In our REIT Rankings series, we introduce and update readers each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.
Within the Hoya Capital Industrial REIT Index, we track the thirteen largest industrial REITs, which account for roughly $105 billion in market value: Prologis (PLD), Duke Realty (DRE), Liberty Property (LPT), Americold (COLD), First Industrial (FR), PS Business Parks (PSB), EastGroup (EGP), Rexford ( REXR), STAG Industrial (STAG), Terreno (TRNO), Monmouth (MNR), Industrial Logistics (ILPT), and Innovative Industrials (IIPR). Industrial REITs comprise roughly 10% of the broad-based Real Estate ETFs (VNQ and IYR).
Investors looking to invest in the sector through a pure-play ETF can do so through the Pacer Benchmark Industrial REIT ETF (INDS). 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 real estate assets have become far more consumer-oriented over the past decade. Once reliant on growth in the manufacturing and industrial sectors of the economy, the logistics-oriented nature of the highest-value industrial assets has made the sector less exposed to international trade and the risks associated with the ongoing trade war between the US and China. While there are risks related to companies holding back logistics investment due to tariff-related supply chain uncertainty, the sector has only minimal direct exposure to negative impacts from the slowdown in manufacturing and industrial production. Illustrating that point, scanning the earnings calls of each of the thirteen REITs this past quarter, the word "trade war/conflict" were mentioned fewer times than "Amazon." 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.
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), Home Depot (HD), Target (TGT), and Costco (COST) have been among the biggest investors in e-commerce distribution over the last three years.
Ironically, the more worrying trends for industrial REITs are related to a Retail Apocalypse 2.0, as store closings have unexpectedly surged in 2019 as the combination of higher minimum wages, tariff-related cost pressures, and heavy discounting have pressured margins at softline and specialty retailers. Many of these troubled retail categories including clothing and general retail (which includes department stores) rank among the most significant industry exposures for the sector according to Prologis. A concern we raised last quarter, while the sector has benefited more than any from e-commerce, an intensification of retailer bankruptcies would concentrate more power in their largest tenant: Amazon, a similar issue faced by another high-flying REIT sector, data centers. 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.
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 continue to enjoy perhaps the strongest property-level fundamentals across the real estate sector. Demand has outpaced (or roughly matched) supply growth in each of the past nine years and has shown few signs of slowing. Prologis Research forecasts 250 million square feet of net absorption and 260 million square feet of new supply in 2019, which may break the nine-year streak of positive demand imbalances, but would also keep vacancy rates at or near record-lows.
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, same-store occupancy reached a new record-high at the end of 2017 and has remained above 96% through the first half of 2019 according to NAREIT T-Tracker data. Industrial REIT occupancy ranks the best among the four major property sectors tracked by NAREIT.
Re-leasing spreads actually accelerated last quarter to the strongest rate in more than a decade at just shy of than 10%, indicative of a substantial and mounting shortage of industrial real estate space and substantial pricing power enjoyed by real estate owners. Already "priced for perfection," 2Q19 earnings were yet again even better than "perfect" as more than half the sector beat NOI and leasing estimates. Same-store NOI topped 4.6% in the quarter among the sample of eight REITs we track most closely while occupancy moderated slightly to 96.7%, still within shouting distance of record-highs.
Industrial REITs weren't always the cool kids on the block and in fact, were almost a sure bet to underperform before the huge tailwinds from e-commerce and the "need for speed" began to emerge early in this decade. 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. On a trailing twelve-month basis, industrial REIT same-store NOI growth moderated slightly to 4.4% from 4.7% in the prior quarter. Only the manufactured housing and single-family rental sectors have seen comparably strong same-store NOI growth over the past three years.
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. Prologis notes, "The primary driver behind these mission-critical buildouts is the need to meet higher service level expectations with a decentralized distribution network." 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 four out of the eight REITs raising full-year same-store NOI estimates after five REITs boosted guidance in Q1. We think same-store NOI guidance remains conservative and 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.
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 at $6.6B, roughly even with last quarter and slightly below all-time highs set in 4Q18.
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. 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. Prologis notes, "The U.S. logistics real estate market is poised for a broader array of outcomes that correspond to barriers to new supply. The length of the expansion—10 years and counting—has been a boon to developers, who have used that time to bring new supply online in markets with lower barriers to entry."
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 and increased their pace of net acqusitions in 2Q19 to the highest level in four years at $1.2B. 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' recently- announced $4B acquisition deal for non-traded REIT Industrial Properties Trust. We think 2019 will see more private-to-public M&A activity given the premium cost of equity capital conditions enjoyed by these REITs.
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 (IBI)- 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. Prologis notes that the IBI in the second quarter "came in at about 60—a healthy and sustainable level after 2018’s exceptionally strong (yet ultimately unsustainable) activity." We "recreated" the IBI with up-to-date data and note that the slowdown has continued in the two months since Prologis' July update.
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. Seeing how the sector has become far more consumer-oriented than a decade ago, we suspect that the IBI may be overly bearish on the extent of the forecasted slowdown in industrial business activity.
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.
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."
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. 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.
Industrial REITs are a case-study in why an investor’s time should be allocated to understanding supply and demand dynamics and long-term macroeconomic trends ahead of static valuation metrics. Despite trading at "expensive" valuations for most of the past half-decade, 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.
After declining by 3% last year, the sector is back to it's winning ways in 2019, with the Hoya Capital Industrial REIT Index jumping more than 38%, significantly outpacing the still-impressive gains on the broader REIT indexes. The broad-based REIT ETFs are now higher by more than 25% in 2019 as the ideal "Goldilocks" macroeconomic conditions of low inflation and moderate, consumer-led growth continue to provide a favorable backdrop for outperformance from the domestic-focused commercial and residential real estate sectors.
Cannabis-focused Innovative Industrial continues to be the under-the-radar story in the industrial REIT sector this year. Bringing some added excitement (and volatility) to the REIT sector, IIRP has seen its share price nearly double this year but has pulled back by nearly 20% over the past month. Outside of that "high" flyer, Rexford, Terreno, industrial sector stalwart Prologis have been the top-performers, each climbing more than 44% YTD. Yield-seeking favorites Monmouth, Industrial Logistics, and STAG have again been the laggards on the year. Apart from those three laggards, the other eleven REITs are higher by at least 20% YTD.
Investors have systematically under-owned this sector, waiting for the pull-back that never came. 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 REITs pay an average dividend yield of 2.6%, which is below the REIT average of roughly 3.6%. (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 70% of their available cash flow, leaving a decent cushion for development-fueled growth and future dividend increases.
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.
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.
Powered by the “need for speed”, fundamentals remain stellar. Market rents are poised to grow by roughly 6% in 2019 after rising 8% in 2018 and 9% in 2017. Industrial REITs have seen minimal impact from the elevating tensions between the US and China. Ironically the more worrying trends are related to a Retail Apocalypse 2.0. Investors shouldn't forget that while Amazon is a massive player, the majority of this e-commerce spending (and logistics demand) comes from brick-and-mortar based retailers who will need to remain healthy for industrial demand to continue at this pace. A concern we raised last quarter, while the sector has benefited more than any from e-commerce, an intensification of retailer bankruptcies would concentrate more power in their largest tenant: Amazon.
That said, 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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