In our REIT Rankings series, we analyze REITs within each of the commercial and residential sectors, focusing on property-level fundamentals and the macroeconomic forces driving overall supply and demand conditions. We then analyze REITs based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.
(Co-Produced with Brad Thomas through iREIT on Alpha)
One of the four "major" commercial property sectors, industrial REITs comprise roughly 10% of the broad-based Real Estate ETFs (XLRE and VNQ). Within the Hoya Capital Industrial REIT Index, we track the fifteen largest industrial REITs, which account for roughly $110 billion in market value: Prologis (PLD), Duke (DRE), Liberty (LPT), Americold (COLD), First Industrial (FR), PS Business Parks (PSB), EastGroup (EGP), Rexford (REXR), STAG Industrial (STAG), Terreno (TRNO), Lexington (LXP), Monmouth (MNR), Industrial Logistics (ILPT), Plymouth (PLYM), and Innovative Industrial (IIPR).
Riding the e-commerce wave, industrial REIT performance has been relentless over the past half-decade as retailers and logistics providers have invested heavily in supply chain densification and physical distribution networks in a relentless "need for speed" arms race. Importantly, it's not just Amazon (AMZN) that is making heavy investments their e-commerce business. The traditional brick-and-mortar powerhouses have honed the omni-channel 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 several years. While we have raised concerns about the looming long-term competitive threat from Amazon's growing influence on the industrial real estate market, for now, the tenant roster of industrial REITs is quite diversified and includes many of the largest retailers as well as the major logistics providers including FedEx (FDX), UPS (UPS), and XPO (XPO).
Prologis segments industrial real estate assets into four major segments: Gateway Distribution, Multi-Market Distribution, City Distribution, and Last-Touch Centers. Along that continuum towards the end-consumer, the relative value of these properties (on a per square foot basis) increases, as do the underlying barriers to entry. Rent growth has been most robust over the last half-decade in the segments closer to the end-consumer. Prologis Research notes, "Looking forward, the future direction of supply chains should produce logistics real estate outperformance in Last Touch and City distribution properties, as well as highly-functional Gateway and Multi-market properties in areas with high barriers to new supply."
The end users of industrial real estate properties have become far more consumer-oriented over the past decade with nearly 80% of industrial space usage coming from consumer-oriented tenants. 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, but more closely linked with consumer spending and retail sales. Outside of Amazon, 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 that face a higher potential disintermediation risk from Amazon itself.
Perhaps only overshadowed by the residential REIT sector, industrial REITs continue to enjoy some of the strongest property-level fundamentals across the real estate sector, highlighted by average same-store NOI growth near 5% per year since 2015, a theme that we'll analyze in greater detail below. Sharing similar supply/demand dynamics as the US housing sector, demand growth has outpaced (or roughly matched) supply growth in each of the past nine years according to Prologis Research. While development has indeed increased significantly over the past five years, it hasn't been nearly enough to relieve upward pressure on rents. Tangible barriers to entry through physical and regulatory supply constraints have held back supply growth even as market rent growth continues to average mid-to-high single digits across major US markets.
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 have come from e-commerce. Importantly, e-commerce is far less efficient than traditional brick and mortar from an industrial space usage perspective as brick and mortar shelf space is effectively "replaced" by back-end logistics space. 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.
Investors shouldn't forget, however, 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 frenzied pace and a healthy consumer is certainly a critical driver of not only e-commerce sales but also business investment into e-commerce supply chains. For now, capital investments into e-commerce logistics remains a high-priority for the majority of these major retailers and we believe that the significant long-term secular tailwinds of supply chain densification may still be in the relatively early innings.
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, which have seen significant rent growth and more favorable supply/demand conditions due to tangible constraints on land availability. Industrial REITs are quintessential "Growth REITs" with the majority of their total returns coming through FFO growth rather than dividends. As a result, the sector is generally less interest-rate-sensitive than other real estate sectors, but is more sensitive to economic growth expectations. Investors looking to invest in the sector through a pure-play ETF can do so through the Pacer Benchmark Industrial Real Estate SCTR ETF (INDS).
Once viewed as a chronically underperforming sector with limited barriers to entry and unclear competitive advantages gained under the REIT structure, industrial REITs have been on fire for the last half-decade, on pace to outperform the broader REIT index for the fourth consecutive year. 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 60% during this time.
Despite the trade-war-related slowdown in the industrial and manufacturing sectors, the Hoya Capital Industrial REIT Index has surged more than 46% this year as the US consumer has shown notable resilience and as retailers show few signs of relenting on the logistics arms race. The broad-based Real Estate ETF (VNQ), meanwhile, has gained roughly 23% this year, powered by a continuation of the "Goldilocks" macroeconomic conditions of lower interest rates and steady economic growth that has lifted share prices to record-highs across the broader real estate sector.
Consistent with the trends seen over the last three years, the higher-valued and lower-yielding logistics-focused REITs including Terreno, Rexford and Prologis and continue to outperform with gains of more than 50% each. Consistent with our calls last quarter that we'd see continued M&A in the industrial sector, the big news out of the last quarter was Prologis' announced plans to acquire Liberty Property, the third largest industrial REIT for $12.6B in the second-largest industrial REIT M&A deal of all-time after the $16B merger between Prologis and AMB. Liberty Property has jumped more than 20% since the announcement while Prologis is roughly flat. Also notable is cannabis-focused Innovative Industrial, which has surged more than 70% this year.
Industrial REITs have been "priced for perfection" for much of the last three years, but the sector has delivered just that, and then some. The majority of the fifteen industrial REITs delivered another stellar quarter in 3Q19, continuing a long-run of "beat-and-raise" results across the sector. While same-store NOI growth and occupancy retreated a bit from last quarter in our coverage of the eight largest REITs in the sector, re-leasing spreads actually accelerated to the strongest rate in more than a decade at just shy of than 17%, indicative of a substantial and mounting shortage of industrial real estate space and substantial pricing power enjoyed by real estate owners.
The strong leasing spreads in 3Q19 represented a nearly 700 basis point jump from 3Q18. The ease at which these REITs have been able to push rent growth over the last several years has been most impressive, as occupancy levels remain near record-highs despite many tenants seeing double-digit percentage point increases in annual rents. Same-store occupancy reached a new record-high at the end of 2017 and has remained above 96% through the first three quarters of 2019 according to NAREIT T-Tracker data. Industrial REIT occupancy ranks the best among the four major property sectors tracked by NAREIT.
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 3.6% from 4.4% in the prior quarter. Since the start of 2015, industrial REITs are tied with residential REITs for the strongest average annual same-store NOI growth at 4.8% per year.
More encouraging than the 3Q19 results themselves were the outlook for full-year 2019 and the commentary around 2020 and beyond. Four of the seven REITs that report guidance in our coverage boosted same-store NOI growth and these seven REITs now see same-store NOI growth averaging 4.6% this year and occupancy averaging 97%. Four of the five REITs boosted full-year net acquisition guidance while three of the four REITs that report development starts guidance boosted full-year guidance.
Also notable after the quarter was Prologis' REITworld presentation in which the firm forecasted 10.5-11.5% annual "total returns" through 2022 composed of 8-9% FFO growth and 2.5% dividend growth. Prologis expects the FFO growth to come from a combination of roughly 4% organic same-store growth and 4-5% coming from a mix of external growth and efficiency improvements. The midpoint of Prologis' 2020 guidance - projections which have proved to be conservative over the last half-decade - calls for same-store NOI growth at 4.75% and another $2 billion in development starts, each roughly in-line with the full-year 2019 results.
(Source: Prologis 2019 REITworld Presentation)
In addition to robust organic growth, industrial REITs continue to benefit from the added tailwind of external growth. After years of relying on ground-up development to fuel external growth, elevated equity valuations have allowed industrial REITs to go on a buying spree and get back to doing what REITs do best: using their equity as "currency" to fund accretive acquisitions. Doing just that, 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' two major acquisitions this year, the announced $4B acquisition deal for non-traded REIT Industrial Properties Trust and Prologis' acquisition of Liberty Property Trust discussed above. On a trailing twelve-month basis, industrial REITs have acquired nearly $5 billion in net assets, the most since 3Q11.
While the acquisition channel has only recently opened back up, these REITs continue to see significant value-add opportunities in ground-up development as well with development yields averaging 6-8% compared to cap rates between 4-6%. Historically, there has been a tight (lagged) correlation between same-store NOI growth and the size of the REIT development pipeline. According to NAREIT data, the industrial REIT development pipeline ended 3Q19 at $6.25B, down slightly from the recent peak in 3Q18, consistent with the slight moderation in same-store NOI growth from its peak near 6% in late 2016 to roughly 4% in 2019.
Even with many of these industrial REITs trading at-or-near record-highs, investors still have plenty of reasons to be bullish on the industrial real estate sector. Trends over the past three years lead us to believe to there are indeed mounting barriers to entry and clear supply constraints, as we are still not seeing the type of significant supply response that would be expected given the robust high-single-digit annual rent growth. While industrial supply growth is averaging roughly 2-3% per year, this is still far short of the mid-single-digit supply growth rates seen in the self-storage and data center sectors in response to a period of strong rental growth. Similar to our outlook on the residential real estate sector, we see the trends of limited supply and robust demand continuing well into the next decade.
In addition to our outlook that organic growth metrics should remain strong given the clear signs of impediments to supply growth, 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 and other e-commerce giants become more aggressive and concentrated powers in the logistics space. Below we outline the five primary reasons that investors are bullish on the industrial REIT sector.
There are reasons for caution, as well. 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. As noted above, industrial REITs remain sensitive to economic activity and exposed to any potential slowdown in consumer spending. Given the relatively large supply pipeline, the sector remains more exposed than most to an unexpected economic downturn.
As we discussed in our last report, considering the massive presence of Amazon, there's also risk to industrial REITs that large tenants like Amazon could increasingly dictate the terms of the relationship, which could weaken pricing power. Additionally, warehouse users are increasingly focusing on technologies to improve the efficiency and utilization of existing space, which could incrementally reduce the need for physical logistics space. 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.
As they have for most of the past five years, industrial REITs continue to trade at sizable free cash flow (aka AFFO, FAD, CAD) premiums to the REIT averages according to our estimates. When we factor in medium-term 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 65% 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 fifteen industrial REITs. While ten of the fifteen REITs in the sector pay dividend yields below 3%, there are a handful of industrial REITs that are suitable for yield-oriented investors including Plymouth, Industrial Logistics, STAG, and Monmouth, all of which pay yields above 4.6%. While these names pay the highest yields, it should be noted that they do so by allocating a higher share of free cash flow towards dividend payments and generally have exhibited more limited growth potential than the lower-yielding names.
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. Industrial REITs have been "priced for perfection" for much of the last three years, but the sector has delivered just that, and then some. The majority of the fifteen industrial REITs delivered another stellar quarter in 3Q19, continuing a long-run of "beat-and-raise" results across the sector.
Similar to our favorable fundamental outlook on the residential real estate sectors, we see the trends of limited supply and robust demand continuing well into the next decade for the industrial real estate sector. Trends over the past several years confirm that there are indeed mounting barriers-to-entry and clear supply constraints developing through limited available land and regulatory hurdles for the most in-demand logistics-focused properties.
While we noted that long-term competitive dynamics may shift over time to become less favorable and that there are near-term pressures from slowing global growth, we believe that industrial REITs will retain significant pricing power and recognize growth rates near the top of the REIT sector average for at least the next half-decade.
While UPS may have retired their famous "We Love Logistics" slogan, we think that the tagline should be appropriately awarded to industrial REITs, which we think are perhaps best-positioned to capitalize on the continued rapid growth of e-commerce and the intense arms-race of supply chain densification.
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