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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Welcome to the Prologis Q1 Earnings Conference Call. My name is Kim and I will be your operator for today's call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] Also note, this conference is being recorded. I would now like to turn the call over to Tracy Ward. Tracy, you may begin.
Thanks, Kim, and good morning, everyone. Welcome to our first quarter 2018 conference call. The supplemental document is available on our website at prologis.com under Investor Relations. This morning, we'll hear from Tom Olinger, our CFO, who will cover results and guidance. And then Hamid Moghadam, our Chairman and CEO, who will comment on the company's strategy and outlook. Also, joining us for today's call are Gary Anderson, Mike Curless, Ed Nekritz, Gene Reilly, Diana Scott and Chris Caton.
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 the industry in which Prologis operates, as well as management's assumptions and beliefs. 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 and SEC filings.
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'll turn the call over to Tom and we'll get started.
Thanks, Tracy. Good morning and thank you for joining our call. I will cover the highlights for the quarter, provide updated 2018 guidance and turn the call over to Hamid. By now you've seen our supplemental reporting package which reflects the harmonization of our operating metrics with the logistics sector we announced last quarter.
As we previously mentioned, the new definitions had an immaterial impact on our operating metrics. During this quarter, we've also taken the opportunity to report our leasing data based on commencement date versus signed date. This change better aligned our NOI metrics and is consistent with how we manage our real estate internally.
Now let's turn to our results. We had a strong first quarter and are well positioned to deliver another year of sector leading earnings growth in 2018. Core FFO reported was $0.80 per share which included $0.09 of net promotes. The net promotes we earned was from our China venture and came in higher than forecasted due to increased property values as well as favorable foreign currency.
Core operations also came in better than expected driven primarily by same store NOI and lower interest expense. Our share of net effective rate change on a roll was approximately 22% led by the US more than 32%. This marks the fourth consecutive quarter of global rent change above 20%. Occupancy ticked down sequentially to 96.8% in line with normal seasonality.
Our share of cash same store NOI growth in the quarter was 7.9% led by the U.S. at more than 9%. While these results reflect the excellent market conditions around the globe they were favorably impacted by two factors. First, we had approximately 150 basis points of free rent burn up in the quarter which was primarily driven by higher lease commitment in the first quarter of 2017. Second, we had approximately 50 basis points of non-recurring adjustment that also benefitted same store.
For the full year, we expect cash same store NOI growth to be higher than our initial forecast and I'll cover this in more detail when I give guidance.
Moving to capital deployment for the quarter, I'd like to highlight development stabilization which had an estimated margin of almost 30%. Margins on starts remained very healthy as well. This is notable given that build to suit accounted for nearly two-thirds of our start volume in the quarter. We completed more than $600 million of contribution and dispositions and a weighted averaged stabilized cap rate of 5.2%. Buyer interest for assets remained strong and market cap rates continued to caress particularly in Europe.
Turning to capital markets, we continue to have significant liquidity and the internal capacity to self-fund our growth for the foreseeable future. I'd like to spend a minute on two financing transactions we completed in the quarter. In January, we issued a two-year EUR 400 million note with an all-in effective interest rate of negative 10 basis points. This transaction underscores our ability to access capital globally at very attractive rates. We also realized the gain from the settlement of a swap that reduced interest expense order.
Looking forward, we expect the quarterly interest expense run rate for the remainder of the year to be approximately $5 million higher. Now moving to guidance for the year. I'll cover the significant updates on our share basis but for complete detail refer to page five of our supplemental. Based on the strength of our first quarter results, we're increasing the range of our cash same store NOI by 50 basis points to between 5.5% and 6.5%.
Given the market rent growth in the first quarter, our in place rent continue to be below market by more than 14% globally and 18% in US. This continues to position us for strong operating performance for the next several years. For strategic capital, we now expect net promote income for 2018 the range between $0.11 and $0.13 per share, which is up $0.06 from our previous guidance. We expect to recognize the remainder of the revenue in the fourth quarter.
Given our strong leasing pipeline, we're increasing our development starts guidance by $200 million to range between $2.2 billion and $2.5 billion. Build to suit were comprised about 50% of this volume. We're also increasing our disposition guidance by $475 million to a range between $1.4 billion and $1.7 billion. With this volume, we will effectively close out our non-strategic asset sales. This initiative began in 2011 and upon completion will total $14 billion on an owned and managed basis.
As a result of our deployment guidance changes, we now expect to generate an additional $300 million of net sources for the full year. Putting this all together we're increasing our 2018 Core FFO [ph] by $0.08 they are in the range between $2.95, and $3.1 per share. Our revised guidance represents a year-over-year increase of 6% at the midpoint or 8% excluding promotes. This increase is particularly strong as we expect average leverage in 2018 to be approximately 250 basis points lower than 2017.
The capacity we have to normalize leverage will be a catalyst for future earnings growth as every 100 basis points and additional leverage translates to about 1% Core FFO growth. To sum up we had a great quarter and are excited about our prospects for the remainder of the year and beyond and with that I'll turn it over to Hamid.
Thanks Tom and good morning everyone. I don't have a whole lot to add to what Tom talked about because our results speak for themselves. While we remain vigilant and on the lookout for any signs of market weakness, we feel great about our business or optimistic about our company prospects.
Let me now turn it over to Kim for your questions.
Your first question comes from Manny Korchman from Citi. Your line is open.
Hi, good morning everyone. Tom, if we think about your increase in starts guidance. How much did the percentage of built to suit in that starts guidance changed and is that what gives you confidence that the supply picture remains healthy as you and others think about starting new projects?
This is Mike, I'll take that one. As Tom mentioned our build to suit had a great first quarter and almost two-thirds. That should normalize around 45% to 50% over the year which is a very solid number and so that's driven a lot of our confidence in raising our development guidance. 90% of our activities identified and I should point out the spec that we're doing in our parks and cities that are 97% waste, so those two-combined give us a lot of confidence to raise the guidance in a manner that we did.
Your next question comes from John Guinee from Stifel. Your line is open.
Great. Is everybody smiling out there are you guys pretty happy?
We're always happy John. Especially when we hear from you.
Great news on all the build to suit. Somebody told me the other day that Amazon has a new prototype out there 30 or 40 they're considering throughout the country where it's a multi-level but not multi-truck court level elevator oriented six or seven storey 100,000 to 200,000 square foot footprint on six or seven storey prototype that they're thinking about. And I'm sure you're in those discussions with them.
Can you elaborate at all?
John it's Mike again. We don't give out lot of details about any particular customers plan. Safe to say, we certainly have to happen reading on few of these opportunities and its very early days on that right now more to come on that future.
Hey John, let me give you also a background without getting specific on Amazon. Generally, if you want to get closer and you got to shrink your footprint and go vertical. So, anybody who's trying to get close in to where the population is has to be thinking of that and the idea of a multi-level warehouse or Amazon specifically is not a new one. The number of stories may be at some point, but certainly you've seen new mezzanine levels in our building that we've stored with investors. So, shrinking of the footprint and going more vertical would be a logical extension of that getting.
Your next question comes from Tom Catherwood from BTIG. Your line is open.
Thank you and good morning. Hamid can I speak on that point that you mentioned tenants trying to get closer and closer to population centers. 30% of your portfolio is buildings under 100,000 square feet. I assume this include the number of legacy assets in more densely populated areas. Given the challenge of acquiring land today, how much of an opportunity is available to redevelop some of these older well-located buildings?
Actually, quite a bit and we're adding to it all the time. And if you look at what we've done in San Francisco we bought a lot of parking areas, a lot of older obsolete buildings. Interestingly they all need to clear heights for rapid in and out distribution. So, some of those buildings work really well and you need to assemble a fairly good-sized site before you can put a multi-storey building on it. So, there are lots of ways you can increase the value of those older assets by just basically cleaning them up and using them for more rapid infill delivery and also eventually for the larger parcels knocking them down and building something multi-storey.
I just want to remind you that the old, this is not a new strategy the old A and B strategy was very much in fill in the larger market. So, and that's probably I don't know a third maybe 40% of our portfolio. So people, you got to offer product along the entire size of the supply chain. You have to have 500 mile product, you have to have 50 mile product, and you have to have the last 5 mile products. So, we're active in all those different segments.
Your next question comes from the line of Craig Mailman from KeyBanc Capital Market. Your line is open.
Hi, it's Jordan Sadler here with Craig. Regarding same store, cash same store was a big driver of the gross last couple quarters unconsolidated in particular has been a bigger driver particularly on the revenue side. Can you talk about the driver of the unconsolidated same store growth versus the more flattish looking revenue growth you're seeing in the consolidated same store portfolio?
And then just maybe as a follow-up there's a big spread between cash same store and effective this quarter almost 260 basis points and wondering if there was anything in particular going on there?
Let me take the latter and you can answer the former. I think on the issue of cash versus GAAP I think we have unsuccessfully described our preference for GAAP for several years. But everybody asked us about cash. So, we basically said okay starting 2018 we're just going to report cash because that seems to be what everybody is asking us all the time. We do have the GAAP number in the supplemental, so it's not like we're not providing that.
But it gets really confusing if you start talking about all that, our share, cash, GAAP and all that. So, we're really going to our share and cash as the relevant number that you guys need to look at or seems to want to look at. So that was a decision that I made. Now Tom, do you want to?
Yes. So, Jordan on your first question. I think, I'm not sure if you are looking at owned and managed. But clearly when you look at it graphically the U.S. versus outside the bulk of our share is going to be driven roughly 75% by the U.S. and I don't see anything performance difference between on an our share basis by geography, very consistent.
Yeah, it's just mix. It's just that our fund business is a heavier percentage overseas than it is in the U.S. We own more of our U.S. portfolio. But within the U.S portfolio, consolidated - unconsolidated, we don't even manage our business that way. We don't even look at the…
Your next question comes from Jeremy Metz from BMO. Your line is open.
Hey good morning. In terms of your cap rate compression is really held back any pick up in rent growth. At the start of the year Hamid you talked about possibly nearing an inflection point on this dynamics. I'm wondering if you can just give us an update on what you are seeing on the ground over there in terms of rent growth, which markets perhaps are seeing rent growth early materialize ahead of expectation and has your outlook changed at all over there from a few months ago.
I think with every passing quarter, we get more optimistic about rental growth in Europe. I think I talked about the cross-over point being later in 2019 and 2020, backend of 2019 and 2020. So, we're some distance away from that. But Europe continues to accelerate in terms of rental growth. The best market - I would say the highest absolute rental growth in the past has been U.K. followed by Germany and Northern Europe and probably the laggard has been Poland and maybe France, if you want to put it in that bucket. So, but even those markets are picking up inter-activity and decreasing. So, I think we're going to get more pricing power in those markets and I think rental growth in Europe will be a couple of points this year and we're in that…
Your next question comes from Jamie Feldman, Bank of America. Your line is open.
I'd like to get your team's big picture thoughts on trade war risk, how people should be thinking about what it could mean longer term for the warehouse business. And then maybe, just as you talk to your clients or maybe your clients aren't really talking about it, but what's the sentiment among tenants about what they are seeing in the press and the tweets and what this all might mean?
Let me give you the bad news first and I'll tell you the good news next. I think the bad news is that any kind of trade war or which way, I don't think we're quite there yet. But any kind of trade war is bad for economic growth generally. And that will affect everything including our business. So, if the economy grows at 30 to 40 basis points slower than it would have otherwise, which is what I see most people talking about, that's not good for anybody's business including ours.
Now, on the mitigating side of this, first of all, its' really early in those discussions. Those tenants haven't even kicked in and who knows what the latest pronouncements on TVP - I mean I don't know what to read into any of that stuff. So, and I would say most of our customers, all of our customers that I'm aware of have basically - have their head down doing their business and not paying too much attention to what comes out in the tweets in the morning until there is something specific they can react to.
The other thing that I would point out to you is that most of the tenants at least to-date have been on intermediate material or raw material that goes into production. And as you know we are not that active on the production end of the supply chain anyway. We're at the consumption end of the supply chain. So, it has less of an effect on us than our places that are focused more on production. So - and by the way a lot of these goods don't even go through a warehouse. Steel doesn't go through warehouses, aluminum doesn't go through warehouses. So, I guess the simplest way of thinking about it is that we are concerned by the talk. We are not yet concerned by the action and we'll just see what the action is going to be.
Your next question comes from Blaine Heck from Wells Fargo. Your line is open.
Thanks. Good morning. Hamid can you talk a little bit about what you are seeing with respect to supply in general and more specifically on construction financing, we've heard that banks and other lenders have recently become a little bit more willing to lend for industrial construction in particular. Is that consistent with what you are seeing and does that give you any concern as you look out into 2018 and 2019?
Yeah, I don't think the banks were hesitant to lend on industrial construction. They just wanted to lend at equity in the deal which made it more difficult for developers to finance projects. So, you can get bank finance, and you just have to have 40% equity in the deal, which means that you usually have to bring in a partner and that complicates. And the partner has to get the returns and the developer has to get his return. So, it just gets to be a tighter calculus. Having said that, I think actually the bigger constraint on industrial development is really land availability and entitlements. I mean these buildings are getting bigger. The need for flat ground is getting in large parcels is getting to be more intense and the sublicense streams are more severe than ever.
So, that's what's really constraining the supply, particularly in the markets where a lot of demand is. So, Gene, do you have anything to add to that?
I mean I think our concerns about supply have revolved around the same markets, I believe the last two years, and that's basically South Dallas, Atlanta, and Central Pennsylvania. And what we've seen is these markets will bounce from a temporary over supply being imbalanced to oversupply, currently all those three are in a supply [ph]. But otherwise supply is [ph].
Your next question comes from Vikram Malhotra from Morgan Stanley. Your line is open.
Just maybe the last few quarters, you sort of outlined the strategy of willing to sort of push rent at the expense of occupancy to some extent. Maybe just big picture, if we look out over the next few years, certainly there is a lot of room in terms of mark-to-market. So, how much would you have to see occupancy adjust to sort of step back and say, maybe we need to tweak it a little bit?
So, Vikram, this is Gene and I'm probably a little unsure of exactly what the question is, but we don't really think of it as, you know intentionally dropping the occupancy achieve a certain result from the rent change side. We think of more so focusing more on what rent we really ought to be achieving in each case. You know, when you are in a dynamic market environment, there is a bias typically in the field managed for occupancy. If you manage to a budget every year, you are naturally going to do that. And we're trying hard to get away from that basic way of doing business. So we're really looking to push rents and we've frankly been pretty successful doing so. But it isn't based on some sort of calculation dropping occupancy. As a natural result, you will leak a little bit, but at these levels of occupancy.
Let me make that a little more specific for you. If you are the person leasing space in X market, and you have a vacancy, you have a tenant lease coming over for renewal in the middle of the year. If you don't make that deal, it's likely that that space will remain vacant for the balance of the year and you'll miss your budget, because particularly you don't have benefit of diversification of a really large portfolio like we do sort of at the company level. For that person, that's a big miss on the budget. If you're not careful that sum of all those individual decisions will bias you towards more conservatism so that you want to increase the probability of renewing that lease, with a virtual certainty. And that makes you leave a lot of money on the table.
So, we got to derisk that behavior for the field, so that that individual doesn't have the incentive to just keep renewing at whatever old rent they can get. So, there is some behavioral stuff that we're working on over here that maximizes the bottom-line for the company while individual locations and individual people may underperform and some of their other colleagues will over perform. So, what maximizes the benefit for an individual - or performance for an individual is not necessarily the same thing that maximizes the performances for the company. That's what we're trying to do.
Your next question comes from Vincent Chao from Deutsche Bank. Your line is open.
Hey good morning everyone. Just wanted to go back to the discussion of land and maybe on the covered land side if you could provide some additional details around what the size of that portfolio looks like to maybe on a square footage basis or NOI being generated today, and you know how long it might take to realize that covered land bank?
Hey Vincent, this is Tom. I just want to put our land in three buckets. You've got land we owned, we've got land under option, and then we have covered land plays. I think the covered land plays probably from a total build out and this could be over the next five plus years, but that number is probably north of $2 billion of incremental development and Hamid said, that we work really hard at continuing to increase that pool, but that's the magnitude and there is probably more upside over the long-term.
And remember there is no - in the short-term it shows up as operating real-estate because by and large you are getting a yield to very close to what you would have gotten, had it had a building on it. So, that that's why it's called covered. So, in the short term, it's an operating asset and in the long-term position redevelopment to the tune of the two [ph].
Your next question comes from Dick Schiller, Baird. Your line is open.
Thanks. Good morning everyone. A quick question on the loan package you guys took our $400 million at a negative interest rate. Does that give you guys comfort to be more aggrieve on acquisition front or if - looking at development starts, be putting more money capital to use into the development pipeline. How are construction cost bouncing your IRR and expected return from that development pipeline.
Look, we look at our overall cost of capital, weighted average cost of capital and that varies by geography and just because on a given maturity in a given day in a given currency, we can borrow money on a very attractive basis. We don't run around trying to match that with uneconomic deals. So, our thresholds for what makes sense for us to deploy capital remains pretty much unchanged other than big changes in plus capital in different locales, so no change in that. And generally, I would say in terms of the incremental yield that we're looking at for development, it's usually on the order of 100 to 150 basis points of yield above the exit cap rate and if you want to translate that to margins, it's about on the low-side 10% for a really safe and secure build-to-suit and at market land value is about a 15% on spec, but we keep exceeding that because of excess rental growth and excess cap rate impression. So the margins as you've seen have been a lot higher than that and some of our land as older basis so that further boost the margins. But at market, like I've always said spec development should about 15 and build to suit [ph] and we're getting better than that now.
Your next question comes from Rob Simone from Evercore. Your line is open.
On the free rent impact on same store, I guess with the 150 basis point impact, does that kind of imply that impact should - or that benefit should trail off as the year progresses, just given that you know you guys have been saying the difference between gap and cash will be about 100 basis points, plus or minus. And then I have a really quick follow-up after that, if possible?
This is Tom. So, you are right. The free rent impact as I mentioned was about $150 basis points in the quarter and it was driven by the high amount of the above average amount of lease commencements we had in Q1 2017. If you look at the rest of 2017 by quarter, the commencements are much more in line with what we did in Q1 and if you want to just think big picture cash same store looking forward, and I do think it's going to moderate the spread between cash and GAAP to about 100 basis points.
And if you think about the components of the cash same store NOI, you are going to have rent change, we're going roll about 20% of the portfolio of cash. Rent change is going to be 10%, so call that 200 basis points. You are going to have bumps on the 80%. That's not rolling, that's about 250 basis points of same store occupancy. We talked about a year-over-year occupancy impact of about 50 basis points last quarter and then you have free rent and indexation which is another 50 basis point. So, that's a nice high level way to think about cash same store going.
Great. Thanks. That's really helpful. And just really quickly on the promote, so the balance of the revenue is going to be recognized in Q4, but will you guys like in past year also had some amortization in Q2 and Q3 that could drag on those quarter slightly?
That's correct about $0.01 of capital expense related to -- because of the timing difference spin revenues all upfront and the mode expense comes in over time.
Your next question comes Eric Frankel from Green Street Advisor. Your line is open.
Thank you. Can you just identify the markets at which you plan to sell assets? What is the source of the increased disposition guidance and then second, I think there are a couple larger portfolios in the market for purchase. So, I wanted to just understand what your criteria are for [ph] and whether you're going to end with some capital partners to join in those purchases given increased investor interest. Thank you.
Yes. Our disposition strategy Eric haven't really changed. The timing of it may have been accelerated because the market, we're leasing up some of our other strategic assets faster and so they're becoming positioned earlier for sale and the market is good so we're taking advantage of those opportunities. But they're generally that remaining non-strategic assets in Europe and the U.S. that we identified long time ago we're not changing that, it's just that we're getting through it faster than we would have otherwise.
With respect to capital deployment, but we look at everything and you know I mean since we are we in the really big, buy a big portfolio and before Katie are within buy a big portfolio. Just that a lot of these instances and quality of what's available and our desire for maintaining the portfolio that we have, so diligently constructed over the last five or six years I mean we've sold $14 billion real state as Tom mentioned.
I mean we really worked hard at perfecting the quality of this portfolio. When we look at a portfolio or most of these portfolios we would have to sell 60%, 70% of them to get down to the 30% or 40% we like. So, obviously we got to price them so we can sell them and still come out as a good valuation for what we want to keep and that becomes kind of difficult to do.
So, we're buying large not a big portfolio buyer because of the fifth issue but in terms of return requirements again I go back to my previous answer we have a cost of capital that is different for each jurisdiction and we need to get an appropriate spread before we deployed capital.
Your next question comes from Ki Bin Kim from SunTrust. Your line is open.
Thanks. Good morning everyone. So, I kind of imagine that one of the bigger challenges that you guys have is finding smart ways to deploy development capital in size. So, could you talk about where are the next rounds of opportunities are globally?
Sure. I mean there we have a really great way of deploying capital which is in the market that's in the high 4% we can deploy capital development which will not only service the needs of our customers but will also monetize our land bank and we control based on our current land bank and the option land and even excluding the covered lamp place we have a close to $10 billion opportunity to deploy capital. So, that's a couple of years of activity that doesn't depend on anything else or any portfolio acquisition or the like and we are - it's not a static number we're always adding to it and growing it.
So, I think primarily the global development platform very few people actually attribute any value to is a driver of our growth and it's a pretty unique and special driver of deployment and earnings growth. So that's our primary way. The acquisition stuff tends to be more value added tends to be cover land played there's got to be an angle. If we're going toe to toe on just the cost to capital race with the latest sovereign wealth fund or pension fund that wants to be out there that's generally not our ammo particularly when you are related to quality that I talked about earlier.
Your next question comes from Michael Miller from JP Morgan. Your line is open.
Thanks. Hi and I apologize. I missed some of the intro comments if this was asked. But looking out to 19 and 20 it looks like you have about 13% to 15% of square footage expiring each year. How much pull forward should we expect on top of those levels?
Hi Michael, this is Tom. I don't think you should expect a lot of pull forward to those levels. We're obviously I think you're going to see our churn over time naturally come down slowly because of longer lease duration. So, I wouldn't expect.
But I think what he's asking is that in a typical year we lease about 5% more than the rollover we have. So, I think in the 15% roll here it's going to be about 20% because we're pulling basically six months of the next year-end. We're always running ahead. Although you know we're getting a little smarter about that. It took us a while to figure it out.
But by moving things forward, in the rapidly escalating market you are actually blocking and lease rates at a lower rate than you should have and that's another behavioral thing that we're working on here. So, I think the answer is, specific answer to your question is about 5% more but there's a rent aspect to that that you got to keep them.
Your next question comes from John Guinee from Stifel Nicolaus. Your line is open.
Hey, Mike Curless follow-up call. When you're looking at development overall lot of moving pieces, land, and entitlement costs, hard costs, required, yields by you and others as well as rental rates. What do you think are good examples of what's happening to land versus hard costs versus required yield in various markets that you're looking at new development?
We're certainly seeing. As Gene mentioned the scarcity is well at this side particularly in the markets that are closer to the customers. Scarcity there is going to be driving up and is driving up land prices, construction costs are being driven up in select markets as well because that's going on with steel. But in the places that we're doing business, we're seeing the corresponding rental rates being there and emerging.
I got to tell you this construction cost thing is no joke in the bay area. Construction costs are 20%, 25% percent up last year. That by the way thanks to other parts of California too. So, they have been stable for many years and now it's the time for the contractors and stuff and buyers to make some hay while the sun is shining.
So, construction costs are really tough and some of that has been mitigated by yield compression on the required return side, but it's getting tougher to pencil spec development in some of these markets and that's good news I guess for rental growth over time because that marginal product coming to market is [ph] now.
Your next question comes from Eric Frankel from Green Street Advisor. Your line is open.
Thank you. I just want to address the topic of rent paying abilities among tenants. Obviously, the rent increases you are pushing through the tenants especially in close markets. They don't think much of rent I guess is what's been phrased the last few years. Can you talk about what how higher rents fit into your tenants supply chains at this point especially population dense markets and it certainly seems for you know potential multi-storey development in the future that you need rents to be in the $15 to $30 range for the economic to work. Can you talk about which tenant can actually afford those types of prices?
Sure. First of all, keep in mind that while nominal rate rental rates have increased a lot in terms of real rants we're still way below the high water marks of the late nineties and early 10,000 substantially below. So real rent is really what matters over time. Second, a lot of these marginal player, marginal in terms of bad but marginal meaning players that need close and can fill space are really substituting retail space so the difference between retail and industrial is blending and they get a lot more throughput in last you know last touch delivery and therefore by eliminating a retail rounds and another a lot of other supply chain costs. I think they can afford to pay a lot more, those particular tenants can certainly pay a lot more for higher cost real estate.
The third consideration is that there are not a lot of these opportunities around to develop so it's not like a greenfield situation where you can go and all these new buildings and all that. But probably the most important factor is that industrial rents are a tiny tiny tiny portion of the entire supply chain cost. I mean certainly under 5% and in many many cases under 2%.
And in particular categories like parcel delivery, food, construction, municipal items and all that you got to be there to provide those services close end. So those tenants tend to be less rent sensitive. If you're distributing tires you're not going to be in those locations because you're very rent sensitive. But those are not the kind of tenants you are finding in those locations.
Your next question comes from Jon Petersen from Jefferies. Your line is open.
Great. Thank you. So, the promotes this quarter came in well ahead of your guidance. Just wondering if you can give some color on why it was so much higher than the outlook you gave a couple months ago. I think it was often the China fund. And then kind of stepping back to the bigger picture. I'm just curious when you provide guidance, how do you go about underwriting what the promote potential is?
Do you guys assume a 25 basis point increase in cap rates or slower NOI growth or something conservative like that to derive the number just trying to think about how you guys I think about that when you get guidance.
Jon, thanks for the question. So, our approach on promotes is we generally provide guidance based on smart valuation and what we saw on the first quarter was China values pretty meaningfully and we had a positive tailwind from Fx. The RMB strengthened against the dollar in the quarter and vis-à-vis from our calculations obviously be sensitive to valuation. So, we give you the sport values on promotes.
As we mentioned the fourth quarter promote is based on fund in Europe and we'll recognize all the revenue.
Yes. It's more like an option price, I mean it's an effective call on appreciation of the portfolio plus the preferred return. So, it's very sensitive to that exit value and cap rates have been there and rent. So, we do our best we're not trying to step on the scale or anything in. Sometimes most of the times it and the downward compressing cap rate environment it's just been price to the up side.
Your last question comes from Jamie Feldman from Bank of America. Your line is open.
Great. Guy's sticking with your last statement just on compressing cap rates, I mean what are your thoughts and how much lower cap rates can go or maybe a better day to ask you that is just to talk about demand you are seeing out there for industrial assets and what the transaction market looks like and what underwriting assumptions look like for buyers?
I think that's based on what we're saying people are paying mid for cap rates for some very mediocre export polio than in the past markets. Like LA some of the cap rates are would lead to that market are in the high three. So. and that translates into maybe a 5.5 on leverage IRR are on a good day. So that's what we're seeing in the marketplace.
And what it should be I don't know, we're not buying a lot of real estate at 0.3 cap rate. So, I don't really know what was the most the first party question. Jamie could you ask the first part of your question again.
Okay, you're gone. All right you can call me privately, I forgot the first part. Anyway, thank you very much for your interest in the company and look forward to communicating with you over the course of the quarter.
This concludes today's conference call you may now disconnect.