Prologis' CEO Discusses Q1 2014 Results - Earnings Call Transcript

Apr.22.14 | About: Prologis (PLD)

Prologis, Inc. (NYSE:PLD)

Q1 2014 Results Earnings Conference Call

April 22, 2014, 12:00 PM ET

Executives

Tracy A. Ward – SVP of IR and Corporate Communications

Hamid R. Moghadam - Chairman, Chief Executive Officer

Thomas S. Olinger - Chief Financial Officer

Eugene F. Reilly - Chief Executive Officer of the Americas

Gary E. Anderson - Chief Executive Officer of Europe and Asia

Michael S. Curless - Chief Investment Officer

Analysts

Brendan Maiorana - Wells Fargo Securities, LLC

James C. Feldman - BofA Merrill Lynch

Michael Bilerman - Citigroup Inc.

Vance H. Edelson - Morgan Stanley

John W. Guinee - Stifel, Nicolaus

George Auerbach – ISI Group

Craig Mailman - KeyBanc Capital Markets Inc.

Eric Frankel - Green Street Advisors, Inc.

David B. Rodgers - Robert W. Baird & Co. Incorporated

Michael J. Salinsky - RBC Capital Markets, LLC

Ross T. Nussbaum - UBS Securities

Michael W. Mueller - JPMorgan

Ki Bin Kim - SunTrust Robinson Humphrey, Inc.

David Harris - Imperial Capital

Operator

Good afternoon. My name is Shirley, and I will be your conference operator today. At this time I would like to welcome everyone to the Prologis First Quarter Earnings Conference Call. (Operator Instructions). Thank you. Ms. Tracy Ward, Senior Vice President of Investor Relations, you may begin your conference.

Tracy A. Ward

Thanks Shirley, and good morning, everyone. Welcome to our first quarter 2014 conference call. The supplemental document is available on our website at prologis.com under Investor Relations. This morning we'll hear from Hamid Moghadam, our Chairman and CEO, who will comment on the company's strategy and the market environment; and then from Tom Olinger, our CFO, who will cover results and guidance. Also joining us for today's call are Gary Anderson, Mike Curless, Ed Nekritz, Gene Reilly and Diana Scott.

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 in the industry in which Prologis operates, as well as management's beliefs and assumptions. Forward-looking statements are not guarantees of performance and actual operating results may be affected by a variety of factors. For a list of those factors please refer to the forward-looking statement notice in our 10-K or SEC filing.

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 will turn the call over to Hamid and we'll get started. Hamid?

Hamid R. Moghadam

Thanks, Tracy and good morning everyone. We had a strong first quarter and 2014 is shaping up to be a good year for us. We see excellent momentum across all our business lines and geographies. Markets continue to improve pretty much everywhere around the world. Rents and occupancies are recovering at a pace ahead of the forecast we gave you at our investor forum last fall.

In the U.S. absorption is running more than double the pace of new completions, pushing occupancies above pre-crisis levels. We expect this trend to continue throughout 2014 albeit at a more modest pace. We see no general signs of overbuilding although speculative starts in Dallas are getting ahead of demand. There is also a fair amount of new construction in the Inland Empire and Houston but we are not concerned about those markets as absorption is more than keeping pace with new supply.

Turning to capital flows we see significant investor demand for quality industrial real estate. Appraisals lag real time transactions and our view of the market by 25 to 50 basis points. At the same time the market chatter about portfolio pricing is a further 25 to 50 basis points inside where we think the real market is today.

Moving to Europe the leasing markets are also improving but at an uneven pace. UK and Northern Europe are strong and Southern Europe is slowly getting better. While strengthening Italy and Romania are the two softest markets in Europe. Across the Continent cap rates are compressing rapidly and appraisals are 50 to 100 basis points behind real time transactions.

In Brazil, Mexico and China the markets are much stronger than the economic headlines would suggest, consumer interest -- the customer interest in our product remains solid. In Japan markets continue to tighten and rents are increasing faster than our previous expectations. Japan is a market with the biggest upward pressure on construction cost.

Switching to our three lines of business, ops led the way in the first quarter. Overall occupancies held up better than our expectations and rental growth was above plan. In our development business margins on starts and stabilizations were well above average. Our pipeline for the rest of the year continues to look strong in terms of volume and projected profit margins. We had a good quarter of acquisitions in Europe ahead of compressing cap rates.

As we look forward given the strength of pricing in the U.S. we're putting more of our non-strategic assets on the market for sale in 2014. With respect to acquisitions here in the U.S., we are only spending time on transactions where we can have a competitive advantage in terms of our scale and our expertise or see value at discounts to replacement costs.

In investment management business we experienced another quarter of strong fund raising across all our vehicles. Our ongoing dialogue with perspective investors is as strong as I remember in our entire history. We are turning away more business than we choose to take on.

We are now rated BBB Plus by S&P in the top quintile of REITs. This represents the second full upgrade over the last 12 months and is a long way away from where we started at the close of the merger. We still plan to have one of the top balance sheets in the business and to attain an A rating in the near future.

To sum it all up we're feeling pretty good about our business, where it is today and where it's going. We expect strong rental growth through the balance of the year and beyond, development and investment management businesses are two powerful engines for profitable growth going forward. And finally we are at the point in our evolution where we can grow significantly in scale with very little incremental investment in corporate overhead. With that let me turn it over to Tom who will take you through the numbers.

Thomas S. Olinger

Thanks, Hamid. I'll start with our results for the first quarter. Core FFO was $0.43 per share, about $0.01 ahead of our expectations. The outperformance was driven by higher NOI. Additionally interest income was higher than expected due to the recovery of a notes receivable that was fully reserved. Leasing volume totaled 32 million square feet consistent with the first quarter of 2013.

Our quarter-end occupancy was 94.5%, down 60 basis points from year-end and in-line with our historical first quarter seasonality. Americas and Asia occupancy outperformed expectations with the drop from year end at 30 and 40 basis points respectively. Europe occupancy was modestly lower than forecast, dropping a 130 basis points. GAAP rent change on rollover was 7% and positive across all geographic divisions led by the Americas at 10.4%. Notably Europe's rent change on rollover was 3%. Cash rent change on rollover was positive 1.1% for the quarter.

Same-store NOI for the quarter increased 3% on a GAAP basis and 4.1% on an adjusted cash basis. G&A was $63 million in the first quarter which is typically our highest quarter due to the seasonal nature of incentive compensation.

Turning to capital deployment, in the first quarter development stabilizations were $264 million, with an estimated margin of 22% generating our share of value creation of $51 million or about $0.10 a share. Building acquisitions were $371 million with the weighted average stabilized cap rate of 7% and were primarily in Europe. We also started a $172 million of new development projects at an estimated margin of 22%.

For dispositions and contributions in the quarter we completed $1.2 billion generating $568 million, our share at a weighted average stabilized cap rate of 6.2% with most of this activity related to the U.S. logistics venture contributions.

Moving to investment management; operating income was $21 million in the quarter in-line with our expectations. Following a record year in 2013 institutional investor demand remained strong. Year-to-date we've raised $582 million of third-party equity, primarily for our European ventures. Our capital raising and deployment drove investment management AUM higher to more than $27 billion at the end of the quarter.

Switching gears to capital markets, we completed $1.2 billion of financings in the first quarter. We continue to capitalize on low interest rates particularly with euro-denominated debt to extend term, lower interest cost and align the currency of our debt and assets. Our LTV and debt-to-EBITDA credit metrics increased slightly this quarter due to deployment timings. However we expect our credit metrics will continue to improve with NOI growth from high occupancy and rising rents.

We repatriated the majority of the $700 million euro bonds proceeds back to U.S. dollars, which increased our U.S dollar held equity to 82% from 77% at year-end. Subsequent to quarter-end we redeemed a $175 million of bonds maturing in 2015 and repaid $239 million of secured debt. Additionally Prologis European Properties Fund 2 issued a $300 million Euro bond.

The recent credit rating upgrade from Standard & Poor's to BBB plus is affirmation of our earnings trajectory, liquidity, access to multiple sources of public and private capital and our commitment to build one of the strongest balance sheets in the REIT sector. For 2014 we continue to expect year-end occupancy to reach between 95% and 96% and GAAP same-store NOI to range between 3% and 4%.

On expenses; net G&A is forecasted to range between $233 million and $243 million. For capital deployment we continue to expect $1.8 billion to $2.2 billion of development starts with 80% our share and building acquisitions between $500 million and $1 billion with our share at 40%. For contributions our forecast is unchanged at $2 billion to $2.25 billion with 50% our share.

For dispositions; given the increase in divestiture demand as Hamid mentioned we're raising our guidance by $250 million to range between $750 million and $1.25 billion with 80% our share. The increased dispositions will be primarily in the U.S. We can self-fund our growth this year as proceeds from contributions and dispositions approximately equal our forecasted deployment. Our investment management guidance remains unchanged with revenue ranging between $200 million and $210 million and expenses between $95 million and $100 million representing an operating margin of about 50%. This guidance includes the promote we expect to recognize in the second quarter net of expenses of approximately $20 million from our open-ended target U.S. Logistic Fund.

We have added promote eligibility date disclosure in the supplemental and you should note that we have an opportunity to earn a promote in each year of the foreseeable future. For FX we are continuing to assume the euro with 1.35 and the Yen at 105 for the year and our U.S. dollar net equity to range between 85% and 90% at year-end.

Putting this all together given the strong start to the year we are raising the low end of our prior guidance and now expect full year core FFO to range between a $1.76 and a $1.82 per share. At the midpoint of our guidance range 2014 core FFO is expected to grow more than 8% year-over-year

We expect second quarter core FFO to be higher than the first quarter principally as a result of the USLF promote. As we are moving to the second half of the year we expect rent growth and increased NOI from development stabilizations to steadily increase core FFO. To sum it up we had a good quarter and we are excited about our prospects for the remainder of the year.

With that I’ll turn it to the operator to open it up for questions.

Tracy A. Ward

Shirley?

Question-and-Answer Session

Operator

I apologize ma’am I was on mute. (Operator Instructions). Our first question comes from the line of Brendan Maiorana from Wells Fargo Securities. Your line is open.

Brendan Maiorana - Wells Fargo Securities, LLC

Thanks, good morning. Tom I wanted to ask about guidance and you went through the details. It seemed like the main change from the parameters that you give us was the increased dispositions to take advantage of strong pricing that was out there. But you did raise the low end by a couple of pennies. So I am just wondering what the offset is given that it seems like the deployment expectations are about the same. Is it better on the operation side, is it better on the financing side or is there something else that’s driving the move up when dispositions would be -- could be a little bit of a headwind?

Thomas S. Olinger

Brendan, this is Tom, thanks for your question. It is driven by better NOI in the first quarter and our confidence with the operating fundamentals going forward. It's also the result of deploying our excess -- significant liquidity we had at the end of the year and in early January, a little faster than we thought. And we also have a little more visibility now on the size of the promote from USLF in the second quarter.

Looking forward we’ll be as efficient as we can on redeploying any excess disposition proceeds and as we mentioned we took our guidance up there. We’ll continue to look on how to do that efficiently on deployment, including redeeming bonds where we think the economics make sense.

Operator

Our next question comes from the line of Jeff Specter from Bank of America. Your line is open.

James C. Feldman - BofA Merrill Lynch

Thank you. This is Jamie Feldman here. Can you talk a little bit more about the occupancy dip in the first quarter? I think you had said it was pretty sizable in Europe and then taking it forward kind of what gives you conviction that you’ll get to your occupancy guidance by the end of the year?

Hamid R. Moghadam

Let me take that second part of that first. Jamie, it’s kind of happened every year in the last, I don’t know 25 years. So it's a good expectation. Our expectation is that it always dips in the first quarter and it always comes back and we have pretty good visibility in the leases we are working on for the second quarter and beyond. So that one is pretty much a given. I will let Gary talk about Europe.

Gary E. Anderson

Yeah so Jamie in Europe we are still bullish there. The macroeconomic recovery is accelerating, it's broadening. The recovery -- actually over the course of the past 90 days GDP forecast has increased by 30 basis points. We are sitting at about 1.5% GDP growth for the entire year. So the recovery as Hamid said is uneven and our operating results are sort of reflective of that. Things played out pretty much as we expected in Northern Europe and the UK, occupancies dropped while we started to push rents, makes perfect sense; we’re right in the sweet spot in those two geographies sitting at 96%, 97% occupancy and the ability to push rents.

We had hoped that we would be able to hold occupancies in Southern Europe and Central and Eastern Europe and we didn’t. There is not a concern there. There is no systemic issue at all and I expect occupancies to increase certainly about the third quarter of this year. So net-net we feel good about the operating results there and again this is the third consecutive quarter that we had positive rental growth in Europe, so 3% so all-in-all a pretty good result I think in Europe.

Operator

Our next question comes from the line of Michael Bilerman from Citi. Your line is open.

Michael Bilerman - Citigroup Inc.

Yeah, good morning up there, Kevin Varin's on the phone with me as well. Tom or Hamid I just wanted to talk sort of about free cash flow, equity, sort of dividend raise and when you look at the results in the first quarter, your core AFFO was effectively on top of the dividend which you lifted 18% to $0.33. When you think about the back half of the year if you put aside the $0.04 promote that you in the second quarter your core FFO was about $0.43 to $0.45. Let's assume the $0.10 drop from FFO to AFFO is similar, you got pretty tight coverage and so I guess from your perspective why raise the dividend and give away that free-cash flow ability and then also put an ATM in place of $750 million, potentially putting pressure even though the decisions are good and you can match fund this year, putting pressure on the need to raise equity where you got free cash, if you were to maintain the dividend where it was?

Hamid R. Moghadam

Wow, that was a pretty long winded question. I think you are assuming two businesses away which are pretty important as part of our overall lines of business. I mean you just put investment management away by assuming away promotes. That's a pretty important part of our business. And you also put away the development business that makes us $300 million to $400 million a year really, really.

So yes, if you just consider our operating business the dividend and our earnings power from just the rent business, assuming no growth in rents and occupancies which is again a draconian assumption, is right on top of the dividend but of course our view is that there will be growth in our rents and our occupancies and that the development in investment management business will be strong contributors to our overall financial picture. Tom, do you have anything to add?

Thomas S. Olinger

I will just add on the development side you have to remember that realized development gains or taxable income and that has to be distributed to shareholders, so you need to look at as Hamid said the totality of that business not just with the operating business. And when you look at on that basis our AFFO payout ratio would be in the mid to low 80% range.

Operator

Our next question comes from the line of Vance Edelson from Morgan Stanley. Your line is open.

Vance H. Edelson - Morgan Stanley

Thank you for taking the questions. So you touched on construction cost in Japan and you also discussed where you are seeing some construction activity domestically. Could you update us on the replacement cost in relation to rents in the U.S., the relative growth in both and how your own construction costs are trending domestically?

Eugene F. Reilly

Yeah, sure Vance it's Gene, I'll hit that one. So as we look at actual construction cost in the United States we saw sort of a 3% to 4% increase year-over-year. And we expect that to increase not significantly at this point but probably that goes to sort of a four to five range. And that's one component of replacement cost obviously. Land it's moving, I mean that's really all across the board but in a healthy market it is moving really quickly. So you are seeing sort of 10%, 15% increase.

When you boil all that together and you are probably looking on a go-forward basis something in the 7% plus range all-in. So we've got a keen eye on replacement cost and as you know we do a lot of development so it is something on one hand we are worried about, but on the other hand it sort of underpins where rent levels are and also underpins the growth in those rents.

Hamid R. Moghadam

Our rental forecast on our Investor Day was predicated on a 10% real growth in construction cost above and beyond inflation in the period between 2013 and 2016, that's kind of was the basis for that analysis which we shared with you in September of '13. I would say and that was a global forecast. I would say if you look at where we are and we were going to do that analysis over again I would say construction cost would be higher than those projections primarily because Japan is much, much higher and I would say the U.S. is higher and the growth is coming a little earlier than we thought in that analysis.

So I think there is -- that's why we think that forecast that we put out there is actually looking pretty conservative right now and we're ahead of it both in terms of occupancy, we're ahead of it in terms of rent. The only headwind to that forecast is that I would say cap rates have come in a little bit lower. So development can occur a little sooner with the same level of profitability than before.

So compared to September I would say global cap rates are down maybe 25 basis points. Where we really think they are now where the price stock is, the price stock is all kinds of -- if you really believed the price stock cap rates are down 50 maybe even more than that. I don't believe the price stock. But really, really cap rates are down 25 basis points, so that's a bit more of a headwind that will negate the construction cost increase. So roughly I think replacement cost rents are about where they were when we forecasted them in September.

Operator

Our next question comes from the line of John Guinee from Stifel. Your line is open.

John W. Guinee - Stifel, Nicolaus

Great. Thank you. Hey Tom can you -- I think it was Mr. Bilerman asked about dividend increase et cetera. Can you expand a little bit more for educational purposes on the -- basically in developing, merchant building investment sales business in the U.S. versus Europe. Because in the U.S., for the most part your normal real estate annual corporate taxes are sheltered via the REIT rules and you can usually -- if you want to do a 10-31 exchange and do other assets, how much leakage do you have in Europe because the U.S. REIT don't apply and you may or may not be able to use 10-31 exchanges. And how does that all translate into a percentage of your dividend that is almost guaranteed to go up as your merchant building business expands?

Thomas S. Olinger

Thanks for the question, John. So when you look at outside the U.S. the friction you get, well number one is those gains do come back and it is taxable income. You cannot shelter those gains through a 10-31 mechanism like you can in the U.S. So those earnings when they are repatriated come back and that's taxable income. The leakage on that is actually very minimal. We're very efficiently structured, both out of Europe and Asia and that leakage is generally in the low to mid-single digits, from a leakage perspective.

Hamid R. Moghadam

But here is the important point, John, they only are taxed when they come back here. So in terms of present value they are very low in terms of their net economic impact because they often times unless you're doing a lot of balance sheet gymnastics in terms of expanding or shrinking your balance sheet in these regions, which by the way we've being doing a lot of, but now we're in the stable mode given that we have all these fund structures in place and all that, we shouldn't be doing a whole bunch of repatriating.

We've moved up the share of our U.S. dollar equity to 82% already. So there isn't that much more of money coming back and forth. So I think you can think of effectively the present value of that leakage overseas if the absolute number is in the low single-digits the present value impact is going to be virtually zero.

Thomas S. Olinger

And then from a sizing perspective when you think about the size of our development pipeline and this is on a long-term run-rate basis if you just assume for even that $2 billion of development that stabilizes a year and a long-term margin of 15% that's $300 million. Probably two-thirds of that is happening outside the U.S. and will ultimately affect your taxable income. So a rough way to look at it would be about $200 million of potential taxable income as Hamid mentioned when it's repatriated could come back to your USTIs.

Operator

Our next question comes from the line of George Auerbach from ISI Group. Your line is open.

George Auerbach – ISI Group

Great, thanks. Hamid you mentioned the investment opportunity in Europe a few times now. Can you give us a sense for any portfolio sized deals in the market today? And how long of a horizon you see to put capital to work in Europe at above average returns.

Hamid R. Moghadam

Well. Cap rates in Europe have compressed a lot faster than I ever thought. You really have this unusual situation where the appraisal community in Europe I would say is 50 to 100 but probably really more like 75 to 100 basis points behind real deals and we were very successful in the middle, actually all in 2013 and early part of this year. But now we are finding that we are actually losing deals, portfolio deals by maybe 25 basis points on the cap rate.

So markets in Europe have adjusted very, very quickly. You still have a good discount to replacement costs because rents are pretty low and you can still buy properties at the replacement cost. But the big surprise for me has been -- well UK really normalized in 2012, 2013 but the continent was right after it.

And if I were going to guess, probably since our Norges transaction there has been, which I think was basically the coasts are clear and the water is safe sign I have mentioned those cap rates were down 75 basis points, may be a 100 basis points and heading lower. So the investment opportunities in Europe are quickly, quickly dissipating. They are still attractive because you still have rent growth but you don’t have the combination of really high cap rate compression or rent growth like you had before. So still good but not great.

Gary E. Anderson

George, I would just add that our pipeline is still pretty strong and we were looking at over €1.8 billion worth of acquisition opportunities. And it’s a mix of one-off deals smaller portfolios call it in a $100 million range and then some larger portfolios. But there is pretty good activity there and better product again then I have seen in the last decade that’s come in to market. So there is still opportunity, I think.

Operator

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

Craig Mailman - KeyBanc Capital Markets Inc.

Thanks, good afternoon guys. Maybe could we just hit on U.S. development a little bit, you mentioned Dallas, looks like it may be getting a little bit ahead of itself but -- and then Inland Empire and Houston they are still on demand there to absorb the supply but on the other side you said cap rates in the U.S. are coming in a little bit more than you thought and may be that makes development easier. I guess as you guys look out on the horizon are there more markets sort of on the bubble of getting to Dallas or even Houston, Inland Empire type developments starts there that get you guys worried, or at this point is the runway still pretty good here in the U.S. for development?

Eugene F. Reilly

Craig, it is Gene I’ll take that one. Generally the answer to your question is yes, it does look pretty good. If you look across U.S. markets three of them stand out in particular, Dallas recently we mentioned, the Inland Empire and Houston. But in all of those cases if you study the metrics you look at where their actual vacancy rates are today, you look at historical absorption and supply as a percentage of stock, it’s kind of in balance but it's ramping up quickly as Hamid mentioned in Dallas it's ramping up really quickly.

So those are three markets we have our eyes on. We are very active in development in all three of them. There is no doubt as this recovery takes shape that more markets will fall into that category, but none of them are flashing red lights yet at this point.

Hamid R. Moghadam

So the only thing I would add is that keep the overall numbers in mind. The overall numbers are last year 65 million feet of new supply, 225 million feet of absorption. We under-built the market by about a 160 million square feet. That directly translated into vacancy rates dropping by more than any other year ever. And by the way that doesn’t account for obsolescence, putting that aside. This year we think absorption is going to be around 200 million with construction increasing to about a 100 million square feet. So the deficit that we had at the 160 million feet last year is going to be more like a 100 million feet this year which will mean that this will be the second best year for vacancy drop.

So now of that 100 million feet of supply my guess is 50% of it is in that three markets we’ve just talked about. And the reason that development is occurring in those markets, guess what rents have recovered, to replacement type rents. It’s not because people had more development talent or less disciplined or any -- or banks are more exuberant there. It’s just that the rents have recovered earliest in those markets and those rents are [through peaks] [ph].

So I think this volume of construction is directly related to rents. If rents pop 20% sooner than we thought you will get more development coming in these markets but until the other markets recover to the same extent I don't think you will see development.

Operator

Our next question comes from the line of Ki Bin Kim from SunTrust. Your line is open. Again Ki Bin Kim, your line is open.

Hamid R. Moghadam

Ki Bin, there is something wrong with your mike. Why don't we skip over and come back to him.

Operator

Our next question comes from the line of Eric Frankel from Green Street Advisors. Your line is open.

Eric Frankel - Green Street Advisors, Inc.

Thank you. I was wondering if you could just talk about your development pipeline a little bit. It seems like the number of starts is a little bit lower than I had probably anticipated given the amount of development you're expecting to be this year, may be you can just comment on that? Thank you.

Michael S. Curless

Sure, Eric this is Mike Curless. We are not particularly concerned about the first quarter. Historically our first quarter is always by far our lightest quarter. This year we started 13 projects they happen to be some smaller projects just due to mix and certainly weather was an impact on a couple of projects that we moved into the second quarter.

But relative to the overall volume for the year we certainly think there is bias to the upside, 80% of all of our activity is already identified. That's a very high number for this time of the year. And 80% was going to take place on land that we already own. The ramp up is already underway in Q2. And we expect that to increase steadily all the way through to the end of Q4 which is pretty typical for our pattern of development for the year.

We continue to have bias to the upside in Europe. And in Asia and don't rule out our [WC] business given our customer reach and our land control. So we feel pretty good about some upside opportunities in those three important categories. If history any indication we expect good margins again for the third year in a row. So I feel real good about not just the quantity of the activity but more importantly the quality of that activity.

Operator

Our next question comes from the line of Dave Rodgers from Robert W. Baird. Your line is open.

David B. Rodgers - Robert W. Baird & Co. Incorporated

Yeah, maybe for Gene and/or Hamid, I want to talk about capital raising in the U.S. obviously fairly quiet in the first quarter and tying that into your disposition acceleration the election to pursue disposition as opposed to contribution. So I guess one can you tie together the concept of capital raising in the U.S., the appetite here both for you as well as the partners out there.

And then the second is if it's more of a property quality issue that you are trying to clean-up, can you may be give a little color around cap rates and timing?

Hamid R. Moghadam

Sure, I think disposition is what we are buying and what we are selling are very different things. We have some residual cleanup of the portfolio left in our non-strategic markets and also the less strategic assets in core markets. And we're just getting along with that quicker than we would have otherwise because we see an opportunity to get good valuation. So but what we are buying on for USLF primarily, which is our active vehicle in the U.S. we're being very selective and we're buying for not just quality core products, that's a mandate of that fund. And we are very mindful of replacement cost and like I said in my prepared comments we're looking at situations that either our scale or expertise can add value.

But it's getting tougher and tougher and one of the things that we don't want to do is sign up for a huge pipeline of capital. There is plenty of interest for people who want to give us money. We are being selective in managing our pipeline so that we not only can raise money but can invest that money intelligently without any undue pressure for people who want to get their capital to work. So that's the balance. It's not lack of interest from investors. Quite to the contrary there is a lot of interest on the part of the investors and we're just trying to balance that with the opportunities that we see in the market.

Operator

Our next question comes from the line of Michael Salinsky from RBC Capital Markets. Your line is open.

Michael J. Salinsky - RBC Capital Markets, LLC

Good morning. Tom just given your comments about the increase in dispositions, can you just give us an update where you expect in the year in terms of U.S. equity exposures also overall leverage? And then also just so we have greater clarity in the promote, I think you had said $0.04 last quarter, is that still a good number to use?

Thomas S. Olinger

Sure Michael I'll take those up. First the equity we expect to end the year, our U.S. equity balance between, somewhere 85% and 90%. So right on top of what our long-term goal is there. From a leverage perspective if you look at the mid points of our sources and usage in our deployment and guidance that would put us right around 35% LTV at the end of the year. If you remember when you look out to the first quarter 2015 two things are happening, first we've got the convertible debt that we would expect to convert into equity. That is roughly about 200 basis points of LTV.

And then we also have optionality around the sell down of our interest in the Health venture that would get us to the low, very low near 30% LTV. And your last question was on the promote. Yes, I said we expect that to be around $20 million net of expenses or roughly $0.04 recognized in the second quarter.

Operator

Our next question comes from the line of Ross Nussbaum from UBS Securities. Your line is open.

Ross T. Nussbaum - UBS Securities

Thanks. Tom just on the same-store guidance, how much of a tailwind should we expect on the expense side going forward for the remainder of the year?

Thomas S. Olinger

I think what you saw -- I don't think there will be much of a tailwind for the rest of the year. What you saw in the first quarter was really the result of Q1 '13 expenses being higher than normal. So you shouldn't see much of any tailwind at all from expenses. We talked about this last quarter but when you look at same-store increase year-over-year you've got about 1.5% driven by just rent change. So I think about 15% portfolio of your portfolio turning over, 10% rent change, about a 150 basis points of occupancy improvement. So that's another 1.5% and then there is about 50 basis points of indexation that's not reflected in straight line rent.

So it's in this indexation, primarily in Europe where it's not a fixed income but it's based on an index that floats therefore you can't straight line it. So that indexation also comes through and that's about 50 basis points.

Operator

Our next question comes from the line of Michael Mueller from JPMorgan. Your line is open.

Michael W. Mueller - JPMorgan

Hi. I joined a little late, I apologize if I missed this. But I think you talked about longer-term development margins. If you're looking at the next round of developments starts and where do you see the stabilized yields coming in and the margins on this next batch?

Hamid R. Moghadam

I think for our starts this year the margins are going to be above 20% and I think, I said this now I think three years in a row and I've been wrong I think they are going to gravitate down to 15 but I may be wrong. I think our land is on the books at a pretty attractive price. So while we're monetizing that land I think our margins will be over stated until we work our way through that land and have to buy new land at market.

Thomas S. Olinger

And it's about a 2.5 year to 3 year supply, the land on our books today.

Hamid R. Moghadam

I think if we're going to pick a number for our land today on the books of the 1.6 billion I would say that land is easily 20% or 25% undervalued with the big area up.

Operator

Our next question comes from the line of Ki Bin Kim from SunTrust. Your line is open.

Ki Bin Kim - SunTrust Robinson Humphrey, Inc.

Thanks. Just have one follow-up on promote. In 2015 it looks like a larger portion of it does come from some of your newer -- newly established joint -- JVs in Europe and given your commentary about cap rate compression there and if your promotes are structured the way they are historically as such are based on IRR than sort of the laddered promote structures.

I think it will be a pretty sizable promote just even if a 100 basis points of cap rate compression would drive a big part of the IR calculation. As of today could you talk a little bit about what that size of promote would like potentially in 2015?

Hamid R. Moghadam

Ki Bin it's dangerous to do that because a million things have to happen before that promote is realized, including appraisers actually closing the gap between reality and what they are appraising. That's been very sticky in Europe and they are really lagging as I've now said three times I think by 75 or 100 basis points. I have no idea when they are going to start recognizing the evidence in the market, very, very sticky. But the best way I think to think about our promotes is that if you think that we're going to outperform our indices by call it 200 basis points of performance and historically that’s been about the order of magnitude or the outperformance that the company's experienced with that big range but kind of averaging around 200 basis points above the indices. The promotes are 15% to 20%.

So that translates into $0.30 to $0.40 of gross promotes, and the net promote is about 60% of the gross promote. So I think of it as a 25%, 25 basis point of AUM, third party AUM of-course we are not charging ourselves promotes, right. So take the third party AUM and if you want to model something that's relatively regular that’s the number I would use, particularly now that we are getting into the period that there is almost a promote coming in every period.

You are going to get some volatility around that but that’s of a kind not a bad bullet point. And I would say they would be biased towards the upside of that in the next three or four years given that we are recovering from a really horrible three or four year period where there were no promotes and most values are reverting to the norm. So I think we are entering a good period of promotes for the company and it’s a real part of our business I wish people would go spread it forth.

Operator

Our next question comes from Brendan Maiorana from Wells Fargo Securities. Your line is open.

Brendan Maiorana - Wells Fargo Securities, LLC

Thanks, I had a couple of follow-ups. Just first on the new supply versus the net absorption calculation or projection, I know for 2014 it’s been consisting a 100 million of its new expectations versus 200 million. I wonder, based on where the development starts are shaping up how you think that outlook may trend in 2015? And then second question the improvement in the secondary market location, which is causing you had sell some of your none-core assets. Is that driven by improvement in fundamentals in those markets, is it accelerating more in the secondary markets? Or is it just capital slowing into those markets because cap rates in primary markets are low?

Hamid R. Moghadam

I think fundamentals are getting better in all markets, so including the secondary market. So the way the capital means that you can achieve better pricing in those markets in terms of timing then we thought otherwise. So the transactions that were slated for late there is no sense waiting for later because you can achieve the same thing earlier and the decision, the same those have been determined to be non-strategic and so we are going to sell it. And what was the first part of question?

Brendan Maiorana - Wells Fargo Securities, LLC

The ag -- what happened in 2015?

Hamid R. Moghadam

Supply will be up only because rents will be up and it will make more sense to build in more market. So again we shouldn’t think about these issues in compartments. Supply relates to where rents are and where profitable development can take place. And if you buy the thesis of recovery in a broader range of markets you would see development in a broader range of market. But again let me put this in perspective I’ve been in this business since 1983. That’s I hate to say it but that’s 31 years.

There have never been periods where we have under-built the demand in the U.S. anywhere near these levels that we experienced last year and this coming year and next year. It’s just unprecedented so vacancies are compressing rapidly. And I think together with that rents are increasing rapidly and it’s not because this all of a sudden became the best business in the worlds. It’s because we are climbing out of the basement, the basement that we all fell into in '08 and '09. So afterwards -- climbing out of the basement let’s see how disappointed people are just to point that we will have a good long term sustainable period of rent growth once we’ve reached a equilibrium. But between now and equilibrium expect a rapid rent growth.

Operator

Our next question comes from the line of Jeff Specter of Bank of America. You line is open.

James C. Feldman - BofA Merrill Lynch

Great, thanks it's Jimmy Feldman again. I was hoping you guys could talk a little bit more about the types of tenant demand you are seeing? And may be how it’s changing or how you might expect it to change over the near term given where we are in the economic cycle? In fact in terms of sectors then and what people are doing with this base?

Michael S. Curless

Jimmy this is Mike Curless certainly seeing a lot of movement in a variety of sectors and our customer demands e-commerce, packaging, housing related auto related. E-commerce is a real large driver there, probably see them doing about 15% of the activity in our existing portfolio in our new space in the development pipeline those numbers are more like 30% of that activity, the space sizes tend to much larger than traditional brick and mortar uses. So plenty of activity in e-commerce. The customers are gravitating towards large population centers, the Amazon affect is well underway in terms of people wanting to be closer to the customers for the possibility of same day delivery. So we're seeing a lot of activity in our global markets and that plays very well with our platform given our high percentage of land and buildings in those particular markets.

Hamid R. Moghadam

The only thing that I would add is that the three PLs are back. There are big customer segment for us. And if you would ask me a year ago how the three PLs were reacting, they were securing a contract, logistics contract before the secured real-estate and today it's exactly the opposite. They realized that because of the dwindling supply they have to secure the real-estate in order secured logistics contract. So I would say that's an interesting trend that's occurred over the course of last 12 months.

James C. Feldman - BofA Merrill Lynch

Globally?

Hamid R. Moghadam

Globally, yeah.

Operator

Our next question comes from the line of Michael Bilerman from Citi. Your line is open.

Michael Bilerman - Citigroup Inc.

Yes, I had a few follow ups almost rattle them off just things to NOI you present the gross basis, I am just curious what that would be on a pro-largest share effectively your consolidated plus your share of joint ventures, number one. Number two, the Japan land sale 21 acres for $55 million, $107 per billable foot seems high. I know land prices are high in Japan, just curious what's going on there.

The third just ATM, I know you had the ATM last June you didn't issue anything you -- how should we think about your intent to use it going forward. And lastly just on the expense recovery rate, it was about 79% this quarter which was higher than last year, higher than the first quarter of last year so it seems like that perhaps had something to do, I am not sure with same-store expenses and revenues, if you can just clarify what's your hope that would be helpful? Thanks.

Hamid R. Moghadam

So Michael I would be happy to answer any one of those questions that you select. What would you like me to take, which one would you like to take. We are trying to have the fair process for everybody to get their questions in, so.

Michael Bilerman - Citigroup Inc.

All right you can answer equity one first and then I'll re-queue up for the same-store which would be the second one just to understand.

Hamid R. Moghadam

So that would be great. We don't foresee any need for equity in our business for all the reasons that Tom talked about. And yes, we do have the ATM program in place and we did renew but we don’t expect to be underneath it unless our investment, opportunities set changes from where it is today and where we see it today.

Operator

Our next question comes from the line of Eric Frankel from Green Street Advisors. Your line is open.

Eric Frankel - Green Street Advisors, Inc.

Thank you. Can you maybe just discuss what's causing the increase in prices or decrease in cap rates. Our understanding is that a lot of the institutional capital has been partnering with most of those to build those new shiny product. But it appears that it's now kind of gone the other way where B product is getting a little bit of better because rapidly improving better fundamentals.

I am just trying to figure out is a lot of new capital also or the same capital willing to allocate more.

Hamid R. Moghadam

Our impression is that there is a lot of private equity that's interested in the sector and it is the weight of capital and it's almost interested in bulking up plays are popular. So I guess that's the incremental capital we see in the marketplace, the institutional stuff. And the non-traded green sector continue to be active. But I would say the incremental capital is really private equity Mike do you have more --?

Michael S. Curless

More to add there, Yeah when you see 15 or 20 people trying to buy a product in LA and obviously only one could be successful. You are seeing four or five people on that list moving to B product and or moving to regional markets as well. We continue to see a real lot of capital and quite a few new players in the mix these days.

Operator

Our next question comes from the line of Michael J. Salinsky from RBC Capital Markets. Your line is open.

Michael J. Salinsky - RBC Capital Markets, LLC

May be just going back to the compression you talked about in cap rates in Europe over the last six months relative to what you are seeing in terms of rent growth are return thresholds coming in or is your expectation in '14, '15, '16 that the growth is going to accelerate to justify that compression at this point?

Thomas S. Olinger

I think it's anticipation of rent growth and availability of financing in Europe that are the two things that changed and also I think Financing in Europe that are the two things that are changed. And also I think it is the fact that the ice was broken, I really think our Norges transaction without dwelling on that too much was really a sign that the waters are safe. And almost immediately after that people start piling into Europe in a big way. So I think primarily the cap rents that were high, higher than elsewhere in the globe because the financing markets were more frozen then the rest of the globe, attracted people in.

Now that cap rates have compressed I think people are attracted to Europe not because there is a little bit more cap rates compression that’s going to happen but also rent growth is kicking in and you can still buy product that’s below. So I think that’s the attraction and it can be all finance now which it couldn’t be two years ago so those are the dynamics.

The way I would think about it Michael was that is just like the U.S. may be two and half year lag with may be the UK being only a year and half behind the U.S. and some of the parts of Eastern and Southern Europe been three years behind the U.S. and sort of the average of Europe being two and half years failing the U.S. same pattern.

Hamid R. Moghadam

Focus on the core market today in Europe and they will gravitate to the secondary markets over time.

Our next question comes from the line of Michael Bilerman. Your line is open.

Michael Bilerman - Citigroup Inc.

More questions than -- can you hear me now?

Hamid R. Moghadam

Michael, it’s your turn again.

Michael Bilerman - Citigroup Inc.

Yeah, I can hear you. Can you hear me?

Hamid R. Moghadam

We can hear you fine.

Michael Bilerman - Citigroup Inc.

I thought round two we get more questions, I apologize. I didn’t read the rules correctly enough. So just on saying that…

Hamid R. Moghadam

Okay, I may give you two.

Michael Bilerman - Citigroup Inc.

Okay. Same-store NOI you presented on the total share what would that be in terms of just Prologis’ share and were there anything funky going on in the consolidated portfolio on expense recovery is that certainly higher year-over-year and I don’t know if it played until the total things stores well?

Thomas S. Olinger

So Michael -- so you are right. What we present is that on demand it's across our entire stack at same-store. I don’t have our proportionate share committed to memory, I can certainly follow up on that but it's certainly higher than the owned to manage because of the rails of U.S. waiting. So when you think about our U.S. equity now across 80% that will really drive our underlying earnings. And when you look at how the U.S. is leading the charge on all the operating metrics whether it’s rent change on rolling in the quarter was 10.4%. So our bottom line our look through would be better than owned to manage.

And then on the expense recovery side as I mentioned earlier there is nothing going on unusual other than Q1 of ’13 expenses were higher than normal and that's the trail off that you see this year and going forward for the rest of this year, we don’t expect any unusual expense changes and that’s going to be the real occupancy and rents driving same store.

Hamid R. Moghadam

Hey Michael by the way one thing I would add just to philosophically so you understand why we don’t crack that number separately is that we’ve really always operated under this philosophy of one portfolio policy and there -- our people on the field don’t really differentiate whether we own 20% or something 50% or something or a 100%or something we run it on ownership blind basis. And the stats are reported on an ownership blind basis for that reason. That’s the only way we can do a good job for our institutional investors. So really the only thing that Mike -- that Tom is talking about is the mix. We have more fund mix in our non U.S. business then our U.S. business. So -- and given that the U.S. is early that the mix would drive you to that conclusion. But we actually don’t track those kinds of numbers by ownership type at all.

Operator

(Operator Instructions). Our next question comes from the line of David Harris from Imperial Capital. Your line is open.

David Harris - Imperial Capital

Yeah hello, thanks for taking my question. I apologies if you covered this, I was a little late on the call but if I look at your development cost capitalization you are running it fairly close to a $150 million on an annualized basis. Is that cost fully reflected in the development margins that you are quoting on page 23 and 24 of the current development program?

Thomas S. Olinger

Yes it is David and it’s a good question. I'm actually glad somebody asked it because I get that question at NAREIT all the time. The development margins that we report not only includes capitalized overhead that matches the number that you mention but it also includes a full carry on the entire capital not just on the debt portion that's assigned to that project. So we capitalize carry throughout the development process until it reaches stabilization. So I know some people don't do it quite that way and therefore our margins if they were done in the alternative way would even appear higher than they are today.

Hamid R. Moghadam

Okay, last opportunity for Michael to ask a question. The line is clear. Hearing none I want to thank you for your time on this call and look forward to talking to you at NAREIT, bye-bye.

Operator

This concludes today's conference call. You may now disconnect.

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