One of the top-performing property sectors in 2020, Industrial REITs have been relatively immune from coronavirus-induced pain that has encumbered much of the commercial real estate sector. In the Hoya Capital Industrial REIT Index, we track the 14 largest industrial REITs, which account for roughly $100 billion in market value. Riding the e-commerce wave, Industrial REITs have delivered seemingly relentless outperformance over the past half-decade, powered by the "need for speed" in consumer goods distribution, and comprise between 10% and 15% of the broad-based Core Equity REIT ETFs.
Fueled by the "Stay-at-Home" economy, the coronavirus pandemic has significantly accelerated the adoption and penetration rate of e-commerce, which has positive long-term implications for industrial real estate demand. Nearly half of retail sales were completed through e-commerce channels since the beginning of the pandemic and the critical importance of having sophisticated and seamless e-commerce operations has become even more self-evident to retailers and consumers alike. The e-commerce penetration has jumped to nearly 25% in May 2020 from less than 15% at year-end 2019.
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 (PLD), and retailers have invested heavily in supply chain densification. It's not just Amazon (AMZN) that is making heavy investments in its 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, the fruits of which were clearly on display during the pandemic-related shutdowns.
Prologis segments industrial real estate assets into four major segments: Gateway Distribution, Multi-Market Distribution, City Distribution, and Last-Touch Centers. 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.
As we'll discuss throughout this report, while the pandemic poses a continued threat to the economically-sensitive industrial real estate sector, signs of a sharp consumer-led rebound in economic activity in recent months combined with WWII-levels of fiscal stimulus have quelled our near-term concerns about a potential damaging slowdown in consumer spending and we remain bullish on the underlying fundamentals of industrial REITs. Below, we present our framework for analyzing each property sector based on their direct exposure to the anticipated COVID-19 effects as well as their general sensitivity to a potential recession. We note that industrial REITs fall into the "Low" category in the direct COVID-19 sensitivity but do tend to be one of the more economically-sensitive sectors, falling into the "Medium/High" category.
To that point, industrial REITs haven't yet skipped a beat since the outset of the pandemic and rent collection was largely a non-issue for the sector. Industrial REITs collected roughly 96% of rents in April and 95% of rents in May, led by near-perfect collection rates from the logistics-focused firms including Prologis, Duke (DRE), and Rexford (REXR). By comparison, rent collection averaged less than 30% for the mall REIT sector and less than 75% for the shopping center and net lease sector as "non-essential" tenants generally skipped rental payments during the economic shutdowns. By comparison, "essential" property sectors including housing, industrial, and technology REITs, along with self-storage and office REITs, all reported collection of more than 90% of rents in both April and May.
Outside of small-cap Plymouth (PLYM), industrial REITs have so-far been untouched by the wave of dividend cuts and suspensions that have hit the sector over the past three months. Other economically-sensitive property sectors - namely the retail and lodging sectors - have seen widespread dividend cuts and we've now tracked 57 equity REITs out of our universe of 165 equity REITs that have now announced a cut or suspension of their common dividends. As we'll discuss in more detail below, with near-perfect rent collection and resilient property-level fundamentals, we believe that industrial REITs are one of the most immune sectors from dividend cuts, along with residential and technology REITs.
Once viewed as a chronically underperforming sector with limited barriers to entry and unclear competitive advantages, industrial REITs have been on fire for the last half-decade, outperforming the broader REIT index for the fourth consecutive year in 2019 and are on pace to outperform yet again in 2020. Rallying back from declines as steep as 30% at the lows in late March, industrial REITs are now lower by just 1.9% in 2020 trailing only the technology REIT sectors while the broad-based Real Estate ETF (VNQ) has declined by 20.8% and the S&P 500 ETF (SPY) has pulled back 5.5%.
Industrial REITs didn't skip a beat from the trade war, but we raised concerns last quarter that a coronavirus-induced recession poses a different kind of threat due to the consumer-heavy nature of logistics tenants. These REITs have become increasingly more levered to U.S. consumer spending than international trade. Once reliant on growth in the manufacturing and industrial sectors of the economy, nearly 80% of industrial space usage now comes from consumer-oriented tenants. While the economic impact of the pandemic remains uncertain, it is clear that the U.S. consumer - which has been a consistent ray of light over the past half-decade - is being asked to shoulder even more of the burden to keep the wheels of the global economy turning.
Stronger-than-expected economic data over the last two months - including a record rebound in retail sales in May - has driven the rebound in industrial REIT shares since late March and investors continue to be caught off-guard by the pace of the rebound, reflected in record-high readings on the Citi Economic Surprise Index. Demand for warehouse space has historically shown a high correlation with several consumer-sensitive economic indicators reflected in the Prologis IBI Activity Index - PMI, retail sales, job growth, and inventories - which will be key indicators to watch as a predictor of leasing demand for industrial space. In its most recent report, Prologis noted that its Activity Index jumped 16 pts off its April bottom, recovering to 45 the May 21-26 survey, up from a record low of 29 in April.
Consistent with the trends across most of the REIT sector since the start of the pandemic, there has been a "flight-to-quality" within the industrial REIT sector this year and balance sheet quality has been awarded a premium by investors. The higher-valued and better-capitalized logistics-focused REITs including Prologis, Duke, Terreno (TRNO) have delivered some of the strongest relative performance. While REITs utilizing higher amounts of leverage - including Plymouth - have been among the laggards. The "highest flyer" of 2019 has remained so in 2020 as the cannabis-focused Innovative Industrial Properties (IIPR), which we discussed in our recent report: A High-Flying Cannabis REIT has gained more than 20% in 2020 after surging 70% last year.
The good news is that industrial REITs enter 2020 with stellar fundamentals. 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. 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, which have roughly doubled since 2015 and rose another 8% in 2019.
The strong momentum continued into 1Q20 earnings season as the majority of the 14 industrial REITs delivered Q1 NOI and FFO results above consensus estimates. Same-store NOI growth topped 5% in Q1 while occupancy rates remained near record-highs at 96.4%. Leasing spreads topped 20%, indicative of a substantial and mounting shortage of industrial real estate space and substantial pricing power. Citing "supply-constrained population centers," Prologis Research noted that market rental growth was approximately 1.2% in the first quarter while noting that "400 million square feet or more of total additional U.S. logistics real estate demand will be created in the next two to three years as companies adjust to higher e-commerce volumes and higher inventory levels."
While the vast majority of REITs in other property sectors suspended their full-year guidance citing pandemic-related uncertainty, all of the industrial REITs continued to provide guidance in Q1, certainly a reassuring signal to investors. That said, all of the REITs that provide guidance did lower full-year NOI forecasts as the sector is now expected to record 2.3% NOI growth in 2020 compared to the 3.8% prior guidance. Same-Store NOI growth for industrial REITs, 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. Since the start of 2015, industrial REITs are tied with residential REITs for the strongest average annual same-store NOI growth.
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 in 2019 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 emerged over the past several quarters that did not exist from 2016 through 2018, highlighted perfectly by Prologis' two major acquisitions last year; the $4B acquisition for non-traded REIT Industrial Properties Trust and Prologis' roughly $13B acquisition of Liberty Property Trust.
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% and 6%. While industrial supply growth is averaging roughly 2-3% per year, this is still shy 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. Trends over the past three years lead us to believe to there are mounting barriers to entry and supply constraints, but industrial REITs have built up a sizable land bank over the last decade and are now responsible for a significant percentage of total industrial real estate development.
The combination of strong organic (same-store) growth and robust external growth resulted in FFO growth of 7.7% last year, second only to the manufactured housing REIT sector. 2020 was posted to be even better prior to the pandemic, but industrial REITs are nevertheless likely to deliver FFO growth near the top of the REIT sector this year. Despite downward FFO guidance revisions across the sector, industrial REITs still expect FFO to grow 6.5% this year while the REIT sector as a whole is likely to see the sharpest decline in FFO growth since 2009.
Strong fundamentals come at a price, however, and industrial REITs haven't screened as "cheap" for the better part of a decade. 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, however, the sector appears more attractively valued. Industrial REITs currently trade at a roughly 10-20% premium to consensus Net Asset Value, which should keep the acquisition channel open, helping to fuel external growth in 2020.
Industrial REITs pay an average dividend yield of 2.8%, which is below the REIT average of roughly 3.6%. Industrial REITs pay out roughly 60% of their available free cash flow, leaving an ample cushion for development-fueled growth and future dividend increases. In our recent report, "The REIT Paradox: Cheap REITs Stay Cheap", we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts.
Within the sector, we note the varying strategies of the 14 industrial REITs. While six of the fourteen 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 (ILPT), STAG (STAG), and Monmouth (MNR), all of which pay yields above 4.5%. The higher-growth names including Prologis, Americold (COLD), Terreno, and Rexford pay dividend yields of 2.5% or below but have recognized some of the highest dividend growth rates across the REIT sector.
As tracked in our all-new REIT Preferred Stock & Bond Tracker available to iREIT on Alpha subscribers, six of the fourteen REITs offer preferred securities including three issues from Rexford (REXR.PA, REXR.PB, REXR.PC), one issue from Stag (STAG.PC), a suite of four issues from PS Business Parks (PSB.PW, PSB.PX, PSB.PY, PSB.PZ), one convertible issue from Lexington (LXP.PC), one from Monmouth (MNR.PC), and one from Plymouth (PLYM.PA). These preferreds have delivered steady performance in 2020 and pay an average yield of 5.5% while trading at a mild premium to par value. While these 11 issues are lower by an average of 2.6% this year, they have outperformed their respective common shares by an average of 3.3% in 2020.
One of the top-performing property sectors in 2020, Industrial REITs have been relatively immune from coronavirus pain that has encumbered much of the commercial real estate sector. Performance has been driven by the "need for speed" in consumer goods delivery as retailers continue to invest heavily in supply chain densification, driving relentless demand for industrial space. 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.
Fueled by the "Stay-at-Home" economy, the coronavirus pandemic has significantly accelerated the adoption and penetration rate of e-commerce. While the pandemic poses a continued threat to the economically-sensitive industrial real estate sector, signs of a sharp consumer-led rebound in economic activity in recent months combined with WWII-levels of fiscal stimulus have quelled our near-term concerns about a potential damaging slowdown in consumer spending.
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