The Hottest (And Most Unlikely) Real Estate Sector

Summary

• The global economy is growing at the fastest rate since the end of the recession. Booming global trade and the rise of e-commerce have boosted demand for warehouse distribution space.
• Industrial REITs have benefited from the insatiable demand for well-located distribution facilities. Occupancy is near record-highs, rent growth is relentless, and demand indicators suggest that there’s further room to run.
• E-commerce continues to be the primary demand driver for industrial space. E-commerce requires more 2-3 times more logistics space than traditional brick and mortar, a function of fast delivery requirements.
• 3Q17 earnings generally exceeded expectations as leasing conditions remain tight and same-store NOI growth continues to be above the REIT average. The robust development pipeline should continue to support growth.
• Supply growth has heated up and threatens to spoil the party if demand moderates. The infill nature of the high-quality distribution centers does serve as a mild barrier to entry.

REIT Rankings: Industrial

In our REIT Rankings series, we analyze one of the fifteen real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter.

We encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Industrial Sector Overview

Industrial real estate assets are critical nodes in the global supply chain. One of the major real estate sectors, industrial REITs, comprise roughly 10% of the REIT Indexes (VNQ and IYR). Within our market value-weighted Industrial index, we track the eight largest industrial REITs, which account for roughly $70 billion in market value: DCT Industrial (DCT), Duke Realty (DRE), EastGroup Properties (EGP), First Industrial (FR), Liberty Property Trust (LPT), Prologis (PLD), PS Business Parks (PSB), and STAG Industrial (STAG). Industrial REITs own roughly 10% of industrial real estate assets in the United States.

Above we show the size, geographical focus, and quality focus of the eight Industrial REITs we track. There are three primary categories of industrial real estate assets: bulk distribution centers, general warehouse, and flex office/warehouse. The highest-value industrial real estate assets are bulk distribution facilities located near major metropolitan cities. These distribution facilities enable fast delivery of goods to consumers. These "infill" assets tend to have higher barriers to entry as well-located undeveloped land is relatively scarce.

General warehouse space, on the other hand, is generally smaller and located on the outskirts of major distribution hubs and serve multiple roles as storage, manufacturing, and general distribution facilities. "Flex" industrial assets are business parks that combine office space, industrial space, and manufacturing space. As these two types of industrial assets are more ubiquitous and easier to replicate, the value of these assets are generally lower per-square-foot than well-located distribution-focused assets.

Demand for industrial space is driven primarily by global trade, industrial production, inventory levels, and consumer spending. The density of the supply chain and the efficiency of space utilization also affect the need and location of industrial real estate space. The "need for speed" in e-commerce distribution has resulted in intense densification of supply chains and resulted in an insatiable demand for well-located distribution and warehouse facilities.

Supply of industrial space has historically kept up with demand, a function of the short construction time frame and relatively low capital requirements. As a result, rent growth has generally been modest as demand imbalances were quickly equalized with increased supply. The growing importance of strategically-located assets, however, has resulted in higher barriers to entry for new supply, which has resulted in favorable fundamentals and tight leasing conditions, particularly for the highest-quality, distribution-focused assets.

Recent Developments and Quarterly Performance

Industrial REITs have outperformed the broader REIT average over every recent measurement period. The sector is higher by 20% YTD and higher by 2% over the past quarter. Prologis, DCT Industrial, and EastGroup have been the best-performing industrial REITs this year.

3Q17 earnings generally exceeded expectations. Of the eight industrial REITs, six beat quarterly estimates while two met. Forward guidance was similarly strong. Occupancy remained near record-highs but ticked lower by 35 bps from 3Q16. Leasing results were impressive and signal continued pricing power. Prologis and DCT led the way, achieving 23% and 24% higher lease rates, respectively.

External growth continues to be powered by development rather than acquisitions, which we discuss below. Duke completed the sale of its medical office building portfolio for $2.85 billion in cash to Healthcare Trust of America (HTA), a welcome step to becoming a pure-play industrial REIT.

Across the sector, same-store NOI grew 5.1%, slowing slightly from record levels in 2Q17. Same-store NOI has outpaced the REIT average since early 2016, but appears to have reached a cyclical peak in 2016.

On earnings calls and at the recent NAREIT conference, several key themes are being discussed. We focus primarily on the Prologis earnings call and its in-house Prologis Research.

Fundamentals Remain Strong, Barriers To Entry Grow

First and most importantly, fundamentals remain strong for logistics assets, particularly the high-quality assets located near major metropolitan markets. Prologis expressed confidence that this robust demand is expected to continue and the barriers to entry towards new supply growth are beginning to mount. From the Prologis earnings call:

"In the U.S. market conditions remain excellent. Consumption has been growing at a faster pace than available stock, leading to vary tight market conditions.…For the first time in my career, net absorption is being constrained by a serious shortage of space. Tight land and labor markets are acting as governors on new construction. We are hearing consistent feedback from our customers to tell us that they are operating at capacity and that is difficult for them to find additional quality space in the right locations. These favorable conditions have elevated the mark-to-market in our portfolio. In-place rents in the U.S. are now 18% below market, expanding our organic growth for a long period into the future."

Supply growth has heated up to roughly 2% of existing supply, but demand has been even stronger. Absorption continues to outpace supply, keeping occupancy rates near record lows and leasing conditions tight for tenants.

Pipeline Remains Full, Cap Rates Compress

Since 2016, external growth has been increasingly fueled by new development rather than acquisitions. These REITs continue to see more value-add opportunities in ground-up development and see development yields at 6.4% compared to cap rates in the high-4s to low-5s. On a trailing 12-month basis, industrial REITs have sold $2.8 billion more assets than they have acquired. Meanwhile, the development pipeline has swelled to $6.6 billion. REITs continue to expect this pipeline to fuel accretive growth over the next several years.

According to JLL's 3Q17 Industrial report, cap rates have declined modestly over the past year. Combined with roughly 5% rent growth, industrial real estate property values have risen in the mid- to high-single-digit range over the past year.

Global Economic Growth Accelerates, Some Concern Over NAFTA

This week the OECD released its Economic Outlook. The organization sees the strongest level of global economic growth since 2010 led by the US and the Eurozone. World trade is expected to grow nearly 5% in 2017, providing a very strong macro backdrop for industrial REIT assets.

Amid the positive data and strong sentiment, however, there is concern over the future of NAFTA and its potential impact on industrial REITs. The Trump administration is taking a hard line on trade negotiations. NAFTA encompasses more than a third of US trade, so a withdrawal would cause significant disruptions to US supply chains. While we think a withdrawal from NAFTA is unlikely, we should note that a withdrawal would have the greatest effects on industrial assets in states along the Mexico and Canada border and have relatively less of an effect on the assets along the coasts.

Below is our REIT Heat Map, showing the YTD performance in relation to other sectors. As we mentioned, industrial REITs have significantly outperformed the broader REIT index over the prior quarter and YTD.

2 Reasons To Be Bullish On Industrial REITs

1) Demand Indicators All Point Towards Continued Growth

Industrial warehouses are a critical node in the global supply chain. Demand for industrial real estate space is driven by the expansion and densification of supply chains, which are built out as companies compete to get their products in the hands of consumers in the timeliest and most cost-efficient manner. Demand for warehouse space has historically shown a high correlation with several economic indicators, most of which are trending in a positive direction after a half-decade of relative stagnation. Prologis' IBI Activity Index, which is an index of leading economic indicators for industrial warehouse demand, is at its highest level since mid-2015. The IBI's strength is being driven by the strongest level of world GDP growth since 2010, highlighted by 4.8% growth in trade, an 8% rise in US imports, strong retail sales, and renewed strength in industrial production.

As the leading indicators point towards continued growth in industrial demand, Prologis also notes that existing tenants are utilizing their space at record-high efficiency levels. Tenants are at or near maximum capacity in their existing locations, so incremental growth will thus require more warehouse space rather than expansion or efficiency improvements within existing facilities.

2) E-Commerce Growth and Increased Space Requirement

Demand for industrial space has been substantial over the last five years, primarily driven by the rapid growth of e-commerce and the "need for speed" when it comes to distribution. Besides Amazon (AMZN), industrial REITs are perhaps best positioned to capitalize on the growth of e-commerce. E-commerce sales still represent just a small fraction of total retail sales, but roughly half of the incremental growth in retail sales over the past three years has come from e-commerce.

Importantly, e-commerce is far less efficient than brick-and-mortar from an industrial space perspective. Each dollar spent on e-commerce requires roughly three times more logistics space than brick and mortar, according to estimates from Prologis. Consumers have shown an unwillingness to wait for more than two for delivery of most items, forcing e-commerce retailers to densify their distribution networks.

2 Reasons To Be Bearish on Industrial REITs

1) Supply Growth Has Heated Up

New supply seems to be one of the few factors that could spoil the party for industrial REITs. As discussed above, supply has historically kept up with demand for industrial real estate due to the short construction time and low capital requirements. New entrants could easily buy-up land and develop warehouse assets with relatively little advantage to the incumbent. This paradigm appears to have changed as location has become a more important factor in site selection.

Construction spending on warehouse assets has increased substantially beginning in early 2014. Over 200 million square feet of space was delivered in 2016 with even more expected for 2017 and 2018, the highest levels of supply growth since the early 2000s. New development, however, has moderated in recent quarters. As a percent of existing inventory, new annual supply growth remains near 2%. As discussed above, lack of desirable space for new development, high construction costs, a tighter financing environment, and longer permitting processes are keeping supply growth in check.

2) E-Commerce Growth May Be Slowing As Retailers Focus on Omni-Channel

While the growth of e-commerce has been impressive, the data suggests that the sentiment regarding the "demise of brick and mortar" and rise of e-commerce seems to be overstated. Last week, we analyzed retail sales for October, which is obviously a focus during this Holiday season. October retail sales were stronger than expected, led by a resurgent "brick-and-mortar" segment. Shockingly, nonstore retail sales (e-commerce) were negative for the third month out of the past five. E-commerce growth has continued to slow through 2017 while brick and mortar sales have been solid above 2.5% YoY. Below we see that the SAAR rate for nonstore retail reached the lowest YoY growth rate since June 15 while brick-and-mortar saw the highest YoY SAAR since Feb. 16. We continue to point out that while online sales growth continues to take incremental market share away from traditional retail, the sentiment around brick-and-mortar retail appears to be far too negative given the data.

Our favorite chart below shows the "Amazon effect" or lack thereof in many of the retail categories. Restaurants, furniture stores, grocery stores, and building/home improvement retail sales continue to be strong. Even in the "retail losers" category, we've seen recovery in the general merchandise and clothing categories in recent months, which are now in positive growth territory YoY. Only the electronics and sporting goods/books categories have seen negative YoY growth.

E-commerce represents just over 10% of total retail sales but nearly 20% of "at-risk" categories (total retail minus auto, gas, and food). Where will the "at-risk" e-commerce market share top out? Estimates vary widely, but we continue to believe it will be at the low end of the estimates for the next decade, evidenced by the already slowing rate of e-commerce growth. This has significant implications for retail real estate: if the state of brick-and-mortar retail is not really as dire as the valuations and narrative suggest, there may be strong investment opportunities in the space and the base-case scenario for the industrial real estate sector may not come to fruition.

Valuation of Industrial REITs

Industrial REITs trade at significant premiums to the REIT averages. Industrial REITs are the second most expensive sector based on both current Free Cash Flows and forward 2017 FCF. When we factor in two-year growth expectations, the sector still appears expensive. Expected to grow FCF at 8% over the next two years, industrial REITs are among the fastest growing REIT sectors, above the REIT average of 6%.

Within the sector, we can see how the high-quality e-commerce focused REITs (DCT, DRE and PLD) continue to trade at sizable premiums to the sector average.

Sensitivities to Equities and Interest Rates

Industrial REITs are not highly sensitive to interest rates and respond more closely to movements in the equity markets.

We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. As a sector, industrial REITs fall under our "Growth REIT" category and should be used by investors seeking longer-term dividend growth rather than immediate income (Click on each link to read more information about our methodology).

Within the sector, we note the variation in growth/yield characteristics. First Industrial, Prologis, and PS Business Parks are characterized as Growth REITs while the other five are Hybrid REITs.

Dividend Yield and Payout Ratio

Based on dividend yield, industrial REITs rank towards the bottom, paying an average yield of 3.0%. Industrial REITs pay out roughly 83% of their available cash flow, slightly higher than the sector average.

Within the sector, we note the varying strategies of the eight REITs. STAG and LPT command the highest dividend yields, but it's important to see how they do it. STAG pays out close to 100% of available cash flow, giving it less flexibility to deploy its capital towards development and leaving very little cushion to maintain the dividend if fundamentals weaken. Investors should expect more limited dividend growth potential from REITs that pay out excessive amounts of available cash flows. For investors seeking yield and dividend growth, we see PLD, DCT, DRE, and PLD as more attractive options.

Bottom Line: Industrial REITs Leveraged To Global Growth

The global economy is growing at the fastest rate since the end of the recession. Booming global trade and the rise of e-commerce have boosted demand for warehouse distribution space. Industrial REITs have benefited from this insatiable demand for well-located distribution facilities. Occupancy is near record highs, rent growth is relentless, and demand indicators suggest that there's further room to run. E-commerce continues to be the primary demand driver for distribution space. E-commerce requires more 2-3 times more logistics space than traditional brick and mortar, a function of fast delivery requirements.

3Q17 earnings generally exceeded expectations as leasing conditions remain tight and same-store NOI growth continues to be above the REIT average. The robust development pipeline should continue to support growth. Supply growth has heated up and threatens to spoil the party if demand moderates. The infill nature of the high-quality distribution centers does serve as a mild barrier to entry.

Industrial REITs have several appealing properties that could make them good long-term additions to a portfolio. Their focus on e-commerce provides an excellent growth opportunity and a hedge against an expectation of weakness in brick-and-mortar retail sales growth. Industrial REITs have relatively low sensitivities to interest rates, providing downside protection if rates should increase faster than economic growth. Finally, particularly with Prologis, industrial REITs add international exposure and are leveraged with growth in global trade, a characteristic shared by few other REIT sectors.

We aggregate our rankings into a single metric below, the Hoya Capital REIT Ranking. We assume that the investor is seeking to maximize total return (rather than income yield) and has a medium- to long-term time horizon. Valuation, growth, NAV discounts/premiums, leverage, and long-term operating performance are all considered within the ranking.

The REITs that focus on high-quality distribution centers remain the most attractive names in the space. We view Prologis as the most attractively valued industrial REIT, followed by DCT and Duke Realty. To see where industrial REITs fit into a diversified real estate portfolio, be sure to check out our full REIT Rankings series: Single Family Rental, Healthcare, Apartment, Net Lease, Data Center, Mall, Manufactured Housing, Student Housing, Storage, Hotels, Cell Towers, Office, Shopping Centers, and International.

Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Disclosure: I am/we are long VNQ, SPY, MAA, CPT, OHI, PLD, GGP, STOR, SHO, SUI, ELS, ACC, EDR, DLR, COR, REG, CUBE, PSA, EXR, BXP, EQR, INVH, SPG, HST, TCO, AMT, SBRA. 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.