#40 – Doug Kiersey: Logistics Properties, Dermody

0:05Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, investment, and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, a leading investment advisory firm. Learn more about our show at insightfulinvestor.org.

0:38Joining me today is Doug Kearcy. Doug is CEO and president of Dermody Properties, which has developed and acquired industrial logistics assets with an aggregate value in excess of$8 billion since its founding all the way back in 1960. Doug joined Dermody in 2011 and has over 35 years of experience in logistics properties. Doug, thank you so much for joining me today. My pleasure, Alex. Great to be with you. Well, Doug, you've been investing in the industrial sector for over 40 years now. What would you say originally attracted you to this sector? Well, I was a product of a real estate family. And so that was the dinner table talk originally.

1:24And when I graduated from Oregon State University, I wandered into the offices of Cushman and Wakefield and talked my way into a role as a junior broker. Another gentleman came in at about the same time and about the same age, and the manager, judging this other gentleman to be a little more talented than me, sent him off to the office market and sent me out to the dusty streets of Portland's industrial districts. And so that's where I got my start, cold calling in 1983. It's been a long road since then. And I spent 11 years there. And then one day got a phone call from the good folks at Prologis.

2:09And I pioneered their offices in the Pacific Northwest, including Seattle. And then in 1999, they asked me if I'd move my family to Chicago and handle the Chicago office. And then ultimately that became the central region of Prologis. And I joined Dermody, as you said, in 2011. So in those 40 plus years, I've had three business cards so far. That's a pretty good track record. Obviously, you've seen a lot in those 40 years. Would you walk us through the big shifts that the industry has experienced over that timeframe? The biggest shifts is the sophistication of our customers. And for your listeners, I use the term customer instead of tenant.

2:53So you'll hear me talk about customers. But our customers have become much, much more sophisticated in how they've optimized their supply chains. They now have sophisticated programs and algorithms that they are using to determine exactly where these buildings should be located. And so that's a huge change. We are but a small part. Rent is but a small part of their total cost of their supply chain, something like less than 10 percent. So with transportation, inventory, and labor being the major cost drivers, they're generally doing their studies internally. And then they're coming to us and saying, we think we need to be here to optimize this particular operation.

3:41So that's a major shift over the past 40 years. And of course, the buildings have changed significantly. In the past, a 24-foot clear, clear-height building would have been considered to be a Class A building. And now for buildings over 500 ,000 square feet, that needs to be 40-foot clear. So the sophistication of the material handling equipment is another major change that has been changing our marketplace and continues to do so. I suppose moving up is just natural, right? If you can operate with space above you, in some ways, it's free real estate. That's right. And of course, the cost to run the material handling equipment and design it and so on, there is an increment.

4:27There is a marginal cost of moving up. But many companies who have become quite sophisticated have indicated that that's a positive tradeoff for them. And so as a provider of the brick and mortar, of course, we want to supply what our customers want. Well, Dermody started in 1960, so you've been around for a long time. Would you tell us about the different stages that the company has experienced since its inception? I can tell you that I was not here when the company started. It was started by John Dermody, who had relocated his family from the Bay Area to Reno, Nevada after World War II and had procured for himself the Philco television license, if you will, to sell in the Reno market.

5:16And of course, after World War II, a lot of appliances and a lot of televisions were sold. In 1960, he decided to sell his appliance business, but kept the warehouse and became a landlord. And from there, he grew the company into an acquirer and ultimately a developer of warehouse space, mostly in Nevada. And then when Michael Dermody, our current executive chairman, joined the firm in 1976, he led a push into other U.S. logistics real estate markets, mostly because of the customer relationships that he had engendered. And customers said, can you help us in Pennsylvania? Can you help us in Indianapolis?

5:58Can you help us in Atlanta? And so the second phase then was really Michael bringing in institutional capital. In 1990, we were partners with CalPERS, which rolled into a partnership with Lazard Ferrer and then ultimately a partnership with CalSTRS. All of those assets were sold at the peak of the prior cycle in 2007 to a partnership between Lehman Brothers and Prologis right before the great financial crisis. After the GFC, then we embarked on a series of individual joint ventures around the country with a handful of institutions. But the big shift came in 2016 when we took the leap from kind of owner-operator-developer into the investment management world with the formation of Dermody Properties Industrial Fund One.

6:57And we just closed on the raise for DPIF-4. And the strategy of our flagship funds has remained the same. Their value-add funds closed in, co-mingled. And the strategy has been to both acquire and develop on the value-add scale and to do it in a manner that separates us from a lot of our competitors, mostly due to our locational preferences. So there's 64 years in about a minute and a half. I'm curious if there was a vision of what we're experiencing today with the boom in logistics many, many years ago, or was it more that the market just took the firm there? That's a great question. I think if you're speaking about the e-commerce revolution, I believe that we started to become cognizant of that sort of in the 2005 range.

7:59And there were some nascent signals that firms were finding a way to be directly B2C rather than B2B. And so that started to take off in the early 2010s. But I will tell you, as I was making my rounds, talking to potential investors, even as late as 2014 or 2015, I still had to explain what e-commerce was and how it was going to change demand for our product. Now, of course, almost 10 years on, I'll go into the same meeting and people just flip right past that part of the deck. Okay, we get the e-commerce story. We see the tailwinds. We see that it's a secular change in our business. And so it's really only the last 10 or 15 years that this has really been in the collective consciousness of industry players.

8:56That's pretty amazing. When thinking about it today, it seems like we've known about this for a long time, but as you just stated, it's relatively new and that can be easily overlooked. We have a lot to thank Mr. Bezos for on many, many levels in our business. And there are other pioneers, but of course, what Amazon has done stands out as a model for a lot of the pure e-commerce play that we see today. That's great. We'll get into all that momentarily. But if we take a step back, would you define industrial real estate for our audience so that we're all on the same page? Sure. We still use the term industrial, but if you use that term in Europe or Asia, and you're talking to European or Asian investors, and you say industrial, they think smokestack.

9:47So we're trying to talk more about logistics real estate. And that's maybe a distinction without a difference, because I think the majority of your listeners and viewers would say, okay, warehouse space. And so it is that, but there's more to it. We're trying to take an old-fashioned term and narrow it down to today's modern logistics facilities that have the sorts of features that I described to you earlier, plus newer features like being solar ready on the roof structure, being EV ready for the electric vehicle transformation that we're in the nascent stages of. So it's really trying to take what is a much broader term and make it a little more narrow.

10:33So for context, depending on whose numbers you believe, CBRE or JLL or some of the other large firms in the US, there's about 17 or 18 billion square feet of industrial space. I would suggest to you that probably half of that is what you and I would consider to be in the competitive set. Okay. And then would you just define logistics more precisely? That's what we're going to be talking about and also why it's Dermody's core focus. Sure. Well, of course, logistics describes the movement of goods through the supply chain, starting at where it is that they're manufactured and then it's shipped and then stored and then ultimately brought to, transported to their final destination, whether that's a business or a consumer.

11:26But again, I would define modern logistics space is having the qualities that we talked about, which is the appropriate clear height, the appropriate off-building trailer parking capacity, loading capacity, etc. And that has changed over the last few years to the extent that it's made a lot of buildings that are perhaps only 15 or 20 years old prematurely obsolete because they don't have these qualities. So the definition keeps changing and it's our job to stay ahead of those changes. I focus on this segment. It seems like as a real estate investor and developer, it's a pretty narrow sector. And is it overly risky to focus on that sector?

12:14Or how do you think about just that whole side of the equation? If you look at the universe of institutional real estate in the United States, people talk about the four main food groups, office, retail, multifamily, and industrial. So you have enough scale in our business to have liquidity. And of course, you have to have liquidity to be able to monetize the gains that we hope to earn. And so we definitely meet that standard. But of those four main food groups, and you would ask, well, what's attractive about US logistics, real estate. Of course, we have these secular tailwinds that we just described.

12:54But we also have some headwinds for large investors who want to have exposure to the space. They're generally underweight U.S. logistics real estate assets. And the reason for that is these buildings are, you know, for the most part, 25 and 50 and maybe$75 million sorts of bite-sized investments. Some are larger, but it's not as if you can stroll into Midtown Manhattan and buy a billion dollar building. You can't do that in the industrial space. So what we find is, and our strategy has been to aggregate these bespoke portfolios that we know that the universe of large investors will want to have access to, but they can't do it because they're not set up to do these little bites.

13:50So when we give them a billion dollars or$2 billion worth of a portfolio well-leased to great tenants, then we find that there's a lot of interest for that. So So from an investor's perspective, hard to get scale and industrial. From our perspective and our investor's perspective, we're the ones providing that scale and that quality. Right. And you're doing it in a sector that has pretty material tailwinds, particularly in contrast to some of the other sectors that you described, particularly office and retail. And much lower volatility in terms of NOI and in terms of vacancy at the very low point of the great financial crisis in that cycle, call it 2009, 2010 for the real estate part of it.

14:44national occupancies in the U.S. were still in the high 80s. It had really been the first time in recorded history that U.S. logistic real estate had dropped below 90 % occupancy levels. And of course, now at the COVID peak, if you will, or just following COVID, national occupancies were in the high 90s. So we're not a sector that tends to have a tremendous amount of volatility and investors like that. And do you believe that the reason that's the case is because there's just a persistent shortage of supply relative to the growing demand? Well, at the current time, supply has recovered. There was, of course, during the go-go days of the pandemic, everyone was leasing everything they could build as fast as they could deliver it.

15:36And that's cooled. There's a little bit of a hangover on the supply side in some markets in the U.S., not all markets. And demand has cooled from the frenzy of, let's call it 2022 at its peak. The sector has come back into more balance where national occupancy rates have moved down into the mid-90s, which is still considered to be a very healthy market from a landlord's perspective. Generally, occupancy is at 94%, 95 % in a given sub-market or market. You're still going to see a lot of landlord pricing power. Occupancies falling into the low 90s would indicate tenant pricing power. and we haven't gotten there yet.

16:21So if I could belabor the point for a minute, I think we were maybe going to get to this, but I'll mention it now. For many reasons, supply is a big issue and supply has been cut off to the point where most markets are 60 or 70 % off peak. And because there's a lag of about a year from the time something starts to when it's delivered, we're going to see a real constriction of supply moving into the middle 25 and beyond because of all that's happened over the course of the last year and a half. So near term, rent growth is moderated. Midterm, we think we'll go back to some pretty good pricing power next year and the year after that.

17:05It may be helpful for some listeners to better understand the infrastructure that goes beyond what they see. So somebody goes online, they click, they want to buy something. Would you walk us through the infrastructure and how a product reaches a customer's doorstep after an online order? Sure. My wife and I have been invited to a wedding recently. I think we just ordered a KitchenAid mixer for the young couple. And I'm not exactly sure where those are manufactured, but let's for the minute assume they're manufactured somewhere in Asia and they come over by ship and they come into the port of LA and Long Beach.

17:46And then they're taken by train to Chicago, where they're brought in bulk at the pallet level and the container level into a warehouse. And that's where the stories diverge. So if that's a mixer that's going to a retailer's, let's say it's target, if it's going to a target store, it's probably being broken down from the container level to the pallet level. And a pallet is going to this store, and a pallet's going to that store. And then, of course, the consumer makes his or her choice. If it's to be delivered directly to the consumer, it's brought into a completely different kind of warehouse where it's stored with a much higher number of different sorts of products that are then mixed.

18:38So if a buyer goes on Amazon and the buyer wants a KitchenAid mixer, a packet of diapers, a thing of pens and some other book, that's a much different order to be fulfilled because is someone has to go into that warehouse and pull those things physically into a basket and put it into a shipping box and then send it out to the customer's home. And so you can imagine the difference between dealing with these mixers that are stacked 40 feet high in a warehouse on one hand, and on the other hand, having 25 of those available exactly where you think the customer demand is going to be. And so our brick and mortar solutions are very much in alignment with what each of those customers needs.

19:31Some need the bulk storage. Others need to be delivered within two hours in a 20-mile radius of a last-mile facility. So we try to work with our customers on both ends of the spectrum. The technology in order to go from click to doorstep in a few hours is pretty remarkable. It's amazing how far that's come. It's an incredible thing of these automated warehouses. I will say that some of our customers have significantly more invested in the material handling equipment and the automation equipment, including robots, than we have invested in the brick and mortar. Wow. That's pretty remarkable. So all of this came about because of this boom in e-commerce.

20:19Is there a risk that the e-commerce trend is going to slow or possibly even reverse? That's a really interesting question. We're about at 20 % of US retail sales ex-autos. That's kind of where most people think e-commerce is today in terms of penetrating the consumer dollar. There's a thought that that could easily go into the 30%, 35 % range over the course of the next few years. But one of the things that the pandemic did was it changed consumer behavior and many consumers who had never tried to navigate an e-commerce site or an omni-channel retailer's website, and I use those two terms a little bit the same way, that those consumers by necessity were introduced to the convenience of having things delivered to their doorstep.

21:15much of that behavior has been sticky. And although there's been some fall off from the peak, we saw a little bit of fall off and then the rate of growth at about a 15 % per annum kegger kicked right back into where it was before. So there's always a risk, but at the same time, it's still a fairly young industry with a lot of growth. And then if you consider that the The algorithms and the optimization tools that the omnichannel retailers have and the e-commerce folks have is always telling them to do something different based on their orders. I don't think we're going to run out of work in the very near future.

21:55Now, if e-commerce picks up and retailers suffer as a result, then I guess that's positive for one type of logistics property, and it's negative for the properties that go directly to the targets of the world. Now, how does that net out? So if you take away from one and you add to the other, are you pretty much diversified against that or is there some risk? Some studies have been done that say that in terms of warehouse space demand, that the e-commerce delivery method that we've been describing takes two to three times the square footage per product for SKU as traditional warehouse does. So it's much less space efficient, if you will.

22:42So I guess to the extent that there is this transition towards more B2C home deliveries, that that's probably a good thing for providers of brick and mortar like us. That's interesting. And I guess it's because there's less bulk, right? There's less bulk. More variety. It's probably far more complex. Dr. Justin Marchegiani Extraordinarily so. And so we're the beneficiaries of that as providers of a logistics space. So if we talk about the process, it seems that the distribution side of logistics has achieved economies of scale and is relatively efficient. But I'm sure there are other areas of the process that are fairly inefficient and ripe for improvement.

23:29Would you talk about that? Well, the whole ecosystem around the delivery of our product, our warehouse product to our customers is extraordinarily inefficient. And on behalf of our investors, we're taking advantage of those inefficiencies. So it's very difficult and time consuming to find the right piece of land, get the entitlements, do all the feasibility studies, negotiate the contracts around that and be able to construct these buildings. So that's a very inefficient process. And I don't see that changing. And from a pricing perspective, we're taking advantage of our local relationships with the ecosystem around brokerage firms, land sellers, some corporate sellers, a lot of private sellers of land.

24:23So that whole land process is time consuming. It's expensive. And it's a high barrier for competitors to try to come in and replicate. So we like that. We like high barriers and we like taking advantage of those inefficiencies. The building of the buildings from a vertical basis, once you have your infrastructure work done, is fairly straightforward. And although we like to think our buildings are of the nicer variety, most of these buildings have very similar qualities to them. So the real difference maker is where they are. And we know that our customers want to be close to their customers. And it's fairly easy to articulate that strategy, but it's quite difficult to execute it because of the very high barriers that I just spoke about.

25:16I've heard that another inefficient part of the process are returns. If somebody buys something, that's become relatively efficient. But when they want to return, that's relatively inefficient. It's extraordinarily inefficient. I think the statistics I've seen that if you go to Nordstrom and you buy something from Nordstrom, the return rate is in the high single digits, which actually seems a little high to me. But that's what I've read about general merchandise retailers. For e-commerce, it could be as high as 25 % to 40 % depending on the product. And that's an extraordinarily high rate. and it suggests that the reverse logistics market is going to explode in a positive way because there should be a lot of demand for that.

26:08But some of our customers would rather just let you keep whatever it is that you bought, even if it's wrong, even if they refund you, than to try to handle it a second time because it just isn't worth it for them. So we see a lot of that as well. They want to handle it once. No one is set up that I know of to efficiently handle the quantity of returns. And it's very much an opportunity for firms to bring some order to that chaos by creating new processes which don't yet exist. And I'll tell you the other thing that you didn't ask me about. What are we going to do with all this cardboard in our lives?

26:52Right? So we have this influx of cardboard coming in. It's all brand new packaging. And I know that all of us probably recycle. But can someone please come up with an idea about how to reuse this packaging material? because it just seems wasteful to me as a consumer that every week I put out this stack of brand new cardboard into the recycle bin. So if someone's looking for a way to become the next billionaire, I would solve that consumer problem in a manner that respects the environment, meets the needs of the consumer, and the needs of the shipping people. How's that for a speech? Love it. I know I'm always breaking down boxes, so I feel exactly what you're talking about.

27:41So let's talk about the customers or the tenants in industrial real estate. Who are they generally? We know Amazon is a big player, but they're not the only player. Right. So whoever's listening to this, if you just look around the room you're sitting in, everything that you see, touch, and have in that room came out of a warehouse, from the paint to the floor covering, to the clothes that you wear. And so it's a very fragmented and broad industry. It's, of course, we've belabored the e-commerce a little bit. And Amazon, I believe, is about 10 % of, well, it's about 10 % of the competitive base in the US, probably closer to 5 % if you take the big picture of all industrial assets.

28:29So obviously, they're a massive customer and the largest customer by far. In fact, there was a point a couple of years ago where it was thought that Amazon as a single company was responsible for about 25 % of all of that year's absorption of new logistics space in the U.S. But setting that aside for a second, food and beverage, consumer durables, think washing machines, consumer non-durables, think Pampers. And then we have this entire grouping of what are called third-party logistics providers who, on a contract basis, are working with much smaller firms, aggregating their product, providing labor, warehousing, and transportation solutions for their customers.

29:18So the 3PL segment, taken as a whole, is one of our largest customer segments as well. It's very diverse. How does rent growth for the industrial sector, the logistics sector, compare to rent growth in some of the other property sectors like office and retail, which we know have been struggling? Right. Long time ago, we used to think of rent growth as being sort of at the rate of inflation, roughly 3 % year over year, or roughly at the rate of the growth of GDP. So again, 2.5 % or 3 % a year. And then e-commerce came along and then COVID came along and turbocharged everything. Rent growth in some markets exploded during the pandemic years.

30:08I'm talking about rents doubling every 18 months, which is obviously not sustainable. We're thinking about national U.S. rent growth now sustainably in the mid-single digits. Yeah. And then locally higher than that. And then in the submarkets that we try to pick, perhaps even in the high single digits. But I think the near-term era of double-digit rent growth is taking a pause, as you would suggest that it would, just not to be sustainable. But it's still very positive right now. It's just slowed down a bit off of a very high peak. And that's clearly much better than other sectors like retail and office.

30:53Yes, I'm thankful every day that the manager chose me for industrial and not for office. I'm no expert. I do know that assets will find a value, there'll be a mark to market, and then the recovery will start. I just couldn't tell you when that is. But in the meantime, it gets back to my point about the appetite for institutional investors. They really want logistics, and they're still, I think, bullish on multi. and everything else to them. Their daily lives on the asset management side consist of trying to solve problems. So we come in, we have great credit profile with our customers. So quality of the NOI is very high and it gets a lot of attention from that group.

31:41What's the balance between property acquisition and developments in your investment strategy? So we want to invest where we're going to create value for our investors. And it's different points in the cycle that might lean us into value-add acquisitions. And I'll talk about the definition in a second on one hand versus development on the other. Value-add acquisitions are generally buildings where you're buying class A product. So we avoid dysfunction. That's for starters. Never want to be in a dysfunctional asset. it. You're buying class A product that has one of several conditions, either has near-term vacancy role.