UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2012
For the transition period from to
Commission File Number: 001-13545 (Prologis, Inc.) 001-14245 (Prologis, L.P.)
Prologis, Inc.
Prologis, L.P.
(Exact name of registrant as specified in its charter)
Maryland (Prologis, Inc.)
Delaware (Prologis, L.P.)
94-3281941 (Prologis, Inc.)
94-3285362 (Prologis, L.P.)
(415) 394-9000
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing for the past 90 days.
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website; if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter periods that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one):
Prologis, Inc.:
Prologis, L.P.:
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).
The number of shares of Prologis, Inc.’s common stock outstanding as of November 1, 2012 was approximately 460,910,000.
EXPLANATORY NOTE
This report combines the quarterly reports on Form 10-Q for the period ended September 30, 2012 of Prologis, Inc. and Prologis, L.P. Unless stated otherwise or the context otherwise requires, references to “Prologis, Inc.” or the “REIT”, mean Prologis, Inc., and its consolidated subsidiaries; and references to “Prologis, L.P.” or the “Operating Partnership” mean Prologis, L.P., and its consolidated subsidiaries. The terms “the Company”, “Prologis”, “we”, “our” or “us” means the REIT and the Operating Partnership collectively.
Prologis, Inc. is a real estate investment trust and the general partner of the Operating Partnership. As of September 30, 2012, the REIT owned an approximate 99.59% common general partnership interest in the Operating Partnership and 100% of the preferred units in the Operating Partnership. The remaining approximate 0.41% common limited partnership interest is owned by non-affiliated investors and certain current and former directors and officers of the REIT. As the sole general partner of the Operating Partnership, the REIT has full, exclusive and complete responsibility and discretion in the day-to-day management and control of the Operating Partnership.
We operate the REIT and the Operating Partnership as one enterprise. The management of the REIT consists of the same members as the management of the Operating Partnership. These members are officers of the REIT and employees of the Operating Partnership or one of its direct or indirect subsidiaries. As general partner with control of the Operating Partnership, the REIT consolidates the Operating Partnership for financial reporting purposes, and the REIT does not have significant assets other than its investment in the Operating Partnership. Therefore, the assets and liabilities of the REIT and the Operating Partnership are the same on their respective financial statements.
We believe combining the quarterly reports on Form 10-Q of the REIT and the Operating Partnership into this single report results in the following benefits:
enhances investors’ understanding of the REIT and the Operating Partnership by enabling investors to view the business as a whole in the same manner as management views and operates the business;
eliminates duplicative disclosure and provides a more streamlined and readable presentation since a substantial portion of the Company’s disclosure applies to both the REIT and the Operating Partnership; and
creates time and cost efficiencies through the preparation of one combined report instead of two separate reports.
We believe it is important to understand the few differences between the REIT and the Operating Partnership in the context of how we operate as an interrelated consolidated company. The REIT’s only material asset is its ownership of partnership interests in the Operating Partnership. As a result, the REIT does not conduct business itself, other than acting as the sole general partner of the Operating Partnership and issuing public equity from time to time. The REIT itself does not issue any indebtedness, but guarantees the unsecured debt of the Operating Partnership. The Operating Partnership holds substantially all the assets of the business, directly or indirectly, and holds the ownership interests in the Company’s investment in certain entities. The Operating Partnership conducts the operations of the business and is structured as a partnership with no publicly traded equity. Except for net proceeds from equity issuances by the REIT, which are contributed to the Operating Partnership in exchange for partnership units, the Operating Partnership generates the capital required by the business through the Operating Partnership’s operations, its incurrence of indebtedness and the issuance of partnership units to third parties.
Noncontrolling interests, stockholders’ equity and partners’ capital are the main areas of difference between the consolidated financial statements of the REIT and those of the Operating Partnership. The noncontrolling interests in the Operating Partnership’s financial statements include the interests in consolidated entities not owned by the Operating Partnership. The noncontrolling interests in the REIT’s financial statements include the same noncontrolling interests at the Operating Partnership level, as well as the common limited partnership interests in the Operating Partnership, which are accounted for as partners’ capital by the Operating Partnership.
In order to highlight the differences between the REIT and the Operating Partnership, there are separate sections in this report, as applicable, that separately discuss the REIT and the Operating Partnership including separate financial statements, controls and procedures sections, and separate Exhibit 31 and 32 certifications. In the sections that combine disclosure of the REIT and the Operating Partnership, this report refers to actions or holdings as being actions or holdings of Prologis.
PROLOGIS
INDEX
PART I.
Financial Information
Item 1.
Financial Statements
Consolidated Balance Sheets – September 30, 2012 and December 31, 2011
Consolidated Statements of Operations – Three and Nine Months Ended September 30, 2012 and 2011
Consolidated Statements of Comprehensive Income (Loss) – Three and Nine Months Ended September 30, 2012 and 2011
Consolidated Statement of Equity – Nine Months Ended September 30, 2012
Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2012 and 2011
Consolidated Statement of Capital – Nine Months Ended September 30, 2012
Prologis, Inc. and Prologis, L.P.:
Notes to Consolidated Financial Statements
Reports of Independent Registered Public Accounting Firm
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II.
Other Information
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Item 6.
Exhibits
Item 1. Financial Statements
PROLOGIS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
ASSETS
Investments in real estate properties
Less accumulated depreciation
Net investments in real estate properties
Investments in and advances to unconsolidated entities
Notes receivable backed by real estate
Assets held for sale
Net investments in real estate
Cash and cash equivalents
Restricted cash
Accounts receivable
Other assets
Total assets
LIABILITIES AND EQUITY
Liabilities:
Debt
Accounts payable and accrued expenses
Other liabilities
Liabilities related to assets held for sale
Total liabilities
Equity:
Prologis, Inc. stockholders’ equity:
Preferred stock
Common stock; $0.01 par value; 460,897 shares and 459,401 shares issued and outstanding at September 30, 2012 and at December 31, 2011, respectively
Additional paid-in capital
Accumulated other comprehensive loss
Distributions in excess of net earnings
Total Prologis stockholders’ equity
Noncontrolling interests
Total equity
Total liabilities and equity
The accompanying notes are an integral part of these Consolidated Financial Statements.
1
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)
Revenues:
Rental income
Rental recoveries
Private capital revenue
Development management and other income
Total revenues
Expenses:
Rental expenses
Private capital expenses
General and administrative expenses
Merger, acquisition and other integration expenses
Impairment of real estate properties
Depreciation and amortization
Other expenses
Total expenses
Operating income
Other income (expense):
Earnings from unconsolidated entities, net
Interest expense
Impairment of other assets
Interest and other income, net
Gain on acquisitions and dispositions of investments in real estate, net
Foreign currency and derivative gains (losses), net
Gain (loss) on early extinguishment of debt, net
Total other income (expense)
Earnings (loss) before income taxes
Current income tax expense (benefit)
Deferred income tax expense (benefit)
Total income tax expense (benefit)
Earnings (loss) from continuing operations
Discontinued operations:
Income attributable to disposed properties and assets held for sale
Net gain (loss) on dispositions, including related impairment charges and taxes
Total discontinued operations
Consolidated net earnings (loss)
Net earnings attributable to noncontrolling interests
Net earnings (loss) attributable to controlling interests
Less preferred share dividends
Net earnings (loss) available for common stockholders
Weighted average common shares outstanding - Basic
Weighted average common shares outstanding - Diluted
Net earnings (loss) per share available for common stockholders - Basic:
Continuing operations
Discontinued operations
Net earnings (loss) per share available for common stockholders - Basic
Net earnings (loss) per share available for common stockholders - Diluted:
Net earnings (loss) per share available for common stockholders - Diluted
Dividends per common share
2
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
Other comprehensive income (loss):
Foreign currency translation gains (losses), net
Unrealized loss and amortization on derivative contracts, net
Comprehensive income (loss)
Other comprehensive loss (income) attributable to noncontrolling interests
Comprehensive income (loss) available for common stockholders
CONSOLIDATED STATEMENT OF EQUITY
Nine Months Ended September 30, 2012
Balance as of January 1, 2012
Consolidated net earnings
Adjustment to the Merger purchase price allocation
Effect of common stock plans
Capital contributions, net
Purchase of noncontrolling interests
Distributions and allocations
Balance as of September 30, 2012
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating activities:
Adjustments to reconcile net earnings (loss) to net cash provided by operating activities:
Straight-lined rents
Stock-based compensation awards, net
Distributions and changes in operating receivables from our unconsolidated entities
Amortization of debt and lease intangibles
Non-cash Merger, acquisition and other integration expenses
Impairment of real estate properties and other assets
Net (gain) loss on dispositions, net of related impairment charges, included in discontinued operations
Gains recognized on acquisitions and dispositions of investments in real estate, net
Loss (gain) on early extinguishment of debt, net
Unrealized foreign currency and derivative losses (gains), net
Increase in restricted cash, accounts receivable and other assets
Increase (decrease) in accounts payable and accrued expenses and other liabilities
Net cash provided by operating activities
Investing activities:
Real estate development activity
Real estate acquisitions
Tenant improvements and lease commissions on previously leased space
Non-development capital expenditures
Investments in and advances to unconsolidated entities, net
Return of investment from unconsolidated entities
Proceeds from dispositions of real estate properties
Proceeds from repayment of notes receivable
Investments in notes receivable backed by real estate and advances on other notes receivable
Cash acquired in connection with the Merger
Acquisition of PEPR, net of cash received
Acquisition of NAIF II, net of cash received
Net cash used in investing activities
Financing activities:
Issuance of common stock, net
Dividends paid on common stock
Dividends paid on preferred stock
Noncontrolling interest contributions
Noncontrolling interest distributions
Purchase of noncontrolling interest
Debt and equity issuance costs paid
Proceeds from credit facilities, net
Repurchase of debt
Proceeds from issuance of debt
Payments on debt
Net cash provided by (used in) financing activities
Effect of foreign currency exchange rate changes on cash
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
See Note 16 for information on non-cash investing and financing activities and other information.
4
PROLOGIS, L.P.
LIABILITIES AND CAPITAL
Capital:
Partners’ capital:
General partner - preferred
General partner - common
Limited partners
Total partners’ capital
Total capital
Total liabilities and capital
5
(In thousands, except per unit amounts)
Less preferred unit dividends
Net earnings (loss) available for common unitholders
Weighted average common units outstanding - Basic
Weighted average common units outstanding - Diluted
Net earnings (loss) per unit available for common unitholders - Basic:
Net earnings (loss) per unit available for common unitholders - Basic
Net earnings (loss) per unit available for common unitholders - Diluted:
Net earnings (loss) per unit available for common unitholders - Diluted
Distributions per common unit
6
Comprehensive income (loss) available for common unitholders
CONSOLIDATED STATEMENT OF CAPITAL
Effect of REIT’s common stock plans
7
REIT stock-based compensation awards, net
Proceeds from issuance of common partnership units in exchange for contributions from the REIT, net
Distributions paid on common partnership units
Distributions paid on preferred units
8
PROLOGIS, INC. AND PROLOGIS, L.P.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Business. On June 3, 2011, AMB Property Corporation (“AMB”) and AMB Property, LP completed the merger contemplated by the Agreement and Plan of Merger with ProLogis, a Maryland real estate investment trust (“ProLogis”) and its subsidiaries (the “Merger”). Following the Merger, AMB changed its name to Prologis, Inc. (the “REIT”). As a result of the Merger, each outstanding common share of beneficial interest of ProLogis was converted into 0.4464 of a newly issued share of common stock of the REIT. As further discussed in Note 2, AMB was the legal acquirer and ProLogis was the accounting acquirer.
Prologis, Inc. commenced operations as a fully integrated real estate company in 1997, elected to be taxed as a real estate investment trust under the Internal Revenue Code of 1986, as amended, and believes the current organization and method of operation will enable the REIT to maintain its status as a real estate investment trust. The REIT is the general partner of Prologis, L.P. (the “Operating Partnership”). Through our controlling interest in the Operating Partnership, we are engaged in the ownership, acquisition, development and operation of industrial properties in global, regional and other distribution markets throughout the Americas, Europe and Asia. Our current business strategy includes two reportable business segments: Real Estate Operations and Private Capital. Our Real Estate Operations segment represents the long-term ownership of industrial properties. Our Private Capital segment represents the long-term management of co-investment ventures and other unconsolidated entities. See Note 15 for further discussion of our business segments. Unless otherwise indicated, the notes to the Consolidated Financial Statements apply to both the REIT and the Operating Partnership. The terms “the Company”, “Prologis”, “we”, “our” or “us” means the REIT and Operating Partnership collectively.
As of September 30, 2012, the REIT owned an approximate 99.59% common general partnership interest in the Operating Partnership, and 100% of the preferred units. The remaining approximate 0.41% common limited partnership interest is owned by non-affiliated investors and certain current and former directors and officers of the REIT. As the sole general partner of the Operating Partnership, the REIT has full, exclusive and complete responsibility and discretion in the day-to-day management and control of the Operating Partnership. We operate the REIT and the Operating Partnership as one enterprise. The management of the REIT consists of the same members as the management of the Operating Partnership. These members are officers of the REIT and employees of the Operating Partnership or one of its direct or indirect subsidiaries. As general partner with control of the Operating Partnership, the REIT consolidates the Operating Partnership for financial reporting purposes, and the REIT does not have significant assets other than its investment in the Operating Partnership. Therefore, the assets and liabilities of the REIT and the Operating Partnership are the same on their respective financial statements.
Basis of Presentation. The accompanying consolidated financial statements, presented in the U.S. dollar, are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities as of the date of the financial statements and revenue and expenses during the reporting period. Our actual results could differ from those estimates and assumptions. All material intercompany transactions with consolidated entities have been eliminated.
The accompanying unaudited interim financial information has been prepared according to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted in accordance with such rules and regulations. Our management believes that the disclosures presented in these financial statements are adequate to make the information presented not misleading. In our opinion, all adjustments and eliminations, consisting only of normal recurring adjustments, necessary to present fairly the financial position and results of operations for both the REIT and the Operating Partnership for the reported periods have been included. The results of operations for such interim periods are not necessarily indicative of the results for the full year. The accompanying unaudited interim financial information should be read in conjunction with the December 31, 2011 Consolidated Financial Statements of Prologis, as previously filed with the SEC on Form 10-K and other public information.
Certain amounts included in the accompanying Consolidated Financial Statements for 2011 have been reclassified to conform to the 2012 financial statement presentation.
Recent Accounting Pronouncements. In December 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update that requires disclosures about offsetting and related arrangements to enable financial statements users to evaluate the effect or potential effect of netting arrangements on an entity’s financial position, including rights of setoff associated with certain financial instruments and derivative instruments. The disclosure requirements are effective for us on January 1, 2013, and we do not expect the guidance to have a material impact on our Consolidated Financial Statements.
In December 2011, the FASB issued an accounting standard update to clarify the scope of current U.S. GAAP. The update clarifies that the real estate sales guidance applies to the derecognition of a subsidiary that is in-substance real estate as a result of default on the subsidiary’s nonrecourse debt. That is, even if the reporting entity ceases to have a controlling financial interest under the consolidation guidance, the reporting entity would continue to include the real estate, debt, and the results of the subsidiary’s operations in its consolidated financial statements until legal title to the real estate is transferred to legally satisfy the debt. This accounting standard update is effective for us on January 1, 2013, and we do not expect the guidance to impact our Consolidated Financial Statements.
In September 2011, the FASB issued an accounting standard update to amend and simplify the rules related to testing goodwill for impairment. The update allows an entity to make an initial qualitative evaluation, based on the entity’s events and circumstances, to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The results of this qualitative assessment determine whether it is necessary to perform the currently required two-step impairment test. The new guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. We adopted this standard as of January 1, 2012 and it has not had a material impact on our Consolidated Financial Statements.
9
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In June 2011, the FASB issued an accounting standard update that eliminates the option to present components of other comprehensive income as part of the changes in stockholders’ equity, and requires the presentation of components of net income and other comprehensive income either in a single continuous statement or in two separate but consecutive statements. This accounting standard update is effective, on a retrospective basis, for interim and annual periods beginning after December 15, 2011. We adopted this standard as of January 1, 2012. As this standard is for presentation purposes only, it had no impact on our Consolidated Financial Statements.
In May 2011, the FASB issued an accounting standard update to amend the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements in order to achieve further convergence with International Financial Reporting Standards. We adopted this standard as of January 1, 2012. See Note 14 for additional disclosures.
Merger of AMB and ProLogis
As discussed in Note 1, we completed the Merger on June 3, 2011. After consideration of all applicable factors pursuant to the business combination accounting rules, the Merger resulted in a reverse acquisition in which AMB was the “legal acquirer” because AMB issued its common stock to ProLogis shareholders and ProLogis was the “accounting acquirer” due to various factors, including the fact that ProLogis shareholders held the largest portion of the voting rights in the merged entity and ProLogis appointees represented the majority of the Board of Directors. In our Consolidated Financial Statements, the period ended September 30, 2011 includes the historical results of ProLogis for the entire period, and the results of the merged company are included subsequent to the Merger.
The purchase price allocation reflects aggregate consideration of approximately $5.9 billion. The allocation of the purchase price required a significant amount of judgment and was based on our valuation, estimates and assumptions of the acquisition date fair value of the tangible and intangible assets and liabilities acquired.
Acquisition of ProLogis European Properties
During the second quarter of 2011, we increased our ownership of ProLogis European Properties (“PEPR”) through open market purchases and a mandatory tender offer. In May 2011, we settled our mandatory tender offer that resulted in the acquisition of an additional 96.5 million ordinary units and 2.7 million convertible preferred units of PEPR. During all of the second quarter of 2011, we made aggregate cash purchases totaling €715.8 million ($1.0 billion). We funded the purchases through borrowings under our global line of credit and a new €500 million bridge facility, which was subsequently repaid with proceeds from an equity offering in June 2011.
Upon completion of the tender offer, we met the requirements to consolidate PEPR. In accordance with the accounting rules for business combinations, we marked our equity investment in PEPR from carrying value to fair value of approximately €486 million, which resulted in the recognition of a gain of €59.6 million ($85.9 million). We refer to this transaction as the “PEPR Acquisition”. The fair value was based on the trading price for our previously owned units and our acquisition price for the PEPR units purchased during the tender offer period.
We have allocated the aggregate purchase price, representing the share of PEPR we owned at the time of consolidation of €1.1 billion ($1.6 billion). The allocation of the purchase price required a significant amount of judgment and was based on our valuation, estimates and assumptions of the acquisition date fair value of the tangible and intangible assets and liabilities acquired.
For additional information related to PEPR, see Note 10.
Pro forma Information
The following unaudited pro forma financial information presents our results as though the Merger and the PEPR Acquisition, as well as the equity offering in June 2011 that was used, in part, to repay the loans used to fund the PEPR Acquisition, had been consummated as of January 1, 2010. The pro forma information does not necessarily reflect the actual results of operations had the transactions been consummated at the beginning of the period indicated nor is it necessarily indicative of future operating results. The pro forma information does not give effect to any cost synergies or other operating efficiencies that have resulted or could result from the Merger and also does not include any merger and integration expenses. The results for the nine months ended September 30, 2011 include approximately four months of actual results for both the Merger and PEPR Acquisition, and pro forma adjustments for five months. Actual results in 2011 include rental income and rental expenses of the properties acquired through the Merger and PEPR Acquisition of $325.3 million and $86.7 million, respectively, of which $23.3 million of rental income and $4.0 million of rental expenses are included in discontinued operations.
(amounts in thousands, except per share amounts)
Net loss available for common stockholders
Net loss per share available for common stockholders - basic
Net loss per share available for common stockholders - diluted
These results include certain adjustments, primarily decreased revenues resulting from the amortization of the net asset from the acquired leases with favorable or unfavorable rents relative to estimated market rents, increased depreciation and amortization expense resulting from the adjustment of real estate assets to estimated fair value and recognition of intangible assets related to in-place leases and acquired management contracts and lower interest expense due to the accretion of the fair value adjustment of debt.
10
Acquisitions of Unconsolidated Co-Investment Ventures
On February 3, 2012, we acquired our partner’s 63% interest in and now own 100% of our previously unconsolidated co-investment venture Prologis North American Industrial Fund II (“NAIF II”) and we repaid the loan from NAIF II to our partner for a total of $336.1 million. The assets and liabilities of this venture, as well as the activity since the acquisition date, have been included in our Consolidated Financial Statements. In accordance with the accounting rules for business combinations, we marked our equity investment in NAIF II from its carrying value to the estimated fair value. The fair value was determined and allocated based on our valuation, estimates, and assumptions of the acquisition date fair value of the tangible and intangible assets and liabilities. The preliminary allocation of net assets acquired is approximately $1.6 billion in real estate assets, $27.3 million of net other assets, and $875.4 million in debt. We have not recorded a gain or loss with this transaction, as the carrying value of our investment was equal to the estimated fair value. While the current allocation of the purchase price is substantially complete, the valuation of the real estate properties is being finalized. We do not expect future revisions, if any, to have a significant impact on our financial position or results of operations.
On February 22, 2012, we dissolved the unconsolidated co-investment venture Prologis California (“Prologis California”) and divided the portfolio equally with our partner. The net value of the assets and liabilities distributed represents the fair value of our ownership interest in the co-investment venture on that date. In accordance with the accounting rules for business combinations, we marked our equity investment in Prologis California from its carrying value to the estimated fair value which resulted in a gain of $273.0 million. The gain is recorded in Gains on Acquisitions and Dispositions of Investments in Real Estate, Net in the Consolidated Statements of Operations. The fair value was determined and allocated based on our valuation, estimates, and assumptions of the acquisition date fair value of the tangible and intangible assets and liabilities. The preliminary allocation of net assets acquired is approximately $496.3 million in real estate assets, $17.7 million of net other assets, and $150.0 million in debt. While the current allocation of the purchase price is substantially complete, the valuation of the real estate properties is being finalized. We do not expect future revisions, if any, to have a significant impact on our financial position or results of operations.
We refer to these two transactions collectively as “Q1 Venture Acquisitions”. Our results for 2012 include rental income and rental expenses of the properties acquired in the Q1 Venture Acquisitions of $124.0 million and $30.3 million, respectively, of which $1.7 million of rental income and $0.2 million of rental expenses are included in discontinued operations.
Investments in real estate properties are presented at cost, and consist of the following (in thousands):
Industrial operating properties (1):
Improved land
Buildings and improvements
Development portfolio, including cost of land (2)
Land (3)
Other real estate investments (4)
Total investments in real estate properties
Net investments in properties
In March 2012, we recorded an impairment charge of $16.1 million related to the land received in 2011 in exchange for a note receivable. This impairment was recorded in Impairment of Other Assets in our Consolidated Financial Statements. During the nine months ended September 30, 2012, we recorded impairment charges of $9.8 million related to certain land parcels for which our intent is to sell and therefore, we wrote down to estimated fair value. The impairment was recorded in Impairment of Real Estate Properties in our Consolidated Financial Statements.
11
At September 30, 2012, excluding our assets held for sale, we owned real estate assets on a consolidated basis in the Americas (Canada, Mexico and the United States), Europe (Austria, Belgium, the Czech Republic, France, Germany, Hungary, Italy, the Netherlands, Poland, Romania, Slovakia, Spain, Sweden and the United Kingdom) and Asia (China, Japan and Singapore).
During the nine months ended September 30, 2012, we acquired ten operating buildings aggregating 1.3 million square feet for $60.4 million and 350 acres of land for a total of $112.2 million.
During 2012, we contributed one property aggregating 0.1 million square feet to Europe Logistics Venture I and one property aggregating 0.1 million square feet to Prologis European Properties Fund II.
See Note 6 for further discussion of properties classified as held for sale and properties we sold to third parties that are reported in discontinued operations.
Summary of Investments
We have investments in entities through a variety of ventures. We co-invest in entities that own multiple properties with private capital investors and provide asset and property management services to these entities. We refer to these entities as co-investment ventures. Our ownership interest in these entities generally ranges from 15-50%. These entities may be consolidated or unconsolidated, depending on the structure, our partner’s rights and participation and our level of control of the entity. This Note details our unconsolidated co-investment ventures. See Note 10 for more detail regarding our consolidated investments.
We also have investments in other joint ventures, generally with one partner and that we do not manage. We refer to our investments in the entities accounted for on the equity method, both unconsolidated co-investment ventures and other joint ventures, as unconsolidated entities.
Our investments in and advances to our unconsolidated entities are summarized below (in thousands):
Unconsolidated co-investment ventures
Other joint ventures
Totals
Unconsolidated Co-Investment Ventures
As of September 30, 2012, we had investments in and managed 12 unconsolidated co-investment ventures that own portfolios of operating industrial properties and may also develop properties. Private capital revenue includes revenues we earn for the management services we provide to unconsolidated entities and certain third parties. These fees are recognized as earned and may include property and asset management fees or transactional fees for leasing, acquisition, construction, financing, legal and tax services. We may also earn promote payments based on the third party investor returns over time. In addition, we may earn fees for services provided to develop a building within the co-investment venture and those fees are reflected as Development Management and Other Income in the Consolidated Statements of Operations.
Summarized information regarding our investments in the co-investment ventures is as follows (in thousands):
Earnings (loss) from unconsolidated co-investment ventures:
Americas (1)
Europe
Asia
Total earnings from unconsolidated co-investment ventures, net
Private capital revenue and other income:
Americas
Total private capital revenue
Total
12
We completed the Merger and PEPR Acquisition in the second quarter of 2011. During the first quarter of 2012, we also acquired one of our unconsolidated co-investment ventures and dissolved another, both located in the Americas. Therefore 2011 may not be comparable to 2012. See Note 2 for more information on these transactions.
Private capital revenue included fees and incentives we earn for services provided to our unconsolidated co-investment ventures (shown above), as well as fees earned from other unconsolidated entities and third parties of $0.1 million and $1.6 million during the three and nine months ended September 30, 2012, respectively and $1.9 million and $8.9 million during the three and nine months ended September 30, 2011, respectively.
Information about our investments in the co-investment ventures is as follows (dollars in thousands):
Unconsolidated co-investment ventures by region
Summarized financial information of the co-investment ventures (for the entire entity, not our proportionate share) and our investment in such ventures is presented below (dollars in millions):
2012
For the three months ended September 30, 2012 (1):
Revenues
Net earnings (loss)
For the nine months ended September 30, 2012 (1):
Net earnings (loss) (2)
As of September 30, 2012:
Amounts due to us (3)
Third party debt (4)
Noncontrolling interest
Venture partners’ equity
Our weighted average ownership (5)
Our investment balance (6)
Deferred gains, net of amortization (7)
2011
For the three months ended September 30, 2011 (1):
Net earnings (loss) (8)
For the nine months ended September 30, 2011 (1):
As of December 31, 2011:
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Equity Commitments Related to Certain Unconsolidated Co-Investment Ventures
Certain unconsolidated co-investment ventures have equity commitments from us and our venture partners. We may fulfill our equity commitment through contributions of properties or cash. Our venture partners fulfill their equity commitment with cash. We are committed to offer to contribute certain properties that we develop and stabilize in select markets in Europe and Mexico to certain ventures. These ventures are committed to acquire such properties, subject to certain exceptions, including that the properties meet certain specified leasing and other criteria, and that the ventures have available capital. We are not obligated to contribute properties at a loss. Depending on market conditions, the investment objectives of the ventures, our liquidity needs and other factors, we may make contributions of properties to these ventures through the remaining commitment period.
The following table is a summary of remaining equity commitments as of September 30, 2012 (in millions):
Expiration date for remainingcommitments
Prologis Targeted U.S. Logistics Fund (1)
Prologis
Venture Partners
Prologis SGP Mexico (2)
Venture Partner
Europe Logistics Venture 1 (3)
Prologis China Logistics Venture 1
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Other Joint Ventures
Our investments in and advances to these entities are as follows (in thousands):
Total investments in and advances to other joint ventures
The activity on the notes receivable backed by real estate for the nine months ended September 30, 2012 is as follows (in thousands):
Balance as of December 31, 2011
Elimination upon acquisition of NAIF II
Accrued interest/(interest payments received), net
Held for Sale
As of September 30, 2012, we had land and 23 operating properties that met the criteria to be classified as held for sale. The amounts included in held for sale as of September 30, 2012 represent real estate investment balances and the related assets and liabilities for each property.
Discontinued Operations
During the nine months ended September 30, 2012, we disposed of land subject to ground leases and 113 operating properties aggregating 14.4 million square feet to third parties. During all of 2011, we disposed of land subject to ground leases and 94 operating properties aggregating 10.7 million square feet to third parties.
The operations of the properties held for sale or disposed of to third parties and the aggregate net gains or losses recognized upon their disposition are presented as Discontinued Operations in our Consolidated Statements of Operations for all periods presented. Interest expense is included in discontinued operations only if it is directly attributable to these properties.
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Discontinued operations are summarized as follows (in thousands):
Rental income and recoveries
Depreciation and amortization expense
Net gain (loss) on dispositions, net of taxes
Impairment charges
All debt is held directly or indirectly by the Operating Partnership. The REIT itself does not have any indebtedness, but guarantees the unsecured debt of the Operating Partnership. We generally do not guarantee the debt issued by non-wholly owned subsidiaries.
Our debt consisted of the following (dollars in thousands):
Credit Facilities
Senior notes (2)
Exchangeable senior notes (3)
Secured mortgage debt (2)
Secured mortgage debt of consolidated entities (2)
Other debt of consolidated entities (2)
Other debt
We have a global senior credit facility (“Global Facility”), where funds may be drawn in U.S. dollar, euro, Japanese yen, British pound sterling and Canadian dollar on a revolving basis. The loans cannot exceed $1.71 billion (subject to currency fluctuations). We may increase the Global Facility to $2.71 billion, subject to currency fluctuations and obtaining additional lender commitments. The Global Facility is scheduled to mature on June 3, 2015, but the Operating Partnership may, at its option and subject to the satisfaction of certain conditions and payment of an extension fee, extend the maturity date to June 3, 2016. Pricing under the Global Facility, including the spread over LIBOR, facility fees and letter of credit fees, varies based upon the public debt ratings of the Operating Partnership. The Global Facility contains customary representations, covenants and defaults (including a cross-acceleration to other recourse indebtedness of more than $50 million).
We also have a ¥36.5 billion (approximately $470 million at September 30, 2012) yen revolver (the “Revolver”). The Revolver matures on March 1, 2014, but we may, at our option and subject to the satisfaction of customary conditions and payment of an extension fee, extend the maturity date to February 27, 2015. We may increase availability under the Revolver to an amount not exceeding ¥56.5 billion (approximately $728 million at September 30, 2012) subject to obtaining additional lender commitments. Pricing under the Revolver is consistent with the Global Facility pricing. The Revolver contains certain customary representations, covenants and defaults that are substantially the same as the corresponding provisions of the Global Facility.
We refer to the Global Facility and the Revolver, collectively, as our “Credit Facilities”.
Commitments and availability under our Credit Facilities as of September 30, 2012 were as follows (dollars in millions):
Aggregate lender - commitments
Less:
Borrowings outstanding
Outstanding letters of credit
Current availability
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Exchangeable Senior Notes
In connection with the Merger and exchange offer, our convertible senior notes became exchangeable senior notes issued by the Operating Partnership that are exchangeable into common stock of the REIT. As a result, the accounting for the exchangeable senior notes now requires us to separate the fair value of the derivative instrument (exchange feature) from the debt instrument and account for it separately as a derivative contract. We have determined that the exchangeable notes issued in 2010 are the only exchangeable notes where the fair value of the derivative is not zero at September 30, 2012, therefore this modification in accounting for the exchangeable notes only affected these notes. At each reporting period, we adjust the derivative instrument to fair value with the resulting adjustment being recorded in earnings as Foreign Currency and Derivative Gains (Losses), Net. The fair value of the derivative associated with our exchangeable notes was a liability of $36.6 million and $17.5 million at September 30, 2012 and December 31, 2011, respectively. We have recognized an unrealized loss of $6.7 million and $19.1 million for the three and nine months ended September 30, 2012, respectively. We recognized an unrealized gain of $61.0 million and $51.3 million for the three and nine months ended September 30, 2011, respectively.
We redeemed $448.9 million of the exchangeable notes issued in 2007 in April 2012, which was when the holders had the right to require us to repurchase their notes for cash.
Secured Mortgage Debt
TMK bonds are a financing vehicle in Japan for special purpose companies known as TMKs. In 2012, we issued ¥35.6 billion ($458.0 million as of September 30, 2012) of new TMK bonds with maturity dates ranging from March 2017 to May 2019 with interest rates ranging from 0.8% to 1.4%, and secured by eight properties with an undepreciated cost at September 30, 2012 of $819.4 million.
In addition, we amended our existing TMK bonds, increasing amounts outstanding by ¥12.4 billion ($160.3 million as of September 30, 2012). As a result, the range of maturities on these bonds changed from 2012 to 2014 to a range of December 2014 to April 2018, and the interest rates were reduced from a range of 1.8% to 3.95% to a range of 1.0% to 1.8%.
In the first quarter of 2012 in connection with the acquisition of NAIF II (see Note 2 for more details), we have assumed additional secured mortgage debt of $875.4 million, with maturity dates through December 2018. Subsequent to the acquisition, we have paid down a portion of outstanding debt and reduced the balance to $718.4 million, secured by 92 properties with an undepreciated cost of $1.1 billion at September 30, 2012.
In the first quarter of 2012 in connection with the acquisition of our share of Prologis California (see Note 2 for more details), we assumed additional secured mortgage debt of $150.0 million payable in 2014 and secured by 24 properties with an undepreciated cost of $320.7 million at September 30, 2012.
Secured Mortgage Debt of Consolidated Entities
On June 20, 2012, one of our consolidated co-investment ventures incurred $23.0 million of secured mortgage debt, including $13.0 million at 4.50% due December 2016 and $10.0 million at 4.78% due December 2018. This debt is secured by four real estate properties with an aggregate undepreciated cost of $40.3 million at September 30, 2012.
Other Debt
On February 2, 2012, we entered into a senior term loan agreement where we may obtain loans in an aggregate amount not to exceed €487.5 million ($633.2 million at September 30, 2012). The loans can be obtained in U.S. dollar, euro, Japanese yen, and British pound sterling. We may increase the borrowings to approximately €987.5 million ($1.3 billion at September 30, 2012), subject to obtaining additional lender commitments. The loan agreement is scheduled to mature on February 2, 2014, but we may extend the maturity date three times at our option, in each case up to one year, subject to satisfaction of certain conditions and payment of an extension fee. We fully drew the senior term loan and used the proceeds to pay off two term loans assumed in connection with the Merger and the remainder to pay down borrowings on our Credit Facilities.
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Long-Term Debt Maturities
Principal payments due on our debt, for the remainder of 2012 and for each of the years in the ten-year period ending December 31, 2021 and thereafter are as follows (in millions):
Maturity
2012 (1) (2)
2013 (1) (2)
2014
2015
2016
2017
2018
2019
2020
2021
Thereafter
Subtotal
Unamortized (discounts) premiums, net
Debt Covenants
Our debt agreements contain various covenants, including maintenance of specified financial ratios. As of September 30, 2012 we were in compliance with all covenants.
Other liabilities consisted of the following, net of amortization, if applicable, as of September 30, 2012 and December 31, 2011 (in thousands):
Income tax liabilities
Tenant security deposits
Unearned rents
Lease intangible assets
Deferred income
Environmental
Value added tax and other tax liabilities
Other
Operating Partnership
For each share of common stock or preferred stock the REIT issues, the Operating Partnership issues a corresponding common or preferred partnership unit, as applicable, to the REIT in exchange for the contribution of the proceeds from the stock issuance. In addition, other third parties and certain current and former directors and officers of the REIT own common limited partnership units that make up approximately 0.41% of the common partnership units.
Preferred Stock of the REIT
We had the following preferred stock issued and outstanding (in thousands, except per share and par value data):
Series L Preferred stock at stated liquidation preference of $25 per share; $0.01 par value; 2,000 shares
Series M Preferred stock at stated liquidation preference of $25 per share; $0.01 par value; 2,300 shares
Series O Preferred stock at stated liquidation preference of $25 per share; $0.01 par value; 3,000 shares
Series P Preferred stock at stated liquidation preference of $25 per share; $0.01 par value; 2,000 shares
Series Q Preferred stock at stated liquidation preference of $50 per share; $0.01 par value; 2,000 shares
Series R Preferred stock at stated liquidation preference of $25 per share; $0.01 par value; 5,000 shares
Series S Preferred stock at stated liquidation preference of $25 per share; $0.01 par value; 5,000 shares
Total preferred stock
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The holders of the preferred stock have preference rights with respect to distributions and liquidation over the common stock and certain rights in the case of arrearage. Holders of the preferred stock are not entitled to vote on any matters, except under certain limited circumstances. The series L, M, O, P, R and S preferred stock are redeemable solely at our option, in whole or in part. The series Q preferred stock will be redeemable at our option on and after November 13, 2026.
We report noncontrolling interests related to several entities we consolidate but do not own 100% of the common equity. These entities include three real estate partnerships that have issued limited partnership units to third parties. Depending on the specific partnership agreements, these limited partnership units are exchangeable into shares of our common stock (or cash), generally at a rate of one share of common stock to one unit. We evaluated the noncontrolling interests with redemption provisions that permit the issuer to settle in either cash or common stock at the option of the issuer to determine whether temporary or permanent equity classification on the balance sheet is appropriate, including the requirement to settle in unregistered shares, and determined that these units meet the requirements to qualify for presentation as permanent equity.
We also consolidate several entities in which we do not own 100% but the units are not exchangeable into our common stock. If we contribute a property to a consolidated co-investment venture, the property is still reflected in our Consolidated Financial Statements, but due to our ownership of less than 100%, there is an increase in noncontrolling interest related to the contributed properties, which represents the cash we receive from our partners.
REIT
The noncontrolling interest of the REIT includes the noncontrolling interests presented in the Operating Partnership, as well as the common limited partnership units in the Operating Partnership that are not owned by the REIT. As of September 30, 2012, the REIT owned approximately 99.59% of the common partnership units of the Operating Partnership.
The following is a summary of the noncontrolling interest and the consolidated entity’s total investment in real estate and debt at September 30, 2012 and December 31, 2011 (dollars in thousands):
Partnerships with exchangeable units (1)
Prologis Institutional Alliance Fund II (2)
PEPR (3)
Mexico Fondo Logistico (AFORES) (4)
Prologis AMS (5)
Other consolidated entities
Operating Partnership noncontrolling interests
Limited partners in the Operating Partnership (6)
REIT noncontrolling interests
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Under our incentive plans, we had stock options and full value awards (restricted stock, restricted share units (“RSUs”) and performance based shares (“PSAs”)) outstanding during 2012.
Summary of Activity
The activity for the nine months ended September 30, 2012, with respect to our stock options, was as follows:
Balance at December 31, 2011
Exercised
Forfeited
Balance at September 30, 2012
The activity for the nine months ended September 30, 2012, with respect to our unvested restricted stock, was as follows:
Granted
Vested
The activity for the nine months ended September 30, 2012, with respect to our RSU and PSA awards, was as follows:
Distributed
Forfeited/Expired
During the nine months ended September 30, 2012, we granted 1,570,498 RSUs, which, generally, will vest over three years. In addition, 39,029 PSAs were earned based on 2011 performance.
In connection with the Merger, we have incurred significant transaction, integration, and transitional costs. These costs include investment banker advisory fees; legal, tax, accounting and valuation fees; termination and severance costs (both cash and stock based compensation awards) for terminated and transitional employees; non-capitalized system conversion costs; and other integration costs. These costs are expensed as incurred, which in some cases will be through the end of 2012. Certain of these costs were obligations of AMB and expensed prior to the closing of the Merger by AMB. At the time of the Merger, we terminated our existing credit facilities and wrote-off the remaining unamortized deferred loan
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costs associated with such facilities, which is included as a merger expense. In addition, we have included costs associated with the acquisition of a controlling interest in PEPR in 2011, the liquidation of PEPR in 2012, as well as some costs associated with restructuring the finance organization in Europe. The following is a breakdown of the Merger and Acquisition costs incurred (in thousands):
Termination, severance and transitional employee costs
Professional fees
Office closure, travel and other costs
Write-off of deferred loan costs
We determine basic earnings per share/unit based on the weighted average number of shares of common stock/units outstanding during the period. We compute diluted earnings per share/unit based on the weighted average number of shares outstanding combined with the incremental weighted average effect from all outstanding potentially dilutive instruments.
The following table sets forth the computation of our basic and diluted earnings per share/unit (in thousands, except per share/unit amounts):
Noncontrolling interest attributable to exchangeable limited partnership units
Adjusted net earnings (loss) available for common stockholders
Weighted average common shares outstanding - Basic (2)
Incremental weighted average effect on exchange of limited partnership units
Incremental weighted average effect of share awards
Weighted average common shares outstanding - Diluted (3)(4)
Net earnings (loss) per share available for common stockholders - Basic and Diluted
Adjusted net earnings (loss) available for common unitholders
Weighted average common partnership units outstanding - Basic (2)
Weighted average common partnership units outstanding - Diluted (3)(4)
Net earnings (loss) per unit available for common unitholders - Basic and Diluted
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Derivative Financial Instruments
In the normal course of business, our operations are exposed to global market risks, including the effect of changes in foreign currency exchange rates and interest rates. To manage these risks, we may enter into various derivative contracts. We may use foreign currency contracts, including forwards and options, to manage foreign currency exposure. We may use interest rate swaps or caps to manage the effect of interest rate fluctuations. We do not use derivative financial instruments for trading purposes. The majority of our derivative financial instruments are customized derivative transactions and are not exchange-traded. Management reviews our hedging program, derivative positions, and overall risk management strategy on a regular basis. We only enter into transactions that we believe will be effective at offsetting the underlying risk.
Our use of derivatives does involve the risk that counterparties may default on a derivative contract. We establish exposure limits for each counterparty to minimize this risk and provide counterparty diversification. We have established strict counterparty credit guidelines that are continually monitored. Substantially all of our derivative exposures are with counterparties that have long-term credit ratings of single-A or better. We enter into master agreements with counterparties that generally allow for netting of certain exposures; therefore, the actual loss we would recognize if all counterparties failed to perform as contracted would be significantly lower. To mitigate pre-settlement risk, minimum credit standards become more stringent as the duration of the derivative financial instrument increases. To minimize the concentration of credit risk, we enter into derivative transactions with a portfolio of financial institutions. Based on these factors, we consider the risk of counterparty default to be minimal.
All derivatives are recognized at fair value in our Consolidated Balance Sheets within the line items Other Assets orAccounts Payable and Accrued Expenses, as applicable. We do not net our derivative position by counterparty for purposes of balance sheet presentation and disclosure. The accounting for gains and losses that result from changes in the fair values of derivative instruments depends on whether the derivatives are designated as, and qualify as, hedging instruments. Derivatives can be designated as fair value hedges, cash flow hedges or hedges of net investments in foreign operations.
For derivatives that will be accounted for as hedging instruments in accordance with the accounting standards, we formally designate and document, at inception, the financial instrument as a hedge of a specific underlying exposure, the risk management objective and the strategy for undertaking the hedge transaction. In addition, we formally assess both at inception and at least quarterly thereafter, whether the derivatives used in hedging transactions are effective at offsetting changes in either the fair values or cash flows of the related underlying exposures. Any ineffective portion of a derivative financial instrument’s change in fair value is immediately recognized in earnings. Derivatives not designated as hedges are not speculative and are used to manage our exposure to foreign currency fluctuations but do not meet the strict hedge accounting requirements.
Changes in the fair value of derivatives that are designated and qualify as cash flow hedges and hedges of net investments in foreign operations are recorded in Accumulated Other Comprehensive Loss in our Consolidated Balance Sheets. Due to the high degree of effectiveness between the hedging instruments and the underlying exposures hedged, fluctuations in the value of the derivative instruments will generally be offset by changes in the fair values or cash flows of the underlying exposures being hedged. The changes in fair values of derivatives that were not designated and/or did not qualify as hedging instruments are immediately recognized in earnings. For cash flow hedges, we reclassify changes in the fair value of derivatives into the applicable line item in our Consolidated Statements of Operations in which the hedged items are recorded in the same period that the underlying hedged items affect earnings.
Our interest rate risk management strategy is to limit the impact of future interest rate changes on earnings and cash flows as well as to stabilize interest expense and manage our exposure to interest rate movements. To achieve this objective, we have entered into interest rate swap and cap agreements, which allow us to borrow on a fixed rate basis for longer-term debt issuances. The maximum length of time that we hedge our exposure to future cash flows is typically less than 10 years. We use cash flow hedges to minimize the variability in cash flows of assets or liabilities or forecasted transactions caused by fluctuations in interest rates. We also have entered into interest rate swap agreements which allow us to receive variable-rate amounts from a counterparty in exchange for us making fixed-rate payments over the life of our agreements without the exchange of the underlying notional amount. We had 41 interest rate swap contracts, including 33 contracts denominated in euro, five contracts denominated in Japanese yen, two contracts denominated in British pound sterling and one contract denominated in U.S. dollar, outstanding at September 30, 2012.
We had $36.8 million and $28.5 million accrued in Accounts Payable and Accrued Expenses in our Consolidated Balance Sheets relating to these unsettled derivative contracts at September 30, 2012 and December 31, 2011, respectively.
We typically designate our interest rate swap and interest rate cap agreements as cash flow hedges as these derivative instruments may be used to manage the interest rate risk on potential future debt issuances or to fix the interest rate on a variable rate debt issuance. The effective portion of the gain or loss on the derivative is reported as a component of Accumulated Other Comprehensive Lossin our Consolidated Balance Sheets, and reclassified to Interest Expense in the Consolidated Statements of Operations over the corresponding period of the hedged item. Losses on the derivative representing hedge ineffectiveness are recognized in Interest Expense at the time the ineffectiveness occurred.
The amounts reclassified from Accumulated Other Comprehensive Income to interest expense for the three and nine months ended September 30, 2012 were $5.8 million and $11.5 million, respectively. The amounts reclassified to interest expense for the three and nine months ended September 30, 2011 were not considered material. For the next twelve months from September 30, 2012, we estimate that an additional $19.2 million will be reclassified to interest expense. We recorded a loss due to ineffectiveness of $0.6 million and $3.1 million during the three and nine months ended September 30, 2012, respectively. We did not have ineffectiveness during the three and nine months ended September 30, 2011. Amounts included in Accumulated Other Comprehensive Loss in our Consolidated Balance Sheet at September 30, 2012 and December 31, 2011 were losses of $52.1 million and $51.7 million, respectively.
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The following table summarizes the activity in our derivative instruments (in millions) for the nine months ended September 30:
Notional amounts at January 1
New contracts
Acquired contracts
Matured or expired contracts
Notional amounts at September 30
Fair Value Measurements
We have estimated the fair value of our financial instruments using available market information and valuation methodologies we believe to be appropriate for these purposes. Considerable judgment and a high degree of subjectivity are involved in developing these estimates and, accordingly, they are not necessarily indicative of amounts that we would realize upon disposition.
Fair Value Measurements on a Recurring and Non-recurring Basis
At September 30, 2012, other than the derivatives discussed above and in Note 7, we do not have any significant financial assets or financial liabilities that are measured at fair value on a recurring basis in our Consolidated Financial Statements.
Non-financial assets measured at fair value on a non-recurring basis in our Consolidated Financial Statements consist of real estate assets, investments in and advances to unconsolidated entities, and other assets that were subject to impairment charges. We recognized certain impairment charges to reflect the investments at their fair value during the nine months ended September 30 (in thousands):
Included in Continuing Operations:
Operating properties
Land
Discontinued Operations - operating properties
Total real estate assets
Investments in unconsolidated entities
Total other assets
Real Estate Assets
During the nine months ended September 30, 2012 and 2011, we recorded impairment charges when the carrying value exceeded the fair value related to real estate properties for which we changed our intent to sell and no longer hold for long-term investment. The fair value of these assets was primarily based upon letters of intent or purchase and sale agreements.
Other Assets
During the nine months ended September 30, 2011, we recorded impairment charges of $103.8 million related to two of our investments in unconsolidated entities, primarily Prologis North American Industrial Fund III. We determined the fair value of the underlying real estate assets using discounted cash flow models developed externally by a third party, which we corroborated through our discounted cash flow models.
During the nine months ended September 30, 2012, we recorded an impairment charge of $16.1 million related to the land received in 2011 in exchange for a note receivable.
Fair Value of Financial Instruments
At September 30, 2012 and December 31, 2011, the carrying amounts of certain of our financial instruments, including cash and cash equivalents, restricted cash, accounts and notes receivable and accounts payable and accrued expenses were representative of their fair values due to the short-term nature of these instruments and the recent acquisition of these items.
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At September 30, 2012 and December 31, 2011, the fair value of our senior notes and exchangeable senior notes, has been estimated based upon quoted market prices for the same (Level 1) or similar (Level 2) issues when current quoted market prices are available, the fair value of our Credit Facilities has been estimated by discounting the future cash flows using rates and borrowing spreads currently available to us (Level 3), and the fair value of our secured mortgage debt and assessment bonds that do not have current quoted market prices available has been estimated by discounting the future cash flows using rates currently available to us for debt with similar terms and maturities (Level 3). The fair value of our derivative financial instruments is determined through widely accepted valuation techniques, such as a discounted cash flow analysis on the expected cash flows and a Black Scholes option pricing model (Level 2). The differences in the fair value of our debt from the carrying value in the table below are the result of differences in interest rates and/or borrowing spreads that were available to us at September 30, 2012 and December 31, 2011, as compared with those in effect when the debt was issued or acquired. The senior notes and many of the issues of secured mortgage debt contain pre-payment penalties or yield maintenance provisions that could make the cost of refinancing the debt at lower rates exceed the benefit that would be derived from doing so.
The following table reflects the carrying amounts and estimated fair values of our debt (in thousands):
Debt:
Senior notes
Exchangeable senior notes
Secured mortgage debt
Secured mortgage debt of consolidated entities
Other debt of consolidated entities
Total debt
Our current business strategy includes two operating segments: Real Estate Operations and Private Capital. We generate revenues, earnings, net operating income and cash flows through our segments, as follows:
Real Estate Operations – This represents the direct long-term ownership of industrial operating properties and is the primary source of our core revenue and earnings. We collect rent from our customers under operating leases, including reimbursements for the vast majority of our operating costs. Each operating property is considered to be an individual operating segment having similar economic characteristics that are combined within the reportable segment based upon geographic location. Our real estate operations segment also includes development and re-development activities. We develop and re-develop industrial properties primarily in global and regional markets to meet our customers’ needs. We provide additional value creation by utilizing: (i) the land that we currently own in global and regional markets; (ii) the development expertise of our local personnel; (iii) our global customer relationships; and (iv) the demand for high quality distribution facilities in key markets. Land held for development, properties currently under development and land we own and lease to customers under ground leases are also included in this segment.
We own real estate in the Americas (Canada, Mexico and the United States), Europe (Austria, Belgium, the Czech Republic, France, Germany, Hungary, Italy, the Netherlands, Poland, Romania, Slovakia, Spain, Sweden and the United Kingdom) and Asia (China, Japan and Singapore)
Private Capital – This represents the long-term management of unconsolidated co-investment ventures and other joint ventures. We have a direct and long-standing relationship with a significant number of institutional investors. We tailor industrial portfolios to investors’ specific needs and deploy capital in both close-ended and open-ended fund structures and joint ventures, while providing complete portfolio management and financial reporting services. We recognize fees and incentives earned for services performed on behalf of the unconsolidated entities and certain third parties.
We report the costs associated with our private capital segment for all periods presented in the line item Private Capital Expenses in our Consolidated Statements of Operations. These costs include the direct expenses associated with the asset management of the co-investment ventures provided by individuals who are assigned to our private capital segment. In addition, in order to achieve efficiencies and economies of scale, all of our property management functions are provided by a team of professionals who are assigned to our real estate operations segment. These individuals perform the property-level management of the properties we own and the properties we manage that are owned by the unconsolidated entities. We allocate the costs of our property management function to the properties we consolidate (reported in Rental Expenses) and the properties owned by the unconsolidated entities (included in Private Capital Expenses), by using the square feet owned by the respective portfolios. We are further reimbursed by the co-investment ventures for certain expenses associated with managing these property funds.
Each entity we manage is considered to be an individual operating segment having similar economic characteristics that are combined within the reportable segment based upon geographic location. Our operations in the private capital segment are in the Americas (Brazil, Canada, Mexico and the United States), Europe (Belgium, the Czech Republic, France, Germany, Hungary, Italy, the Netherlands, Poland, Slovakia, Spain, Sweden and the United Kingdom) and Asia (China and Japan).
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We present the operations and net gains associated with properties sold to third parties or classified as held for sale as discontinued operations, which results in the restatement of prior year operating results to exclude the items presented as discontinued operations.
Reconciliations are presented below for: (i) each reportable business segment’s revenue from external customers to our Total Revenues; (ii) each reportable business segment’s net operating income from external customers to our Earnings (Loss) before Income Taxes; and (iii) each reportable business segment’s assets to our Total Assets. Our chief operating decision makers rely primarily on net operating income and similar measures to make decisions about allocating resources and assessing segment performance. The applicable components of our Total Revenues, Earnings (Loss) before Income Taxes and Total Assets are allocated to each reportable business segment’s revenues, net operating income and assets. Items that are not directly assignable to a segment, such as certain corporate income and expenses, are reflected as reconciling items. The following reconciliations are presented in thousands:
Real estate operations (1):
Total Real Estate Operations segment
Private capital (2):
Total Private Capital segment
Net operating income:
Real estate operations (3):
Private capital (2)(4):
Total segment net operating income
Reconciling items:
Gain on acquisitions and dispositions of investments in real estate, net (5)
Total reconciling items
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Assets:
Real estate operations:
Private capital (6):
Total segment assets
Non-cash investing and financing activities for the nine months ended September 30, 2012 and 2011 are as follows:
See Note 2 for information related to the Merger in 2011 and the Q1 Venture Acquisitions in 2012.
During the nine months ended September 30, 2012 and 2011, we capitalized portions of the total cost of our stock-based compensation awards of $6.3 million and $6.0 million, respectively, to the investment basis of our real estate or other assets.
During the nine months ended September 30, 2012 and 2011, we received $2.5 million and $1.2 million, respectively, of ownership interests in certain unconsolidated entities as a portion of our proceeds from the contribution of properties to these entities.
In April 2011, we assumed $61.7 million of debt upon the acquisition of the remaining interest in a joint venture that owned one property in Japan.
The amount of interest paid in cash, net of amounts capitalized, for the nine months ended September 30, 2012 and 2011 was $377.3 million and $304.6 million, respectively.
During the nine months ended September 30, 2012 and 2011, cash paid for income taxes, net of refunds, was $27.7 million and $42.7 million, respectively.
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Litigation
In the normal course of business, from time to time, we and our unconsolidated entities are parties to a variety of legal proceedings arising in the ordinary course of business. We believe that, with respect to any such matters that we are currently a party to, the ultimate disposition of any such matter will not result in a material adverse effect on our business, financial position or results of operations.
In December 2011, arbitration hearings began in connection with a dispute related to a real estate development project known as Pacific Commons. The plaintiff, Cisco Technology, Inc., was seeking rescission of a 2007 Restructuring and Settlement Agreement (the “Contract”) and other agreements, and declaratory relief, and damages for breach of the Contract. In August 2012, the arbitrator issued a ruling denying the relief sought by Cisco, and therefore Prologis has no further obligation.
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Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
We have reviewed the accompanying consolidated balance sheet of Prologis, Inc. and subsidiaries (the “Company”) as of September 30, 2012, the related consolidated statements of operations and consolidated statements of comprehensive income (loss) for the three-month and nine-month periods ended September 30, 2012 and 2011, the related consolidated statement of equity for the nine-month period ended September 30, 2012, and the related consolidated statements of cash flows for the nine-month periods ended September 30, 2012 and 2011. These consolidated financial statements are the responsibility of the Company’s management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Prologis, Inc. and subsidiaries as of December 31, 2011, and the related consolidated statements of operations, comprehensive income (loss), equity, and cash flows for the year then ended (not presented herein); and in our report dated February 28, 2012, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2011, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
KPMG LLP
Denver, Colorado
November 6, 2012
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The Partners
We have reviewed the accompanying consolidated balance sheet of Prologis, L.P. and subsidiaries (the “Operating Partnership”) as of September 30, 2012, the related consolidated statements of operations and consolidated statements of comprehensive income (loss) for the three-month and nine-month periods ended September 30, 2012 and 2011, the related consolidated statement of capital for the nine-month period ended September 30, 2012, and the related consolidated statements of cash flows for the nine-month periods ended September 30, 2012 and 2011. These consolidated financial statements are the responsibility of the Operating Partnership’s management.
We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Prologis, L.P. and subsidiaries as of December 31, 2011, and the related consolidated statements of operations, comprehensive income (loss), capital, and cash flows for the year then ended (not presented herein); and in our report dated February 28, 2012, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2011, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with our Consolidated Financial Statements and the related notes included in Item 1 of this report and our 2011 Annual Report on Form 10-K.
Certain statements contained in this discussion or elsewhere in this report may be deemed “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Words and phrases such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “designed to achieve,” variations of such words and similar expressions are intended to identify such forward-looking statements, which generally are not historical in nature. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future – including statements relating to rent and occupancy growth, development activity and sales or contribution volume or profitability on such sales and contributions, economic and market conditions in the geographic areas where we operate and the availability of capital in existing or new co-investment ventures – are forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Although we believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be attained and therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Many of the factors that may affect outcomes and results are beyond our ability to control. For further discussion of these factors see “Part II, Item 1A. Risk Factors” in our 2011 Annual Report on Form 10-K. References to “we,” “us” and “our” refer to ProLogis and its consolidated subsidiaries prior to the Merger (defined below) and to Prologis, Inc. and its consolidated subsidiaries following the Merger.
Management’s Overview
We are the leading global owner, operator and developer of industrial real estate, focused on global and regional markets across the Americas, Europe and Asia. As of September 30, 2012, on an owned and managed basis, we had properties and development projects totaling 565 million square feet (52.5 million square meters) in 21 countries. These properties are leased to approximately 4,500 customers, including third-party logistics providers, manufacturers, retailers, transportation companies, and other enterprises.
Of the 565 million square feet of our owned and managed portfolio as of September 30, 2012:
530 million square feet were in our operating portfolio with a gross book value of $41.1 billion that were 93.1% occupied;
16 million square feet were in our development portfolio with a total expected investment of $1.5 billion that were 46.7% leased;
19 million square feet consisted of properties in which we have an ownership interest but do not manage and other properties we own, including assets held for sale; and
the largest customer and 25 largest customers accounted for 2.2% and 18.1%, respectively, of our annualized base rent.
Prologis, Inc. (the “REIT”) is a self-administered and self-managed real estate investment trust, and is the sole general partner of Prologis, L.P. (the “Operating Partnership”). We operate the REIT and the Operating Partnership as one enterprise, and, therefore, our discussion and analysis refers to the REIT and its consolidated subsidiaries, including the Operating Partnership, collectively.
Our business strategy includes two operating segments: Real Estate Operations and Private Capital. We generate revenues, earnings, net operating income (calculated as rental income less rental expenses), funds from operations (as defined below) and cash flows through our segments primarily through three lines of business, as follows:
Real Estate Operations Segment
Rental Operations—This represents the primary source of our core revenue, earnings and funds from operations (or FFO as defined below). We collect rent from our customers under operating leases, including reimbursements for the vast majority of our operating costs. We seek to generate long-term internal growth in rental income by maintaining a high occupancy rate at our properties, by controlling expenses and through contractual rent increases on existing space and renewals on rollover space, thus capitalizing on the economies of scale inherent in owning, operating and growing a large global portfolio. Our rental income is diversified due to both our global presence and our broad customer base. We expect to generate long-term internal growth in rents by increasing our occupancy rate and through rent increases on existing space and renewals on rollovers. We believe that our property management and leasing teams, regular maintenance programs, capital expenditure programs, energy management and sustainability programs create cost efficiencies, allowing us to leverage our global platform and provide flexible solutions for our customers as well as for us.
Capital Deployment Activities—Our development and re-development activities support our rental operations and are, therefore, included with that line of business for segment reporting. We develop and re-develop industrial properties primarily in global and regional markets to meet our customers’ needs. Within this line of business, we provide additional value creation by utilizing: (i) the land that we currently own in global and regional markets; (ii) the development expertise of our local personnel; (iii) our global customer relationships; and (iv) the demand for high-quality distribution facilities in key markets. We seek to increase our rental income and the net asset value of the Company through the leasing of newly developed space, as well as through the acquisition of properties. Depending on several factors, we may develop properties directly or in co-investment ventures for long-term hold, for contribution into one of our co-investment ventures, or for sale to third parties. Properties that we choose to contribute or sell may result in the recognition of gains or losses. Currently, in the United States, Europe and Japan, we are developing directly while in emerging markets, such as Brazil, China and Mexico, we are developing with our private capital partners in a variety of co-investment ventures.
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Private Capital Segment —We co-invest in properties with private capital investors through a variety of co-investment ventures. We have a direct and long-standing relationship with a significant number of institutional investors. We tailor industrial portfolios to investors’ specific needs and deploy capital in both close-ended and open-ended fund structures and joint ventures, while providing complete portfolio management and financial reporting services. We generally own 15-50% in the ventures. We believe our co-investment in each of our ventures provides a strong alignment of interests with our co-investment partners’ interests. We generate revenues from our unconsolidated co-investment ventures by providing asset management and property management services. We may also earn revenues through additional services provided such as leasing, acquisition, construction, development, disposition, legal and tax services. Depending on the structure of the venture and the returns provided to our partners, we may also earn revenues through incentive returns or promotes. We believe our co-investment program with private capital investors will continue to serve as a source of capital for new investments and provide revenues for our stockholders, as well as mitigate risk associated with our foreign currency exposure. We expect to grow this business with the formation of new ventures and by raising additional third-party capital in our existing ventures.
On June 3, 2011, we completed a merger (hereafter referred to as the “Merger”) in which ProLogis shareholders received 0.4464 of a share of AMB Property Corporation (“AMB”) common stock for each outstanding common share of beneficial interest in ProLogis . Following the Merger, AMB changed its name to Prologis, Inc. In the Merger, AMB was the legal acquirer and ProLogis was the accounting acquirer. In May 2011, we also acquired a controlling interest in and began consolidating ProLogis European Properties (“PEPR Acquisition”). As a result, our nine-month results for 2011 reflect approximately four months of impact of the Merger and the PEPR Acquisition. Therefore, period-to-period comparisons may not provide as meaningful information as if those transactions were reflected in both periods. See Note 2 to the Consolidated Financial Statements in Item 1 for more information relating to both the Merger and PEPR Acquisition.
Upon the closing of the Merger, we established key strategic priorities to guide our path over the next two years. These priorities are:
to align our portfolio with our investment strategy while serving the needs of our customers;
to strengthen our financial position and build one of the top balance sheets in the real estate investment trust industry;
to streamline our private capital business and position it for substantial growth;
to improve the utilization of our low yielding assets; and
to build the most effective and efficient organization in the real estate investment trust industry and to become the employer of choice among top professionals interested in real estate as a career.
Align our Portfolio with our Investment Strategy
We have categorized the portfolio into three main segments – global, regional and other markets. As of September 30, 2012, global markets represented approximately 83% of our overall owned and managed platform (based on our share of net operating income of the properties) and regional markets represented approximately 12% of our total owned and managed platform. We intend to hold only the highest quality class-A product in our regional markets. We also own a small number of assets in other markets, which account for approximately 5% of our owned and managed platform and that we plan to exit from in an orderly fashion in the next few years. By segmenting our markets in this manner, we were able to construct a strategy that includes culling the portfolio for buildings and potentially submarkets that are no longer a strategic fit. We expect to use the proceeds from dispositions to pay off debt that is collateralized by the disposed asset, if any, pay debt as it becomes due and to recycle capital into new development projects or strategic acquisitions.
Strengthen our Financial Position
We intend to further strengthen our financial position by lowering our financial risk and currency exposure and building one of the strongest balance sheets in the real estate investment trust industry. We expect to lower our financial risk by reducing leverage with proceeds from contributions and asset sales, increasing the size of our unencumbered asset portfolio and maintaining staggered debt maturities, which will provide us with more financial flexibility and allow continued access to debt capital markets. This financial flexibility will position us to capitalize on market opportunities across the entire business cycle as they become available. We will reduce our exposure to foreign currency exchange fluctuations by borrowing in local currency where appropriate, and we might also enter into derivative contracts to hedge our foreign denominated equity and swap U.S.-dollar-denominated debt into obligations denominated in foreign currencies. We expect to also lower our currency exposure by holding assets we own outside the United States primarily in co-investment ventures in which we maintain an ownership interest and provide services generating private capital revenue. We will accomplish this through contributions and sales to our existing and newly formed co-investment ventures. In addition, we expect that new development projects, particularly in emerging markets such as Brazil, China and Mexico, will be done in conjunction with our private capital partners.
Streamline Private Capital Business
We are working with our private capital investors to evaluate certain of our co-investment ventures. Some of our legacy co-investment ventures have fee structures that do not adequately compensate us for the services we provide. Also, some ventures have governance or decision making processes in place that we would like to change. Therefore, we may terminate or restructure certain of these co-investment ventures. In other cases, we may combine some co-investment ventures to gain operational efficiencies. In every case, however, we will work very closely with our partners and venture investors who will be active participants in these decisions. We plan to grow our private capital business with the deployment of the private capital commitments we have already raised, formation of new co-investment ventures and raising incremental capital for our existing co-investment ventures.
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Improve the Utilization of Our Low-Yielding Assets
We plan to increase the value of our low-yielding assets by stabilizing our operating portfolio to 95% leased, completing the build-out and lease-up of our development projects and monetizing our land through development or sale to third parties.
Build the most effective and efficient organization in the real estate investment trust industry and become the employer of choice among top professionals interested in real estate as a career
We have identified more than $115 million of Merger cost synergies on an annualized basis, compared to the combined expenses of AMB and ProLogis on a pre-Merger basis. These synergies include gross general and administrative savings, reduced global line of credit facility fees and lower amortization of non real estate assets. We believe the majority of these synergies have been realized and expect to recognize the full amount by the end of 2012, and we continue to look for additional savings opportunities. In addition, we are in the process of implementing a new enterprise wide system that will include a property management/billing system (implemented in April 2012), a human resources system (implemented in July 2012), a general ledger and accounting system and a data warehouse. In connection with this implementation, we are striving to utilize the most effective global business processes with the enhanced system functionality. As of January 1, 2012, we implemented two new compensation plans that we believe will better align employees’ compensation to our performance. We believe these efforts and others will help us with the attainment of this objective.
Summary of 2012
During the nine months ended September 30, 2012, we completed the following activities in support of our strategic priorities:
We purchased our partner’s interest in Prologis North America Fund II (“ NAIF II”) and dissolved Prologis California and divided the portfolio equally with our partner (collectively “Q1 Venture Acquisitions”). These two transactions increased our investment in real estate by $2.1 billion, and our debt by $1.4 billion. See Note 2 to our Consolidated Financial Statements in Item 1 for more details.
We concluded Prologis North American Fund XI by disposing of the remaining asset in the fund during the third quarter of 2012.
During the third quarter, PEPR completed its delisting from the European stock exchanges; as part of the liquidation of PEPR, we have acquired all of the assets and liabilities. We may continue to own these properties, contribute them to a new or existing co-investment venture or sell them to a third party.
In 2012, we issued secured property-level debt on assets in Japan (known as TMK bonds) or increased existing TMK bonds for a combined amount of ¥48.0 billion ($618.3 million as of September 30, 2012).
We generated aggregate proceeds of $1.1 billion from the disposition of land, land subject to ground leases and 113 properties to third parties and the contribution of two properties to two unconsolidated co-investment ventures and four properties to one consolidated co-investment venture. We used the proceeds to reduce our outstanding debt, repurchase PEPR units, acquire real estate properties and fund our development activities.
We began 23 development projects on an owned and managed basis aggregating 9.6 million square feet with a total expected investment of $825.6 million (our share was $745.7 million), including 13 projects (or 73% of the total expected investment) that were 100% leased prior to development.
We entered into a €487.5 million ($633.2 million as of September 30, 2012) multi-currency senior term loan agreement and used the proceeds to pay off two outstanding term loans with the remainder used to pay down our credit facilities.
As of September 30, 2012, our total owned and managed operating portfolio was 93.1% occupied and 93.6% leased as compared to 92.2% occupied and 92.5% leased at December 31, 2011 and 91.0% occupied and 91.6% leased at September 30, 2011.
Operational Outlook
Global trade volumes remain well above their pre-crisis peak, and while revised slightly down, the International Monetary Fund forecasts growth of over 3% for this year and 4.5% for 2013. Consumption in the United States is strong with retail sales coming in at over 5.4% year-over-year and online sales growing three times faster. The National Retail Federation forecasts a year-over-year increase of 4.1% for all holiday sales, which compares favorably to the ten-year average increase of 3.5%. Real inventories have also increased at an average annual rate of 2.5% for the first nine months of 2012. Inventories are the only major economic indicator of demand for industrial real estate that remains below peak, by about 3%. We think there is significant opportunity for growth in inventories as consumer confidence improves.
According to CBRE Econometric Advisors, net absorption of the U.S. industrial space measured 20 million square feet in the third quarter of 2012. The overall availability rate in the United States fell by 10 basis points during the third quarter to 13.1% and 20 basis points to 12.2% in the hub and gateway markets. While this is slightly below our forecast, it’s worth noting that new supply also came in below our forecast. Deliveries in the quarter represented a fraction of the obsolescence rate. The third quarter marks the ninth consecutive quarter of improving occupancy and indicates that despite the deceleration in third quarter net absorption, the market is firmly on track to tighten. We believe that pent-up demand could result in a robust net absorption in the fourth quarter.
Our occupancy in the Americas was up 110 basis points from June 30, 2012, with strong leasing activity across the majority of our markets, particularly in the San Francisco Bay Area, Eastern Pennsylvania, Dallas and Mexico City. Notably, we have seen a pick-up in demand in the border markets of Mexico for the first time in a few years. Growing demand and increases in occupancy are also having a positive impact on rents. Following three years of rent rolldowns, we appear to be at a positive inflection point and we expect rent change on rollovers to be positive for 2013.
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Within Europe and Japan, we believe significant supply chain reconfiguration, obsolescence and growing customer preference to rent rather than own will continue to fuel additional demand for industrial space. Moreover, the undersupply of class-A distribution space in Japan has continued and will continue to create demand for more modern, earthquake-resistant product, especially following the devastating earthquake and tsunami that occurred in March 2011. Demand for logistics real estate in emerging markets where we have investments primarily through our co-investment ventures, such as Brazil, China, and Mexico, remains strong due to growing economies.
In our total owned and managed operating portfolio, we leased 104.8 million square feet of space during the nine months ended September 30, 2012. Including the properties that were part of the Merger, we leased 101.2 million square feet of space during the nine months ended September 30, 2011. The effective rental rates on leases signed during the third quarter of 2012 in our same store portfolio (as defined below) decreased by 1.8% when compared with the rental rates on the previous leases on that same space. The total owned and managed portfolio was 93.1% occupied at September 30, 2012, up from 92.2% at December 31, 2011. During the nine months ended September 30, 2012, we retained 82.9% of customers whose leases were expiring as compared to 73.0% during the first nine months of 2011.
Due to the lack of supply of class-A facilities, high space utilization rates and decreasing vacancy rates, we expect development volume to increase in our markets. Our development business consists of speculative development, build-to-suit development, value-added conversions and redevelopment. We expect to develop directly and within the co-investment structures depending on location, market conditions, submarkets or building sites and availability of capital. In response to this emerging demand, we are actively pursuing various development opportunities, and we have commenced development of 23 properties in our owned and managed portfolio during the first nine months of 2012.
Results of Operations
Nine Months Ended September 30, 2012 and 2011
Summary
The following table illustrates the net operating income for each of our segments, along with the reconciling items to Earnings (Loss) from Continuing Operations in our Consolidated Statements of Operations in Item 1 for the nine months ended September 30 (in thousands):
Net operating income—Real Estate Operations segment
Net operating income—Private Capital segment
Other:
Gains on acquisitions and dispositions of investments in real estate, net
Income tax expense
See Note 15 to our Consolidated Financial Statements in Item 1 for additional information regarding our segments and a reconciliation of net operating income to Earnings (Loss) Before Income Taxes.
The net operating income of the Real Estate Operations segment consisted of rental income and rental expenses from industrial properties that we own and consolidate and is impacted by our capital deployment activities. The size and percentage of occupancy of our consolidated operating portfolio fluctuates due to the timing of acquisitions, development activity and contributions. Such fluctuations affect the net operating income we recognize in this segment in a particular period. Also included in this segment is revenue from land we own and lease to customers under ground leases and development management and other income, offset by acquisition costs and land holding costs. The net operating income from the Real Estate Operations segment for the nine months ended September 30, excluding amounts presented as Discontinued Operations in our Consolidated Financial Statements in Item 1, was as follows (in thousands):
Rental and other income
Rental and other expenses
Total net operating income—Real Estate Operations segment
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The increase in rental income and rental expense in 2012 from 2011 was due primarily to the impact of the Merger and the PEPR Acquisition in the second quarter of 2011, the Q1 Venture Acquisitions in 2012 and increased occupancy in our consolidated operating properties (from 89.4% at September 30, 2011 to 93.0% at September 30, 2012), including the completion and stabilization of new development properties. The results for 2012 included rental income and expenses from properties acquired through the Merger, PEPR Acquisition and Q1 Venture Acquisitions of $760.0 million and $198.7 million, respectively, while 2011 included approximately four months of rental income and expense of properties acquired through the Merger and PEPR Acquisition of $302.0 million and $82.7 million, respectively.
In our consolidated portfolio, we leased 62.7 million square feet for the nine months ended September 30, 2012 compared to 38.6 million square feet for the nine months ended September 30, 2011. In our total owned and managed portfolio, we calculate the change in effective rental rates on leases signed during the quarter as compared to the previous rent on that same space in our same store portfolio (as defined below). During the first, second and third quarters of 2012, the percentage decrease was 1.1%, 3.9% and 1.8%, respectively, compared to a decrease of 8.9%, 6.1% and 8.6% during the first, second and third quarters of 2011, respectively. A decline in rental rates is due to: (i) leases turning that were put in place when market rents were at or near peak and (ii) decreased market rents. Under the terms of our lease agreements, we are able to recover the majority of our rental expenses from customers. Rental expense recoveries, which are included in both rental income and expenses, were 74.6% and 73.1% of rental expenses for the nine months ended September 30, 2012 and 2011, respectively.
Our consolidated operating properties were as follows (square feet in thousands):
September 30, 2012 (1)
December 31, 2011 (2)
September 30, 2011
Private Capital Segment
The net operating income of the Private Capital segment consisted of fees and incentives earned for services performed for our unconsolidated co-investment ventures and certain joint ventures and third parties, reduced by our direct costs of managing these entities and the properties they own.
The direct costs associated with our Private Capital segment totaled $47.7 million and $39.2 million for the nine months ended September 30, 2012 and 2011, respectively, and are included in the line item Private Capital Expenses in our Consolidated Statements of Operations in Item 1. These expenses include the direct expenses associated with the asset management of the unconsolidated co-investment ventures provided by our employees who are assigned to our Private Capital segment. In addition, in order to achieve efficiencies and economies of scale, all of our property management functions are provided by a team of professionals who are assigned to our Real Estate Operations segment. These individuals perform the property-level management of the properties in our owned and managed portfolio including properties we consolidate and the properties we manage that are owned by the unconsolidated entities. We allocate the costs of our property management function to the properties we consolidate (reported in Rental Expenses) and the properties owned by the unconsolidated entities (included in Private Capital Expenses), by using the square feet owned by the respective portfolios. The increase in Private Capital Expenses in 2012 is due to the increased private capital platform and infrastructure that was part of the Merger, offset partially with a decline in the portion of our property management expenses that are allocated to this segment due to the consolidation of PEPR and the Q1 Venture Acquisitions.
The net operating income from the Private Capital segment, representing fees earned reduced by private capital expenses, for the nine months ended September 30 was as follows (in thousands):
Europe (2)
Asia (3)
Total net operating income - Private Capital segment
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See Note 4 to our Consolidated Financial Statements in Item 1 for additional information on our unconsolidated entities.
Other Components of Income
General and Administrative (“G&A”) Expenses
G&A expenses for the nine months ended September 30 consisted of the following (in thousands):
Gross G&A expenses
Reported as rental expenses
Reported as private capital expenses
Capitalized G&A expenses
Net G&A
The increase in G&A expenses and the various components was due principally to the larger infrastructure associated with the combined company following the Merger and the PEPR Acquisition. The increase in capitalized G&A is due to our increased development and leasing activities since the Merger.
We capitalize certain costs directly related to our development and leasing activities. Capitalized G&A expenses included salaries and related costs, as well as other general and administrative costs. The capitalized G&A costs for the nine months ended September 30, was as follows (in thousands):
Development activities
Leasing activities
Costs related to internally developed software
Total capitalized G&A expenses
For the nine months ended September 30, 2012 and 2011, the capitalized salaries and related costs represented 23.5% and 21.8%, respectively, of our total capitalizable salaries and related costs. In addition, in 2012, we capitalized $0.9 million of salaries and related costs related to internally developed software that were included as Merger, Acquisition and Other Integration Expenses. Salaries and related costs are comprised primarily of wages, other compensation and employee-related expenses.
Merger, Acquisition and Other Integration Expenses
In connection with the Merger and other related activities, we have incurred significant transaction, integration and transitional costs. These costs include investment banker advisory fees; legal, tax, accounting and valuation fees; termination and severance costs (both cash and stock based compensation awards) for terminated and transitional employees; non-capitalized system conversion costs; and other integration costs. These costs are expensed as incurred, which in some cases will be through the end of 2012. Certain of these costs were obligations of AMB and expensed prior to the closing of the Merger by AMB. At the time of the Merger, we terminated our existing credit facilities and wrote-off the remaining unamortized deferred loan costs associated with such facilities, which is included in Merger, Acquisition and Other Integration Expenses. In addition, we have included costs associated with the acquisition of a controlling interest in PEPR in 2011 and the liquidation of PEPR in 2012. The following is a breakdown of the costs incurred during the nine months ended September 30 (in thousands):
The costs incurred during 2011 principally include transaction and transitional costs directly related to the Merger and PEPR Acquisition. The costs in 2012 were related principally to severance in connection with the Merger; our system implementation, as portions of the project move into the phase when the costs are expensed (i.e., training and data conversion); additional costs due to the liquidation of PEPR and severance and related costs due to announced organizational changes in Europe to gain efficiencies. We expect to incur similar costs for the remainder of 2012.
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Impairment of Real Estate Properties and Other Assets
During the nine months ended September 30, 2012, we recorded impairment charges of $29.1 million; $13.0 million related to real estate properties in Europe and Japan and $16.1 million related to land received in 2011 in exchange for a note receivable. During the nine months ended September 30, 2011, we recorded impairment charges of $103.8 million primarily related to two of our investments in unconsolidated co-investment ventures; one investment was in the United States where our carrying value exceeded the fair value and was deemed to be other than temporary, and the other was in South Korea which was sold to our venture partner in July 2011.
Depreciation and Amortization
Depreciation and amortization expenses were $560.6 million and $377.2 million for the nine months ended September 30, 2012 and 2011, respectively. The increase is due to additional depreciation and amortization expenses associated with the assets (including intangible assets) acquired in the second quarter of 2011 relating to the Merger and PEPR Acquisition along with the Q1 Venture Acquisitions in the first quarter of 2012, as well as completed and leased development properties and additional leasing in our operating properties.
Earnings from Unconsolidated Entities, Net
We recognized net earnings from unconsolidated entities of $20.4 million and $56.0 million for the nine months ended September 30, 2012 and 2011, respectively. These earnings relate to our investments in unconsolidated entities that are accounted for under the equity method. The earnings decreased in 2012 from 2011 due to the consolidation of PEPR, NAIF II and Prologis California, previously accounted for under the equity method. This decrease was partially offset by earnings from investments acquired through the Merger. In the second quarter of 2012, we recorded a loss of $5.0 million for our share of a loss on the early extinguishment of debt in Prologis North American Industrial Fund III. In the third quarter of 2011, we recognized a gain of $13.9 million representing our share of the gain on the disposal of 13 properties in another co-investment venture in the Americas. The earnings we recognize are impacted by: (i) variances in revenues and expenses of the entity; (ii) the size and occupancy rate of the portfolio of properties owned by the entity; (iii) our ownership interest in the entity; and (iv) fluctuations in foreign currency exchange rates used to translate our share of net earnings to U.S. dollar, if applicable. We manage the majority of the properties in which we have an ownership interest as part of our total owned and managed portfolio. See discussion of our portfolio results in the section, “Portfolio Information”. See also Note 4 to our Consolidated Financial Statements in Item I for further breakdown of our share of net earnings recognized.
Interest Expense
Interest expense from continuing operations for the nine months ended September 30 included the following components (in thousands):
Gross interest expense
Amortization of discount (premium), net
Amortization of deferred loan costs
Interest expense before capitalization
Capitalized amounts
Net interest expense
Gross interest expense increased in 2012 from 2011 primarily due to higher debt levels as a result of the Merger, the PEPR Acquisition and the Q1 Venture Acquisitions in the first quarter of 2012, partially offset by lower effective borrowing costs.
Our weighted average effective borrowing costs (including amortization of deferred loan costs) was 4.6% and 5.6% for the nine months ended September 30, 2012 and 2011, respectively. Our future interest expense, both gross interest and the portion capitalized, will vary depending on, among other things, the level of our development activities. As a result of the Merger and PEPR Acquisition, we increased our debt from $6.4 billion at March 31, 2011 to $12.1 billion at June 30, 2011, which was reduced by $1.1 billion with proceeds from a June 2011 equity issuance. During the remainder of the year, we reduced our debt to $11.4 billion at December 31, 2011. Our debt increased to $12.6 billion as of September 30, 2012, principally from the Q1 Venture Acquisitions ($1.4 billion), partially offset by repayments with proceeds from sales and contributions of properties. One of our strategic objectives is to reduce our debt with proceeds from property dispositions. See Notes 2 and 7 to our Consolidated Financial Statements in Item 1 and Liquidity and Capital Resources for further discussion of our debt and borrowing costs.
Interest and Other Income, Net
During the nine months ended September 30, 2011, we recognized a $5.2 million charge related to one of our buildings in Japan that was damaged from the earthquake and related tsunami in March 2011.
Gains on Acquisitions and Dispositions of Investments in Real Estate, Net
We recognized net gains on acquisitions and dispositions of investments in real estate in continuing operations of $281.0 million and $114.7 million during the nine months ended September 30, 2012 and 2011, respectively. Included in 2012 is a $273.0 million gain related to the Prologis California transaction in the first quarter, which represents the adjustment to fair value of our equity investments at the time we gained control and consolidated the entity.
Included in 2011 were gains we recognized in the second quarter related to the PEPR Acquisition ($85.9 million) and the acquisition of our partner’s interest in a joint venture in Japan ($13.5 million). These gains represent the adjustment to fair value of our equity investments at the time we gained control and consolidated the entities.
See Note 2 to our Consolidated Financial Statements in Item 1 for more details on these transactions.
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Foreign Currency and Derivative Gains (Losses), Net
In connection with the Merger and the exchange offer discussed in Note 7 to our Consolidated Financial Statements in Item 1, our convertible senior notes became exchangeable senior notes issued by the Operating Partnership that are exchangeable into common stock of the REIT. As a result, the accounting for the exchangeable senior notes changed, which required us to separate the fair value of the derivative instrument (exchange feature) from the debt instrument and account for it separately as a derivative. We adjust the derivative instrument at each reporting period to fair value with the resulting adjustment being recorded in earnings. We recognized an unrealized loss of $6.7 million and $19.1 million for the three and nine months ended September 30, 2012, respectively. We recognized an unrealized gain of $61.0 million and $51.3 million for the three and nine months ended September 30, 2011, respectively.
Gain (Loss) on Early Extinguishment of Debt, Net
During the nine months ended September 30, 2012, we extinguished some secured mortgage debt, unsecured credit facilities of PEPR and two term loans prior to maturity, which resulted in the recognition of $4.9 million in net gains, primarily in the first quarter. The gains or losses represent the difference between the recorded debt (net of premiums and discounts and including related debt issuance costs) and the consideration we paid to retire the debt, including fees.
Income Tax Expense (Benefit)
During the nine months ended September 30, 2012 and 2011, our current income tax expense was $11.0 million and $7.2 million, respectively. We recognize current income tax expense for income taxes incurred by our taxable real estate investment trust subsidiaries and in certain foreign jurisdictions, as well as certain state taxes. We also include in current income tax expense the interest associated with our liability for uncertain tax positions. Our current income tax expense fluctuates from period to period based primarily on the timing of our taxable income and changes in tax and interest rates. During the third quarter of 2012, we recognized a current tax benefit of $18.1 million, which included benefits due to the statute of limitations expiring related to certain tax positions. During the third quarter of 2011, we recognized a current tax benefit of $4.6 million, which included similar but smaller credits.
During the nine months ended 2012 and 2011, we recognized a net deferred tax benefit of $10.8 million and deferred tax expense of $2.8 million, respectively. Deferred income tax is generally a function of the period’s temporary differences and the utilization of net operating losses generated in prior years that had been previously recognized as deferred income tax assets in certain of our taxable subsidiaries operating in the U.S. or in foreign jurisdictions. In 2012, the deferred tax benefit was primarily due to the reversal of deferred tax liabilities in connection with the disposition of properties as well as the period’s temporary differences. The deferred tax benefit related to dispositions are generally offset with the current income tax expense associated with these transactions.
As of September 30, 2012, we had 23 operating properties that met the criteria to be recorded as held for sale and are included in discontinued operations. During the nine months ended September 30, 2012, we disposed of land subject to ground leases and 113 properties aggregating 14.4 million square feet to third parties that met the criteria for discontinued operations. During all of 2011, we disposed of land subject to ground leases and 94 properties aggregating 10.7 million square feet to third parties. The net gains or losses on disposition of these properties, net of related impairment charges and taxes, are reflected in discontinued operations during the period, along with the results of operations of these properties for all periods presented.
See Note 6 to our Consolidated Financial Statements in Item 1.
Other Comprehensive Income (Loss)—Foreign Currency Translation Gains (Losses), Net
For our consolidated subsidiaries whose functional currency is not the U.S. dollar, we translate their financial statements into U.S. dollar at the time we consolidate those subsidiaries’ financial statements. Generally, assets and liabilities are translated at the exchange rate in effect as of the balance sheet date. The resulting translation adjustments, due to the fluctuations in exchange rates from the beginning of the period to the end of the period, are included in Other Comprehensive Income (Loss).
During the nine months ended September 30, 2012 we recognized unrealized gains of $7.1 million and losses of $90.0 million, respectively, in Other Comprehensive Income (Loss) related to foreign currency translation of our foreign subsidiaries into U.S. dollar upon consolidation.
There was very little change in the euro, pound sterling and yen rates at September 30, 2012 compared to December 31, 2011. In the third quarter 2012, the euro, pound sterling and yen all strengthened against the U.S. dollar as of September 30, 2012 compared to June 30, 2012. The euro, pound sterling and yen rates increased to the U.S. dollar by 2.2%, 3.8% and 2.5% respectively, from June 30, 2012 to September 30, 2012.
The yen strengthened against the U.S. dollar and the euro and pound sterling remained relatively unchanged as of September 30, 2011 compared to December 31, 2010. The yen rates increased 5.8% from December 31, 2010 to September 30, 2011. The euro and pound sterling both weakened significantly against the U.S. dollar and were offset slightly due to the strengthening of the yen against the U.S. dollar as of September 30, 2011 compared to June 30, 2011. The euro and pound sterling rates decreased to the U.S. dollar by 5.5% and 2.7%, respectively, and the yen increased to the U.S. dollar by 4.6% from June 30, 2011 to September 30, 2011.
Three Months Ended September 30, 2012 and 2011
Our results for the three months ended September 30, 2012 and 2011 include a full quarter of results related to the Merger and PEPR Acquisition, while the results for the nine months ended September 30, 2011 include four months of results for the Merger and PEPR Acquisition. Except as separately discussed above, the changes in net earnings attributable to common shares and its components for the three months ended September 30, 2012, as compared to the three months ended September 30, 2011, are similar to the changes for the nine month periods ended on the same dates.
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Portfolio Information
Our total owned and managed portfolio of properties includes operating industrial properties and does not include properties in our development portfolio, properties held for sale or non-industrial properties and was as follows (square feet in thousands):
Consolidated
Unconsolidated
Same Store Analysis
We evaluate the performance of the operating properties we own and manage using a “same store” analysis because the population of properties in this analysis is consistent from period to period, thereby eliminating the effects of changes in the composition of the portfolio on performance measures. We include properties owned by us, and properties owned by the unconsolidated entities (accounted for on the equity method) that are managed by us (referred to as “unconsolidated entities”), including those owned and managed by AMB prior to the Merger, in our same store analysis. We have defined the same store portfolio, for the three months ended September 30, 2012, as those properties that were in operation at January 1, 2011, and have been in operation throughout the three-month periods in both 2012 and 2011. We have removed all properties that were disposed of to a third party or were classified as held for sale from the population for both periods. We believe the factors that impact rental income, rental expenses and net operating income in the same store portfolio are generally the same as for the total portfolio. In order to derive an appropriate measure of period-to-period operating performance, we remove the effects of foreign currency exchange rate movements by using the current exchange rate to translate from local currency into U.S. dollar, for both periods. The same store portfolio, for the three months ended September 30, 2012, included 514.0 million of aggregated square feet.
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Rental Income (1)(2)
Consolidated:
Rental income per our Consolidated Statement of Operations
Rental recoveries per our Consolidated Statement of Operations
Adjustments to derive same store results:
Rental income and recoveries of properties not in the same store portfolio—properties developed and acquired during the period and land subject to ground leases
Effect of changes in foreign currency exchange rates and other
Unconsolidated entities:
Rental income of properties managed by us and owned by our unconsolidated entities
Same store portfolio—rental income (2)(3)
Rental Expenses (1)(4)
Rental expenses per our Consolidated Statement of Operations
Rental expenses of properties not in the same store portfolio—properties developed and acquired during the period and land subject to ground leases
Rental expenses of properties managed by us and owned by our unconsolidated entities
Same store portfolio—rental expenses (3)(4)
Net Operating Income (1)
Net operating income per our Consolidated Statement of Operations
Net operating income of properties not in the same store portfolio—properties developed and acquired during the period and land subject to ground leases
Net operating income of properties managed by us and owned by our unconsolidated entities
Same store portfolio—net operating income (3)
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Environmental Matters
A majority of the properties acquired by us were subjected to environmental reviews either by us or the previous owners. While some of these assessments have led to further investigation and sampling, none of the environmental assessments have revealed an environmental liability that we believe would have a material adverse effect on our business, financial condition or results of operations.
We record a liability for the estimated costs of environmental remediation to be incurred in connection with certain operating properties we acquire, as well as certain land parcels we acquire in connection with the planned development of the land. The liability is established to cover the environmental remediation costs, including cleanup costs, consulting fees for studies and investigations, monitoring costs and legal costs relating to cleanup, litigation defense, and the pursuit of responsible third parties. We purchase various environmental insurance policies to mitigate our exposure to environmental liabilities. We are not aware of any environmental liability that we believe would have a material adverse effect on our business, financial condition or results of operations.
Liquidity and Capital Resources
Overview
We consider our ability to generate cash from operating activities, dispositions of properties and from available financing sources to be adequate to meet our anticipated future development, acquisition, operating, debt service, dividend and distribution requirements.
Near-Term Principal Cash Sources and Uses
In addition to dividends to the common and preferred stockholders of the REIT and distributions to the limited partnership unitholders of the Operating Partnership, we expect our primary cash needs will consist of the following:
repayment of debt, including payments on our credit facilities and scheduled principal payments in the remainder of 2012 of $43 million and in 2013 of $1.6 billion;
completion of the development and leasing of the properties in our consolidated development portfolio (a);
investments in current or future unconsolidated entities, as discussed below, primarily for the development and/or acquisition of properties depending on market and other conditions;
development of new properties for long-term investment;
capital expenditures and leasing costs on properties;
depending on market and other conditions, acquisition of operating properties and/or portfolios of operating properties in global or regional markets for direct, long-term investment (this might include acquisitions from our co-investment ventures); and
depending on market conditions and other factors, we may repurchase our outstanding debt or equity securities through cash purchases, in open market purchases, privately negotiated transactions, tender offers or otherwise.
We expect to fund our cash needs principally from the following sources, all subject to market conditions:
available unrestricted cash balances ($158.2 million at September 30, 2012);
property operations;
fees and incentives earned for services performed on behalf of the co-investment ventures and distributions received from the co-investment ventures;
proceeds from the disposition of properties, land parcels or other investments to third parties;
proceeds from the contributions or sales of properties to current or future co-investment ventures;
borrowing capacity under our current credit facility arrangements discussed below ($902.4 million available as of September 30, 2012), other facilities or borrowing arrangements;
proceeds from the issuance of equity securities; and
proceeds from the issuance of debt securities, including secured mortgage debt.
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On February 2, 2012, we entered into a senior term loan agreement where we may obtain loans in an aggregate amount not to exceed €487.5 million ($633.2 million as of September 30, 2012). The loans can be obtained in U.S. dollar, euro, Japanese yen, and British pound sterling. We may increase the borrowings to approximately €987.5 million ($1.3 billion as of September 30, 2012), subject to obtaining additional lender commitments. The loan agreement is scheduled to mature on February 2, 2014, but we may extend the maturity date three times at our option, in each case up to one year, subject to satisfaction of certain conditions and payment of an extension fee. We used the proceeds of the entire senior term loan to pay off the two term loans assumed in connection with the Merger and the remainder to pay down borrowings on our credit facilities.
In the first quarter of 2012 in connection with the Q1 Venture Acquisitions, we assumed additional debt of approximately $1.0 billion. See Note 2 to our Consolidated Financial Statements in Item 1 for more details on these transactions.
In 2012, we issued TMK bonds or increased existing TMK bonds for a combined amount of ¥48.0 billion ($618.3 million as of September 30, 2012).
In April 2012, we redeemed $448.9 million related to the exchangeable notes and repaid $58.9 million of senior unsecured notes at maturity, both of which were paid from our cash on hand and borrowings on our Credit Facilities.
As of September 30, 2012, we were in compliance with all of our debt covenants. These covenants include customary financial covenants for total debt ratios, encumbered debt ratios and fixed charge coverage ratios.
See Note 7 to our Consolidated Financial Statements in Item 1 for further information on our debt.
Equity Commitments Related to Certain Co-Investment Ventures
Certain co-investment ventures have equity commitments from us and our venture partners. We may fulfill our equity commitment through contributions of properties or cash. Our venture partners fulfill their equity commitment with cash. We are committed to offer to contribute certain properties that we develop and stabilize in select markets in Europe and Mexico to certain co-investment ventures. These ventures are committed to acquire such properties, subject to certain exceptions, including that the properties meet certain specified leasing and other criteria, and that the ventures have available capital. Generally, the venture obtains financing for the properties and, therefore, the equity commitment is less than the acquisition price of the real estate. We are not obligated to contribute properties at a loss. Depending on market conditions, the investment objectives of the ventures, our liquidity needs and other factors, we may make contributions of properties to these ventures through the remaining commitment period.
Expiration date for remaining
commitments
Total Unconsolidated
Prologis Brazil Fund
Fund Partner
Total Consolidated
Grand Total
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For more information on our investments in unconsolidated co-investment ventures, see Note 4 to our Consolidated Financial Statements in Item 1.
Cash Provided by Operating Activities
For the nine months ended September 30, 2012 and 2011, operating activities provided net cash of $373.3 million and $104.9 million, respectively. In the first nine months of 2012 and 2011, cash from operating activities was less than the cash distributions paid on common and preferred shares and distributions to noncontrolling interests by $75.6 million and $187.0 million, respectively. We used cash flows from operating activities and proceeds from the disposition of real estate properties ($1.0 billion in 2012 and $812.2 million in 2011) to fund dividends on common and preferred shares and distributions to noncontrolling interests. In 2011, cash provided by operating activities was lower largely due to Merger and integration cash expenses of $103.9 million.
Cash Investing and Cash Financing Activities
For the nine months ended September 30, 2012 and 2011, investing activities used net cash of $47.9 million and $798.5 million, respectively. The following are the significant activities for both periods presented:
For the nine months ended September 30, 2012 and 2011, financing activities used net cash of $345.9 million and provided net cash of $874.0 million, respectively. The following are the significant activities for both periods presented:
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Off-Balance Sheet Arrangements
Unconsolidated Co-Investment Ventures Debt
We had investments in and advances to certain unconsolidated co-investment ventures at September 30, 2012 of $2.0 billion. These unconsolidated ventures had total third party debt of $7.2 billion (in the aggregate, not our proportionate share) at September 30, 2012. This debt is either secured or collateralized by properties within the venture and is non-recourse to Prologis or the other investors and matures as follows (in millions):
Prologis North American Properties Fund I (2)
Prologis North American Industrial Fund
Prologis North American Industrial Fund III (3)
Prologis Targeted U.S. Logistics Fund
Prologis Mexico Industrial Fund
Prologis SGP Mexico
Prologis European Properties Fund II (4)
Prologis Targeted Europe Logistics Fund
Prologis Japan Fund 1
Total unconsolidated co-investment ventures
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In July 2012, Prologis European Properties Fund II (“PEPF II”) entered into a new senior unsecured term loan and a new secured loan, pursuant to which it can obtain loans up to €194 million (approximately $252 million at September 30, 2012). The loans can be obtained in euro and pound sterling. As of September 30th, 2012 we had €172.5 million ($224.0 million) outstanding under this term loan. In October 2012, PEPF II issued $300 million of senior unsecured debt in a private placement in the U.S.
Contractual Obligations
Distribution and Dividend Requirements
Our dividend policy on our common stock is to distribute a percentage of our cash flow to ensure we will meet the dividend requirements of the Internal Revenue Code, relative to maintaining our real estate investment trust status, while still allowing us to retain cash to meet other needs such as capital improvements and other investment activities.
We paid a cash distribution of $0.28 per common share for the third quarter on September 28, 2012. Our future common share distributions may vary and will be determined by our Board upon the circumstances prevailing at the time, including our financial condition, operating results and real estate investment trust distribution requirements, and may be adjusted at the discretion of the Board during the year.
At September 30, 2012, we had seven series of preferred stock outstanding and all but one series are redeemable at our option. The annual dividend rates on preferred stock are 6.5% per Series L, 6.75% per Series M, 7.0% per Series O, 6.85% per Series P, 8.54% per Series Q, 6.75% per Series R and 6.75% per Series S. The Series Q, R and S were preferred shares of ProLogis prior to the Merger and dividends on those shares have been reflected in the Consolidated Financial Statements in Item 1 for both periods ended September 30, 2012 and 2011. The dividends on the Series L, M, O and P preferred stock have been included in the Consolidated Financial Statements since the Merger, and thus, the nine-months period ended September 30, 2011 includes approximately four months of dividends only. The dividends on preferred stock are payable quarterly in arrears.
Pursuant to the terms of our preferred stock, we are restricted from declaring or paying any dividend with respect to our common stock unless and until all cumulative dividends with respect to the preferred stock has been paid and sufficient funds have been set aside for dividends that have been declared for the relevant dividend period with respect to the preferred stock.
Other Commitments
On a continuing basis, we are engaged in various stages of negotiations for the acquisition and/or disposition of individual properties or portfolios of properties.
New Accounting Pronouncements
See Note 1 to our Consolidated Financial Statements in Item 1.
Funds from Operations (“FFO”)
FFO is a non-GAAP measure that is commonly used in the real estate industry. The most directly comparable GAAP measure to FFO is net earnings. Although the National Association of Real Estate Investment Trusts (“NAREIT”) has published a definition of FFO, modifications to the NAREIT calculation of FFO are common among real estate investment trusts, as companies seek to provide financial measures that meaningfully reflect their business.
FFO is not meant to represent a comprehensive system of financial reporting and does not present, nor do we intend it to present, a complete picture of our financial condition and operating performance. We believe net earnings computed under GAAP remains the primary measure of performance and that FFO is only meaningful when it is used in conjunction with net earnings computed under GAAP. Further, we believe our consolidated financial statements, prepared in accordance with GAAP, provide the most meaningful picture of our financial condition and our operating performance.
NAREIT’s FFO measure adjusts net earnings computed under GAAP to exclude historical cost depreciation and gains and losses from the sales, along with impairment charges, of previously depreciated properties. We agree that these NAREIT adjustments are useful to investors for the following reasons:
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Our FFO Measures
At the same time that NAREIT created and defined its FFO measure for the real estate investment trust industry, it also recognized that “management of each of its member companies has the responsibility and authority to publish financial information that it regards as useful to the financial community.” We believe stockholders, potential investors and financial analysts who review our operating results are best served by a defined FFO measure that includes other adjustments to net earnings computed under GAAP in addition to those included in the NAREIT defined measure of FFO. Our FFO measures are used by management in analyzing our business and the performance of our properties and we believe that it is important that stockholders, potential investors and financial analysts understand the measures management uses.
We use these FFO measures, including by segment and region, to: (i) evaluate our performance and the performance of our properties in comparison to expected results and results of previous periods, relative to resource allocation decisions; (ii) evaluate the performance of our management; (iii) budget and forecast future results to assist in the allocation of resources; (iv) assess our performance as compared to similar real estate companies and the industry in general; and (v) evaluate how a specific potential investment will impact our future results. Because we make decisions with regard to our performance with a long-term outlook, we believe it is appropriate to remove the effects of short-term items that we do not expect to affect the underlying long-term performance of the properties. The long-term performance of our properties is principally driven by rental income. While not infrequent or unusual, these additional items we exclude in calculating FFO, as defined by Prologis, are subject to significant fluctuations from period to period that cause both positive and negative short-term effects on our results of operations in inconsistent and unpredictable directions that are not relevant to our long-term outlook.
We use our FFO measures as supplemental financial measures of operating performance. We do not use our FFO measures as, nor should they be considered to be, alternatives to net earnings computed under GAAP, as indicators of our operating performance, as alternatives to cash from operating activities computed under GAAP or as indicators of our ability to fund our cash needs.
FFO, as defined by Prologis:
To arrive at FFO, as defined by Prologis, we adjust the NAREIT defined FFO measure to exclude:
We calculate FFO, as defined by Prologis for our unconsolidated entities on the same basis as we calculate our FFO, as defined by Prologis.
We believe investors are best served if the information that is made available to them allows them to align their analysis and evaluation of our operating results along the same lines that our management uses in planning and executing our business strategy.
Core FFO
In addition to FFO, as defined by Prologis, we also use Core FFO. To arrive at Core FFO, we adjust FFO, as defined by Prologis, to exclude the following recurring and non-recurring items that we recognized directly or our share recognized by our unconsolidated entities to the extent they are included in FFO, as defined by Prologis:
gains or losses from acquisition, contribution or sale of land or development properties;
income tax expense related to the sale of investments in real estate;
impairment charges recognized related to our investments in real estate (either directly or through our investments in unconsolidated entities) generally as a result of our change in intent to contribute or sell these properties;
impairment charges of goodwill and other assets;
gains or losses from the early extinguishment of debt;
merger, acquisition and other integration expenses; and
expenses related to natural disasters
We believe it is appropriate to further adjust our FFO, as defined by Prologis for certain recurring items as they were driven by transactional activity and factors relating to the financial and real estate markets, rather than factors specific to the on-going operating performance of our properties or investments. The impairment charges we recognized were primarily based on valuations of real estate, which had declined due to market conditions, that we no longer expected to hold for long-term investment. We currently have and have had over the past several years a stated priority to strengthen our financial position. We expect to accomplish this by reducing our debt, our investment in certain low yielding assets, such as land that we decide not to develop, and our exposure to foreign currency exchange fluctuations. As a result, we have sold to third parties or contributed to unconsolidated entities real estate properties that, depending on market conditions, might result in a gain or loss. The impairment charges related to goodwill and other assets that we have recognized were similarly caused by the decline in the real estate markets. Also in connection with our stated priority to reduce debt and extend debt maturities, we have purchased portions of our debt securities. As a result, we recognized net gains or losses on the early extinguishment of certain debt due to the financial market conditions at that time.
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We have also adjusted for some non-recurring items. The merger, acquisition and other integration expenses include costs we incurred in 2011 and that we expect to incur in 2012 associated with the Merger and PEPR Acquisition and the integration of our systems and processes. We have not adjusted for the acquisition costs that we have incurred as a result of routine acquisitions but only the costs associated with significant business combinations that we would expect to be infrequent in nature. Similarly, the expenses related to the natural disaster in Japan that we recognized in 2011 are a rare occurrence but we may incur similar expenses again in the future.
We analyze our operating performance primarily by the rental income of our real estate and the revenue driven by our private capital business, net of operating, administrative and financing expenses. This income stream is not directly impacted by fluctuations in the market value of our investments in real estate or debt securities. As a result, although these items have had a material impact on our operations and are reflected in our financial statements, the removal of the effects of these items allows us to better understand the core operating performance of our properties over the long-term.
We use Core FFO, including by segment and region, to: (i) evaluate our performance and the performance of our properties in comparison to expected results and results of previous periods, relative to resource allocation decisions; (ii) evaluate the performance of our management; (iii) budget and forecast future results to assist in the allocation of resources; (iv) provide guidance to the financial markets to understand our expected operating performance; (v) assess our operating performance as compared to similar real estate companies and the industry in general; and (vi) evaluate how a specific potential investment will impact our future results. Because we make decisions with regard to our performance with a long-term outlook, we believe it is appropriate to remove the effects of items that we do not expect to affect the underlying long-term performance of the properties we own. As noted above, we believe the long-term performance of our properties is principally driven by rental income. We believe investors are best served if the information that is made available to them allows them to align their analysis and evaluation of our operating results along the same lines that our management uses in planning and executing our business strategy.
Limitations on Use of our FFO Measures
While we believe our defined FFO measures are important supplemental measures, neither NAREIT’s nor our measures of FFO should be used alone because they exclude significant economic components of net earnings computed under GAAP and are, therefore, limited as an analytical tool. Accordingly, they are two of many measures we use when analyzing our business. Some of these limitations are:
We compensate for these limitations by using our FFO measures only in conjunction with net earnings computed under GAAP when making our decisions. To assist investors in compensating for these limitations, we reconcile our defined FFO measures to our net earnings computed under GAAP. This information should be read with our complete financial statements prepared under GAAP.
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FFO:
Reconciliation of net earnings (loss) to FFO measures:
Add (deduct) NAREIT defined adjustments:
Real estate related depreciation and amortization
Impairment charges on certain real estate properties
Net loss (gain) on non-FFO dispositions and acquisitions
Reconciling items related to noncontrolling interests
Our share of reconciling items included in earnings from unconsolidated entities
Subtotal-NAREIT defined FFO
Add (deduct) our defined adjustments:
FFO, as defined by Prologis
Japan disaster expenses
Income tax expense on dispositions
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to the impact of interest rate changes and foreign-exchange related variability and earnings volatility on our foreign investments. We have used certain derivative financial instruments, primarily interest rate swap and cap agreements, to reduce our interest rate market risk. We have also used foreign currency put option and forward contracts to reduce our foreign currency market risk, as we deem appropriate. We do not use financial instruments for trading or speculative purposes and all financial instruments are entered into in accordance with established policies and procedures.
We monitor our market risk exposures using a sensitivity analysis. Our sensitivity analysis estimates the exposure to market risk sensitive instruments assuming a hypothetical 10% adverse change in interest rates or foreign currency exchange rates. The results of the sensitivity analysis are summarized below. The sensitivity analysis is of limited predictive value. As a result, our ultimate realized gains or losses with respect to interest rate and foreign currency exchange rate fluctuations will depend on the exposures that arise during a future period, hedging strategies at the time and the prevailing interest and foreign currency exchange rates.
Interest Rate Risk
Our interest rate risk objective is to limit the impact of future interest rate changes on earnings and cash flows. To achieve this objective, we primarily borrow on a fixed rate basis for longer-term debt issuances. As of September 30, 2012, we had a total of $3.9 billion of variable rate debt outstanding, of which $1.2 billion was outstanding on our Credit Facilities, $0.6 billion was outstanding under a multi-currency senior term loan, and $2.1 billion was outstanding secured mortgage debt (including $0.9 billion of debt within PEPR that we began consolidating in 2011). As of September 30, 2012, we have entered into interest rate swap agreements to fix $1.6 billion of our variable rate secured mortgage debt.
Our primary interest rate risk not subject to interest rate swap or cap agreements is created by the variable rate Credit Facilities, senior term loan and selected secured mortgage debt. During the nine months ended September 30, 2012, we had weighted average daily outstanding borrowings of $1.5 billion on our variable rate debt not subject to interest rate swap agreements. Based on the results of the sensitivity analysis, which assumed a 10% adverse change in interest rates and is based on our outstanding balances during the nine months ended September 30, 2012, the impact was approximately $2.1 million for the nine months ended September 30, 2012, which equates to a change in interest rates of 18 basis points.
Foreign Currency Risk
Foreign currency risk is the possibility that our financial results could be better or worse than planned because of changes in foreign currency exchange rates.
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Our primary exposure to foreign currency exchange rates relates to the translation of the net income and net investment of our foreign subsidiaries into U.S. dollar, principally euro, British pound sterling and yen, especially to the extent we wish to repatriate funds to the U.S. To mitigate our foreign currency exchange exposure, we borrow in the functional currency of the borrowing entity, when appropriate. We also may use foreign currency put option contracts or other forms of hedging instruments to manage foreign currency exchange rate risk associated with the projected net operating income or net equity of our foreign consolidated subsidiaries and unconsolidated entities. Hedging arrangements involve risks, such as the risk that counterparties may fail to honor their obligations under these arrangements. The funds required to settle such arrangements could be significant depending on the stability and movement of foreign currency. The failure to hedge effectively against exchange and interest rate changes may materially adversely affect our results of operations and financial position. At September 30, 2012, we had no put option contracts outstanding and, therefore, we may experience fluctuations in our earnings as a result of changes in foreign currency exchange rates. On October 31, 2012, we entered into foreign currency forward contracts that expire in April 2013 with an aggregate notional amount of €600 million ($781 million using the forward rate of 1.30) to further hedge a portion of our investment in Europe at a fixed euro rate in U.S. dollars. Based on a sensitivity analysis, a strengthening or weakening of the U.S. dollar against the euro by 10% would result in a $78.1 million positive or negative change, respectively, in our cash flows upon settlement of the forward contract. These derivatives were designated and qualify as hedging instruments and therefore the changes in fair value of these derivatives will be recorded in Accumulated Other Comprehensive Income in our Consolidated Balance Sheets. We may enter into similar agreements in the future to further hedge our investment in Europe.
We also have some exposure to movements in exchange rates related to certain intercompany loans we issue from time to time and we may use foreign currency forward contracts to manage these risks. At September 30, 2012, we had no forward contracts outstanding and, therefore, we may experience fluctuations in our earnings from the remeasurement of these intercompany loans due to changes in foreign currency exchange rates.
Item 4. Controls and Procedures
Controls and Procedures (Prologis, Inc.)
Prologis, Inc. carried out an evaluation under the supervision and with the participation of management, including the Co-Chief Executive Officers and Chief Financial Officer, of the effectiveness of the disclosure controls and procedures (as defined in Rule 13a-14(c)) under the Securities and Exchange Act of 1934 (the “Exchange Act”) as of September 30, 2012. Based on this evaluation, the Co-Chief Executive Officers and the Chief Financial Officer have concluded that the disclosure controls and procedures are effective to ensure the information required to be disclosed in reports that are filed or submitted under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.
There have been no changes in the internal controls over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
Controls and Procedures (Prologis, L.P.)
Prologis, L.P. carried out an evaluation under the supervision and with the participation of management, including the Co-Chief Executive Officers and Chief Financial Officer, of the effectiveness of the disclosure controls and procedures (as defined in Rule 13a-14(c)) under the Exchange Act as of September 30, 2012. Based on this evaluation, the Co-Chief Executive Officers and the Chief Financial Officer have concluded that the disclosure controls and procedures are effective to ensure the information required to be disclosed in reports that are filed or submitted under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.
PART II
Item 1. Legal Proceedings
From time to time, we and our unconsolidated entities are party to a variety of legal proceedings arising in the ordinary course of business. We believe that, with respect to any such matters that we are currently a party to, the ultimate disposition of any such matters will not result in a material adverse effect on our business, financial position or results of operations.
In December 2011, arbitration hearings began in connection with a dispute related to a real estate development project known as Pacific Commons. The plaintiff, Cisco Technology, Inc. was seeking rescission of a 2007 Restructuring and Settlement Agreement (the “Contract”) and other agreements, and declaratory relief, and damages for breach of the Contract. In August 2012, the arbitrator issued a ruling denying the relief sought by Cisco, and therefore Prologis has no further obligation.
Item 1A. Risk Factors
As of September 30, 2012, no material changes had occurred in our risk factors as discussed in Item 1A of our Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
48
Item 4. Mine Safety Disclosures
Not Applicable.
Item 5. Other Information
Item 6. Exhibits
49
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Exchange Act, the registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized.
/s/ Thomas S. Olinger
/s/ Lori A. Palazzolo
Date: November 6, 2012
Index to Exhibits