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Edited Transcript of DRE earnings conference call or presentation 27-Apr-17 7:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 Duke Realty Corp Earnings Call

INDIANAPOLIS May 2, 2017 (Thomson StreetEvents) -- Edited Transcript of Duke Realty Corp earnings conference call or presentation Thursday, April 27, 2017 at 7:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James B. Connor

Duke Realty Corporation - CEO, President and Director

* Mark A. Denien

Duke Realty Corporation - CFO and EVP

* Ronald M. Hubbard

Duke Realty Corporation - VP of IR

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Conference Call Participants

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* Emmanuel Korchman

Citigroup Inc, Research Division - VP and Senior Analyst

* Eric Joel Frankel

Green Street Advisors, LLC, Research Division - Analyst

* James Colin Feldman

BofA Merrill Lynch, Research Division - Director and Senior US Office and Industrial REIT Analyst

* John W. Guinee

Stifel, Nicolaus & Company, Incorporated, Research Division - MD

* Ki Bin Kim

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Michael Bilerman

Citigroup Inc, Research Division - MD and Head of the US Real Estate and Lodging Research

* Michael Carroll

RBC Capital Markets, LLC, Research Division - Analyst

* Nicholas Yulico

UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst- REIT's

* Richard C. Schiller

Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst

* Richard Charles Anderson

Mizuho Securities USA Inc., Research Division - MD

* Sumit Sharma

Morgan Stanley, Research Division - Research Associate

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by. Welcome to the Duke Realty First Quarter 2017 Earnings Call. (Operator Instructions) Just a reminder, today's conference is being recorded. I'd like to turn the conference over to Mr. Ron Hubbard, Vice President of Investor Relations. Please go ahead.

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Ronald M. Hubbard, Duke Realty Corporation - VP of IR [2]

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Thank you, Paul. Good afternoon, everyone, and welcome to our first quarter earnings call. Joining me today are Jim Connor, Chairman and CEO; and Mark Denien, Chief Financial Officer.

Before we make our prepared remarks, let me remind you that statements we make today are subject to certain risks and uncertainties that could cause actual results to differ materially from expectations. For more information about those risk factors, we would refer you to our December 31, 2016, 10-K that we have on file with the SEC.

Now for a prepared statement, I'll turn it over to Jim Connor.

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James B. Connor, Duke Realty Corporation - CEO, President and Director [3]

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Thank you, Ron, and good afternoon, everybody. We followed up a very strong 2016 with a great start to 2017. We grew rents substantially, increased our already record high occupancy and added significant new developments to our pipeline, while increasing our preleased percentage.

During the quarter, we increased our in-service and total portfolio occupancies by 20 basis points. Our in-service occupancy is now 97.7%, and our total portfolio occupancy is now 95.8%. We believe this increase is impressive, given that we are already at record high levels of occupancy and the fact that this was primarily driven by strong re-leasing of existing space.

Nationally, industrial market momentum continues to be good. Supply in the local market is still imbalanced despite small increases in supply in several markets. Supply chain modernization and expansion is continuing to drive demand from e-commerce customers, 3PLs and traditional warehousing customers.

Preliminary net absorption numbers for the quarter are coming in at around 33 million square feet, which is down from about 47 million square feet last quarter. New supply in the first quarter was 44 million square feet, which is very consistent with previous quarters. Overall, we saw vacancies tick up slightly by 6 to 8 basis points to nationally 4.9%. Our outlook for these fundamentals continues to be favorable for the remainder of 2017 and into early 2018.

We continue to have great momentum in our portfolio with the completion of 5.5 million square feet of leasing for the quarter. Notable activity this quarter included the 646,000 square foot lease signed with Amazon for an existing facility in the airport submarket in Cincinnati. This space had been vacated at year-end, and the transaction exceeded our re-leasing expectations set at the beginning of the year.

In tandem with this new lease, we signed a renewal with Amazon, totaling 598,000 square feet, located in the same business park. This is a prime example of our scale on local expertise, offering site facility solutions, totaling 1.2 million square feet for a significant customer. With this strong leasing activity and our in-service industrial portfolio occupancy approaching 98%, we continue to be able to push rents as indicated by our rent growth on second-generation leases of over 23%.

I'd like to make one more note on our operating activities. As many of you are aware, one of our tenants, hhgregg, a retailer in the consumer electronics business, recently filed bankruptcy, and announced plans they were liquidating. They leased approximately 750,000 square feet from us in 3 Southeast markets. We have received rent through April. Rent payable for the remaining 8 months of the year is approximately $2.2 million, and will negatively impact occupancy by about 60 basis points. At this point in time, we're uncertain as to the ultimate outcome and timing, but feel comfortable with our ability to backfill these spaces which are well located in Atlanta, Orlando and Raleigh. However, we have removed all of the rent as part of our previous revisions to FFO and AFFO guidance, which I'll expand on later.

Let me also note we that have a thorough tenant credit review and underwriting process that has resulted in rent loss of only 20 basis points annually over the last 10 years. In discussing the performance of the medical office portfolio, I'd first like to address a news report and some recent analyst commentary around the potential sale of this business. Consistent with past practices, we have a policy of not commenting on rumors in the marketplace. As such, we have nothing else to say other than our medical office business is in great shape.

In-service occupancy declined slightly to 94.3%, but this was the result of 2 new development deliveries totaling 182,000 square feet in Chicago and Philadelphia that were 67% preleased in aggregate. Excluding these development deliveries, MOB occupancy was relatively flat for the quarter. Co-leasing and operating fundamentals remain very strong in our MOB portfolio, along with good activity in our new development pipeline.

Turning to development. We started off the year very strong with $278 million of projects across 8 markets, totaling 3.4 million square feet that are 76% preleased in the aggregate. On the medical side, we started one project in Houston, a 99,000 square foot 100% preleased facility with Memorial Hermann, the dominant A+ rated health system in Southeast Texas. As a part of the same transaction, we acquired a 71,000 square foot medical office building in the sale-leaseback located on the same campus.

5 of the development starts totaling 2.5 million square feet were industrial build-to-suits. One of the larger transactions was a 477,000 square foot project on a land site in Southern California's Mid County submarket. Many of you recall, we put this 22-acre site under contract in very early 2016 and went through a complicated site cleanup and building permitting process. While we intended to start this project on a speculative basis during the quarter, just prior to construction commencements, our Southern California team successfully executed the 477,000 square foot lease for the entire space with UPS. We estimate the value creation on this transaction since the time the site was put under contract is in excess of 50% due largely to rising rents, increasing land values and cap rates continuing to compress. 2 other large build-to-suit transactions were 1 million square foot project with Amazon in Houston, a 557,000 square foot project with Shippers Warehouse in Dallas. And finally, we commenced 2 other 100% pre-lease build-to-suit transactions totaling 440,000 square feet in Columbus and Indianapolis.

On the speculative development side, we started 3 projects ranging from 166,000 to 337,000 square feet in Atlanta, South Florida and St. Louis. Our overall development pipeline at quarter end had 30 projects under construction, totaling 11 million square feet and a projected $875 million in stabilized costs at our share. We expect these projects to create a 20-plus percent margin, and generate about a 6.4% initial stabilized cash. We believe these margins are impressive due to the relatively low risk nature of the pipeline, given that it is nearly 73% pre-leased.

With respect to capital recycling activity, we post $90 million of building dispositions during the quarter at in-place cap rate of just under 9%. Majority of these proceeds came from a suburban office portfolio in Indianapolis that closed in January, and was facing quite a bit of near-term rollover. We also generated $25 million in proceeds from surplus land sales.

On the acquisition front, we recycled disposition proceeds into a portfolio for newly constructed modern industrial buildings in Southern California, totaling 752,000 square feet. The facilities are located in the Inland Empire West and San Gabriel Valley submarkets. The portfolio was 75% leased when we placed it under contract, and subsequent to closing, we executed lease on one vacant building to bring the portfolio to 100% leased. With lease escalators of around 3% and submarket vacancies in the 2% to 3% range, we like the long-term risk-adjusted returns these assets will generate. We're pleased to make progress on our strategic objective of portfolio growth in Tier 1 high barrier markets.

We also acquired 100% interest -- 100% leased, 225,000 square foot recently completed property in Atlanta, in addition to the previously mentioned medical office property in Houston.

Now I'll turn the call over to Mark to discuss the financial results and capital transactions.

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Mark A. Denien, Duke Realty Corporation - CFO and EVP [4]

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Thanks, Jim. Good afternoon, everyone. Core FFO was $0.32 per share for the first quarter of 2017 compared with $0.31 per share for the fourth quarter of 2016. The increase was the result of continued improved operational performance, as Jim just noted, in addition to a lease buy out in one of our few remaining suburban office assets. The lease buyout contributed an additional $0.02 per share to core FFO, which is net of $2 million of related tax expense recognized because the property is owned by our taxable lease subsidiary.

AFFO totaled $118 million for the first quarter of 2017 and $90 million for the fourth quarter of 2016. The fourth quarter of 2016 included approximately $15 million more of recurring capital expenditures compared with the first quarter of 2017, resulting from the timing of leasing activity.

Same-property NOI growth for the 3 months ended March 31, 2017, was 5.2%. This growth is a result of both increased occupancy and substantial rental rate growth that Jim touched on earlier.

And with that, I'll now turn the call back over to Jim.

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James B. Connor, Duke Realty Corporation - CEO, President and Director [5]

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Thank you, Mark. In reflection of our strong operational performance in the first quarter of the year and positive outlook, we raised guidance for core FFO to a range of $1.24 to $1.30 per share or $0.03 per share increase at the midpoint. This includes the $0.02 per share from the lease buyout fee Mark just noted, in addition to strong overall operating fundamentals in excess of our original expectations.

Similarly, we increased the range of growth in adjusted funds from operation on a share adjusted basis to a range of 4.7% to 10.3% from a previous range of 1.9% to 7.5%. These improved expectations include the assumption that no rent will be collected for the remainder of the year from hhgregg, which is currently in the bankruptcy process, as I alluded to earlier. This assumption also included our decision not to change our same-property NOI guidance.

Regarding development expectations, given the strong start in Q1 and strong prospects for the remainder of the year, we raised our development guidance to $500 million to $700 million, up $50 million from the original midpoint. We continue to expect to drive strong pre-leasing levels in this pipeline. The estimate for acquisitions was also increased to a range of $100 million to $150 million from the previous range of $50 million to $100 million, reflective of the strong start to the year.

Finally, the estimate for dispositions was increased to a range of $300 million to $500 million from the previous range of $150 million to $350 million. The majority of the projected increase for dispositions is from a healthcare system in Ohio that approached us earlier in the year about buying properties they leased from us as a part of their corporate recapitalization. We executed on the sale of their 10 building medical office portfolio for about $155 million, which just closed this week.

In closing, the industrial and health care business drivers remain very strong. Our hospital system clients are growing and have increased demand for MOB care facilities. Our traditional distribution markets remain incredibly strong. E-commerce is continuing to create new customers and forcing competition for all players to modernize their supply chain strategies for delivering and storing goods. While these trends will cause disruption and create some winners and losers, we are comfortable that losing a handful of weaker tenants is more than being offset by the incremental demand from stronger growing clients. We view this as a net positive for the long term outperformance for Duke Realty.

We're also very pleased with our team's execution through the first quarter of leasing performance, capital redeployment and development starts, and we are optimistic about our strong performance for the remainder of the year.

We'll now open up the lines to all of the callers. (Operator Instructions)

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Michael Carroll.

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Michael Carroll, RBC Capital Markets, LLC, Research Division - Analyst [2]

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Jim, can you kind of run through your recent MOB, I guess, acquisitions and development starts? And what were the reasons for pursuing these deals? Were these with the existing relationships and you just wanted to expand with those relationships?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [3]

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Well, the Memorial Hermann relationship is a newer relationship, and the acquisition and the new development deal were tied together. We like both buildings being 100% leased on Memorial Hermann's main campus in Houston. So I think we're very pleased and happy with that transaction. And then as I alluded to in the latter part of the -- of my prepared remarks, we were able to execute on the disposition with one of our major healthcare clients in Ohio that was doing a major corporate recapitalization and wanted to redeploy some of that capital back into their real estate holdings, so we were able to come to terms and close on that transaction.

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Michael Carroll, RBC Capital Markets, LLC, Research Division - Analyst [4]

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Great. Can you give us, I guess -- was there a cap rate given on that transaction that you can provide us?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [5]

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No because it closed after the quarter, so it's not in any of this information. But there's been market reports, and there's a fairly decent amount of information out there, and you'll conclude it's about a 5 cap.

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Operator [6]

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We have a question from Ki Bin Kim.

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Ki Bin Kim, SunTrust Robinson Humphrey, Inc., Research Division - MD [7]

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Could you just talk to your larger plans with the medical office portfolio in terms of, strategically, is this something that you want to hold on to longer-term or maybe at this point of the cycle, monetization looks even more appealing?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [8]

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Well, as we've consistently said, guys, we like the business, and we're continuing to focus on growing the business. Executing on the acquisition of the new development deal with Memorial Hermann in Houston is a great example of that. It opens up a new market for us. It allows us to create a relationship with the top health care system in Houston who happens to have a great fantastic balance sheet. And then the other side of it was just strategic pooling. The portfolio in the Midwest, we're a little overweight in the Midwest in our MOB portfolio. Some of those were a little bit older, so we were happy to -- with the pricing on those assets and like the remaining balance of our portfolio and the outlook for the business going forward.

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Ki Bin Kim, SunTrust Robinson Humphrey, Inc., Research Division - MD [9]

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Okay. And maybe a quick question on the supply. What is the kind of outlook for some of your bigger markets, like Indianapolis, because if we look at the brokerage part, it seems like supply is increasing pretty significantly.

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James B. Connor, Duke Realty Corporation - CEO, President and Director [10]

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Well, supply is up a little bit. I wouldn't characterize it as pretty significantly. And I think we need to keep in mind that this is the first quarter, which for the industrial markets is typically a weaker performing quarter. But if you go back to the numbers I cited earlier, you saw supply outpace demand nationally by about 11 million or 12 million square feet, or I don't know, whatever it is, 13 billion square foot U.S. market. That's not a lot. I think we should all make note of it, and watch that as a trend coming forward if that continues in the second and third quarters. I think you'll see us and a lot of our peers probably rethink the supply side in the latter part of the year. But most of the people we talk to feel pretty bullish about the balance of the year, and we've talked about supply and demand meeting equilibrium, and that could happen later in this year or early next year. But right now, I think we're in pretty good shape, and I wouldn't read too much into that slight differential in the first quarter.

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Operator [11]

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We have a question from Sumit Sharma.

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Sumit Sharma, Morgan Stanley, Research Division - Research Associate [12]

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So Jim, with regards to hhgregg, I understand this isn't a large needle mover for you, but as you look at the broader industrial market and the privately held or sort of retail developed, family-owned facilities, how concerned are you when you look at retailer bankruptcies and store closures that, that will spill over into some of the warehouse demand, maybe not for your portfolio or REIT portfolios, but across the market?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [13]

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Well, I think it's a trend that is concerning to all of us, and one that we're watching carefully. Thankfully, with the exception of hhgregg, all of the other retailers that have filed bankruptcy, we have not had as tenants. So one of the things I alluded to in my prepared remarks was we do pretty detailed a job of credit review and make what we think are pretty prudent decisions about where we're going to invest our capital, particularly as it relates to retail tenants. And one of the things on that subject that I've talked about at previous conferences and in meetings with you guys is this is no different than any other time in the past. There are always going to be winners and losers, and today, unfortunately, there's a few recognizable iconic retail names that are likely to be losers, and that's unfortunate, but that's life. There are a lot of companies who are succeeding very well, who are growing their sales, who are not having store closings, who are investing a great deal of money in their supply chain infrastructure, which is a big benefit to us and our peers. So as I said in the comments, I feel bad for the hhgregg people, and I'm not particular happy about taking 750,000 feet back, but when your bulk portfolio is almost 98% leased, I'm not at all uncomfortable about re-leasing those spaces, growing rents and putting better credit tenants in there. So we'll take it in stride, and we'll keep watching the balance of the portfolio.

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Sumit Sharma, Morgan Stanley, Research Division - Research Associate [14]

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One a little bit about the acquisition in -- the portfolio acquisition in L.A., was this announcement transaction was -- any kind of special circumstances? I guess the pricing suggests this is more of a core plus kind of purchase. And as Seinfeld would say, not that there's anything wrong with that. I'm just trying to get a sense of how much you're willing to pay to gain exposure in top-tier markets?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [15]

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Well, I would say -- it was a competitive process, so it was not an off market deal. It was a regular arm's-length deal, and we paid up to get it. But I -- we liked the real estate. We liked the opportunity to lease the last building, so that we could create a little bit of upside for ourselves there. But as we look at the acquisitions and dispositions and developments that we have in the pipeline and for the balance of the year, and with the slightly increased disposition proceeds, we were happy to deploy that into core plus real estate in Southern California. So I won't tell anybody we stole the property, but I think we paid a reasonable fair price in today's marketplace, and we're happy with the real estate. And my acquisitions guys like to say, "We'll own it forever."

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Operator [16]

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We have a question from Manny Korchman.

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Emmanuel Korchman, Citigroup Inc, Research Division - VP and Senior Analyst [17]

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Jim, I appreciate your comments on tenancy, but if you look at your watch list today versus in the past, what are you looking at differently? Because it's probably not just about credit. It's probably a little bit about trend plus credits. So how do you approach your watch list differently? And maybe in that same light, how do you approach new leasing differently to make sure that 10 doesn't quickly end up on the watch list?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [18]

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Well, yes. We'd have a significant issue if we did leasing and development, somebody was immediately put up on the watch list, I'd have a few questions for that. But it's basic fundamentals. The first and foremost is it's the creditworthiness of the entity. And even if they're not a publicly traded company with readily available financials, we get financials before we do the deal and on an annual basis, so we can monitor the health and well-being of our clients. But beyond that, you got to look at industry segments. And we all can point to certain segments that have been affected by trends in the retail marketplace, whether it's e-commerce, whether it's competition from the larger suppliers, and I think the hhgregg situation is one of those unfortunate situations where you had a smaller regional player that unfortunately just got squeezed out by the bigger players and probably to some extent, by e-commerce. So those are the kinds of thought process we go through. As we're looking in evaluating deals in the marketplace before we ever get into leasing is, is this a customer we're willing to invest money in, in terms of our real estate for the next 5 or 10 years, depending on the term of the lease? And again, given where our portfolio occupancy is, we can afford to be a little bit selective, much more so than the years gone by.

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Emmanuel Korchman, Citigroup Inc, Research Division - VP and Senior Analyst [19]

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And then maybe going back to your previous comment about something you want to own forever, you guys have been pretty nimble about selling off a piece of your portfolio that probably when you bought them, you thought you'd own them forever. How do you today make that decision about an asset or a market that seems pretty good, but just might not be forever? And so when do you make that sell decision?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [20]

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Well, let me make a point of clarification. My acquisitions guys say we'll own it forever. I don't necessarily agree that we'll own it forever. But all kidding aside, when we're looking at investing money, particularly when we're making acquisitions, if we're buying brand-new buildings, much like we're developing, and we can redeploy them at that capital into Tier 1 high barrier markets at what we believe are reasonable prices today, I think we're happy to do that when we've got surplus proceeds. It would be a very much different situation if we didn't have those proceeds coming in, I mean, we're happy to go out and raise equity and borrow money to do that. I think we'd be having a different conversation then.

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Operator [21]

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We have a question from Jamie Feldman.

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James Colin Feldman, BofA Merrill Lynch, Research Division - Director and Senior US Office and Industrial REIT Analyst [22]

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Looking at the developments under construction, you've got several assets scheduled for delivery in the second quarter and third quarter that are not leased. Can you just talk us through those projects and you think you'll have those leased by delivery?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [23]

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Hold on, we're flipping pages to get those. Let's see. So I'm on Page 26 of our supplemental development projects under construction. Coming into the second quarter, a 600,000-foot project in the Lehigh Valley in Pennsylvania, a lot of activity there. I'm not particularly worried about that one, a small 150,000-foot building in Chicago that we've got a lot of activity as well from single users and multi-tenants. Camp Creek, which is a building where we've had a lot of success in Atlanta, down by the airport, 448,000 square feet. We've got good activity there. Looking at Washington, D.C., now that's the data center deals we talked about last quarter. Columbus is already leased. Southern California, that's an infill redevelopment project of about 200,000 square feet. And I think that date is actually a little bit off with the weather and the rain that California had. I think the delivery on that is a little bit behind schedule, but they're tilting walls, and they've got reasonably good activity there. So Jamie, I would tell you, looking at the list that's coming at us, we've got prospects and proposals out multiple proposals for every one of those, so sitting here today. I'm not worried about any of them. I hope that helps.

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James Colin Feldman, BofA Merrill Lynch, Research Division - Director and Senior US Office and Industrial REIT Analyst [24]

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So like, what's the tipping point to actually get a lease signed? They actually want to see the building and walk it?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [25]

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I think, in a lot of instances, having the 4 port of the walls going up or the steel kind of makes people a little bit more believers, I guess. I don't know. That's kind of when you generally start to see increased activity. And then anywhere between maybe 75% complete to shortly after completion is when you really see the bulk of the leasing activity. So again, at this point, in every one of those projects to have multiple proposals out, I'm not too worried.

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James Colin Feldman, BofA Merrill Lynch, Research Division - Director and Senior US Office and Industrial REIT Analyst [26]

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Okay. And if I could just ask for a clarification on your comments before you said you did not change the same-store guidance, but I inferred from that, maybe you could have. But can you just talk us your thoughts on same-store and the ins and outs?

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Mark A. Denien, Duke Realty Corporation - CFO and EVP [27]

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Yes, Jamie, this is Mark. Basically, what we're trying to infer is that the impact of assuming that we will not collect any rent from hhgregg is about 40 basis points -- 40 to 45 basis points hit to same-property phase. So I guess one way of looking at it is, if it wouldn't have had happened to us, you probably could have expected a 40 to 45 basis point increase. But sitting here today, we think it's prudent to just go ahead and assume we won't get any rent, and we may do some refurbishment of one of those buildings, and it may take us a few quarters to get it leased. So we just didn't put any of that NOI into our numbers for our guidance.

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Operator [28]

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We have a question from John Guinee.

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John W. Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [29]

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So you didn't steal the property?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [30]

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We did steal the property, which one are you talking about?

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John W. Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [31]

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The one you just said you weren't going to tell anyone you stole the property.

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James B. Connor, Duke Realty Corporation - CEO, President and Director [32]

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Oh, the building. I thought you were referring to your favorite landside in Mid Counties that we stole.

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John W. Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [33]

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Oh, my God. So you're down from $1 billion, with Atlanta $200 million?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [34]

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About just under $250 million. Yes, we monetized just under $100 million of land this quarter, $25 million of sales, which are -- which were included in my remarks and about $75 million monetized through development. We actually acquired about $50 million of land through the quarter, but still we're able to bring our overall land inventory down. So I'm particularly pleased with how our local guys are performing. And you can never get it perfect. You can never project the right number, and you can never get the right amount in all the markets. But today, I would tell you, we're in pretty good shape across the country.

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John W. Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [35]

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Okay, so 2 serious questions. First, talking to someone the other day, evidently, Amazon leases about 100 million square feet throughout the country and has RFPs or build-to-suit requests out there for another 36 million square feet. If you could -- are aware or comment on those statistics. And then the second question would be, as we all know, land prices are going up and construction costs are going up fairly significantly. When you buy the $50 million worth of land you acquired this quarter, are you underwriting that land to a 6 yield on costs, 7 yield on costs, 8 yield on cost, what kind of -- what do you have to put in your pro forma to win the bid?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [36]

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Okay, the first question, as it relates to Amazon, I believe the $100 million number you quoted is accurate based on numbers that we've historically seen as it relates to Amazon. I'm not aware that they have RFPs for that much space out. I guess it doesn't surprise me, given the rapid growth that they've had and their plans to continue that growth, not only in their traditional fulfillment centers, but sortation centers in the last mile, and probably the newest aspect of growth to their business is AmazonFresh and Amazon Pantry, which is the home delivery of groceries. So I can't comment on the accuracy, but if that's the number that's out on the street, I guess I'm not surprised. They have very serious and aggressive plans to grow and they're a good partner of ours as we announced the deal in Houston this quarter. So we'll obviously, hopefully, continue to have opportunities to do more business with them. In terms of the yield on cost, 2 things that we look at is what are we buying? So if we're buying a single site that we are going to put into production right away, we can be a little bit more aggressive because we know that we'll be able to put that in production and deliverability inside of the year, and we're reasonably comfortable where our rents, stabilized yields and cap rates are, so we could be a little bit more aggressive. When we're buying a site that might hold 2 or 3 buildings, and we're going to put 1 in production, we've got to be a little bit more conservative on buildings 2 and 3. It's more art than science at this point, but that's just kind of common sense. As you know, John, you've known us for an awfully long time, the biggest thing that we've done that has really helped the company's performance recently is change our operating culture. And in years gone by, we wanted to control 500-acre parks. And even in the best of markets, that's probably a 10-year supply, and it just doesn't make good fiscal sense to own a land for that long. So today, we buy it in much smaller increments and we tend to put it in production much faster. So you eliminate the risk. You eliminate a lot of the carry on these larger sites.

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John W. Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [37]

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So dirt plus debt wasn't a good idea?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [38]

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That would be correct. Thank you.

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Operator [39]

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A question from Eric Frankel.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Analyst [40]

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First, your re-leasing spread figure was quite high this quarter. Was there any particular deal that drove that or was this across-the-board? Market rents seem to be growing?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [41]

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Eric, it was really pretty much across the board.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Analyst [42]

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And what was that number on a cash basis?

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Mark A. Denien, Duke Realty Corporation - CFO and EVP [43]

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Probably in the high single digits to maybe even pushing probably 10%.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Analyst [44]

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Okay, great. And then related to Amazon, obviously, they've been a terrific customer of yours. They now represent roughly 5% of the portfolio rental revenue and it could be more if something happens to the medical office portfolio in the future, and then plus you have a couple of really large build-to-suits in the pipeline. So do you have any additional thoughts on what the upper cap is in terms of tenant concentration?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [45]

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Well, we don't have any hard and fast caps, Eric. We'd monitor all of our top 20 tenants across the portfolio. Clearly, our relationship with Amazon is very good. They have an A-rated balance sheet. They typically are doing very long-term leases on these facilities, so we're very comfortable. That having been said, we've done a pretty good job of being prudent asset managers, and you've seen us sell Amazon fulfillment centers over the years. And I think in the last few years, we've probably sold 4 of them, Delaware, a couple in Phoenix and one is Columbus, Ohio. So we managed that, but again, we're not managing to a hard fast 5% or anything like that.

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Operator [46]

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We have a question from Rich Anderson.

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Richard Charles Anderson, Mizuho Securities USA Inc., Research Division - MD [47]

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So I just did the back of the envelope. To get to a 3.8% same-store NOI growth, that takes into account the hhgregg impact of 40 basis points; and if you do, you did 5.2% this quarter, you need to average 3.3% the rest of the year to get to 3.8% same-store NOI growth? Is that really a possibility based on all the good things we're hearing about? Or if that happens, you might be -- you might have a little issue with the stock price. I imagine it's going to be better than that. And I'm just curious if you want to let it play out or what you're really thinking about applying conservatism to the outlook.

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James B. Connor, Duke Realty Corporation - CEO, President and Director [48]

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I think it's a combination of a little bit of conservatism because it is so early in the year. It was fairly easy for us to make the other adjustments, given how strong a start we had. There's still a handful of variables out there, and I think we'd like another quarter under our belt before we seriously readdress that.

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Mark A. Denien, Duke Realty Corporation - CFO and EVP [49]

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Yes. Last, I would add just one little thing to that, Rich, is we've averaged about 20 basis points of bad debt expense over the last 10 years. We've had virtually 0 in the last 18 to 24 months, and then hhgregg just said this. So we did of put a little bit of a additional bad debt expense in that guidance to get back up to that average that we've been running at over 10 years. So to the extent that doesn't happen, there could be some upside here.

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Richard Charles Anderson, Mizuho Securities USA Inc., Research Division - MD [50]

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And then a follow-up question, when you guys look at the implied value of your 2 portfolios, industrial and medical office, do you have a sense of -- are the cap rates, the implied cap rate lower or higher in industrial versus medical office? Or is that just too difficult of a question to answer off the top of your head?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [51]

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Well, I think we can give you our humble opinion. I would tell you, based on consensus, we think both cap rates for industrial and MOB are probably above where they should be in today's market. Now recognizing we're at a great point in the cycle for both product types, but I think on average, most people have our industrial between 5.25 and 5.5 and have our medical office north of a 5.5. And I think based on things that we're seeing in the marketplace, cap rates are consistently below that. And I think you have to recognize the quality of our portfolio as it relates to other portfolios that have traded out there or in comparison to our peers. And if you look at the quality of the real estate, the average age, the size, the lease terms and everything else, we think we've got the best portfolio. So we ought to benefit from the lowest possible cap rate. But again, it's a theoretical analysis, so it's -- we just look at it. It's not worth getting too worked up about.

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Richard Charles Anderson, Mizuho Securities USA Inc., Research Division - MD [52]

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Have you seen any deals, medical office deals with a 4 handle line if they're big enough and high quality enough?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [53]

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We haven't seen a lot of portfolio deals just simply there hasn't been a lot that have traded, but there's been any number of one-off to maybe 2 and 3 building deals that have traded with 4 handles on them.

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Operator [54]

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We have a question from Dick Schiller.

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Richard C. Schiller, Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst [55]

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How does the investment sales market look in terms of -- are there big bulk portfolios that are on the market that are being marketed today?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [56]

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No, it's really pretty quiet. An opportunity for us to buy a 4-building package is probably the -- one of the larger things we've seen out there that we thought was worth pursuing. And again, we've been fairly disciplined. We really only want to put or invest capital in those Tier 1 markets if we're going to stretch and pay the prices we have to pay for today. So yes, I think you can go back and look in probably the last couple of quarters. There just haven't been any of those bigger portfolios that would predominantly be in Tier 1 markets, where we really would be interested in stepping up.

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Richard C. Schiller, Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst [57]

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Okay, makes sense. The lease buy out. Was that an MOB portfolio or the bulk distribution?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [58]

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It was one of the very last remaining office assets that we have. It was teed up to be sold. And it's a 3-building complex that's the headquarters for Interactive Intelligence that was recently bought by a company called Genesis. And they're going to continue to occupy 2 of the 3 buildings a long-term basis. So we did a lease buyout on the third which is the newest building here in Indianapolis, and we'll sell that as a user opportunity in the marketplace.

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Richard C. Schiller, Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst [59]

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Got it. And the last for me, are there any other retailers that you're keeping your eye out that might go the same way as hhgregg that are in your portfolio today?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [60]

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I think the only real exposure that we've got concern for is Sears right now. We've got a large appliance distribution facility in the Lehigh Valley. So obviously, given Sears' recent statements, that's a concern to us. On the other side, we have a little bit of reason to be optimistic because the appliance business within Sears is really the only profitable business, and that ultimately could get sold to another user and we may have an opportunity to keep going, but that's really the only one from the headline companies that we've got exposure to. As I alluded to earlier, the Gander Mountain's and the Sports Authorities and those others, we don't have any leases with.

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Operator [61]

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We have a question from Nick Yulico.

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Nicholas Yulico, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst- REIT's [62]

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As I look at your largest tenants list, it looks like Catholic Health Initiatives fell off. Were they the buyer of this MOB portfolio?

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Mark A. Denien, Duke Realty Corporation - CFO and EVP [63]

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No.

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James B. Connor, Duke Realty Corporation - CEO, President and Director [64]

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No. Well, that's CHI (inaudible). Yes. Mark's flipping pages. I may have to get it. We have to recheck that, but we'll get back to you on that one, Nick.

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Nicholas Yulico, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst- REIT's [65]

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Okay. And then going back to that sale, can you help me -- help us understand why a hospital system would want to pay a 5 cap rate for buying properties back, unless there was -- was there some sort of a writer-first refusal agreement in place here, a ground lease, where there was 0 maybe looking to sell the properties and so they had an option, but they had to pay market price?

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Mark A. Denien, Duke Realty Corporation - CFO and EVP [66]

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No, really nothing like that. They did, like I think we said, a recapitalization. They went out and just got rated, and get a big bond deal, took out some debt that they had excess proceeds with their borrowing rate. Their borrowing rate is substantially lower than the cap rate they paid for the assets, and that's what they wanted to do. It's that simple.

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Nicholas Yulico, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst- REIT's [67]

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Okay. And can you just remind us as well for the medical office division, how much of the portfolio is subject to ground leases of hospitals, where they would be some sort of writer-first refusal agreement, how that process would work if you were looking to sell assets?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [68]

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I can't remember those numbers off the top of my head, but I would tell you that given the relationships with the health care systems, it would be a substantial number that would have all sorts of the ROFOs and ROFRs and options and things like that. Hospital systems tend to be very careful and cautious about laying leases on their campus. So they tend to protect themselves very well, but off the top of my head, we don't track that day in and day out.

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Nicholas Yulico, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst- REIT's [69]

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You were saying that this specific sale did not have any sort of agreement like that in place?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [70]

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No. Well, it did, but it was an exercise. They came to us done, want to buy the buildings.

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Nicholas Yulico, UBS Investment Bank, Research Division - Executive Director and Equity Research Analyst- REIT's [71]

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Okay. And just, I guess, one other question on this is that is there also a typical sort of -- is it like a 30-day type of agreement, where you're looking to sell properties and there's a ground lease in place, some sort of ROFO? Is that typically a 30-day type of agreement or if you're looking to sell an asset, there's like a 30-day window where the hospital system has the...

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Mark A. Denien, Duke Realty Corporation - CFO and EVP [72]

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Yes. Nick, we've got 85 buildings totaling, I don't know, 5 million square feet with a variety of different systems. They're all different. But the -- none of these are governed by what I would call industry standards, so we've got them on some. We don't have them on others. Some have very quick triggers and some have longer triggers. It's just the course of a negotiation with the each individual hospital systems as we develop a relationship and we do development.

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Operator [73]

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Our next question is from Manny Korchman.

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Michael Bilerman, Citigroup Inc, Research Division - MD and Head of the US Real Estate and Lodging Research [74]

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Jim, it's Michael Bilerman. As I think back over the history of Duke and from the large asset sales you've done when -- I remember when you exited the flex business, when you exited the suburban office business, the proceeds were largely used to delever, which was the main source. And somewhat, in some cases, for special dividends where you needed to -- and fund from acquisition volume. You look at the company today, correct me if I'm wrong, but you're probably below your target leverage levels from a net to growth asset value and debt to EBITDA or at least towards that much lower end? So I guess, if you sold assets, what would you do with the money?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [75]

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Well, Michael, I'll give you the standard answer that we shared with a lot of people at conferences earlier this year when this was a very popular topic. If you think back in years gone by, particularly, in 2014 when we did the Starwood sale, which was $1 billion in and of itself, on top of that, we did another $1 billion of dispositions. And in that year, we basically pulled 5 different levels -- levers, I should say. In no particular order, we fund development, we fund acquisitions, we delever, we pay special dividends and we use seller financing. And I think what I've told everybody is, anytime we had a significant amount of dispositions in excess of what we could redeploy accretively into development and acquisitions, we pull those out of 3 levers, and that's, I think -- we've demonstrated that in the past. I think you're absolutely right, we like where our leverage is. It's a little below our initial targets, but if we had to -- if we were sitting on a bunch of cash, we could delever that a little bit lower in the short term and save some dry powder and play offense in the future.

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Michael Bilerman, Citigroup Inc, Research Division - MD and Head of the US Real Estate and Lodging Research [76]

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But arguably, if you think about those 5 things, I assume seller financing in this type of environment, not there. Deleveraging is probably not the first choice. Acquisitions, you've said the biggest thing you're looking at is a 4-property portfolio, so unless you're going to make a run at some public company, that doesn't seem that that's going to be there. Development has been ramping, but arguably, you're trying to tread lightly as not putting too much supply into the marketplace. And then at least the special dividend or returning capital to shareholders maybe through a stock buyback, but you may think your stock is at all the levels. So I'm still struggling if there was a large capital transaction, where does the money go other than sitting on the balance sheet?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [77]

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Well, I -- you've answered your own question to a certain extent, Michael, because that's exactly what we've said. Why would we sell a big chunk of our business today? What would we do with the money? In theory, those are the 5 buckets that I can pull. You're absolutely right. None of them are particularly attractive. There are great acquisition opportunities out there to redeploy a significant amount of capital. We're pretty well funded on the development pipeline. I don't really need to or want to do delever more. A special dividend money and returning money to the shareholders is always an option, and I think you're right. So if anything is not particularly attractive with the debt markets being where they are today, so all of that would lead you to the conclusion of you wouldn't want to do a major disposition.

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Michael Bilerman, Citigroup Inc, Research Division - MD and Head of the US Real Estate and Lodging Research [78]

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Right. Unless you were able to line something up almost immediately or you felt strategically, it would enhance your overall equity valuation.

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James B. Connor, Duke Realty Corporation - CEO, President and Director [79]

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Agreed.

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Operator [80]

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We'll move on to Eric Frankel.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Analyst [81]

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Related to the hhgregg move or bankruptcy, have you actually started marketing the space yet or you're just on a wait-and-hold period?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [82]

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No, no, no. We are actively marketing the space. They're still occupying it. And under the terms of the bankruptcy codes, if they continue to occupy the space into May, they are obligated to pay us rent, so we'll see how that plays out. As Mark mentioned earlier, we're not counting on any of that rent in our FFO and AFFO reprojections from the year, but yes -- no, we're out -- actively market all 3 spaces.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Analyst [83]

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Okay. That's helpful. It was interesting, your pre-lease that you executed in Southern California with UPS, do you have a relationship with that company prior to the transaction? What is their -- do you gather what their strategy is related to e-commerce?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [84]

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Well, yes, we have a relationship with UPS. They're a fantastic company, and obviously, they lease a lot of space across the country. They, along with some of their peers, who have benefited significantly from the e-commerce growth in this last 5 to 7 years, they are investing extensively in their distribution network and growing quite quickly. Earlier this year or late last year, we announced the sale of a very large vacant land track in Atlanta to Federal Express for a large facility as well. So yes, we do a lot of business with these guys and they're good quality people to deal with.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Analyst [85]

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In terms of locations, is there a -- how is their model different now than, say, pre-e-commerce, if you are to call it 10 years ago?

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James B. Connor, Duke Realty Corporation - CEO, President and Director [86]

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Oh, I don't think it's substantially different. I think their needs follow the population. And so if you -- if we all think back, we've driven by UPS and FedEx hubs that were closed in for that last mile because, historically, they have been the last mile, and I think you'll continue to see them do that business that doesn't garner nearly the headlines of facilities like this do. But they are investing and creating high-volume high throughput distribution centers to handle that need and this is just another example of one of those.

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Operator [87]

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At this time, there are no further questions in queue.

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Ronald M. Hubbard, Duke Realty Corporation - VP of IR [88]

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Thanks, Paul. I'd like to thank everyone for joining the call. We look forward to seeing many of you at [May] Reeds in New York in early June. Operator, you may disconnect the line.

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Operator [89]

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Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Executive TeleConference. You may now disconnect.