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.
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Industrial Sector Overview
One of the major real estate sectors, industrial REITs comprise roughly 10% of the REIT Indexes (VNQ and IYR). Within the Hoya Capital Industrial REIT 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.
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.
The Bull and Bear Thesis For Industrial REITs
Industrial warehouses are a critical node in the global supply chain. Demand for warehouse space has historically shown a high correlation with several economic indicators (particularly manufacturing PMI, retail sales, job growth, and inventories) most of which are trending in a positive direction after a half-decade of relative stagnation. The Prologis IBI Activity Index, which is an index of leading economic indicators for industrial warehouse demand, remains near its highest level since mid-2015.
The growing importance of strategically-located assets 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. Below we outline the five primary reasons that investors are bullish on the industrial REIT sector.
Besides significant disruptions to the supply chain resulting from protectionist trade policies, new supply growth is one of the few factors that could spoil the party for industrial REITs. 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 because demand imbalances were quickly equalized with increased supply. Further, sky-rocking rents and land prices have forced tenants and potential developers to find innovative ways to reduce their footprint. Utilization rates of warehouse space is near record-highs.
Construction spending on warehouse assets has increased substantially beginning in early 2014. As a percent of existing inventory, new annual supply growth remains near 2%. Below we outline the five reasons that investors are bearish on the sector.
Recent Share Performance
Industrial REITs have been the best-performing real estate sector since the start of 2012, returning an average of 19% per year. The sector produced a total return of 31% in 2016 and 21% in 2017. The outperformance has continued into 2018, but the sector has not been immune from the broader interest rate-related weakness in the REIT sector.
Industrial REIT performance has been especially strong since the start of earnings season one month ago, surging more than 8%. DCT is higher by nearly 20% after Prologis announced plans to acquire the $6 billion firm. So far in 2018, higher quality logistics-focused portfolios (DCT, DRE, and PLD) have outperformed the lower-quality warehouse portfolios (STAG, PSB, FRT), continuing a broader longer-term trend.
Recent Fundamental Performance
1Q18 earnings generally exceeded expectations as the sector with seven of the eight REITs beating first-quarter estimates. All four REITs that reported guidance raised full-year estimates. Same-store NOI grew 6.1% in the quarter, a mild acceleration from the 5.1% rate in 2017. Occupancy climbed to 96.9%, higher by an average of 31 bps from last year. Leasing spreads topped 9.4% on a cash-basis as market rents rose an estimated 5-10% over the past twelve months.
Before 2014, industrial REITs were a rather boring sector that had historically underperformed the REIT average in SS NOI growth. Everything changed with the emergence of e-commerce and the growing importance of well-located distribution facilities. Industrial REITs now command some of the most favorable fundamentals in the REIT sector. SS NOI growth nearly doubled the REIT average of 2.6% and that spread should widen further in 2018.
The highest-quality REIT portfolios continue to deliver the strongest organic growth metrics. PLD and DCT delivered 6.0% SS NOI growth in 2017, followed by PSB and FR. STAG, which operates under a net lease model with longer lease terms and fixed escalators, continues to have SSNOI growth below the inflation rate.
Despite supply growth that has averaged nearly 2% per year since 2015, occupancy reached a new record-high at the end of 2017. According to NAREIT data, occupancy dipped as low as 88% in 2009 and has risen in every year since then, ending 2017 above 96%.
In addition to robust organic growth, industrial REITs continue to benefit from the added tailwind of external growth, primarily fueled by development. REITs expanded their asset base by an average of 2% in 2017 despite being net-sellers on the acquisition front, a trend that is expected to continue into 2018. Despite rising construction and land costs, development yields remain favorable and the development pipeline remains "full" at roughly 6% of assets.
Recent Developments & Earnings Calls
Over the past quarter and during earnings calls, several key themes and recent developments are being discussed. In general, the tone of earnings calls continue to be overwhelmingly positive as REIT executives continue to enjoy a fundamental backdrop that, absent an unexpected recession or "trade war," remains highly favorable for the foreseeable future. We discuss the six most important trends and topics that are affecting industrial REITs.
1) Prologis Further Solidifies Itself As Logistics Giant
Last month, Prologis announced plans to acquire DCT Industrial, the fourth largest industrial REIT, in an all-stock deal valued at a 16% premium to the prior closing price. Expected to close in the third quarter of this year, the deal is expected to further solidify Prologis' position as a logistics juggernaut. The deal is expected to increase Prologis' Core FFO per share run-rate by 2-3% per year.
DCT is another high-quality logistics-focused portfolio with significant overlap to the Prologis portfolio. For the past five years, DCT has been Prologis' fiercest competitor in many logistics-focused markets. For Prologis, the deal is expected to realize immediate synergies of $80 million, of which $30 million comes from G&A corporate overhead savings. Prologis is now five times the size of the next largest industrial REIT, Duke Realty. Nearly 2% of global GDP already flows through Prologis assets.
Prologis traded down on the news and remains lower by 1% since the announcement. While some analysts and investors are concerned that Prologis may be overpaying for these assets, Prologis sees substantial long-term value in DCT's rich land bank and potential to develop high-quality logistics centers in these locations.
2) Fundamentals Remain Strong
Demand remains strong for logistics assets, particularly the high-quality assets located near major metropolitan markets. Powered by the strongest synchronous global economic growth since the recession, forward economic indicators have strengthened in recent quarters above an already strong 2016 and 2017. Economic indicators suggest that demand for industrial space will further intensify in 2018 as there continue to be signs that tax cuts and deregulation in the US are resulting in a reacceleration in economic growth. Most notably, intermodal rail traffic has sharply risen by 5.9% so far in 2018 while air freight demand is on pace to rise 4-5% this year. Meanwhile, e-commerce sales continue to grow at a 10% rate, and the US manufacturing sector has seen the strongest job growth in decades.
Supply growth has heated up to roughly 2% of existing supply, but demand has been even stronger. For the first year since 2010, new supply exceeded new absorption in 2017, but by a very slim margin. Prologis expects the pace of supply growth to moderate in 2018. From last quarter's Prologis earnings call:
"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."
Prologis highlights that on an inflation-adjusted basis, rents remain lower than their prior peak, supporting future rent growth. Rents account for less than 5% of the total cost of the average supply chain.
3) Development Pipeline Continues to Drive External Growth
Since 2016, external growth has been increasingly fueled by new development rather than acquisitions. According to NAREIT data, the industrial REIT development pipeline ended 2017 at $6.5B, near the highest level since 2008, but showing few signs of further acceleration for this cycle. Based on guidance, 2018 is expected to see a slight reduction in the development pipeline.
These REITs continue to see more value-add opportunities in ground-up development and see development yields at roughly 6-7% compared to cap rates between 5-6%. This development yield spread has compressed in recent years as construction and land costs have increased, which is a double-edged sword for REITs. While profit margins have been compressed for REITs on these projects, the tight spreads have also reduced the appetite from private developers to add new supply to the market.
4) Private Market Values Tick Higher, Net Acquisitions Slow
Fears of rising interest rates have pressured REIT valuations since the end of 2017, but the impact on private market valuations of the same real estate assets have been far more muted. For that reason, a sizable valuation mismatch has emerged across much of the REIT sector between private and public market implied valuations. This NAV discount can be an issue for REITs that rely on acquisition-fueled growth but is less of an issue for development-focused REITs. All REITs, however, tend to benefit from modest NAV premiums and have more limited external growth options when trading at a NAV discount. Private market valuations of industrial real estate assets climbed 5-15% in 2017 and are higher by an estimated 0-5% so far in 2018.
Strong performance in the industrial sector over the past month has allowed the sector to recapture their coveted NAV premium. While industrial REITs are not as dependent on acquisition-fueled growth as many other REIT sectors, these REITs are not immune from the NAV-related cost of capital issues that have emerged in the wake of the post-tax-reform REIT selloff. As a result, industrial REITs continue to be net-sellers. On a trailing 12-month basis, industrial REITs have sold $2.1 billion more assets than they have acquired.
5) Trade War Not A Concern… Yet
Earlier this year, the Trump administration enacted tariffs on steel and aluminum imports, sparking concerns over a possible "trade war." The impact of this specific tariff, which has yet to be implemented and exempts Canada and Mexico, would be minimal but the effects would be amplified if other countries take retaliatory actions in response. There is also continued concern over the future of NAFTA and its potential impact on industrial REITs. NAFTA encompasses more than a third of US trade, so a withdrawal would cause significant disruptions to US supply chains.
Uncertainty over trade policy has the potential to disrupt supply chains and alter industrial REIT fundamentals. The fear for industrial REITs is that tenants become less willing to invest heavily to expand and densify their supply chain if they are uncertain over the long-term economics of the facilities, which may be altered by trade policy. While the consensus is that a "trade war" or a withdrawal from NAFTA is unlikely, the continued uncertainty over these trade agreements could be expected to modestly affect industrial REIT fundamentals. From the Prologis 1Q18 earnings call:
“The bad news is that any kind of trade war or which way, I don't think we're quite there yet. But any kind of trade war is bad for economic growth generally. And that will affect everything including our business... [However] we are not that active on the production end of the supply chain anyway. We're at the consumption end of the supply chain. So, it has less of an effect on us than our places that are focused more on production. Steel doesn't go through warehouses, aluminum doesn't go through warehouses. So, I guess the simplest way of thinking about it is that we are concerned by the talk. We are not yet concerned by the action and we'll just see what the action is going to be."
Valuation of Industrial REITs
Industrial REITs continue to trade at a sizable Free Cash Flow (aka AFFO, FAD, CAD) premium to the REIT averages. When we factor in two-year growth expectations, the sector appears more attractively valued. As discussed above, industrial REITs are one of the few real estate sectors that trade at a NAV premium.
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. STAG, a net-lease focused industrial REIT, trades at the widest discount to the sector.
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 81% of their available cash flow, leaving a sizable cushion for development-fueled growth and future dividend increases.
Within the sector, we note the varying strategies of the eight REITs. STAG pays the highest dividend yield at 5.5%, but does so by paying out most of their available cash flow, leaving less capital for external growth.
Interest Rate and Equity Sensitivity
Compared to other REIT sectors, 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 the Growth REIT category and should be used by investors seeking longer-term dividend growth rather than immediate income.
Within the sector, we note the variation in growth/yield characteristics. First Industrial and Prologis are characterized as Growth REITs while the other six are Hybrid REITs.
Industrial REITs have been the best-performing real estate sector since the start of 2012, returning an average of 19% per year. Demand has outpaced supply in every year since 2009. While supply growth has picked up in recent years, markets remain tight. Occupancy is near record-highs, rent growth is relentless, and demand indicators suggest that there’s further room to run.
1Q18 earnings were well above expectations. Same-store NOI growth averaged 6.1% YoY as occupancy increased to 97%. Market rents have climbed 5-10% and economic growth appears to be reaccelerating. Prologis announced plans to acquire DCT Industrial, which will further solidify Prologis’ position as a logistics juggernaut. Prologis sees ample long-term development opportunity in DCT’s e-commerce-focused land bank. Fears of a “trade war” continue to linger over the sector. While trade talks appear to be progressing, modifications to existing policy could disrupt supply chains and alter industrial fundamentals.
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. To see where industrial REITs fit into a well-diversified real estate portfolio, be sure to check out our other REIT Rankings: Data Center, Apartments, Shopping Center, Hotel, Office, Healthcare, Industrial, Single Family Rental, Cell Tower, Net Lease, Mall, Manufactured Housing, Student Housing, and Storage sectors.
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, PLD, AMZN. 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.
Additional disclosure: All of our research is for educational purposes only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.