The "hub of e-commerce" and the hottest property sector of the last half-decade, Industrial REITs have been unfazed by the coronavirus-induced pain that has encumbered much of the REIT sector.
The dramatic acceleration in e-commerce adoption has pulled forward the "retail apocalypse" trends as retailers divert more of their capital away from malls and into distribution supply chains.
While much of the REIT sector was slashing dividends this year, nearly half of industrial REITs have raised dividends in 2020. Rent collection has averaged more than 97% since April.
Underscoring the sector's favorable supply/demand conditions, Amazon's rumored interest in converting malls into last-mile distribution hubs has turned some heads, but the impact on industrial REITs will be immaterial.
Recent earnings reports confirmed that fundamentals are back in-line with pre-pandemic expectations with positive growth expected in 2020. With the pandemic exposing deficiencies in supply chains, we believe the logistics-boom is back in the early-innings.
REIT Rankings: Industrial
(Hoya Capital Real Estate, Co-Produced with Brad Thomas)
Industrial REIT Sector Overview
The "hub of e-commerce" and the hottest property sector of the last half-decade, Industrial REITs have been unfazed by the coronavirus-induced pain that has encumbered much of the REIT sector. In the Hoya Capital Industrial REIT Index, we track the 14 industrial REITs, which account for roughly $100 billion in market value. Riding the e-commerce wave - a wave that has been given an added accelerant by the significant pandemic-related disruptions, Industrial REITs have delivered 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.
With the pandemic exposing significant deficiencies in supply chains, we believe the logistics-boom is back in the early-innings and foresee favorable fundamental conditions for industrial REITs through at least mid-2025. The dramatic acceleration in e-commerce adoption has pulled forward the "retail apocalypse" trends as retailers divert more of their capital away from malls and into distribution supply chains. 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% by August 2020, up from 15% at year-end 2019.
Industrial REITs haven't yet skipped a beat since the outset of the pandemic and rent collection has remained a non-issue for the sector. Industrial REITs have maintained collection rates above 97% since the start of the pandemic, led by near-perfect collection rates from the logistics-focused firms including Prologis (PLD), Duke Realty (DRE), and Rexford (REXR). By comparison, rent collection averaged less than 50% for the mall REIT sector in the second quarter and less than 75% for the shopping center REITs. Underscoring the sector's favorable supply/demand conditions, Amazon's (AMZN) rumored interest in converting malls into last-mile distribution hubs has turned some heads, but the impact on industrial REITs will be immaterial.
While much of the REIT sector was slashing dividends this year, nearly half of industrial REITs have raised dividends in 2020 including EastGroup (EGP), Terreno (TRNO), Innovative Industrial (IIPR), First Industrial (FR), STAG Industrial (STAG), and Prologis. One industrial REIT, however, has cut distributions amid the pandemic - small-cap Plymouth (PLYM), which was one of 64 equity REITs to suspend or reduce their dividend since the start of the pandemic. We've tracked 28 equity REITs that have raised dividends in 2020 to levels above their pre-pandemic rates - primarily in the "essential" property sectors - technology, housing, and industrials.
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. As we'll explain in more detail below, recent earnings reports confirmed that fundamentals are back in-line with pre-pandemic expectations with another year of growth expected in 2020, one of the few REIT sectors that will record positive FFO and NOI growth. 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.
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. With near-perfect rent collection and resilient property-level fundamentals, industrial REITs have rallied back from declines as steep as 30% at the lows in late March and are now higher by 4.7% in 2020. One of just four property sectors in positive territory this year, industrial REITs trail only the red-hot technology REIT sectors. By comparison, the broad-based Real Estate ETF (VNQ) has declined by 19.6% and the S&P 500 ETF (SPY) is higher by 0.7%.
Deeper Dive Into The Industrial Sector
Industrial REITs didn't skip a beat from last year's trade war, but we raised concerns earlier this year that a coronavirus-induced recession poses a different kind of threat due to the consumer-heavy nature of logistics tenants as these REITs have become increasingly more levered to U.S. consumer spending. Once reliant on growth in the manufacturing and industrial sectors, nearly 80% of industrial space usage now comes from consumer-oriented tenants. While the longer-term economic impact of the pandemic remains uncertain, it is now clear that the U.S. consumer - which has been a consistent ray of light over the past half-decade - has stepped up to the plate yet again over the last five months to keep the wheels of the global economy turning.
On that point, led by booming e-commerce sales, the retail industry has shown encouraging signs of a "V-shaped" recovery, having now regained all of the lost ground during the pandemic. Aided by the WWII levels of fiscal stimulus over the last several months, retail sales jumped to all-time record highs on an annualized basis in August, climbing 0.6% from last month and 2.6% from the same month last year. Naturally, e-commerce sales have led the charge this year with online sales now higher by nearly 25% from last year while brick-and-mortar sales are now flat from last year. However, the path forward for retail sales in the months ahead has become less certain given the continued stalemate in extending fiscal stimulus measures.
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 3x more logistics space than the equivalent brick and mortar dollar, according to estimates from Prologis, and retailers have invested heavily in supply chain densification. It's not just Amazon 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), Lowe's (LOW), 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.
Stronger-than-expected economic data over the last five months - including the record rebound in retail sales in August - has driven the recovery 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's bottom, recovering to 58 on the July 2020 survey, up 30 points from the record low of 28 in April.
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 - typically occupied by distributors like UPS (UPS) and FedEx (FDX) - and that trend is likely to be accelerated by the pandemic. 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."
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.
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. 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), which holds the aforementioned 14 REITs as well as self-storage REIT Life Storage (LSI) and small-cap diversified REIT One Liberty Properties (OLP).
Fundamentals Back To Pre-Pandemic Levels
As mentioned previously, recent earnings reports confirmed that industrial REIT fundamentals are essentially back in-line with pre-pandemic expectations after a short-lived downward revision to guidance last quarter. Four of the seven industrial REITs that provide guidance boosted same-store Net Operating Income ("NOI") guidance in Q2, bringing the sector average back to pre-pandemic levels at around 2.5%. 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.
As discussed in REITs: This Time Was Different, it's been a story of "haves and have-nots" in the REIT sector over the past half-decade and that bifurcation will surely intensify further in 2020. Among the "haves" are the "essential" property sectors - housing, industrial, and technology - which continue to report mostly positive same-store NOI growth. Among the "have-nots" are the troubled retail and hotel REIT sectors, which reported massive quarterly declines in same-store NOI growth. As noted below, industrial REITs were one of just four REIT sectors to record positive NOI growth in Q2. Among the four property sectors that NAREIT breaks out, Industrial REITs were the lone sector to record a positive year-over-year increase in occupancy, increasing 60 basis points to 95.9%.
The majority of the 14 industrial REITs delivered Q2 NOI and FFO results above consensus estimates. Among the subset of REITs that provide same-store metrics, NOI growth averaged 3.2% in Q2, down about 200 basis points from the same quarter last year, roughly equivalent with the roughly 2-3% in delayed or deferred rent that is expected to be paid back over time. Leasing spreads, however, topped 21%, indicative of a substantial and mounting shortage of industrial real estate space and substantial pricing power. Meanwhile, occupancy rates remained near record-high levels at 96.7%.
External Growth & Capital Markets
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 nearly 6% last year, second only to the manufactured housing REIT sector. After four upward guidance revisions to FFO in Q2 (PLD, COLD, DRE, and EGP), industrial REITs now expect FFO to grow 7.4% this year, higher than the pre-pandemic rate of around 6%. Investors should note, however, that several of the net lease-focused REITs including Lexington, Monmouth, and STAG Industrial expect negative FFO growth in 2020 as their already-muted growth rates were further pressured by unpaid or deferred rents. Meanwhile, the REIT sector as a whole is likely to see the sharpest decline in FFO growth since 2009.
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 better-capitalized logistics-focused REITs including Prologis, Duke, Rexford, and Terreno have delivered some of the strongest relative performance while REITs utilizing higher amounts of leverage have been among the laggards. The "highest flyer" of 2019 has remained so in 2020 as the cannabis-focused Innovative Industrial Properties, which we discussed in our recent report: A High-Flying Cannabis REIT has gained more than 60% in 2020 after surging 70% last year.
Industrial REIT Valuations and Dividend Yield
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 Price-to-FFO ("Funds from Operations") premiums to the REIT averages according to consensus estimates. When we factor in medium-term growth expectations, however, the sector appears more attractively valued. Industrial REITs currently trade at a roughly 5-15% 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 2.7%, which is below the REIT average of roughly 3.4%. However, it's important to note that Industrial REITs have grown dividend distributions by an average of 10.8% per year and FFO by 7.0% per year since 2016, significantly higher than the REIT sector average of 4.3% and 3.2%, respectively. Industrial REITs pay out roughly 60% of their available free cash flow, leaving an ample cushion for development-fueled growth and future dividend increases.
Within the sector, we note the varying strategies of the 14 industrial REITs. While seven 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, Monmouth, and STAG Industrial, all of which pay yields above 4.5%. The higher-growth names including Prologis, Americold, 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.
Key Takeaways: Back To Early-Cycle Fundamentals
The "hub of e-commerce" and the hottest property sector of the last half-decade, Industrial REITs have been unfazed by the coronavirus-induced pain that has encumbered much of the commercial real estate sector. Recent earnings reports confirmed that fundamentals are back in-line with pre-pandemic expectations with positive growth expected in 2020. With the pandemic exposing deficiencies in supply chains, we believe the logistics-boom is back in the early-innings. Similar to our favorable fundamental outlook on the residential and technology 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, extending the themes of the past decade.
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