets or building sites and availability of capital.

(a) according to the International Monetary Fund.

(b) according to CB Richard Ellis-Econometric Advisors ("CBRE").

(c) according to CBRE, Jones Lang LaSalle and DTZ.

Results of Operations

Real Estate Operations Segment

The rental income and rental expense we recognize is directly impacted by our consolidated operating portfolio. As mentioned earlier, we have had significant real estate activity during the last several years that has impacted the size of our portfolio. In addition, the operating fundamentals in our markets have been improving, which has impacted both the occupancy and rental rates we have experienced, as well as fueling development activity. Also included in this segment is revenue from land we own and lease to customers under ground leases and development management and other income, offset by acquisition, disposition and land holding costs. The results of properties sold to third parties have been reclassified to Discontinued Operations for all periods presented. Net operating income from the Real Estate Operations segment for the years ended December 31, was as follows (dollars in thousands):

                                                           2013            2012            2011
Rental and other income                                 $ 1,239,496     $ 1,469,419     $ 1,026,825
Rental recoveries                                           331,518         364,320         257,327
Rental and other expenses                                 (478,920)       (517,795)       (372,719)

Net operating income - Real Estate Operations segment   $ 1,092,094     $ 1,315,944     $   911,433

Operating margin                                              69.5%           71.8%           71.0%
Average occupancy                                             93.6%           92.6%           89.9%

Detail of our consolidated operating properties as of December 31, was as follows (square feet in thousands):

                                        2013          2012          2011
               Number of properties       1,610         1,853         1,797
               Square Feet              267,097       316,347       291,051
               Occupied %                 94.9%         93.7%         91.4%

Below are the key drivers that have influenced the net operating income ("NOI") of this segment:

• We contributed a significant amount of properties into our unconsolidated co-investment ventures during 2013. We generally used the proceeds from these contributions to repay debt and to fund future growth. As a result of the contributions of properties we made in 2013, our NOI decreased $299.4 million in 2013 from 2012. The net change in NOI from 2011 to 2012 related to contributions of properties during these periods was not significant. Since we have an ongoing ownership interest in these

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ventures, the results remain in Continuing Operations in the Consolidated Statements of Operations in Item 8. In addition to the decrease in NOI in this segment during 2013, we recognized a decrease in Interest Expense and an increase in Investment Management Income and Earnings from Unconsolidated Entities due to our continuing ownership in and management of these properties.

• We completed the Merger and PEPR Acquisition during 2011 and as a result, NOI increased $216.1 million in 2012 from 2011 ($293.6 million in rental income and $77.5 million in rental expense).

• Occupancy of the operating properties has continued to increase. In our Real Estate Operations segment, we leased a total of 87.6 million square feet and incurred average turnover costs of $1.71 per square foot. This compares to 2012, when we leased 92.4 million square feet with turnover costs of $1.41 per square feet. The increase in turnover costs is due to the longer term and higher value on the leases signed, resulting in higher leasing commissions.

• We calculate the change in effective rental rates on leases signed during the quarter as compared to the previous rent on that same space. Rental rate change on rollover (in our total owned and managed operating portfolio) was negative for all periods in 2012 and 2011. Rental change on rollover was positive in all four quarters of 2013 and has continued to increase. Generally we believe that market rents are continuing to increase and the majority of leases that are rolling were put in place at the low end of the cycle. In addition, many of our leases have rent increases throughout the lease term that are based on the consumer price index and are therefore not included in rent leveling and increase the rental revenue we recognize.

• We rationalized and acquired properties or a controlling interest in several of our unconsolidated co-investment ventures:

• 2013 - aggregated total portfolio of $1.1 billion and 16.3 million square feet; and

• 2012 - aggregated total portfolio of $2.3 billion and 46.3 million square feet.

• We have also increased the size of our portfolio through acquisition activity and development activity. After the development properties are stabilized, we may contribute them to co-investment ventures or we may continue to hold and operate within our consolidated portfolio depending on various factors, including geography and market conditions. We expect to continue to increase our consolidated portfolio through both acquisition and development activity in the future.

• Under the terms of our lease agreements, we are able to recover the majority of our rental expenses from customers. Rental expense recoveries, included in both rental income and rental expenses, were 73.4%, 74.2% and 73.8% of total rental expenses for the years ended December 31, 2013, 2012 and 2011, respectively.

Investment Management Segment

The net operating income from the Investment Management segment, representing
fees and incentives earned for services performed reduced by Investment
Management expenses (direct costs of managing these entities and the properties
they own), for the years ended December 31 was as follows (dollars in

                                                       2013            2012            2011
Net operating income - Investment Management
Asset management and other fees                     $   52,030      $   55,448      $   60,240
Leasing commissions, acquisition and other
transaction fees                                        14,078          13,974          16,632
Incentive returns                                        6,366              -               -
Investment management expenses                        (53,689)        (37,785)        (34,228)

Subtotal Americas                                       18,785          31,637          42,644
Asset management and other fees                         53,190          32,951          34,934
Leasing commissions, acquisition and other
transaction fees                                        10,604           4,096          11,153
Investment management expenses                        (22,531)        (15,348)        (15,379)

Subtotal Europe                                         41,263          21,699          30,708
Asset management and other fees                         29,861          19,026          14,585
Leasing commissions, acquisition and other
transaction fees                                        13,343           1,284              75
Investment management expenses                        (13,059)        (10,687)         (5,355)

Subtotal Asia                                           30,145           9,623           9,305

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