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Edited Transcript of DRE earnings conference call or presentation 1-Aug-19 7:00pm GMT

Q2 2019 Duke Realty Corp Earnings Call

INDIANAPOLIS Aug 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Duke Realty Corp earnings conference call or presentation Thursday, August 1, 2019 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 - Chairman & CEO

* Mark A. Denien

Duke Realty Corporation - Executive VP & CFO

* Nicholas C. Anthony

Duke Realty Corporation - Executive VP & CIO

* Ronald M. Hubbard

Duke Realty Corporation - VP of IR

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Conference Call Participants

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* Blaine Matthew Heck

Wells Fargo Securities, LLC, Research Division - Senior Equity Analyst

* Caitlin Burrows

Goldman Sachs Group Inc., Research Division - Research Analyst

* David Bryan Rodgers

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

* Emmanuel Korchman

Citigroup Inc, Research Division - VP and Senior Analyst

* Eric Joel Frankel

Green Street Advisors, LLC, Research Division - Senior Analyst

* John William Guinee

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

* Michael Albert Carroll

RBC Capital Markets, LLC, Research Division - Analyst

* Michael William Mueller

JP Morgan Chase & Co, Research Division - Senior Analyst

* Nicholas Philip Yulico

Scotiabank Global Banking and Markets, Research Division - Analyst

* Richard Charles Anderson

SMBC Nikko Securities America, Inc., Research Division - Research Analyst

* Robert Jeremy Metz

BMO Capital Markets Equity Research - Director & Analyst

* Vikram Malhotra

Morgan Stanley, Research Division - VP

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the Duke Realty Quarterly Earnings Conference Call. (Operator Instructions) And as a reminder, the conference is being recorded.

I would now like to turn the conference over to your host, Ron Hubbard. Please go ahead.

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

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Thanks, Lois. Thank you. Good afternoon everyone, and welcome to our second quarter earnings call. Joining me today are Jim Connor, Chairman and CEO; Mark Denien, CFO; and Nick Anthony, Chief Investment Officer.

Before we make our prepared remarks, let me remind you that certain statements made during this conference call may be forward-looking statements subject to certain risks and uncertainties that could cause actual results to differ materially from expectations. These risks and other factors could adversely affect our business in future results. For more information about those risk factors, we would refer you to our 10-K or 10-Q that we have on file with the SEC and the company's other SEC filings.

All forward-looking statements speak only as of today, August 1st, 2019, and we assume no obligation to update or revise any forward-looking statements.

A reconciliation of the non-GAAP financial measures that we provide to the most applicable GAAP measures on this call is included in our earnings release. Our earnings release and supplemental package were distributed last night after the market close. If you did not receive a copy, these documents are available in the Investor Relations section of our website at dukerealty.com. You can find our earnings release, supplemental package, SEC reports and an audio webcast of this call in the Investor Relations section of our website as well.

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

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James B. Connor, Duke Realty Corporation - Chairman & CEO [3]

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Thanks, Ron. Good afternoon, everyone. Demand for modern logistics space in our markets remains very robust. While a recent data points tied to global trade and business investment have decelerated a bit, consumer confidence and spending remained strong. Moreover, supply chain expansion and reconfiguration trends remain exceptionally strong as we've witnessed first-hand in our business.

Regarding tariffs, in light of the president's tweet earlier today, I'll reiterate what we've been saying for the last 2 or 3 quarters, that we have not been observing any impact on decision-making from our customers. It's not to say that global trade uncertainties could not have an impact on the consumer on the margin, but we believe continued expansion and modernization of the supply chain configuration should be resilient through any soft patches.

Industrial fundamentals continue to remain relatively balanced. Second quarter supply and absorption were both about 40 million square feet, and there was no change to national vacancy rates, which remain at record low 4.3%. Although there are pockets of oversupply in a few submarkets as we've discussed in the last few quarters, we have very little exposure to these submarkets. Generally speaking, there are still labor shortages and land scarcity dynamics which seem to be creating a natural discipline on the supply in the majority of our markets.

Nationally, rents grew 6.4% for the quarter compared to the second quarter year ago, and we expect these rent growth trends to remain consistent for the remainder of the year.

Turning to our own operating results, we are seeing similar strength in our own portfolio with stabilized occupancy at 98.2%. Total portfolio occupancy is up 40 basis points to 93.4% due to the overall leasing volume of 7.5 million square feet in the portfolio, which includes 1.4 million square feet of new leasing in spec projects that had been delivered over the last few quarters as well as 2.2 million square feet of leasing in new build-to-suit transactions.

We've been hearing concerns from some that leasing in larger facilities was slowing. As we've said, other than a few low-barrier submarkets that are a bit oversupplied, we're just not seeing this. For those submarkets, we think it's more a matter of lack of available large spaces than lack of demand. I think our results this quarter would demonstrate this. Our leasing activity during the quarter was broad-based, spread across 18 markets, including 5 leases signed in excess of 500,000 square feet and 13 leases over 200,000 square feet.

Overall, the leasing activity and strong fundamentals led to a record quarter of rent growth of 12% and 28.3% on a cash and GAAP basis, respectively. On a year-to-date basis, we've realized 18% rent growth for buildings under 100,000 square feet, 28% rent growth for buildings between 100,000 and 250,000 square feet, 21% rent growth for buildings between 250,000 and 500,000 square feet and 48% rent growth for buildings greater than 500,000 square feet. This reflects very strong fundamentals, and perhaps more importantly, that we are located in the very best submarket in each MSA.

We started $395 million of development projects this quarter across 8 different markets that were 83% preleased overall. The new starts included 7 build-to-suit transactions highlighted by last night's announced 2-building, 1.3 million square foot transaction with Home Depot. The transaction will comprise 2 state-of-the-art facilities located on a brownfield site in the Perth Amboy submarket of New Jersey. This is a complex project where we had placed the land under contract well over a year ago. Home Depot's investment with us is part of their previously announced $1.2 billion supply chain overhaul to enhance delivery to consumer and commercial customers in 1 day or less.

We also executed 2 100%-leased build-to-suit transactions totaling 164,000 square feet for a major e-commerce retailer to serve their last mile needs. We also executed a 500,000 square foot 100%-preleased build-to-suit in Atlanta near Hartsfield Airport with a 3PL customer.

Lastly, on development leasing, we executed a significant transaction in our development pipeline in South Florida. We began a speculative development in the first quarter totaling 146,000 square feet. Shortly thereafter, a 3PL tenant of ours requested that we expand the facility to 162,000 square feet. As a result, we executed a long-term lease for the entire expanded building, effectively turning this into a build-to-suit transaction, just months after the project started.

Several of you have picked-up on a recent press release by Amazon regarding the development of a new G+3 fulfillment center in Ohio. We are acting as the fee developer for Amazon. We will not own this facility nor are we the general contractor. Therefore, we are not counting this project in our development volume or incorporating it in our revised guidance for new development starts for the balance of the year. Since most of this development volume will occur in 2020, this will have very little impact on our 2019 service operations income, and we'll incorporate it into our 2020 guidance to be released in January of 2020.

Our overall development pipeline at quarter-end had 19 projects under construction, totaling 6.4 million square feet and a projected $821 million in stabilized costs for our share. These projects are 46% preleased, and our margins on the pipeline have improved to over 30%. Though our prelease percentage dipped below 50%, this is due to highly occupied deliveries in the in-service pool this quarter, and keep in mind, our second quarter development starts were 83% preleased. Our development outlook for the remainder of the year is very solid. We have a very healthy pipeline of prospects across our entire platform. This combined with our outstanding year-to-date results is driving our increased guidance for development which Mark will cover later.

I'll now turn it over to Nick Anthony to cover acquisition and disposition activity for the quarter.

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [4]

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Thanks, Jim. We continue to be [selective] (corrected by company after the call) in our strategic capital recycling for the purpose of both contributing to self-funding development, achieving greater Tier 1 geographic exposure.

During this quarter, we closed on the sale of an 855,000 square foot recently completed and 100%-leased facility in Columbus, Ohio, which generated $96 million of proceeds. In turn, we recycled a portion of these proceeds into a 110,000 square foot cold storage facility acquired for $33 million, located in the East Bay submarket of Northern California.

Looking out to the second half of the year, we have a couple of portfolios and one-off assets that are in various stages of the marketing process. At this time, the majority of our remaining asset sales are expected to close near the end of the third quarter. The acquisition market remains challenging due to pricing, and we'll remain selective and disciplined on any transaction.

As Mark will touch on in a moment, our revised guidance of these current market conditions and our desire to [invest] (corrected by company after the call) more capital into our development pipeline. I will now turn our call over to Mark to discuss our financial results and capital transactions.

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [5]

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Thanks, Nick. Core FFO for the quarter was $0.36 per share compared to $0.33 per share in the first quarter of 2019 and $0.33 per share in the second quarter of 2018. Core FFO increased from the first quarter of 2019 due to typical first quarter spike in non-cash general and administrative expense related to our annual stock-based compensation grant in February, along with continued strong operating results. Core FFO increased in the second quarter of 2018 due to growth in our asset base and strong overall operational performance.

We reported FFO as defined by NAREIT of $0.35 per share for the quarter compared to $0.33 per share for the first quarter of 2019 and $0.33 per share in the second quarter of 2018, with the increase also being driven by positive operating results. The impact of the new leasing standard had an approximate $0.01 per diluted share [negative] (added by company after the call) impact on FFO as defined by NAREIT for each of the first and second quarters of 2019.

Same-property NOI growth for the quarter was 4.4% on a cash basis, down from 7.2% in the first quarter. As you may recall from the last quarter, we had noted a 300 basis point positive impact from free rent burn-off for the first quarter. This quarter's growth is a result of continued strong rental rate growth on re-leasing, as well as improved average commencement occupancy in the same-property pool over the prior period. Same-property NOI for the second quarter on a GAAP basis was 3.2%.

Looking forward, and as I noted last quarter, we expect the second half of the year same-property NOI to moderate a bit due to more challenging occupancy comparables given that the second half of 2018 average commencement occupancy was an incredibly high 98.8%. Although we believe our same-property occupancy levels will remain around 98%, it is just not reasonable to assume 98.8% level we had achieved last year.

In addition, the second half of the year will be negatively impacted by about 50 basis points from 2 unique situations. As we mentioned on our last call, we have a tenant in 2 different spaces in our same-property portfolio totaling about 425,000 square feet. They consolidated and expanded into a recently completed 620,000 square foot build-to-suit, with strong rent growth, but this creates a drag on same-property NOI from the vacated spaces of about 30 basis points for the second half of the year. This is still a great transaction for us and will increase total NOI, but will be the drag on same-property NOI for the last half of the year until we can re-lease the former spaces.

The second situation involves the bankruptcy of a tenant in Atlanta this month. The good news is we already have signed a long-term lease to backfill the entire space with very strong rent growth. Even though this is a great outcome that will provide strong future NOI growth, it will be a 20 basis point drag on second half 2019 same-property NOI as the lease and rent for the new tenant won't commence until later this year. Even with the negative impact on same-property [NOI] (added by company after the call) from these transactions and a tough occupancy comps from the prior period, rent growth and overall occupancy are still expected to be better than originally estimated, leading to our increased guidance.

We continue to fund the majority of our growth with internally generated cash flow; such as disposition proceeds, notes receivable and retained cash flow from operations. In addition and as noted before, we also have significant leverage capacity to fund growth for the next several quarters, yet given our significantly increased growth prospects from development, we issued $57 million of equity at an average price of $32.20 to fund a portion of this growth. Equity will not be a major source of capital for the foreseeable future, but we'll consider using our ATM in relatively small amounts if we believe our share price warrants and only if we have outsized opportunities for growth. Based on this, we do expect to file a new ATM program tomorrow to give us adequate capacity to act under the program. We are still targeting a gradual increase in overall leverage to the low to mid-5s on a debt-to-EBITDA basis.

Let me now address revisions to our 2019 expected range of estimates, which is an exhibit at the back of our quarterly supplemental as well as on our website.

To reflect our continued leasing momentum, particularly our recently completed and under-development portfolios, and strong rental rate growth which continues at a pace that continues to exceed our original expectations, we have further increased guidance for Core FFO to a range of $1.41 to $1.45 per share, which equates to an additional $0.01 per share increase at the midpoint and 7.5% growth over the prior year. We are also increasing our guidance for growth in adjusted funds from operations, AFFO, on a share-adjusted basis to a range of 8.5% to 11.9% from the previous range of 5.9% to 11.0%.

Given the year-to-date development starts and a very strong build-to-suit prospect list and momentum heading into the second half of the year, we are raising guidance for development starts to a range of $900 million to $1.1 billion from our previous range of $600 million to $800 million, representing a significant $300 million increase at the midpoint. In addition, we're also decreasing our range on acquisitions by $50 million at the midpoint to a range of $100 million to $200 million.

Revisions to certain other guidance factors can also be found in the Investors Relations section of our website.

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

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James B. Connor, Duke Realty Corporation - Chairman & CEO [6]

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Thanks, Mark. In closing, we're obviously very pleased with our team's execution through midyear. Market fundamentals are exceptionally strong, and we're capturing growth opportunities with both new and existing customers and should achieve our objectives for high single-digit growth in cash flow, corresponding dividend growth and continued investment growth in Tier 1 markets. I also want to point out that last quarter, we published our annual Corporate Responsibility report, which I would encourage everyone to review on our website. It's an important element of our culture and our strategy. We believe our ESG characteristics and the initiatives are a unique and positive differentiator of the Duke Realty investment proposition.

(Operator Instructions) Lois, you can open up the lines for questions now.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And the first question is from the line of Jeremy Metz.

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Robert Jeremy Metz, BMO Capital Markets Equity Research - Director & Analyst [2]

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In terms of the development, your pre-leasing dipped a little bit below 50% here. It sounds like you're comfortable taking on either more spec leasing given the strength in the market. So should we expect to see that number trend a little lower? Or do you want to keep it more balanced at around that 50% mark?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [3]

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No, I think we actually started talking about this as early as probably NAREIT late last year and then again at Citi in NAREIT this year that we were anticipating the possibility that it would dip below 50%. Part of it is just simply timing. The second aspect of it is the size of some of these transactions that we knew we were going to start. So we didn't want anybody to be too surprised. I think you'll see that number moderate in the third quarter somewhere between where it is today and 50%, and then I think by the end of the year, it will be back up over 50%.

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Robert Jeremy Metz, BMO Capital Markets Equity Research - Director & Analyst [4]

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All right. And then I was wondering on the investment front if you guys looked at the IPT portfolio deal. Any thoughts there in terms of pricing if you did underwrite it and then maybe, just bigger picture, willingness or interest in taking down a large portfolio of transaction like that?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [5]

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Well, I'll let Nick talk to underwriting IPT, and then I can give you some higher-level comments.

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [6]

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Yes, Jeremy, we did look at it. Any portfolio we look at today is going to be dilutive to our portfolio from a quality perspective. And actually, as we grow our Tier 1 exposure, especially our high-barrier Tier 1 exposure, the geography isn't as accretive either. So it was a good portfolio out there, and I think it priced really well.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [7]

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Yes, and then Jeremy, I guess last comment in terms of our desire and/or our ability, clearly, we've got the ability with our balance sheet where it is to make some big acquisitions. But it's really hard for the senior leadership team and our Board to endorse a major transaction when at that kind of pricing, you're looking at, at very best, breakeven and, in the case of IPT, probably modestly dilutive. So we'd much rather keep the balance sheet in good shape and reinvest money back into the development pipeline where we're making much higher margins and much more value creation for the shareholders.

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Operator [8]

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Next question is from Caitlin Burrows.

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Caitlin Burrows, Goldman Sachs Group Inc., Research Division - Research Analyst [9]

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Your 2Q leasing spread was the highest in at least recent history, maybe history overall. So I guess I was just wondering if you could comment on your thoughts on in-place rents versus market rates and with the stabilized occupancy of either 97% or 98% you talked about? How do you think you could keep pushing occupancy versus rent going forward?

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [10]

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Yes, Caitlin, I'll start with that. It was our best quarter ever from a rent growth perspective. I think for the balance of the year, we're probably still targeting internally kind of that 10% to 25%, and 10% on a cash basis, 25% on a GAAP for the year. And I think we're still very comfortable that we'll be right around that range for the full year. So last half of the year will probably look a lot like the first half of the year.

Looking into next year obviously gets a little foggier the further out you go, but I think we're still very bullish in our ability to continue to push rents at pretty close to levels we've been doing. Keep in mind, we have a little bit of a drag on our same-property because we have a longer lease terms, but that's a positive. Once they finally do roll, we generally get better rollups because of the leases we're signing even longer ago, so to speak.

So we're trying to balance the occupancy versus rent growth level. The one thing I would say is, and in some respect, a 81% renewal rate, that seems higher than what we would think. You may question, well, are you pushing rents enough, but when you just came off from the best quarter we've ever had, I think that's pretty good evidence that we are pushing rents pretty high.

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Caitlin Burrows, Goldman Sachs Group Inc., Research Division - Research Analyst [11]

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That makes sense. Then maybe just on the development, I know you made a bunch of comments on how that is generally more accretive than acquisitions at this point. The pipeline did grow versus the first quarter. So I guess in terms of buying land and getting entitlements, are you seeing anything to make you think that Duke wouldn't be able to keep its development volumes at least as high as they are today going forward while also staying accretive?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [12]

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No, Caitlin. I would tell you that we already own the land that we need for the balance of the development in the second half of the year. So we're very active in the markets, acquiring land and tying up land and working land through the entitlement process. But our challenge there is for the 2020 and 2021 pipeline. But 2019 looks pretty good right now because that's all on the books already.

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Caitlin Burrows, Goldman Sachs Group Inc., Research Division - Research Analyst [13]

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I guess in terms of the 2020 and 2021 outlook, is it too soon to kind of tell at this point? Or would you say you're rather confident or not in being able to keep the volumes up?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [14]

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Oh, I would tell you I'm confident we'll be able to keep the volumes up as long as the market dynamics justify it. We've got really good talented people on the ground. And like some of the deals we talked about today, the Home Depot deal in Perth Amboy, we tied that site up back in 2017. So we've got really good people on the ground, and that's a strength of ours. So I think we'll be able to continue to find the right opportunities to create value, particularly in the infill markets where the margins are so strong.

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Operator [15]

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The next question is from the line of Manny Korchman.

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Emmanuel Korchman, Citigroup Inc, Research Division - VP and Senior Analyst [16]

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Jim, the Home Depot deal, can we just talk about anything that they're doing that's special in terms of revamping the logistics pipeline? Or is it just a matter of you moving into larger facilities closer to population centers?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [17]

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Well, Manny, I can't tell you that I have enough direct operational knowledge in terms of what's going to go there versus some of the traditional ones, other than what's in our press release and Home Depot's press release about this $1.2 billion investment that they're making in order to get their products to their stores and their customers in a day or less. So I can't tell you that this is e-commerce specific versus supplying the stores or some combination thereof, but they are very active across the country right now. They've become a very good client of ours. They are now in our top 3 clients, and we hope to have the opportunity to do some more business with them.

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Emmanuel Korchman, Citigroup Inc, Research Division - VP and Senior Analyst [18]

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Got it. And then maybe one for Nick. Just anything else out there that you're looking to sell, especially to fund development pipeline?

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [19]

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Yes, we've got our midpoint at $450 million on dispositions. I would tell you we've closed on about a quarter of it. We've got about half of that under agreement, then we got the remainder in process. So like I said earlier, I think we'll have most of this wrapped up close to the end of the third quarter.

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Operator [20]

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The next question is from the line of Blaine Heck.

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Blaine Matthew Heck, Wells Fargo Securities, LLC, Research Division - Senior Equity Analyst [21]

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Just a few follow-up questions on the Home Depot build-to-suits. Number one, can you share how long the lease term is on those projects? Number two, do you guys have any sort of agreement to do more with them in conjunction with their kind of supply chain overall? And number three, can you give us any sort of sense on the yield on such a low-risk build-to-suit project like this versus maybe what you would get on or target on a spec construction?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [22]

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Okay, Blaine. Short and sweet: 20, no and no. I'm just kidding. It's been reported so I can confirm it's a 20-year lease. As I said, they're a very good customers of ours. I think they're now our third-largest tenant in the portfolio. We are active with them, but we do not have any other agreements in place in terms of additional facilities around the country. I would certainly hope, based on our conversations, that we'll be able to garner some more business from them. And I really can't disclose margins or yields on a transaction like that. We just don't do that on individual deals.

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Blaine Matthew Heck, Wells Fargo Securities, LLC, Research Division - Senior Equity Analyst [23]

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Okay, but fair to say it's a little bit lower or 50 bps lower than maybe what you would target on a spec project.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [24]

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You might say, but what I would counter to the kind of the traditional arguments that build-to-suits are much thinner margins is this was a fabulous site and we had an unbelievable amount of demand for this project, and we hope to, when this building is either further along towards completion or once it's complete, host some property tours out there for those of you haven't been by the site or don't know where it is. It's a fabulous infill site with great access, and it's a very, very valuable commodity. We took some risk back in '17 when we tied it up. We took it through entitlement. We took it through environmental cleanup. We raised the site substantially. So there was a lot of value creation there. So I think that combined with a 20-year lease with an A-rated tenant, you might be surprised.

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [25]

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The other thing I would clarify with that, Blaine, like Jim just mentioned, all that happened, getting back in '17, the deal with Home Depot didn't come together until recently so it's not like they were tied together back that far.

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Blaine Matthew Heck, Wells Fargo Securities, LLC, Research Division - Senior Equity Analyst [26]

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All right. That's helpful. And then Jim, you talked about Amazon project where you will be the fee developer. Is that a role you guys think will become more common in development for some of the larger tenants? Or do you see this as more of a one-off or a rare type of situation?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [27]

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I would tell you this is more the exception rather than the rule. As you know, Amazon is a very good partner of ours, and we continue to do a lot of business with them. We had built fulfillment centers for them that we still own all over the country. We're doing last mile facilities. We've done sortation facilities. These G3s and the next generation, we want to have some experience developing those and understanding the technology and the construction techniques. So we've proposed that we'd like to do a few of these with Amazon. So beyond that, I think we'll have to step back and see how it works out and the amount of resources that it takes. But we're committed to trying to do a couple of these with Amazon.

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Operator [28]

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Our next question is from the Vikram Malhotra.

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Vikram Malhotra, Morgan Stanley, Research Division - VP [29]

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I just want a bit more color on your comments around market rent growth. You mentioned 6% is what your expectation is. Can you maybe give us all a little bit more color by market kind of where you're seeing a bit more deceleration versus where there is the most strength in your markets?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [30]

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Yes, sure. I know I sound like a broken record because I think we've referenced this in previous calls and at conferences. We're pretty consistently seeing low double-digit rent growth in the coastal markets and the high-barrier markets and kind of more mid-single digits in the interior and the second and tertiary markets. So I think if you just look at the 6.4%, which is a CBRE-reported number, if you look at 10% to 12% in the coastal and high-barrier markets and, let's say, 5% to 6% in the interior and the second and tertiary, you're going to run about that average. And we've seen that the last few years. And I think we anticipate seeing that going forward at least through the end of the year.

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Vikram Malhotra, Morgan Stanley, Research Division - VP [31]

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Okay, that's helpful. And then just from a value perspective, I heard that you mention sort of the Home Depot 20-year lease. These bigger build-to-suits, whether you've done for Amazon or Home Depot or any of the other large retailers, is there a difference between sort of these boxes today where you're doing sort of 20-year leases versus maybe the typical 5, 7 year that's more average in terms of the economics, the bumps, and then ultimately kind of what these boxes can trade for on a cap rate basis?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [32]

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Well, let me answer that in a couple of ways. I think the build-to-suit facilities tend to be a little bit more -- I'm reluctant to say specialized, but they are in fact in terms of -- they build in the exact amount of parking, trailer storage, clear height, power requirements. So they're probably built to a higher standard with more kind of ups and extras than you would see in a traditional spec building. And as such, they garner better rents. And with that, the clients want to protect their long-term interest in the facility given the amount of money that they're investing inside the facility for material, handling equipment and robotics and everything else. So that's -- the clients are driving these longer-term leases. The numbers are a little bit bigger because the facilities are a little bit more highly improved over a traditional spec building.

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Vikram Malhotra, Morgan Stanley, Research Division - VP [33]

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Okay. That's helpful. And then just last one. You referenced sort of 1 or 2 peers mentioning supply impacting a few markets and maybe a little pullback in some of the starts. Are there any markets that are not -- maybe not flashing red but are sort of yellow where you're seeing, hey, we want to moderate our starts maybe in the future? Across any of your submarkets or markets that you're seeing that?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [34]

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Yes. Well, I think you made the right differentiation in the last part of the statement. It's submarkets and not markets. I will tell you, in any of the markets we're operating in today, we have spec and build-to-suit opportunities, and we are pursuing all of those. You really got to limit it to submarkets. And I picked on these submarkets before, and I'll do it again.

We've all talked about South Dallas; low-barrier market, incentives down there to encourage spec development. We own property in South Dallas, but we don't have anything available right now, and you won't see us build a spec building down there. Northeast Atlanta, in the last quarter or 2, has worked its way under this list, and it's a little soft. We do have one spec building up there. And I would tell you while we've got activity, it's modest. Central PA, we don't have anything in Central PA. All of our stuff is in the Lehigh Valley, and Central PA has been a little soft. And then lastly was kind of the I-80 corridor up in Chicago. Although, I was up in Chicago last week and I would tell you, based on market activity I heard about and talking to our own people and the brokers in the marketplace, I think Chicago is going to make the turn in the third quarter and work its way off that list. But that's really the extent of it. I think the vast majority of the markets and the submarkets, supply is very, very much in check. You've got really good rent growth, and you've got really good demand characteristics.

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Operator [35]

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And our next question is from the line of Eric Frankel.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Senior Analyst [36]

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Just based on some of the portfolio sales that have occurred with IPT and GLP, can you make a comment on whether you've seen overall pricing change? Obviously, you guys have said that you had a difficulty of acquiring the assets you want in the markets that you're targeting. I just wanted to get an understanding of where the things have gotten even more competitive.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [37]

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Well, Eric, I guess I would make a couple of comments. Those pricing levels are not anything new. I mean we started seeing those pricing levels in 2018 with the IDI deal that was done. We've seen it with a number of other small and midsized portfolios. So I think the market has come to accept that industrial portfolios today are going to trade between 4.5 and, let's say, 5 based on size and quality and everything else. I, of course, have made the argument that, that should cause some of you guys to change your NAV calculations.

But industrial is a very strong sector. It's continued to perform well. The size of these portfolios and the size of some of the projects has attracted some of the larger investors who are looking at opportunities to invest in a very strong, performing sector with good-credit tenants, with long-term leases, with good rent escalation. You factor in the fact that there's very little capital that has to go into these buildings during the lease term or after the lease term, and Industrial has become a very attractive place for people to want to put their money. So there's a premium out there. There's a lot of interest for everything that trades out there. Nick can speak to the amount of interest in just the smaller portfolios in the one-off deals that we're selling.

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [38]

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Yes, we've had really good -- better-than-expected activity even on the Midwest portfolio that we've been marketing.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Senior Analyst [39]

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Okay. And maybe just a follow-up on that, I understand that you guys have kind of simplified your operating structure the last couple of years and you've lowered the size and scale of your third-party construction management business and the amount of office and simplified some joint ventures. Have you ever considered partnering up with other private capital to both dilute your interest in some of your Tier 2 and 3 markets where there's probably still a lot of investor interest that you've just stated and help your expansion for some of these other kind of Tier 1 markets?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [40]

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Yes, Eric. I would tell you that we look at -- every time we look at a major acquisition, we look at various structures, whether it's wholly-owned, whether it's a 50-50 joint venture or potentially even a 70-30 joint venture, to use other people's capital that might have lower yield parameters. We also look at it when we look at pruning our portfolio, and we've got a number of smaller joint ventures, some of which we've had in place for probably 15 years. So it's an arsenal that's in our toolbox. It's one that we don't use all that often, but we do use it, and we continue to look at it, particularly given where pricing is today on these portfolios and packages.

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Operator [41]

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The next question will come from the line of John Guinee.

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John William Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [42]

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John Guinee here. First, hey, Nick, I'm looking at Page 25, your acquisitions and dispositions, and there's got to be a typo because it says here that you sold an 855,000 square foot building in Columbus, Ohio for $112 a foot.

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [43]

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John, that is not a typo. That is correct.

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John William Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [44]

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Who? What? Why?

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [45]

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We were just the seller.

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John William Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [46]

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Special improvement? Long-term lease...

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [47]

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So it was on a 15-year lease with a major e-commerce player with 2% bumps, and there's tremendous demand for those types of facilities today.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [48]

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And John, let me go back to the question we answered earlier. This is an opportunity for somebody to put $100 million to work in a single transaction on a long-term lease with an A-rated credit, and we had a lot of strong interest in that deal.

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John William Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [49]

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Okay. And then just out of curiosity, why cold storage in Northern California at $300 a foot?

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [50]

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Well, first of all, we've got about 1.5 million square feet of cold storage in our existing portfolio, not individual -- inside of existing warehouse buildings. We're just intrigued by this transaction. We're not to go buy a bunch of this stuff, but it was a very functional asset in a good location with a good yield, in the mid-5s, and it's a market that we're under allocated. So we liked the deal and transacted on it.

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John William Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [51]

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Okay. And then, Jim, Home Depot, I think you mentioned a multibillion-dollar effort to change their whole supply chain. And then you mentioned Amazon 3G which I guess means third-generation facility in Columbus. When does this result in Amazon or Home Depot giving back functionally obsolescent space into the market and not renewing leases, et cetera?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [52]

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John, that day will come. We have never not renewed Amazon in any of the Amazon-leased facilities that we own. But as I tell our people, it will happen someday. Someday, a building will be too small, too big, too inefficient, and I go back to what we have always said - which is we own the box. We don't own any of the material handling equipment and any of the robotics or any of the mezzanines. And when I get that space back, they're obligated to take it all out and I have a nice clean box, plenty of parking, great loading, good clear height, good power, and I'll go out and re-lease the building to somebody else, either an e-commerce or a retailer or a consumer products company. I'll divide the building if I have to. But that -- we've been very disciplined about that and not invested money inside the box for tenant improvements. And so I think our long-term strategy on all of these big boxes, whether it's Amazon or Home Depot or anybody else, is a very, very sound strategy. I like our basis in all these buildings, and we'll be fine for the long term.

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John William Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [53]

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Even that cold storage building in Northern California?

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [54]

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That cold storage, there's -- no one's building spec space for that, and there is like 1% vacancy in the [market].

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John William Guinee, Stifel, Nicolaus & Company, Incorporated, Research Division - MD [55]

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I know, I know, I know.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [56]

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He knows the answer to his own question.

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Operator [57]

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Our next question is from Dave Rodgers.

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David Bryan Rodgers, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [58]

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Maybe for Mark. Beyond the 2 leases that you'd noted for the second half of the year where you're going to see the same-store impact, as you look out into the end of the year into 2020, are there any other kind of watch-list tenants or tenants that might be moving out of your existing spaces to developments that we should be aware of?

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [59]

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None of any significance, Dave. I think the comp occupancy in the prior period was like 98.8%, I think I'd said. We would probably project it to be closer to 98% flat. And of that, 80 basis point decline, about 50 of it is what I just described in those 2 specific tenants. See the other 30 basis point is what I would just call natural expirations or attrition where we, like I said, are trying to push rents as hard as we can, and ultimately, we'll lose a couple of tenants because we push harder than they're willing to sign. So nothing any significant, -- individually.

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David Bryan Rodgers, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [60]

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And then maybe just for Jim and Mark, maybe together, on the leverage goal, you guys have talked about kind of low to mid-5s, I think. And I think since the second quarter of about 2017, you've been stubbornly well below that. You've been dabbling in the ATM market. I guess what gets you to deploy that extra debt capacity? Because you've created quite a bit of liquidity and capacity out of that but haven't really to this point shown the willingness to really deploy that. So are you waiting for something special? Or give us some more color on that.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [61]

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Dave, did Nick put you up to this question?

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [62]

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I'll just say Nick keeps selling assets on me. That's the problem. Every time that we think we have a need for leverage, Nick goes and sells assets. In all honesty, that is the large reason of it, Dave. I think looking back 1.5 years ago, we would not have projected to be as big of a net seller as we have been. And that's a combination of -- I think it's really asset pricing in the existing asset markets. So I think we've been taking advantage of it more than we thought on the disposition side and being a little bit more disciplined on the acquisition side. So we've been more of a net seller than we would've thought. That's the big reason.

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Nicholas C. Anthony, Duke Realty Corporation - Executive VP & CIO [63]

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Yes, we've accelerated our 3-year plan on the disposition side so we had a disproportionate amount in 2019.

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [64]

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Yes, so we still are targeting that. It's just taking us a little longer to get up to those leverage levels from what we targeted. But I will tell you with increase in development guidance that we just put out today or last night, coupled with what could be a good end of the year and maybe a good start to next year, I think I'll definitely start to see that creep up into early 2020.

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Operator [65]

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The next question is from Nick Yulico.

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Nicholas Philip Yulico, Scotiabank Global Banking and Markets, Research Division - Analyst [66]

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So just going back to your lease expirations. I know you don't disclose your lease expiration by market, but I wanted to see if we can maybe dig in some of the markets, submarkets where you have some supply concerns, Jim. And whether it's South Dallas or Northeast Atlanta, we can kind of go through the list. I mean, how should we think about your expirations over the next year in those submarkets where there are some supplies? I mean, what are you going to be dealing with?

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [67]

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Nick, I'll cover that. Over the next 2 years, we have virtually no rollover in any of those submarkets that Jim mentioned. So South Dallas, Central PA, coming out of Southwest Chicago and in Northeast Atlanta, no rollover. In fact, you'll start to see more of our lease expirations start to hit in the coastal markets. If you look back over the last 12 to 24 months, I think -- I'm just going from memory here, but about 7% of our rollover has been in coastal markets. That's going to move closer to 25% over the next 3 to 5 years, and that's just a function of we're newer to those market so we haven't been through a period of roll yet in those coastal markets. So more of our rolls start to hit in the coastal markets, and those specific submarkets we mentioned have virtually no roll in the near future.

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Nicholas Philip Yulico, Scotiabank Global Banking and Markets, Research Division - Analyst [68]

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Okay, great. That's helpful. And then just going back to the change in guidance for AFFO, I mean you've had this sort of note here about lower capital expenditures this quarter, last quarter. I mean maybe just touch on that topic. I mean, is this something that you can even get more efficiency on over the next year?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [69]

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Well, yes, Nick, I think we're kind of taking a wait-and-see attitude. We're in a very stable position right now, and we like our revised AFFO, and that growth percentage tied to that. I think there's a chance that we could improve on that. At the same time, we're starting to look at capital projects that had been budgeted for '20 and '21 and, probably more importantly, like we did last year, do we have any critical lease rollover the next couple of years that we want to accelerate and put the capital into this year.

So I think we'll potentially have a little bit of room, and I think we're trying to be prudent with that. If we can't find good places to spend it, I think you'll see our AFFO number come up. You certainly won't see it come down from what we put in the reprojected. But it could go up, or we could do some proactive leasing and capital spending just to be safe.

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Operator [70]

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Our next question is from the line of Rich Anderson.

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Richard Charles Anderson, SMBC Nikko Securities America, Inc., Research Division - Research Analyst [71]

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So when I was forming my first question, I was thinking about your elevated level of occupancy and whether or not that could bite into your overall growth profile, same-store growth profile, looking into next year. But then I noticed that you've been kind of sitting at 98% occupied, at least same-store occupied, for the past at least few years. So when you think about some kind of -- giving a little bit of a lay-up here, but when you think about growth into 2020, and I'm not asking for guidance unless you want to give it, do you worry about ability to sustain a level of growth in the absence of occupancy growth?

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [72]

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I don't think we worry about it, Rich. I think that you're right, there will be an absence of occupancy growth. I think that's a prudent thing to think about. Right now, flat's probably pretty good on occupancy. But the reality is, if you think about it like this, the last half of this year, if you just do the math, you're probably going to be in the low to mid-3s on a same-store basis for the last half of the year to equal the midpoint of our guidance. That's sort of what we guided to. And that's coming with an 80 basis point decrease in occupancy, right?

I said we were at 98.8% in the last half of last year and we'll be looking at more like 98% for the last half of this year. So even with, what I would call a fairly substantial decline period over period in occupancy, we're still producing fairly healthy same-property growth. And that's a function of the substantial rent growth that we're getting on deals that just takes a way to work its way into that pool, if you will. And I think that, that profile will still be with us for the foreseeable future headed into next year.

We keep signing these 28 and 12 deals like we did this quarter. That won't really impact same-property until next year. So we keep getting -- that's more of a lagging indicator, if you will, or it's a tailwind for us. So I think we're still bullish on our overall ability to produce nice overall same-property renewals.

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Richard Charles Anderson, SMBC Nikko Securities America, Inc., Research Division - Research Analyst [73]

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Okay. And then, Jim, on the Amazon development fee deal, you called that an exception, not the rule. But along the lines of you saying at some point we're going to lose Amazon in the building at some point in the future, whenever that may be, the question is, with companies like Amazon having to -- leases turn into debt now, is it -- is there a risk that they start to choose to own their real estate because from a balance sheet perspective, it's kind of a wash and if better to control their own real estate? I'm just trying to dig into that transaction a little bit further, more broadly speaking.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [74]

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Yes, Rich, that question has been asked from time to time. And I will tell you Amazon's got right of first offers, right of any -- all the options to protect themselves, and they've never exercised one with us or anybody else. And I think their strategy has been very consistent throughout their roughly 20-year existence. And not only with their industrial, they don't own any other office, they don't own any of their data centers. So they've been very consistent that they don't want to invest in bricks and mortar. It's -- the returns are far too low for them. And they've got significant capital expenditures to go inside of these buildings. So it just -- it's not even on their radar. Could that change in the future? I suppose. In which case, maybe we -- our relationship would evolve into more of a just pure fee developer, but I will tell you right now they're not -- it certainly doesn't appear like they're even thinking about that.

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [75]

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Yes. And the only thing I would add, Rich, on this particular project, it's in a market that we didn't want to be in. I mean we could have owned that building, quite frankly, but it was market-driven and the specifics of the building, not because Amazon wanted to own it. That's not why the transaction happened the way it did.

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Operator [76]

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The next question is from the line of Michael Carroll.

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Michael Albert Carroll, RBC Capital Markets, LLC, Research Division - Analyst [77]

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I want to talk a little bit about, I guess, the development starts. I know you guys have been pretty disciplined over the past few years in terms of pursuing new developments and breaking ground. And obviously, there's a pretty big uptick that was announced today. I mean, what's your thought process behind there? Is there just more interesting deals that you're seeing? Is that just the stronger market so you think you can get more aggressive? I guess, what's your thoughts behind that?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [78]

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Yes, Mike, I'd make a couple of comments. First of all, all the markets are very strong, and so we've got a lot of opportunities. I think probably more impactful for us is you're starting to see our teams in Southern California, Northern California, Seattle and New Jersey, who are newer, younger teams for us that have now been on the ground a year, 2 years, are really starting to make an impact on our development volumes. And as we talked about earlier, many of those are infill developments that take a while to get put together. But the margins on those are incredibly strong. So I think you'll continue to see us pursue those opportunities, and I think that's one of the things that's obviously contributing to our higher development volumes.

In terms of build-to-suit versus spec, I think this quarter's leasing in our spec pipeline just continues to reassure us that we can be prudent about building spec across the country and execute on that, and we still got enough build-to-suit opportunities that we're more or less going to try and keep that pipeline at around 50%, but we're not afraid to dip below. And when we do, we'll try and tell you guys in advance what's driving that. But there's plenty of opportunities out there for us, and we think we're creating great value there, and we'll continue to put our money to work there.

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Michael Albert Carroll, RBC Capital Markets, LLC, Research Division - Analyst [79]

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Okay. So these elevated developments start levels that we're seeing today mean -- can that continue in 2020 and beyond?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [80]

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Yes, I don't know that I can say. Mark's kicking me, telling me that might sound like guidance.

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Michael Albert Carroll, RBC Capital Markets, LLC, Research Division - Analyst [81]

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Stop it, Mark.

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James B. Connor, Duke Realty Corporation - Chairman & CEO [82]

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My general counsel is probably running down the hall right now, but we've been on a pretty good run. If you look at our revised guidance this year and what we've done the last 3 years, it certainly feels as long as the macroeconomic drivers of this marketplace continue like they've been, I think we can continue to put up strong numbers.

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Operator [83]

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Our next question is from the line of Michael Mueller.

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Michael William Mueller, JP Morgan Chase & Co, Research Division - Senior Analyst [84]

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I was wondering, what does the average time it's taking you to lease up the spec developments?

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Mark A. Denien, Duke Realty Corporation - Executive VP & CFO [85]

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Mike, we've been consistent all along in underwriting 12 months, and we're averaging right now right at 9, which we've been averaging 9 probably the last 2 years. So maybe we should change our underwriting. But we continue to underwrite 1 year, and we're right at 9 months.

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Operator [86]

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(Operator Instructions) And we have a follow up from Eric Frankel.

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Eric Joel Frankel, Green Street Advisors, LLC, Research Division - Senior Analyst [87]

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Just a very quick question on big-box leasing. Has the nature of the customer changed at all the last few years in what they're doing? Obviously, I'm guessing that Amazon is probably taking a little bit less of the overall leasing activity than they were, call it, 3 or 4 years ago. I'm just wondering if it's all exclusively e-commerce. Is it business-to-business or some combination thereof?

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James B. Connor, Duke Realty Corporation - Chairman & CEO [88]

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Yes, in general, Eric, I would say it's a combination thereof. The e-commerce guys tend to ebb and flow and they get really busy and then they get quiet for 3 or 4 quarters and then they get really busy. The consumer products guys, grocery, food, liquor has been very strong. We did a nice 3PL deal this quarter, but I would tell you we probably haven't seen the amount of 3PL business that we would've anticipated. It's more been direct with the clients. But it's all across the board. I can't tell you there's any one particular sector that's driving more than the others.

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Operator [89]

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Thank you, and at this time, there are no further questions in queue.

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Ronald M. Hubbard, Duke Realty Corporation - VP of IR [90]

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I'd like to thank everyone for joining the call today, and we look forward to reconvening during our third quarter call tentatively scheduled for October 31st. Thank you.

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Operator [91]

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And 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.