Industrial REITs: It's Prime-Time

by: Hoya Capital Real Estate

Amazon’s push towards two-day and same-day delivery has sparked a supply chain “arms race” among retailers and logistics providers of all sizes. Speed is all about supply chain densification.

Riding the e-commerce wave, industrial REIT performance has been relentless over the past half-decade. Consumers increasingly demand speedy delivery, and retailers need industrial REITs to deliver it.

What Trade War? Despite continued uncertainty over trade and its impact on the supply chain, the secular tailwinds driven by domestic e-commerce has overwhelmed trade-related headwinds so far this year.

Last quarter's earnings results indicated that the best may be yet to come. Leasing spreads jumped nearly 11% while the acquisition pipeline has re-opened given REITs' favorable cost of capital.

"Death By Amazon" has been the mantra across retail, but Amazon's push into logistics - and the potential negative impact on industrial REIT pricing power - shouldn't be ignored.

REIT Rankings: Industrial

In our REIT Rankings series, we introduce and update readers to each of the commercial and residential 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 with new developments for existing readers.

industrial REITs

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Industrial REIT Sector Overview

Industrial REITs comprise roughly 10% of the broad-based Real Estate ETFs (VNQ and IYR). Within the Hoya Capital Industrial REIT Index, we track all thirteen industrial REITs, which account for roughly $100 billion in market value: Prologis (PLD), Duke (DRE), Liberty (LPT), Americold (COLD), First Industrial (FR), PS Business Parks (PSB), EastGroup (EGP), Rexford (REXR), Stag (STAG), Terreno (TRNO), Monmouth (MNR), Industrial Logistics (ILPT), and Innovative Industrials (IIPR). Investors looking to invest in the sector through a pure-play ETF can do so through the Pacer Benchmark Industrial REIT ETF (INDS).

industrial REIT investing

Once thought to be a "boring" real estate sector destined for chronic underperformance, industrial real estate has been on fire for the last half-decade. Demand for industrial space has been relentless, primarily driven by the rapid growth of e-commerce and the "need for speed" in goods distribution. Amazon’s push to two-day and same-day delivery has sparked a supply chain “arms race” among retailers and logistics providers of all sizes where it’s all about supply chain densification. Consumers and businesses alike are demanding ever-shortening delivery windows, necessitating the densification of supply chain networks and the establishment of distribution hubs closer to end-consumers.

industrial REIT overview Outside of Amazon (AMZN), we think that industrial REITs are perhaps best positioned to capitalize on the continued growth of e-commerce, enjoying better competitive dynamics than third-party logistics providers like FedEx (FDX), UPS (UPS), and XPO (XPO) that face a higher potential disintermediation risk from Amazon itself. Industrial REITs own roughly 5-10% of total industrial real estate assets in the United States but own a higher relative percentage of higher-value distribution-focused assets with building sizes averaging around 200,000 square feet. Industrial REITs and have enjoyed some of the most favorable supply/demand fundamentals across the real estate sector over the past half-decade.

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 usage perspective. Each dollar spent on e-commerce requires roughly three times more logistics space than the equivalent brick and mortar dollar, according to estimates from Prologis. According to our estimates, e-commerce still accounts for less than 20% of total "at-risk" retail categories but is taking market share from these sectors at a rate of roughly 1% per year. Importantly, it's not just Amazon that is growing their e-commerce business. The traditional brick-and-mortar powerhouses have honed the omnichannel approach with significant success as Walmart (WMT), Target (TGT), and Costco (COST) have been among the biggest investors in e-commerce distribution over the last three years

e-commerce market share The Bull & Bear Case For Industrial REITs

Industrial REITs continue to enjoy perhaps the strongest property-level fundamentals across the real estate sector. Demand has outpaced supply growth in each of the past nine years and has shown few signs of slowing. As we'll discuss in greater detail below, re-leasing spreads actually accelerated last quarter to the strongest rate in more than a decade at more than 10%, indicative of a substantial and mounting shortage of industrial real estate space and substantial pricing power enjoyed by real estate owners. Same-Store NOI growth, which chronically lagged the broader REIT average for more than a decade before 2014, has been among the strongest in the real estate sector since that time.

industrial REITs NOI

While supply growth has been robust over the past half-decade as well, there are mounting signs that lack of available land is becoming a larger hurdle for new development. Strong share price performance across the industrial sector over the past twelve months has also restored a sizable NAV premium for industrial REITs, giving these companies a cost of capital advantage relative to fuel accretive acquisition-fueled external growth. To that point, size and scale have proven to be an important competitive advantage for industrial REITs and we think the importance of this will only increase over time as Amazon becomes a more aggressive and concentrated power in the logistics space. Below we outline the five primary reasons that investors are bullish on the industrial REIT sector.

bullish industrial REITs Not all investors are quite so bullish on the industrial REIT space, however. An excellent recent report from the Chilton REIT Team discussed some reasons to be cautious about the long-term competitive dynamics of the industrial REIT sector. "Death By Amazon" has been the mantra across the retail sector, but Amazon's push into logistics - and the potential negative impact on industrial REIT pricing power - shouldn't be ignored. The Chilton REIT Team highlights the heavy reliance on Amazon-fueled business across the sector and the potential for the e-commerce giant to disintermediate the industrial real estate space just as they are disintermediating the third-party logistics providers, one step up the supply chain: "Amazon third party logistics (3PL) aspirations have hit the share prices of XPO, UPS, and FedEx, but they are also a risk for the large big-box industrial REITs." amazon industrial REITs

(Source: Chilton REIT Team)

With a fleet of more than 20,000 delivery vans, 500 semi-trucks, and 50 airplanes, Amazon clearly has its sights set on becoming a logistics powerhouse on a scale that will almost undoubtedly rival incumbents FedEx and UPS. The company has shifted its retail offerings towards the far higher-margin third-party marketplace model, which now accounts for more than two-thirds of its retail sales according to research firm eMarketer. Naturally assuming more of a logistics-role through the marketplace model, Amazon now accounts for nearly half of total e-commerce retail sales according to eMarketer's estimates. Considering the massive presence of Amazon, there's risk to industrial REITs that they will increasingly dictate the terms of the relationship, interestingly a risk also shared by the data center REIT sector.

top 10 e-commerce

Additionally, warehouse users are increasingly focusing on technologies to improve the efficiency and utilization of existing space. Given the relatively large supply pipeline, the sector remains more exposed than most to an unexpected economic downturn. For a valuation-perspective, a common theme over the past several years, valuations across traditional metrics like FFO/share for industrial REITs remain lofty. Below we outline the five reasons that investors are bearish on the sector.

bearish industrial REITs

Industrial REIT Fundamentals

While long-term competitive dynamics are uncertain across nearly every sector in the age of Amazon, there's little question that industrial REITs are currently enjoying some of the best property-level fundamentals across the REIT sector. Already "priced for perfection," 1Q19 earnings were seemingly even better than "perfect" as more than half the sector beat NOI and leasing estimates. Year-over-year releasing spreads averaged more than 10%, the best rate in more than a decade. Same-store NOI topped 5.4% in the quarter among the sample of eight REITs we track most closely while occupancy climbed higher to 96.7%, within shouting distance of record-highs.

industrial REIT fundamentals

After growing at a 9% rate in 2017, US industrial rents rose another 8% in 2018 according to Prologis, stronger than the 6% global average. Behind this demand growth, Prologis sees a "greater willingness to pay for quality space as e-commerce, the need to be close to consumers, and rising consumer expectations around speed and product availability are pushing a mandate for quality." The company expects continued rent growth in 2019 and mounting barriers to supply growth in the urban infill markets. Full-year guidance was similarly strong with five out of the eight REITs raising full-year same-store NOI estimates after just one quarter. 2Q19 earnings season begins this week with Prologis reporting earnings on Tuesday. Absent a significant trade-war-related slowdown in the second half of this year, the sector is on-pace to potentially match or exceed the 5.0% same-store NOI growth level which would be the fourth straight year of exceeding that mark.

industrial REIT guidance As we pointed out last quarter, full occupancy is a good problem to have, but it does mean that future same-store growth must come exclusively from rental rate growth. Despite supply growth that has averaged nearly 2% per year since 2015, occupancy reached a new record-high at the end of 2017 and remain above 96% throughout 2018 according to NAREIT T-Tracker data. In their 1Q19 report, Prologis Research notes:

“As of Q1 ’19, most logistics real estate markets remain capacity-constrained, meaning that customers are waiting for new supply to come online in order to expand their distribution networks. Prologis Research sees this pent-up demand reflected in a high proportion of built-to-suit projects and strong pre-leasing in the construction pipeline. As a result, demand and supply should remain roughly in line through 2019, keeping the vacancy rate near its historic low of 4.5% and putting further upward pressure on rental rates.

In addition to robust organic growth, industrial REITs continue to benefit from the added tailwind of external growth, primarily fueled by internal development. After trading at a slight NAV discount early in 2018, the recent REIT rally has allowed industrial REITs to regain the coveted NAV premium, which is critical for further accretive external growth. Despite rising construction and land costs, development yields remain favorable. According to NAREIT data, the industrial REIT development pipeline ended 1Q19 above $6.6B, retreating slightly from 10-year highs set in 4Q18. Again, there are indications that a lack of available land, as well as rising construction costs and tight construction labor markets, may be constraining factors on new development. That said, supply growth is still likely to average nearly 2% per year in 2019 and 2020, towards the higher-end of the REIT sector.

industrial REIT development pipeline

These REITs continue to see more value-add opportunities in ground-up development compared to acquisitions and see development yields at roughly 6-8% compared to cap rates between 4-6%. As a result, industrial REITs were net sellers in each of the past three years but became net buyers for the first time in a while in 1Q19. Driven by the widening NAV premium, accretive acquisition opportunities have emerged over the past several months that did not exist at this time last year, highlighted perfectly by Prologis' just-announced $4B acquisition talks regarding non-traded REIT Industrial Properties Trust that hit the wires just as we typed this piece. We think 2019 will see more private-to-public M&A activity given the premium cost of equity capital conditions enjoyed by these REITs.

industrial REIT acqusitions

Among real estate sectors, industrial REITs were perhaps most positively impacted by the economic surprises from the start of 2016 through mid-2018, aided by corporate tax reform and deregulation, combined with the continued secular tailwind from e-commerce-driven supply chain densification. Demand for warehouse space has historically shown a high correlation with several economic indicators reflected in the Prologis IBI Activity Index - PMI, retail sales, job growth, and inventories- all of which inflected higher in 2018 but have slowed over the past two quarters amid a slowdown in global economic growth and trade-related headwinds. Industrial real estate demand has seemingly been unaffected so far by these headwinds, but investors will be closely monitoring earnings commentary from industrial REITs as well as third-party logistics firms for signs of cracks in the near-term demand outlook.

industrial business activity 2019

Recent & Long-Term Share Price Performance

It wasn't always this way for industrial REIT investors, but the last half-decade has been quite kind to patient investors and those who were willing to "pay-up" for the premium valuations awarded to the industrial REIT sector. Since the start of 2016, no major real estate sector has outmatched the performance of industrial REITs, outperforming the broader REIT index by a cumulative 50% during this time. Despite trading at valuation premiums for most of this time, the sector has outperformed the REIT average in three straight years, outdone only by the four-year outperformance streak of the cell tower sector and the remarkable six-year streak delivered by the manufactured housing sector.

industrial REIT performance

After dipping 3% last year, the sector is back to it's winning ways in 2019, with the Hoya Capital Industrial REIT Index jumping more than 34%, second only to the single-family rental sector's 35% YTD gains. Meanwhile, the broader REIT averages have climbed roughly 20%, almost perfectly in-line with the 20% gain on the S&P 500 (SPY). The broader REIT sector has benefited by receding interest rates and a return of "Goldilocks" economic conditions of low inflation and slow-but-solid domestic economic growth.

industrial performance

The under-the-radar story in the industrial REIT sector this year has been the staggeringly strong performance by cannabis-focused Innovative Industrial, which has seen its share price more than double this year. Outside of that "high" flyer, Rexford and Terreno have been the top-performers, each climbing more than 40% YTD while industrial sector stalwart Prologis has delivered a solid 37% YTD gain. Monmouth and Industrial Logistics have been the laggards on the year. Apart from those two laggards, the other eleven REITs are higher by at least 20% YTD.

industrial REIT performance

Industrial REIT Valuations

As they have for most of the past five years, industrial REITs continue to trade at a sizable Free Cash Flow (aka AFFO, FAD, CAD) premiums to the REIT averages according to our estimates. When we factor in two-year growth expectations in our FCF/G metric, however, the sector appears more attractively valued. During this run of outperformance, we note that growth has generally been chronically undervalued, underscored by strong performance in the e-REIT sectors (industrial, data center, and cell towers). During this time, value has generally underperformed, underscored by weak relatively performance from the retail REIT sector.

Industrial REIT Dividend Yields

Based on dividend yield, industrial REITs rank below the REIT average, paying an average forward yield of 2.7%. (Note that our REIT Average is skewed lower by our coverage universe which generally excludes externally-managed and small-cap REITs under $1B in market capitalization.) Industrial REITs pay out roughly 80% of their available cash flow, leaving a decent cushion for development-fueled growth and future dividend increases.

industrial REIT dividend yields Within the sector, we note the varying strategies of the thirteen industrial REITs. STAG, Monmouth, and Industrial Logistics, which are generally popular with yield-focused investors, pay the highest yield but does so through allocating a higher share of free cash flow towards dividend payments and taking on higher debt levels than the other lower-yielding names in the sector.

industrial REIT dividends

How Macroeconomics Impact Industrial REITs

Compared to other REIT sectors, industrial REITs are not particularly sensitive to interest rates and generally respond more closely to movements in the equity markets. Industrial leases have an average term of around 4 years (roughly average among REIT sectors) and the majority of leases are structured on a net lease basis, meaning tenants assume most or all property-level operating expenses. Property taxes are the most significant operating expense accounting for 50% or more of total expenses. Leases range from as short as two years to as long as fifteen years. In general, longer lease terms and the use of net lease terms are typically associated with higher levels of interest rate sensitivity.

We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. In general, the sector falls into the Hybrid category with a blend of growth-like and yield-like features. As noted above, investors should understand the different distribution strategies employed by each of these firms with some firms focusing on long-term growth while others prioritize near-term dividend distributions.

Bottom Line: Prime-Time for Industrial REITs

Amazon’s push to two-day and same-day delivery has sparked a supply chain “arms race” among retailers and logistics providers of all sizes where it’s all about supply chain densification. Riding the e-commerce wave, industrial REIT performance has been relentless over the past half-decade. Consumers increasingly demand speedy delivery, and retailers need industrial REITs to deliver it.

What Trade War? Despite continued uncertainty over trade and its impact on the supply chain, the secular tailwinds, driven by domestic e-commerce, has overwhelmed trade-related headwinds so far this year. Last quarter's earnings results indicated that the best may be yet to come. Leasing spreads jumped nearly 12% while the acquisition pipeline has re-opened given REIT's favorable cost of capital. "Death By Amazon" has been the mantra for the retail industry, but Amazon's push into logistics - and the potential negative impact on pricing power - shouldn't be ignored.

We remain overweight the industrial REIT sector, noting that while long-term competitive dynamics may shift unfavorably over time and that there are near-term pressures from slowing global growth, the massive long-term secular tailwinds of supply chain densification may still be in the relatively early innings. Also affected by Amazon but unlike the data center sector where barriers to entry are uncertain and the supply picture could be dramatically altered by technology, the availability of land near major population centers and transportation hubs has more defined limits. Sharing similar supply/demand dynamics as the US housing sector, we see robust demand continuing well into the 2020s while total supply remains constrained, leading to continued upward pressure on rents.

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Disclosure: I am/we are long PLD, VNQ, AMZN, TGT, W, COST, WMT. 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: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.

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