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PLD > SEC Filings for PLD > Form 10-Q on 7-May-2014All Recent SEC Filings

Show all filings for PROLOGIS, INC.

Form 10-Q for PROLOGIS, INC.


7-May-2014

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 2013 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 I, Item 1A. Risk Factors in our 2013 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 owner, operator and developer of industrial real estate, focused on global and regional markets across the Americas, Europe and Asia. As of March 31, 2014, we owned and managed operating properties and development projects totaling 574 million square feet (53.3 million square meters) in 21 countries. These properties were leased to more than 4,700 customers, including third-party logistics providers, transportation companies, retailers and manufacturers.

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

Our business is comprised of two operating segments: Real Estate Operations and Investment Management.

Real Estate Operations Segment

Rental Operations - This represents the primary source of our revenue, earnings and funds from operations ("FFO"). We collect rent from our customers under operating leases, including reimbursements for the vast majority of our operating costs. We expect to generate long-term internal growth in rental income by maintaining a high occupancy rate, controlling expenses and through rent increases. Our rental income is diversified due to our global presence and broad customer base. We believe that our property management, leasing and maintenance teams, together with our capital expenditure, energy management and risk management programs create cost efficiencies, and allow us to capitalize on the economies of scale inherent in owning, operating and growing a large global portfolio.

Capital Deployment - Capital deployment includes development, re-development and acquisition of industrial properties that lead to rental operations and are therefore included with that line of business for segment reporting. We deploy capital primarily in global and regional markets to meet our customers' needs. Within this line of business, we capitalize on: (i) our land bank; (ii) the development expertise of our local personnel; (iii) our global customer relationships; and (iv) the demand for high-quality distribution facilities. 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 operating properties. We also develop properties for long-term hold, for contribution into our co-investment ventures, or occasionally for sale to third parties.

Investment Management Segment - We invest with partners and investors through our 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 through publicly traded vehicles such as Nippon Prologis REIT, Inc. ("NPR"). These private and public vehicles provide capital for distinct geographies across our global platform. We hold a significant ownership interest in these ventures ranging between 15-55%, which we believe provides a strong alignment of interests with our partners. We generate investment management revenues from our unconsolidated ventures by providing asset management and property management services. We may earn additional revenues from 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 during the life of a venture or upon liquidation. We believe our co-investment ventures will continue to serve as a source of capital for investments, provide incremental revenues and mitigate risk associated with our foreign currency exposure. We plan to grow this business through the formation of new ventures and growth in existing ventures.

Growth Strategies

We believe the scale and quality of our operating platform, the skills of our team and the strength of our balance sheet provide us with unique competitive advantages. We have a plan to grow revenue, earnings, net operating income ("NOI"), Core FFO (see definition below) and dividends that is based on the following three key elements:

Rising Rents. Market rents are growing across the majority of our markets at a pace ahead of our prior forecast. We believe this trend will continue, as market rents are still 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. As we are able to recover the majority of our operating expenses from customers, the increase in rent translates into increased net operating income, earnings and cash flow. During the first quarter of 2014, rental rates on roll over increased 7% and we had positive rent growth across all geographies. This represented the fifth-consecutive quarter of rent growth.


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Value Creation from Development. We believe one of the keys to a successful development program is to control land in strategic locations. Based on our current estimates, our land bank has the potential to support the development of nearly 180 million additional square feet. We believe that our land bank is carried on the books below the current fair value and we expect to realize this value going forward through development or sales. During the first quarter of 2014, we stabilized development projects with a total expected investment of $264 million. We estimate that after stabilization these buildings have a value that is 22% more than their book value (using estimated yield and capitalization rates from our underwriting models).

Economies of Scale from Growth in Assets Under Management. We believe we have the infrastructure and an acquisition pipeline that will allow us to increase our investments in real estate, with minimal increases to general and administrative expenses. During the quarter, our owned and managed portfolio increased through the acquisition of $370.5 million of buildings, principally in our unconsolidated ventures in Europe, and development starts of $172.2 million.

Summary of 2014

During the three months ended March 31, 2014, we completed the following activities:

We leased 33.7 million square feet in our owned and managed portfolio with average turnover costs (tenant improvements and leasing costs) of $1.26 per square foot. At March 31, 2014, our owned and managed operating portfolio was 94.5% occupied and 94.8% leased. This compares to 95.1% occupied and 95.1% leased at December 31, 2013, and 93.7% occupied and 94.2% leased at March 31, 2013.

Effective rental rates for leases signed during the quarter in our owned and managed portfolio increased 7.0% over in-place rents. In addition, we retained 84.6% of customers whose leases were expiring.

We commenced construction of 13 development projects on an owned and managed basis, aggregating 2.4 million square feet with a total expected investment of $172.2 million (our share was $140.5 million), including three projects (39% of our share of the total expected investment) that were 100% leased prior to the start of development. These projects have an estimated weighted average yield at stabilization of 7.7% and an estimated development margin of 22.2%. We used $35.5 million of land we already owned for these projects. We expect these developments to be completed on or before February 2015.

We invested $281.5 million in one of our unconsolidated co-investment ventures for acquisition of properties and debt repayment.

In January 2014, we closed on a U.S. co-investment venture, Prologis U.S. Logistics Venture ("USLV"), in which we have a 55% equity ownership and consolidate. At closing, the venture acquired a portfolio of 66 operating properties from us aggregating 12.8 million square feet for a purchase price of $1.0 billion.

We generated net proceeds of $81.2 million from the disposition of land and five operating buildings to third parties and recognized a net gain of $16.1 million.

We issued 700 million of senior notes in February and used the net proceeds primarily to repay borrowings under our credit facilities.

We increased the portion of our equity denominated in U.S. dollars to 82% from 77% at December 31, 2013.

Operational Outlook

The global logistics real estate market improved in the first quarter of 2014. Operating fundamentals are strengthening and we believe this trend will continue as the leading indicators of industrial real estate are positive. Global trade is expected to grow 4.3% in 2014 and 5.3% in 2015 (a). Based on our internal analysis, activity levels and space utilization in our facilities continues to trend higher, which means our customers have limited capacity to handle their current needs and potential future growth.

Market conditions in the U.S. are favorable and an ongoing supply and demand imbalance exists. Net absorption continues to exceed new supply, albeit at a more modest pace than in 2013. During the quarter, net absorption totaled 43 million square feet and completions were 23 million square feet (b). These conditions have driven U.S. market vacancy to 7.0%, which is the lowest since 2000 (b). As customer demand remains active and supply pipelines are below historical norms, we expect vacancy to continue to decline and rental rates to increase further.

Operating conditions in our Latin American markets are positive. In Mexico, GDP growth is expected to be 3.0% in 2014, up from just 1.1% last year (a). Demand has continued to recover and the market occupancy rate across the six largest logistics markets (Mexico City, Monterrey, Guadalajara, Juarez, Reynosa and Tijuana) was 91.6% at March 31, 2014, an increase of 0.7% from the prior year, based on internally generated data. Brazil is an underserved logistics market. Consequently, while economic growth has been uneven, demand for modern logistics facilities remains strong as companies serve the growing consumer market.

In Europe, operating conditions are improving although at an uneven pace. Economic momentum turned positive in 2013 and, in our view, brighter macroeconomic prospects are generating demand for logistics facilities. Customer sentiment is also strengthening. The pan-European market occupancy was 91.3%
(c) as of December 31, 2013, higher than the level achieved in 2007 as near-record low development activity has tightened the market. The occupancy rate rose 1.0% in 2013 and we expect further gains in 2014 due to prospects for stronger demand and still-low development levels. We expect net effective rents will increase and the recovery will broaden. We believe improving occupancy and rent growth, combined with a rapid decline in capitalization rates will lead to an increase in European logistics real estate values.


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Market expansion is evident in our Asian markets and our business is a direct beneficiary. In Japan, vacancy rates remain below 5% (b).The availability of Class-A distribution space remains constrained and net effective rents are rising; in part due to upward pressure on construction costs, especially in Tokyo and Osaka. 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. In our view, low vacancy rates will lead to significant rental rate growth. 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 effective rents. We expect to use our land bank to support increased development activity in this environment. Our development business comprises speculative, build-to-suit, value-added conversions and redevelopment activities. 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) based on calculations derived from data from CBRE, Jones Lang LaSalle, DTZ and Gerald Eve

Results of Operations

Three Months Ended March 31, 2014 and 2013

Real Estate Operations Segment

Included this segment is rental income and rental expense recognized from our consolidated operating properties. We had significant real estate activity during 2013 that 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, and has fueled development activity. Also included in this segment is revenue from land we own and lease to customers and development management and other income, offset by acquisition, disposition and land holding costs.

We adopted a new accounting standard as of January 1, 2014, which changed the criteria for classifying and reporting discontinued operations. As a result, none of our property dispositions in 2014 met the criteria to be classified as discontinued operations, while the results of properties sold to third parties during 2013 were reclassified to Discontinued Operations under the previous standard.

NOI from the Real Estate Operations segment for the three months ended March 31 was as follows (dollars in thousands):

                                                    2014            2013
          Rental and other income                $  302,010      $  349,448
          Rental recoveries                          87,362          96,888
          Rental and other expenses                (115,570 )      (134,707 )

          NOI - Real Estate Operations segment   $  273,802      $  311,629

          Operating margin                             70.3 %          69.8 %
          Average occupancy                            94.6 %          93.1 %

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

                                 March 31,        December 31,       March 31,
                                    2014              2013              2013
          Number of properties        1,614               1,610           1,647
          Square Feet               270,527             267,097         259,840
          Occupied %                   94.6 %              94.9 %          93.1 %

Below are the key drivers that have influenced the NOI of this segment:

We contributed a significant amount of properties into two new unconsolidated co-investment ventures in February and March 2013. As a result of the contributions of these properties, our NOI decreased $80.2 million in 2014 from 2013. Since we have an ongoing ownership interest in these ventures, our share of the results remained in Continuing Operations in the Consolidated Statements of Operations in Item 1 through the contribution date.

Average occupancy of our operating properties increased from 93.1% at March 31, 2013, to 94.6% as of March 31,2014. In our Real Estate Operations segment in 2014, we leased a total of 16.7 million square feet and incurred average turnover costs of $1.66 per square foot. This compares to the first quarter of 2013, during which we leased 21.9 million square feet with average turnover costs of $1.52 per square feet. The increase in turnover costs is due to higher leasing commissions as a result of the longer term and higher value on the leases signed.

We recognize changes in rental income from certain contractual rent increases from our existing leases and from rent change on new leases. If a lease has a contractual rent increase based on the consumer price index or similar metric, it is not included in rent leveling and therefore any increase will impact the rental income we recognize.


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We increase the size of our portfolio through acquisition and development activity and expect to continue to do so in the future. During the first quarter of 2014, we completed or acquired 13 properties and in all of 2013, 42 properties.

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 79.0% and 74.3% of total rental expenses for the three months ended March 31, 2014 and 2013, respectively.

Investment Management Segment

The NOI from the Investment Management segment represents fees and incentives
earned for services performed reduced by investment management expenses (direct
costs of managing these entities and the properties they own). The following
table details this information by geographic location for the three months ended
March 31 (dollars in thousands):



                                                                   2014              2013
NOI - Investment Management Segment:
Americas:
Asset management and other fees                                  $  11,827         $  13,297
Leasing commissions, acquisition and other transaction fees          2,748             2,890
Investment management expenses                                     (12,519 )         (13,304 )

Subtotal Americas                                                    2,056             2,883
Europe:
Asset management and other fees                                     17,251             9,836
Leasing commissions, acquisition and other transaction fees          4,449               777
Investment management expenses                                      (8,016 )          (3,742 )

Subtotal Europe                                                     13,684             6,871
Asia:
Asset management and other fees                                      7,819             5,585
Leasing commissions, acquisition and other transaction fees          1,216             1,250
Investment management expenses                                      (3,628 )          (2,863 )

Subtotal Asia                                                        5,407             3,972

NOI - Investment Management segment                              $  21,147         $  13,726

Operating Margin                                                      46.7 %            40.8 %

We had the following assets under management held through our unconsolidated co-investment ventures (in thousands):

                                March 31,       December 31,       March 31,
                                   2014             2013              2013
            Americas:
            Square feet             109,147           108,537          127,869
            Gross book value   $  8,319,944     $   8,252,983     $  9,203,940
            Europe:
            Square feet             136,647           132,876          119,736
            Gross book value   $ 12,183,569     $  11,880,603     $  9,640,742
            Asia:
            Square feet              23,332            22,880           20,027
            Gross book value   $  3,770,146     $   3,697,179     $  3,399,615
            Total:
            Square feet             269,126           264,293          267,632
            Gross book value   $ 24,273,659     $  23,830,765     $ 22,244,297

Investment management income fluctuates due to the size of co-investment ventures that are under management. Investment management expenses, which include direct costs associated with asset and property management, totaled $24.2 million and $19.9 million for the three months ended March 31, 2014 and 2013, respectively. The increase in NOI in 2014 was due to the new ventures that were formed in Europe and Asia during first quarter 2013.

See Note 4 to the Consolidated Financial Statements in Item 1 for additional information on our unconsolidated entities.


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Other Components of Income

General and Administrative ("G&A") Expenses

G&A expenses for the three months ended March 31 consisted of the following (in
thousands):



                                                      2014           2013
        Gross overhead                              $ 117,249      $ 106,745
        Reclass to rental expenses                     (8,123 )       (9,466 )
        Reclass to investment management expenses     (24,163 )      (19,909 )
        Capitalized amounts                           (21,760 )      (21,173 )

        G&A expenses                                $  63,203      $  56,197

The increase in gross overhead was principally due to timing differences and we expect future quarters to be lower than the first three months of 2014. We allocate a portion of our G&A expenses that relate to property management functions to our Real Estate Operations and Investment Management segments.

We capitalize certain costs directly related to our development and leasing activities. Capitalized G&A expenses include salaries and related costs, as well as other general and administrative costs. The capitalized G&A for the three months ended March 31, were as follows (in thousands):

                                                           2014         2013
        Development activities                           $ 16,861     $ 15,190
        Leasing activities                                  4,718        5,485
        Costs related to internally developed software        181          498

        Total capitalized G&A expenses                   $ 21,760     $ 21,173

For the three months ended March 31, 2014 and 2013, the capitalized salaries and related costs represented 23.0% and 24.8%, respectively, of our total salaries and related costs. Salaries and related costs are comprised primarily of wages, other compensation and employee-related expenses.

Depreciation and Amortization

Depreciation and amortization expenses were $160.3 million and $172.1 million for the three months ended March 31, 2014 and 2013, respectively. The decrease was principally a result of disposition and contribution of properties, offset slightly by additional depreciation and amortization from completed development properties and increased leasing activity.

Earnings from Unconsolidated Entities, Net

We recognized earnings related to our investments in unconsolidated entities that are accounted for under the equity method of $29.7 million and $24.8 million for the three months ended March 31, 2014 and 2013, respectively. The earnings we recognize are impacted by: (i) variances in revenues and expenses of the entity; (ii) the size and occupancy rate of the portfolio of properties owned by the entity; (iii) our ownership interest in the entity; and
(iv) fluctuations in foreign currency exchange rates used to translate our share of net earnings to U.S. dollars, if applicable. We manage the majority of the properties in which we have an ownership interest as part of our owned and managed portfolio. See the discussion of our co-investment ventures above in the Investment Management segment discussion and in Note 4 to the Consolidated Financial Statements in Item 1 for further breakdown of our share of net earnings recognized.

Interest Expense

Interest expense for the three months ended March 31 included the following
components (in thousands):



                                                     2014           2013
         Gross interest expense                    $ 102,464      $ 135,812
         Amortization of discount (premium), net      (5,835 )      (10,715 )
         Amortization of deferred loan costs           3,467          3,288

         Interest expense before capitalization      100,096        128,385
         Capitalized amounts                         (14,573 )      (13,744 )

         Net interest expense                      $  85,523      $ 114,641

Gross interest expense decreased in 2014 compared to 2013 due to lower debt levels, offset slightly by an increase in interest rates. As of March 31, 2014, we decreased our debt by $0.2 billion from March 31, 2013. Near the end of the first quarter of 2013, we decreased our debt by $2.7 billion, primarily from the proceeds received with the contributions made to our two new unconsolidated co-investment ventures. Our weighted average effective interest rate was 4.7% and 4.6% for the three month period ended March 31, 2014 and 2013, respectively.

See Note 6 to the Consolidated Financial Statements in Item 1 and Liquidity and Capital Resources for further discussion of our debt and borrowing costs.


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