DCT Industrial Trust's (DCT) CEO Philip Hawkins on Q2 2014 Results - Earnings Call Transcript

Aug. 1.14 | About: DCT Industrial (DCT)

DCT Industrial Trust Inc. (NYSE:DCT)

Q2 2014 Earnings Conference Call

August 1, 2014 11:00 a.m. ET

Executives

Philip Hawkins – Chief Executive Officer

Matthew Murphy – Chief Financial Officer and Treasurer

Neil Doyle – Managing Director, Central Region

Analysts

Kevin Varin – Citigroup

Jamie Feldman – Bank of America Merrill Lynch

Eric Frankel – Green Street Advisors

Craig Mailman – KeyBanc Capital Markets

Gabriel Hilmoe – ISI group

Brendan Maiorana - Wells Fargo Securities

John Guinee – Stifel Nicolaus & Co.

Ki Bin Kim – SunTrust Robinson Humphrey

Paul Adornato – BMO Capital Markets

Michael Mueller – JP Morgan

Emil Shalmiyev - JPMorgan

Operator

Good day, and welcome to the DCT Industrial Trust Second Quarter 2014 Earnings Conference Call. All participants will be in listen-only mode. (Operator instructions) After today’s presentation, there will be an opportunity to ask questions. (Operator instructions) Please note this event is being recorded.

I would now like to turn the conference over to Melissa Sachs, Vice President, Corporate Communications and Investor Relations. Please go ahead.

Melissa Sachs

Thank you. Hello everyone and thank you for joining DCT Industrial Trust second quarter 2014 earnings call. Today’s call will be led by Phil Hawkins, our Chief Executive Officer; and Matt Murphy, our Chief Financial Officer, who will provide more details on the quarter’s results as well as our guidance for the balance of the year. Additionally, Neil Doyle, our Managing Director for the Central Region will be available to answer questions about the markets, and our real estate activities.

Before I turn the call over to Phil, I would like to remind everyone that management’s remarks on today’s call will include forward-looking statements within the meaning of federal securities laws. This includes, without limitations, statements regarding projections, plans, or future expectations. Actual results may differ materially from those described in the forward-looking statements and will be affected by a variety of risks, including those set forth in our earnings release and in our Form 10-K filed with the SEC, as updated by our quarterly reports on Form 10-Q. Additionally, on this conference call, we may refer to certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures are available in our supplemental, which can be found in the Investor Relations section of our website at dctindustrial.com.

And now, I will turn the call over to Phil.

Philip Hawkins

Thanks Melissa and good morning everyone. We had an excellent quarter, with strong operating performance, active capital deployment in recycling and continued progress leasing and growing our development pipeline. The quarter’s results, along with our increased confidence for the balance of the year, allowed us to increase the bottom end of our FFO guidance from $0.45 to $0.46 per share. We have left the top end of the guidance alone at $0.48 per share.

The Industrial leasing environment continues to be very healthy, with good tenant demand across all markets, size ranges and industry verticals, with the possible exception of housing which is not a material source of demand in most markets. Supply also remains favorable relative to tenant demand and the amount under construction held relatively flat from the first quarter in the more active construction markets and actually declined modestly in the Inland Empire, Houston and Pennsylvania. While supply will always be something to watch closely, I continue to believe that institutional equity replacing non-recourse debt as a primary funding source for new construction, especially speculative construction, will impose more discipline on our business than in past cycles. Only time will tell, but I remain optimistic.

Our operating metrics for the second quarter are on or ahead of internal expectations. Leasing volume was 3.9 million square feet, including 1.5 million square feet of new leases. Portfolio occupancy was up 10 basis points to 92.9%, even with the headwinds of the lease with the defaulted tenant in Indianapolis expiring.

Rent on signed leases increased 9.3% on a GAAP basis and 3.9% on a cash basis. As a result of higher occupancy as well higher rents, same-store NOI increased 4.2% on a cash basis and 5.5% on a GAAP basis. We remain active in both acquiring and selling assets, purchasing $87 million and selling $90 million since March 31. Today’s investment market definitely favors the seller, but we continue to find good quality acquisition opportunities that are often off market. We remain focused on highly functional buildings in in-fill locations with either some vacancy and or below market rents that present opportunities in today’s environment to achieve above average NOI growth.

For example, in an off market transaction, we recently closed on a 235,000 square foot three building project in Seattle that while 97% leased, had a lease for 44% of the project expiring at the end of this year. The seller was motivated to sell now rather than waiting to stabilize the building because he was using the proceeds to fund a charitable gift pledge. Because of the near term roll over, we were able to acquire the building at a higher cap rate than if it would have been fully stabilized. At the same time we put the building under contract. We started renewal discussions with the tenant and are close to an agreement on a new lease with rents that are materially higher than what is currently in place, which also includes annual bumps consistent with market practice.

This is a favorable environment from a sellers perspective and in addition to the sales we’ve already closed, we have several packages out in the market and are optimistic about closing most or all of them at prices that are materially higher than we would have expected a year ago. A number of these assets are in secondary markets where cap rates have compressed 100 basis points or so in the past 12 months.

Moving on to development, we signed the lease for the balance of our DCT 55 project in Chicago. While later then underwritten, the rent is significantly higher and the actual stabilized yield of 60 basis points higher than pro forma. Other leases signed on development projects include 190,000 feet or 53% of DCT Northwest Crossroads Logistic Center One in Houston and 105,000 square feet or 56% of Summer South in Seattle. We stabilized three projects located in Southern California, Houston and Seattle. Expected investment in these buildings total $57 million with anticipated stabilized yields of 7.6%. With cap rates for Class A products in each of these markets at or below 5%, our market teams have created a significant value for DCT.

Since March 31, we have started construction on 11 buildings, totaling 2 million square feet, with a projected investment of $115 million. These are located in Inland Empire, Atlanta, Dallas, Houston, Orlando and Seattle. As I said at the beginning of my remarks, this was an excellent quarter in every area of our business, which positions us well for continued success over the balance of the year.

With that, let me turn the call over to Matt, who’ll provide more color on the quarter, as well as update our 2014 guidance.

Matthew Murphy

Thanks Phil. Good morning everyone. Our second quarter operating results reflect very well on our portfolio, the strength of the industrial leasing market today and our market teams ability to capitalize on their strong market. Occupancy leasing spreads, and same-store NOI growth, maintained their positive trends and we continue to create value on the capital deployment front. As Phil mentioned, our operating occupancy increased 10 basis points during the quarter to 92.9%. We closed on the acquisition of a little over a million square feet of operating assets that were 89% occupied, and sold approximately 700,000 square feet of buildings that were 99% occupied. But the decline in occupancy this recycling would have cost was offset by the stabilization of 926,000 square feet of developments in Houston, Seattle and Southern California.

As a result, our same portfolio occupancy showed the same 10 basis point increase as our overall operating portfolio. This increase was achieved despite the predicted move out of our defaulted tenant in Indianapolis, which decreased occupancy by 80 basis points. With the legal wrangling successfully behind us, we were able to take physical possession of the space, and turn our focus to leasing it, as well as pursuing the collection of the receivable.

The news on our leasing front is very encouraging. We have signed a lease on one of the 428,000 square foot spaces, with occupancy beginning in September. And we have excellent activity in all three of the other spaces, although nothing to announce yet. The reason we were able to increase occupancy despite the move out in Indy, was the strength of new leasing. 700,000 square feet of the 1.5 million square feet of new leases executed during the quarter had moved in by June 30. This activity continued to trend over the past several quarters where tenants are making decisions and quickly moving in to accommodate their expanding businesses.

Small tenant leasing continued its positive run during the second quarter as reflected by the 50 leases signed on spaces 50,000 square feet and under. 500,000 square feet, or roughly 34% of the new leases signed during the quarter were on these smaller spaces, which helped drive occupancy in this segment to 93% at June 30, the highest level since the recession. All of this activity, in addition to our strong lease pipeline and excellent market fundamentals, has caused us to increase our expectation of yearend occupancy -- yearend operating occupancy to between 94% and 94.5% and we feel very good about our projections of mid-93s average occupancy. As always, these projections do not take into account the potential effect of any future acquisitions or dispositions.

During the same-store NOI growth, all the same positive factors, along with positive rental rate trends, help produce excellent same-store numbers. Cash same store NOI increased 4.2% for the quarter, and GAAP NOI increased 5.5%. Sequential same-store NOI growth was excellent as well with cash and GAAP coming in at 1.7% and 3.4% respectively. What's most encouraging to me is that even with the 120 basis point average occupancy increase in our same-store pool, over half of the year over year cash revenue increase in the second quarter was caused by embedded rent bumps, and the positive releasing spreads that we’ve been achieving over the past multiple quarters. The embedded growth in our existing lease portfolio, combined with the continued strength in market fundamentals with regards to rents and absorption, should lead to excellent cash flow growth prospects for the remainder of 2014 and beyond.

Consequently, we are raising our expectations for 2014 same-store NOI growth to between 2.75% and 4% on a cash basis, and to between 3.25% and 4.5% on a GAAP basis. From a balance sheet perspective, our March planning strategy continues to play out well. Since the beginning of the year, we’ve acquired $128 million of assets, and invested $58 million in development through the end of the second quarter. This has been funded through the sale of $107 million of assets and proceeds of $86 million from the use of our ATM program.

During the second quarter, we issued 5.4 million shares at an average price of $7.89 per share generating net proceeds of $42.1 million. We expect to continue on the course of generally matching deployment with asset sales and equity issuance, although the bias is likely to continue towards asset sales as pricing and liquidity for these assets continues to improve. We are increasing our guidance for acquisitions for the year to between $200 million and $300 million as our market teams continue to [honor us] attractive opportunities in a very competitive environment. These acquisitions are likely to remain bias towards value add opportunities while our local knowledge and creativity continue to pay dividends, although we expect to find some largely off market stabilized opportunities as well.

Turning to earnings guidance, we are narrowing and raising 2014 FFFO guidance to $0.46, to $0.48 per share. This increase is largely the result of our strong operating results for the first half of the year and excellent leasing which has raised the lower end of occupancy and same-store NOI growth expectations. Our expected ramp and occupancy continues to materialize even in the face of the impact of opportunistically buying vacancy and strategically selling occupied assets. We believe the repositioning of our portfolio and continuously strong execution in the improving leasing conditions noted above have and will continue to position DCT to capitalize on the outstanding outlook in the industrial business.

With that I’ll turn it back over to Denise for questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) The first question will come from Kevin Varin of Citi. Please go ahead.

Kevin Varin – Citigroup

I just had a quick question on the acquisitions guidance. Many of your peers have revised down their guidance ranges for the year citing the competitive landscape. In your opening remarks you said about the off market deals, but could you just talk about what gives you confidence that you can achieve the remainder of your acquisitions guidance with attractive cap rates or ROIs?

Philip Hawkins

I look at our current pipeline could be the short answer. We have a decent pipeline that gives us confidence or optimism not certainty that we’ll get into the new guidance range. We clearly will remain disciplined in terms of location, quality of the asset and economics. And we are more focused on growth and stabilized cap rate than initial cap rate. Our focus is much on value added anything. How can we -- if we can buy an asset with below market occupancy, below market rents, some form of renovation, redevelopment. We’re even buying assets where we’ll tear them down at some point in the near future. That’s the kind of thing we are looking for. The other thing, I think we are able to do given our size is we are able to focus on one off yields. We are not looking for large portfolios. We are buying one building at a time, one deal at a time. That’s all I can comment on it. It’s not easy. The economics aren’t what they were three years ago. But they are I think opportunity to improve the quality of the portfolio, improve growth and create value over time.

Kevin Varin – Citigroup

Okay and just my follow up here. Just looking at the same-store NOI guidance, it implies in acceleration of growth in the back half of the year. But can you break out how much of that same-store NOI growth is from the rolling of the two fairly large value add portfolios purchased last year. I’m just trying to get a sense of how much is from improving fundamentals versus the shift in same-store portfolio.

Matthew Murphy

Kevin, this is Matt, I think for the annual number that we are talking about, very little of it has to do with the value add activity that we did during the year in 2013. We update our same-store pool on a quarterly basis, but obviously on an annual basis, you are only looking at assets they were owned throughout the year. I think the vast majority of it is really having to do with improving fundamentals or with maybe some of the value add that we did in 2012, but the big transactions we did in ’13 will have no impact on the ’14 annual same-store numbers. They will contribute to what I think will be pretty good quarterly numbers in the third and fourth quarter.

Kevin Varin – Citigroup

So then we can kind of think of that as just kind of over top then I guess then for the year then. Is that –

Matthew Murphy

I am not sure what you mean by over the top.

Kevin Varin – Citigroup

It’s just going to be incremental addition to the same-store NOI growth for the year then in fact for the value-ass?

Matthew Murphy

Again, it will positively impact the quarterly numbers for the third and fourth quarter, but ’13 transactions will have no impact on the fourth quarter numbers. Obviously, the performance of those has to do with our FFO numbers for the year, and the continued sort of improvement in that outlook.

Operator

The next question will come from Jamie Feldman of Bank of America Merrill Lynch. Please go ahead.

Jamie Feldman – Bank of America Merrill Lynch

Thank you, and good morning. So you guys, correct me if I'm wrong, but you sound as positive as you sounded this entire cycle in terms of the demand side and even more positive than the last couple quarters on the supply side. So can you just provide a little bit more color about what you’re seeing on the supply side and what gives you this kind of added confidence here? And I thought your commentary specifically about some markets actually seeing lower levels of supplies was particularly interesting.

Philip Hawkins

I'm not sure we’re more confident. I think we’ve been growing confident about both demand and supply remaining in check for at least a year, or maybe more than that. So if there is some difference in words or tone, it's not intentional. I've been feeling good about our business for quite some time. And I've been feeling good about or hopeful about our industry able to be more disciplined on the supply side, than in prior cycles because of this shift towards equity from non-recourse debt. I've been talking about that for probably at least a year, maybe even two years.

I think we saw markets ramp up quickly on construction. It obviously got people’s attention as it should. We’re now seeing that level decelerate or even flatten or decline very slightly, but a decline is a decline, which gives you at least momentary hope that discipline will prevail. No guarantee and I understand that’s exactly why people are looking it and they should look at it. We worry about it. We worry about it on a market basis and a sub-market basis. In terms of demand, I think the shift that we’re talking about today I think is most important, really started at least two quarters ago and that’s small town leasing.

And that to me is a sign of a healthier economy, not just what was driven by the large box tenants who are focused on reducing cost and speed to market. The small tenant leasing I think is just more important to our overall business. And that to me is -- if anything it’s more encouraging today if that continues, despite up and down news, it seems like month to month and quarter to quarter and even day to day on the economic side. And so it's small tenants that continue to make decisions. They move in more quickly as Matt talked about already. And that to me – the durability of that segment is important and seems to be prevailing given our experience, and frankly efforts from our public peers as well.

Jamie Feldman – Bank of America Merrill Lynch

Okay. And then I guess a follow up, are there certain sectors and certain markets where you’re seeing those smaller tenants more active than others or starting to pick up more than others?

Matthew Murphy

I think it's broad-based. Honestly I don’t subdivide by size and by market. But there’s such a large level of activity and it is going across markets that it really feels like it's pretty pervasive. And quite honestly, some of the markets that have been more troublesome in the early parts of the recovery are the ones that are coming on strong right now. It feels really broad-based to me.

Philip Hawkins

One thing Jamie that I mentioned in my remarks is housing which we thought would drive or lead the recovery in this small tenant segment. It hasn’t, with probably the possible exception of the two Texas markets that we’re in, maybe one or two others, Orlando certainly. But housing has been missing and that’s what I think a lot of us theorize would be the driver or a small tenant recovery and it hasn’t been but thankfully doing just fine without it. .

Operator

And our next question will come from Eric Frankel with Green Street Advisors. Please go ahead.

Eric Frankel – Green Street Advisors

Thank you. Maybe you can just provide a little more color on the disposition pipeline, specifically what you have up for sale in terms of square footage and what’s under contract.

Philip Hawkins

Nothing under contract. We have several different packages that are of medium size in today’s standard portfolio size in terms of the dollars, with a bias towards secondary markets, what I would consider secondary markets. Nothing under contract. We are in the receipt of offer stage in several and they are coming in at this moment and seem to be coming in fairly consistent or certainly gives us optimism that we will find a deal.

Eric Frankel – Green Street Advisors

Do you have a sense of what the prospective buyers are underwriting or how they are underwriting deals? I see that there were a few more entrants into the sector.

Philip Hawkins

I’m not sure what you mean by two more entrants.

Eric Frankel – Green Street Advisors

New buyers, new companies, new, whether it’s private equity or private ...

Philip Hawkins

Assuming there can be a lot more buyers, is that a question about secondary markets or a question in general?

Eric Frankel – Green Street Advisors

A question in general.

Philip Hawkins

Yeah. I think buyers are -- a couple of thing. One is constant capital, both debt and equity continue to go down as their alternatives or at least their investors alternatives for investment decline. They are underwriting I think more optimistically rent growth than there might have been a few years ago, so lower IOR thresholds and more optimistic underwriting in general. And frankly for the secondary markets, we sold a package 18 months in Memphis and in Columbus and the buyer there, I don’t know exactly what -- they didn’t show me their underwriting, but the buyers I doubt were underwriting much near term growth. I’m sure there was some optimism that it will eventually get back to some equilibrium, but nothing had really started in that regard. Now with rent growth fully moving forward as well as strong occupancy numbers in those markets, I think that people are much more optimistic about at least near term and intermediate term fundamentals, not just buying on a price per pound or high yields basis, but underwriting growth, which has allowed them or resulted in prices going up and near term yields going down because they are clearly putting more emphasis on future growth and an increase in yield combined with a lower cost of -- a lower threshold of return in the first place.

Operator

The next question will come from Craig Mailman of KeyBanc Capital Markets. Please go ahead.

Craig Mailman – KeyBanc Capital Markets

Hi guys. Matt, I was just wondering if we could follow up on your comments about the percentage of people that moved in by the end of the quarter and maybe just more broadly talk about the trends you are seeing on tenants, the immediacy of space that they are looking for, decision making timeframes, how long you guys have been seeing this trend? Maybe just give a little more color on that.

Matthew Murphy

I think it’s a trend that had been in existence for probably three or four quarters. It really became obvious to me in size in the first quarter and I commented on that in the call. I’ve always thought historically that it’s when you sign a lease you’re going to build out PIs, it’s going to be a two to five month process. And I think larger more complicated tenants, that’s probably still reasonably accurate. But you’ve seen people, you’ve seen negotiations speed up. You’ve seen once the deal is done people moving in. I think people have -- customers have put off some of these decisions for a while and now that they are feeling better about the prospects for their business, it’s time to get going. And it really manifests itself in these cycle times. And moving in half of your new leasing in the quarter that it happens honestly is unheard of in my opinion. Now hard to predict whether that trend continues. I also don’t think you can divorce that from idea that we are doing a lot of small tenant leasing. As Phil mentioned, they move in faster. I think that’s just a historical fact. People are getting going and it shows.

Philip Hawkins

One thing I’ll add related to that, not directly on point. I was talking to the person who negotiates most if not all of our leases, the legal documents and her comment this morning was there’s less of a similar lull that appears to be embarking -- we’re embarking on down the past couple of years. No, that they may go on vacation tomorrow, but the level of activity – lease negotiations activity and urgency seems to be enduring through the summer leasing compared to prior summers. Sure, there’ll be some sort of fall off. There always is, but it’s less and appears to be less than in the last couple years.

Craig Mailman – KeyBanc Capital Markets

Okay. And then just switching over, you’d mentioned that part of the acquisition plan is still to do more one off. You guys aren’t looking at portfolios as much, but as you guys look to underwrite portfolios and are also marketing some, what do you think the portfolio premium is at this point?

Philip Hawkins

I’ll tell you what I’ve heard from active brokers, and I don’t have a way of measuring it, and that is it’s 5% to 10% depending on the quality of the premium – quality of the portfolio in the markets that it's in. But there’s definitely a portfolio premium of some amount. And that includes secondary-type markets.

Operator

The next question will come from Gabriel Hilmoe of ISI group. Please go ahead.

Gabriel Hilmoe – ISI group

Thanks. Matt, just on the occupancy guidance, I know there’s a lot of ins and outs in the operating portfolio, but just from a same-store perspective, I think you ended the quarter around 93%. So when you look at the same-store NOI guidance for the back half of the year, where do you see the same-store occupancy trend in relation to that? I'm just trying to get a sense of where that pool is kind of expected to end of the year.

Matthew Murphy

I think our same-store portfolio is a pretty good representative sample of our overall portfolio. So I still think that plus or minus 94% is the right way to think about it.

Gabriel Hilmoe – ISI group

Okay. And then Phil, just on the development pipeline, obviously there was a good amount of activity in the quarter in terms of new starts. But when you look at what’s in pre-development, what likely gets started sooner than later over that pool in your opinion?

Philip Hawkins

Let me go to that list. DCT River – I'm going on our supplemental Page 11, DCT River West just started. Frankford Trade Center just started. Northwest Crossroads Logistics Center II just started. I think that it was in the press release anyway. Seneca will not start. Those are three different projects. There is a lot of development going on there. I don’t believe they’ll start. The White River Corporate Center Phase 2 North, is that the big building? That will not start in near term. The little building might – where are we? Yeah. I refer to these in different names honestly. But the smaller building in Seattle may start, and then the two Fife buildings unlikely to start. And then Jurupa Ranch is what we also refer to as the Egg Ranch. And that only if we get a prelease would it start in the near-term. It really is – we have a ground lease in place, essentially a ground lease in place and we have the ability – we have to in my opinion first get Rialto leased or substantially leased. Did I say anything wrong, Matt?

Matthew Murphy

No. I think the thematic answer to that is, what you’ll see is where we have multiple phases. The start of the secondary-phase is going to be a byproduct of leasing on the first. I think we’ve been pretty consistent about that, and pretty disciplined about it.

Operator

The next question will come from Brendan Maiorana of Wells Fargo Securities. Please go ahead.

Brendan Maiorana - Wells Fargo Securities

Thanks. Good morning. Matt, so just – I just wanted kind of clarify sources and uses of your revised acquisition guidance. I guess is probably up around $100 million to $150 million left to go this year. And then development spending is that maybe around $100 million or so? So maybe you kind of spend $250 million? And I think if I heard your comments earlier, you’re more biased to fund that with dispositions as opposed to ATM usage?

Matthew Murphy

Yeah. Your math and your hearing are both right on.

Brendan Maiorana - Wells Fargo Securities

Okay. So a broader follow up to that is just over the past several years, you guys have put up about 3.5% same-store, just going back to I think using 2010 as a base year, which is higher than I think any of the peers in the industrial group. And earnings growth has been about 4.5% because as Phil you laid out several years ago, you were going to delever through growth. So you’ve been equity financing 100% of your net growth in the asset base overall. Deleveraging has been pretty -- it’s come down quite a bit. I think your debt to EBITDA is from over eight times to around 6.5 now. Your fixed charge coverage has gone from around 2.5 to about 3.25. At what point do you think that the deleveraging through growth stops such that your FFO growth should move higher versus what your same-store and acquisition and development growth has been?

Matthew Murphy

First of all that is a great synopsis,

Philip Hawkins

You listen well and you have a good memory.

Matthew Murphy

He has a good memory, which I don’t know if that’s good or bad. I think where we are, the essence of that question is where are we comfortable from a credit metrics perspective. And I think we are to the point, I don’t think my map around quite to 6.5 times yet. That’s a right I think point at which you start thinking about changing from deleveraging through growth to maintaining leveraged neutral growth. And I think that’s in the pretty near future. I think that’s a 2015 phenomenon. The other thing from an earnings growth perspective as you are well aware, what we have been doing on the capital recycling side irrespective of the development piece has been dilutive to earnings, particularly in the short term.

So I think the impact of that assuming a similar trajectory that we’ve been on will persist into 2015. Hard to go past that or get too specific until you get closer to it. But there have been two things that have been mitigating or dampening earnings growth if you will. Deleveraging through growth as you mentioned, but also repositioning the portfolio to what we think is better in terms of quality and longer term cash flow growth potential. The first i.e. leverage is nearing its end. Time will tell on the capital recycling where we go from here.

Philip Hawkins

As we continue to sell occupancy and buy vacancy it’s going to be short term dilutive no matter how you get to it.

Brendan Maiorana - Wells Fargo Securities

Yeah. I guess, but that normalizes itself as -- like that’s just part of your normal investment activity. But Matt, so you think next year we eliminate that deleveraging through growth headwind and then selling the non-core stuff, that probably happened through next year and maybe at some point in the future that stops. But at least next year one of those headwinds stops, that’s right?

Matthew Murphy

Yeah. I think we’ll always be selling, I wouldn’t call it non-core maybe at some point, but I’ll call it low growth. You do a 10 year lease on a building that is at peak value because of that lease. You sell that and you reinvest it into development, or you reinvest it into an under leased building or an undermanaged building or whatever. That’s something that we should be doing all the time to add value to our people. And we will continue to do that space on the markets of course.

Operator

The next question will come from John Guinee of Stifel. Please go ahead.

John Guinee – Stifel Nicolaus & Co.

Great. Nice quarter and may I remind you how wonderful your supplemental is, so easy to understand. I guess it would be a question for Phil. You guys know what you are doing. You are largely developing spark, but you are largely leasing these up pretty quickly. It appears to me that if everything works out well, these are eight GAAP yields and if you have to sit on them a while which you haven’t had to sit on them for a while and maybe cut rate, they are still in the six to seven GAAP yields. So you are going to be accretive to your cost of capital. Question is where are these tenants coming from? Are these new tenants into the market? Are they coming out of your competitors B&C buildings? Are they coming out of your B&C buildings? And what’s happening to the overall occupancy number vacancy rates in these particular sub markets as new product is delivering and filling up pretty quickly.

Philip Hawkins

John, I think it’s a culmination of two things. One is new users to the market or frankly to the world. Ecommerce is an obvious example, businesses that didn’t exist or are growing rapidly and new to that market. And then the second is expansion. And particularly expansion from A or A minus. The tenants that are going to development at this point anyway are not upgrading from B and C as much as they are really relocating. It may be a locational change. It’s often expansion. In some way it relates to a reconfiguration of the supply chain. These companies that are leasing new space are not coming from old C space for sure. They are really reconfiguring and moving from one good building into maybe a brand new building for sure. But it’s not a dramatic upgrade.

Operator

The next question will come from Ki Bin Kim of SunTrust Robinson Humphrey. Please go ahead.

Ki Bin Kim – SunTrust Robinson Humphrey

Thank you and good job on capital deployment guys. I think it’s very different than what we see from a lot of REITs out there. Just a couple of quick follow up questions. In terms of development and what you can do in the future, how much land do you have in inventory and are these projects basically on land that you have on inventory or do you have to go out there and buy land going forward.

Philip Hawkins

We have as I went through the supplemental, there’s several that will be starting in the next six months. There’s also a few in the supplemental land sites will be in the next 12 months. We have also a pipeline of land acquisition including a number of shovel sites at least two, one in Pennsylvania and one in Northern California. We’ve had that site under control for some time, but don’t have to buy them until we complete entitlements. And in fact in Pennsylvania one project I forgot just using the supplemental for Gab’s question, we have a project in Lehigh Valley that we’ll be starting construction on in the near future. And frankly we have very string leasing activity early on as well.

We will -- the combination of on balance sheet now, off balance sheet but under legal control and then a natural pipeline of procurement of lands that just takes, land takes time to buy. In often cases we are assembling different pieces to create one parcel that works. Often times we are going through a zoning process, assuming and entitlement process. It takes time and that’s where the skillset and the, I think the ability to take risks and invest peoples time as well as their own capital pay off is really in the land acquisition. In a good market it’s all about land acquisition. It’s the right way and the right place and the right basis. And so far I think our teams have proven their ability to do that reasonably well.

Ki Bin Kim – SunTrust Robinson Humphrey

And maybe I can ask the same question in a different way. What is the average -- maybe you have done this already, but what is the average stabilized yield from the projects you have in your development pipeline today versus when you start going forward and maybe you are having to buy more land at market prices or close to that, what happens to the yield going forward?

Philip Hawkins

I don’t think our yield will change that much because while land prices have gone up, rents have to. Now we’ve outperformed our underwriting assumptions early on as we were an early mover in the development. We were rewarded with both better rents and better lease uptime than we expected in the underwriting. So actual results going forward may not vary as much from pro forma. But rents have certainly moved a lot since we started developing or buying land three, four years ago. I would say in some cases the yields have moved down probably 50 basis points from Southern California from under a pro forma to pro forma. And they probably moved down 25 to 50 basis points in Houston but other markets we’re able -- I think we are able to find land at decent returns. Still seeing spreads of pro forma underwritten yields to stabilize yields of 150 basis points at least and often more than that.

Matthew Murphy

The only thing I’ll add to that is I think is on point is keep in mind that what we’ve been able to achieve thus far isn’t like it’s been on land that we’ve owned for a long time that has been either written down or was bought at a much cheaper basis a long time ago. What you’re seeing is the byproduct of exactly what Phil described is us buying land in the current environment, putting it into production quickly and leasing it up in the current environment. And that’s the – I mean those are the yields that we got achieving.

Ki Bin Kim – SunTrust Robinson Humphrey

Okay. And just a second question. I know you guys don’t typically do this, but I was wondering Phil if you’d be comfortable just kind of giving a broad market rent growth forecast for the next two to three years.

Philip Hawkins

I would if I could. The problem is I break it down in several different types. You’ve got the Midwest secondary market where rent growth is I would say outside. It's late to recover and they’re now in that early stage of recovery where rent has just started to move up. I don’t – I'm not an analytical kind of market research guy, but I'd say 6% to 8%. And then you’ve got the coastal markets that have been recovered for a while, where you’re now seeing nice healthy rent growth of 4% or 5%, but you’re still seeing good rent growth. There’s no market where you’re not seeing – I can think of, of where you’re not seeing decent rent growth.

Ki Bin Kim – SunTrust Robinson Humphrey

And you’re going to continue somewhat even though supply just picked up a little bit?

Philip Hawkins

I think it will continue as long as there’s healthy demand, and supply remains active, but rational. Supply is delivering higher – more expensive space. And as all that space is needed by the market, and therefore they’ll need to pay the freight, the rent has to go up to meet the cost. Now, the $54 question is if supply overshoots that and get in the way of rent growth. At this point, I don’t believe so but again time will tell.

Operator

The next question will come from Paul Adornato of BMO Capital markets. Please go ahead.

Paul Adornato – BMO Capital Markets

Hi. Good morning. Given the ongoing upgrade of the portfolio, was wondering if you could tell us what percent of the NOI stream is coming from primary markets and what percent from secondary markets? And also what would be kind of a good plain vanilla cap rate range to apply to each?

Matthew Murphy

Paul, I'll take the first part of the question where – to the point now we’re depending on how you define primary markets, well over half of our – basically approximately half of our annualized base rent as of June 30 is coming from coastal markets. And that’s a trend that’s – it's a number that’s improved over the last several years, meaningfully over the last several years. And given our investment focus is likely to continue to improve, perhaps not at the same slope that it has over the last couple. With regard to cap rates, it's just so hard to answer because you’ve got to think about mix. So Phil I don’t know if you ..

Philip Hawkins

They’re low. Paul, Page 2, our financing does a nice job with the graph. On the upper left page of the page, focus coastal markets and focus non-coastal markets have both primary – what you would call primary markets. And legacy markets is the – would be– I think entirely secondary markets and that’s about 20%. Hard for me to read this graph with my eyes. So in general we think we’re at about 20% of our assets now trending down in legacy markets. Cap rates on the coast are well below five. I'd say Houston five or even some anecdotes below five. Chicago, Dallas, Houston, you’ll probably first class A in the now sub-6, maybe mid-5. Secondary markets, you now have – Cincinnati, low to mid sixes with Columbus in the low seven to low sevens. Memphis probably they’re on that same level as Columbus. Louisville, probably the mid-sixes. There are a lot of markets that have sixed in front of them that used to sevens and eights and the markets that used to have sixes and sevens now have fours and fives. It's pretty remarkable.

Operator

And the next question will come from Michael Mueller of JP Morgan. Please go ahead with your question.

Michael Mueller – JP Morgan

Thanks. Going back to development, if we’re thinking about the pace of development lease up, is it pretty consistent across most of the projects and markets where you are active or some lagging and some just way ahead?

Philip Hawkins

I think it’s -- I’m very happy with Houston. Southern California we’ve knocked off a few buildings where we had good preleasing, but going forward I think that we’ll be – I view each of the markets as probably fairly consistent. I think depending on you need luck, you need to give the right tenant the right time to show up. But I wouldn’t differentiate between markets going forward in terms of lease up.

Michael Mueller – JP Morgan

Okay. And then I think in one of your earlier comments you were talking about just hoping that people were going to be disciplined at this point and just knowing when not to move forward supply. If you look back over time, what are the types of I guess investors or developers that tend to maybe be a little less disciplined at the margin?

Philip Hawkins

If those who can acquire nonrecourse debt and play a game of heads I win, tails you lose, that’s what does it every time. And that’s what I’m hoping will not happen this time both due to bank discipline. I will not say I want to rely on that too much, but more importantly regulatory discipline which seems to be the difference this time versus last time. The regulatory impact, a restriction on lenders on speculative construction is real. Much more expensive to put your -- to lend your capital to a building without leases in place, and therefore you’ve seen very little nonrecourse lending on speculative construction. What really you have seen has been in markets and relationships that are pretty unique. Just pay attention to the guy below you or above you, or the banker said and do the opposite.

Michael Mueller – JP Morgan

We are in temporary space right now so different building.

Philip Hawkins

Okay, good. Okay, stay away from them.

Operator

And our next question will come from Emil Shalmiyev of JPMorgan. Please go ahead.

Emil Shalmiyev - JPMorgan

Good morning. Just a quick question in terms of off market acquisitions, are there any strategies that you guys use for purchasing properties given the demand in some of the markets?

Philip Hawkins

I’m not sure I fully heard the question other than any strategy we employ. Please repeat that.

Emil Shalmiyev - JP Morgan

In terms of off market acquisition, are there any strategies that you use to buy properties given demand in some of the in-fill markets?

Philip Hawkins

I wouldn’t call it a strategy. I would say we invest in and encourage our markets teams to pursue opportunities directly with sellers, users. And also a lot of them come from brokers who are looking for an opportunity or have an opportunity to tie their package. A lot of the off market deals are there because they can’t really, they are not conducive to being marketed particularly value add. You need some dialogue between seller and buyer often times to really get a full grasp of the ability to execute and value. You’ll see a lot of our off market have been -- many have a broker involved but the broker is going to one or maybe two or three buyers who they feel can understand and help solve and execute. There may be the one in Seattle was just a tremendous relationship between our Seattle team and the seller had a broker. We are the only ones they talked to and related to the need to fund a charitable gift pledge and that was at first started by tax -- funded by tax considerations and a change -- more several different times.

Operator

(Operator Instructions) The next question will be a follow up from Jamie Feldman of Bank of America Merrill Lynch. Please go ahead.

Jamie Feldman - Bank of America Merrill Lynch

Great, thanks. Can you guys talk about your known move outs for the end of the year and then even into 2015?

Matthew Murphy

Jamie, I think known move outs – I don’t like to throw in the towel to early. There are other – really the only two significant ones that I can think of that seem like lost causes are in Chicago, one is 100, one is 125. We have the biggest ones in the first half that I know of in 2015 is 350,000 square feet. And that one I’m not sure I would characterize as absolutely dead. There are no really significant ones that I know of where the people are out already. And more just people think that our chances aren’t very good or in some cases you’ll have people that are, they are building a building, our space can’t accommodate their growth. What we found frankly through this year and really the last couple of years is a lot of times what will happen is those guys will move out, but it doesn’t happen as fast as you think it’s going to. So I don’t really know of any needle movers if you will that I would say are done.

Jamie Feldman - Bank of America Merrill Lynch

Okay, the 100,000 and 125,000 in Chicago, that’s in 2014.

Matthew Murphy

Correct.

Jamie Feldman - Bank of America Merrill Lynch

Okay. And then 2015 you said there’s 315,000. Do you guys have a sense of your mark-to-market as of today for your ‘15 leases?

Matthew Murphy

No. What I will tell you is roughly 60% of the leases that we are all having -- haven’t parsed the numbers exactly in 2015, but the leases that roll in 2015, I’m sorry, in the next 12 months, roughly 60% of those were signed either after the recession, but before the middle of 2011 if you will, at the bottom of the leasing trough if you will, which I think blends itself well to what you would expect from a leasing spread perspective. But it’s just so hard to predict those numbers because you don’t know when the leases are going to sign. I don’t know if that’s helpful.

Operator

And the next question will be a follow up from Eric Frankel of Green Street Advisors. Please go ahead.

Eric Frankel - Green Street Advisors

Thank you very much. Neil, do you subscribe to Phil’s rent forecast for the Midwest?

Neil Doyle

To date I do. Eric, I think when we look at Chicago and then down through Cincinnati, Columbus, Indianapolis, Louisville, you’ve just got these historically low vacancy rates and the movement of supplier is probably, well, more than probably, a little behind the cost. We are enjoying a lack of product. And so we are doing very well in the renewal side and very well on the rent growth side.

Eric Frankel - Green Street Advisors

Thanks and maybe you can touch a little more on the supply picture in Chicago from when there’s tenants just taking up a little bit quicker now especially in I-55 corridor and Wisconsin.

Neil Doyle

It is -- now Southeast Wisconsin is always sort of periphery of the Chicago market. We are not in Southeast Wisconsin. What happens is pretty typical for Chicago that 60% of the leasing year to date has been done in the O’Hare I-55 and I-80 submarkets. And if you take I-80 out of it just for a second only because the size there of the building dwarf everything else. And so what you are finding is that vacancy dropped, supply followed in I-55 and in O’Hare. I-55 you are typically going to see 200,000 to 500,000 square foot buildings. Anything bigger than that you’ll head down to I-80. And O’Hare you are typically seeing 100,000 to 200,000 square foot buildings. To date it continues to absorb. Rents continue to grow. As you are aware we stabilized the DCT 55 project. It rents probably 10% to 12% higher than pro forma at 18 months ago. While supply is starting to show its face, if anyone needs space in the foreseeable future they are going to pay a little more rent than they have historically.

Operator

Ladies and gentlemen, this will concluded our question and answer session. I would like to turn the conference back over to Phil Hawkins for his closing remarks.

Philip Hawkins

Thank you, everybody for your time and interest in DCT. We look forward to talking and communicating more over the coming months and quarters. Take care.

Operator

Ladies and gentlemen this concludes our conference. We thank you for attending today’s presentation. You may now disconnect your lines.

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