When I first wrote about STAG Industrial (NYSE:STAG), it was intended as an observation about the costs of purchasing a bad asset in a secondary market. It was not meant as a bearish article; it was simply intended to be an informative article about a sale I had better than average information about.
At that time, I had not done my due diligence on STAG. It was a stock that I automatically dismissed due to a rejection of STAG's entire investment thesis on its face.
Since that article, I have taken a much more in-depth study of STAG. Through discussions in the comment sections and reading numerous articles on STAG, I have become increasingly bearish on its long-term prospects.
What is clear is that STAG gets a lot of love on Seeking Alpha and that STAG bulls seem to take a number of myths as undeniable truths.
I think shorting STAG is an exercise in futility. However, long term, STAG has significant risks without prospects for significant gain.
STAG Has Outperformed
STAG had an initial amazing run the first two years. After dropping from IPO, STAG surged in 2012, and early investors were well-rewarded, doubling their investment by 2013. There is no question about it: Being an early believer was a great move.
However, that run up has happened. If you caught it, congratulations! For the rest of us, that is an opportunity that has passed. The question we must ask now is whether STAG as a maturing company is going to continue providing good long-term returns.
The myth about STAG that is spread by contributors and commentators across SA is that STAG has had outperforming growth. While this is true if the initial run up is taken into account, what about after? Has STAG continued to outperform?
To test this, I ran the numbers from September 3, 2013, to present. I picked that specific date for a couple of reasons.
First, it was smack in the middle of the first long-term dip since the initial run up, which lasted from June of 2013 to December 2013. Second, investors were getting their first real comparable YOY information. Third, it is the exact date reported by Brad Thomas, a serial STAG Bull, as his entrance point.
At the time, there were a lot of reasons to get excited about STAG. It had a huge prior year, was raising massive amounts of capital and was exponentially increasing its holdings, while sitting in a dip 20% below its highs. For those sold on the basic thesis that secondary industrial markets were underserved and could compete with primary markets, it seemed like an great time to buy.
(Investment of $10,000 on 9/3/2013 and liquidated on 1/20/2016)
To be fair, buying STAG was hardly a bad decision; it has beaten SPY. Also, with over $2,000 in dividends returned on the $10,000 investment, it led the pack in terms of income. However, the total return on STAG has been substantially smaller than industrial REIT peers.
While STAG has slightly outperformed the market at large, and thus was not an objectively bad investment, it was the worst possible choice among industrial REITs. The mythology around STAG would have you believe that it is running circles around its peers. That simply is not the case.
STAG has had some large dips that have allowed for impressive short-term profits for those purchasing in the teens and selling in the mid-20s. However, for long-term holders, STAG has underperformed relative to its peers.
STAG's Dividend Growth Sets It Apart
Long-term income investors know that dividend growth in the future is vital to building a stable income stream and that companies that raise dividends consistently will outperform in the long term. STAG has raised its dividend every year since IPO.
This fact provides long-term investors comfort that even if the stock underperforms today, its yield will continue to increase and lead to long-term outperformance. However, is this growth special? A quick look at industrial REIT peers suggests that it is not.
(Based on total dividends paid 2014 and 2016)
DCT Industrial Trust (NYSE:DCT) and First Industrial Realty Trust (NYSE:FR) can be ignored. Both can be characterized as REITs that were distressed by the recession, and recent dividend growth is an indication of catching back up, rather than an indicator of future growth prospects. Still, STAG's growth is average for the field and lags behind the stars Prologis (NYSE:PLD) and Terreno (NYSE:TRNO).
Rather than being something that sets STAG apart from its peers, its dividend growth rate is simply average for the sector.
STAG Is A Great Investment Because of Amazon
A very common discussion in favor of STAG is that the e-commerce field is growing very rapidly, and industrial warehouses are benefiting from that. On the surface, it makes a lot of sense. The growth of e-commerce is obvious to anyone who is not living in a cave.
As an industrial REIT, STAG does have some exposure to e-commerce, but it isn't enough to substantially impact the bottom line. STAG's logistics exposure only accounts for 12% of its ABR. Digging deeper into its largest logistics tenants, XPO (NYSEMKT:XPO) reports only 6% of its revenue comes from e-commerce. Exel, a division of DHL, does slightly less than €1 billion in US e-commerce revenue - significantly smaller than their air freight and express divisions.
STAG is far more exposed to US domestic manufacturing and retail distribution. Among its top ten tenants are Deckers Outdoor Company (footwear distribution), Solo Cup Company (manufacturing), International Paper Company (pulp and paper manufacturing), Generation Brands (lighting manufacturing), Perrigo (pharmaceutical manufacturing), and American Tire Distributors (tire distribution).
These six companies are all facing increased competition due to e-commerce, which benefits inexpensive products made overseas and challenges the B&M distribution model. An argument that a Trump administration is going to reignite American manufacturing is a much more persuasive argument for STAG than e-commerce growth.
Those looking for industrial REIT exposure to e-commerce should take a look at PLD, with Amazon as its largest tenant, or Monmouth Real Estate Investment Corporation (NYSE:MNR), which continues to aggressively accumulate FedEx (NYSE:FDX) facilities, which currently account for over 50% of base rent.
Secondary Markets Follow Primary Markets (With Higher Yields)
Some STAG bulls consider secondary markets to be a mirror of primary markets, with similar results and higher yields. Secondary markets do have higher yields, but that higher yield doesn't necessarily mean higher returns.
Yield is a factor of two variables: capital cost and rent. Capital cost is straightforward enough: Secondary markets tend to be significantly less expensive than primary markets. Primary areas generally experience higher demand, have higher entry barriers such as strict zoning laws and regulations, and often physical constraints on building new supply.
Secondary markets are smaller, have less strict zoning and legal barriers and usually have plenty of surplus land that could potentially be used for new supply.
This means that primary areas generally experience low elasticity in demand, while having an inelastic supply. Rising rents will have little impact on demand, and supply cannot easily be increased. Tenants who want or need to operate in primary areas often have very few alternatives as rent rises. The high value of real estate creates high barriers to speculation construction or tenant owned property.
Secondary markets experience high elasticity in demand, while also having an elastic supply. A tenant in a secondary market, more often than not, does not have a strong necessity to be in that particular market. Secondary markets do not offer the same uniqueness and desirability that New York, Washington DC or Los Angeles have. In a secondary market, it is much more likely that a building of similar utility can be located on the outskirts of town, or even a few towns over.
As rents rise in secondary markets, tenants have many alternatives, and rent is held in check by the costs of constructing new buildings. Speculation construction in a booming secondary market is relatively low cost and therefore common. As demand spikes, new supply is not far behind.
For REITs, this means that in primary markets, rents can and often do rise much faster than inflation. While they pay a much higher amount in up-front capital and may accept lower initial yields, there is a lot more room for growth over the long term. Meanwhile, as rent grows, typically the value of the real estate itself grows, and it is typical for buildings to sell substantially higher than replacement costs.
In secondary markets, the initial yield is higher, but growth is substantially constrained. With replacement relatively easy, the value of the building will be constrained by replacement costs.
Another significant difference is in liquidity. Primary markets have significantly higher demand, giving real estate owners the ability to liquidate holdings relatively easily when necessary. In a secondary market, a commercial building requires a long time to sell, and liquidating it may require the seller to make significant concessions.
While secondary markets can offer windows of opportunity relative to primary markets, in the long run they have deeper troughs, lower highs and faster crashes.
In the most recent recession, secondary markets were the canary in the coal mine, with the recession starting two quarters earlier in secondary markets than in primary markets. Coming out of the recession, primary markets recovered earlier.
As the only industrial REIT that focuses heavily on secondary markets, STAG is positioned to be the canary for industrial REITs in general. As I pointed out above, STAG has outperformed the market in general. That might lead investors to be attracted to the higher cash flow, and if cash flow is a priority, it might make sense to accept the good return, even if the total return is lower than its immediate peers.
The real risk of STAG is that it will play the role of the canary when the next slow down comes around. When a slowdown hits, STAG might not be able to sell poorly performing property at any price. STAG already suffers from one of the lowest retention rates in the sector.
(2016 Retention Rates)
STAG deals with low retention rates by constantly finding new tenants, which typically means higher leasing commissions and concessions and by selling vacant properties, usually at a capital loss. Thus far, STAG has made this strategy work, though over the next three years it is facing much higher lease expirations than in the past.
With a booming industrial market, finding tenants is relatively easy right now, but what happens when it is not so easy? With a retention of only 70% now, what will it look like when the market is no longer growing? What happens when new tenants cannot be found? STAG already takes a loss on most of its dispositions, what happens when it cannot sell at any price?
The next four years will be a significant test for STAG, with over 60% of its leases expiring. Its ability to fill the spaces it fails to retain will be vital to the future of the company. Investors will want to pay attention to the costs, rental rates and terms.
If STAG continues signing 4-5-year leases, 12%-17% annual expirations will be the new normal for STAG. Which becomes a high risk if the rental market slows.
This risk is one that most STAG bulls seem to ignore. STAG has never been through a recession, and investors should really consider what even a small recession might do to STAG. It is unlikely that there will be a lot of warning, since STAG is likely to be the warning for other industrial REITs.
I find STAG to be an interesting example of investor psychology. In comment sections, it is one of the most-named REITs as a high-quality, dependable stock. This is despite the fact that it has not exhibited unusually high returns for four years without nearly perfect market timing. A lot of attention is paid to its high yields, but very little attention is paid to why those yields are high.
STAG is an interesting stock in that it offers REIT investors strong exposure to secondary industrial markets. Those that strongly believe the Trump administration is going to have a positive impact on American manufacturing, might want to consider some exposure to STAG. However, STAG does not belong in a conservative income portfolio.
STAG is a high-risk stock that investors should be prepared to abandon before the industrial market slows down, not a SWAN for the average Joe.
(Sources: SEC Filings, Integra Realty, CBRE Research)
Disclosure: I am/we are long PLD, TRNO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.