Robotics And Solar: The Future Of Industrial Real Estate As Led By Prologis

Summary

• PLD has been investing in robotics capabilities and this is about to bear fruit.
• Growth looks strong but supply is coming in rapidly.
• Valuation is appropriately high.

The Mildly Bullish Thesis

Fundamentally, Prologis (NYSE:PLD) is great. They have the most extensive industrial portfolio around the world and are positioned to grow via multiple avenues. The large-cap industrial REIT has consistently been on the cutting edge of innovation and is now differentiating itself as the robotics and solar warehouse REIT.

My bullishness is partially tempered by a fairly high price with PLD trading at 25X 2021 estimated FFO. Quite simply, it's a strong company and the market knows it's a strong company. There are, however, a couple aspects of PLD’s business that the market has not fully priced in and these could lead to an upside surprise down the road.

In particular, PLD robotics and solar capabilities are not being appreciated because they are not yet contributing meaningfully to cash flow. To understand the value of these business lines we must first understand the history of industrial real estate.

A bright future but an ugly past

Heading into the Great Financial Crisis, developers were overly enthusiastic about industrial. Not only were they building to suit, but they began building on spec, hoping a tenant would come along. For a while it worked and was highly lucrative, but once the recession hit it was immediately apparent that the market was facing a glut of industrial real estate. In the fight with other owners to maintain occupancy, rental rates were cut severely, in some cases to less than a dollar per foot. It got really ugly and even the best industrial REITs teetered on the edge of collapse.

Source: SNL Financial

In 2009 the industrial REIT index was priced more than 80% below the pre-crisis peak and it was largely a justified price move.

It was a wicked combination of oversupply and a commodity product. The properties consisted of little more than a rectangle of metal siding with a roof and there was almost nothing differentiating one property from another.

Supply remained high, but the sector got bailed out by the boom of e-commerce which created an exponential demand for logistics warehouses. That e-commerce boom continues today and has led to industrial being among the most sought-after class of real estate. The industrial REITs now trade at a median FFO multiple of 23.9X

This is a significant premium to the median non-industrial REIT at 16.6X.

Going forward, oversupply is threatening to rear its ugly head yet again with many markets getting an annual new supply of 2% to 3%-plus of existing inventory.

Source: Marcus and Millichap

This new supply is made worse by the minimal degree of differentiation in the product. E-commerce demands certain ceiling heights and aisle widths as well as loading bays of certain dimensions/quantity, but just about all the new builds meet those requirements. It's still a game of rinse and repeats with the same blueprint being built very inexpensively in great quantity.

So while the market is very excited about industrial REITs, I'm a bit more cautious as there is the looming threat of oversupply. It's fine for now, but it will become a problem once a real recession hits.

The COVID recession actually benefited warehouses because the unique nature of it pushed everything into e-commerce, but if we get an economically-driven proper recession where cost savings become the course of action rather than avoiding other people, demand will legitimately be interrupted.

Upon demand taking a breather, the vast supply of undifferentiated products will become apparent. It's at this point in time that Prologis will have the opportunity to outperform. As a leader in innovation, it has a more differentiated product with robotic and solar capabilities.

Prologis Robotics

Prologis is one of the early financial backers of Locus Robotics and recently invested more as one of the buyers of the $150mm series E round of funding (as reported by SNL Financial on 2/19/21).

From its position, PLD has access to the latest robotics technology and is incorporating it in some of its warehouses. LocusBots move with the worker to accelerate the picking process.

Source: Locus

Beyond these sorting robots which can pick up and move stacks to wherever they need to go, e-commerce benefits from extensive systems of conveyor belts which can quickly and efficiently route product to a variety of destinations within the warehouse. The performance differential of an automated warehouse compared to a manual warehouse is enormous for two reasons:

1. Cost of labor
2. Availability of labor

I was fortunate to be on a 2/22/21 call with Professor Robert Shiller hosted by Barclays in which he extensively discussed the imminent threat of automation. As an economist, he was of course viewing it as a threat to the economy given the potential for it to spike unemployment. From a humanitarian perspective, I entirely agree, but as a real estate investor, I also see it as a huge opportunity.

Industrial real estate that is decked out with the latest automation and robotics can save its tenants massive amounts of money on labor and can thus charge substantially more rent.

Industrial real estate also can be limited by the availability of labor in the surrounding radius. A few years back I toured some properties of Plymouth Industrial (PLYM) and they discussed the extent to which labor availability factored into their underwriting. Their property was fully tenanted and running smoothly while a couple of other facilities just a few miles down the road were vacant and the difference was that PLYM’s property was on the bus line. It had access to labor while the others got choked out.

Automation, by reducing the number of required workers, greatly alleviates problems with the availability of labor.

Finally, the last major factor benefiting industrial warehouses with robotics is the rising cost of labor. There is talk of a national wage increase to $15.00 and whether or not that happens companies are already paying workers more in some areas. Amazon, for example, is already paying its warehouse workers north of $15 per hour.

The unfortunate reality is that the higher wages are, the more workers will be replaced with robots.

Solar differentiation

Prologis has a well-developed solar platform. Across 10 countries PLD’s rooftop solar is generating 212 megawatts which qualifies PLD to rank No. 3 among U.S. corporations for on-site solar capacity by SEIA.

Much like robotics the solar works by saving tenants money, in this case on electricity and in exchange PLD can charge more rent.

Industrial rooftops are in many ways the perfect platform for solar installations because they are flat, enormous and have no other competing function. This lends itself perfectly to full coverage by solar panels as seen below on PLD’s warehouse.

Source: PLD

Neither solar nor robotics are what one typically thinks of as a REIT asset, so that brings us to explore the following question:

Are solar and robotics REIT qualifying assets?

Technically no, but functionally yes.

Two of the aspects the IRS stipulates for a piece of property to be considered real estate are that it has to be stationary and passive. Photovoltaic electricity production of solar panels is an active function and robots move. Thus, neither qualifies as a REIT asset, but the REIT can fully circumvent this problem in the same way that apartments get around the problem of furniture not being a REIT asset. The REIT isn’t charging the tenant for the use of solar or robotics directly just as the apartment isn’t charging its tenants for the furniture. It just so happens to be the case that a warehouse decked out with this fancy equipment can charge significantly more rent in the way that an apartment that comes fully furnished can charge more rent.

In both cases, the tenant is technically paying rent for the use of the real estate, so all of the revenue is REIT qualifying. It's just the case that the non-REIT assets are indirectly bolstering the amount of REIT income.

Now that we have discussed PLD’s edge in robotics and solar let's go back a bit to see how that fits into the overall fundamental story.

Fundamental outlook

Like most industrial REITs, PLD is growing nicely. Funds from operations per share or FFO/share is expected to increase from $3.31 in 2019 to $4.32 in 2022 as per sell side consensus.

Source: SNL Financial

That growth is coming from a combination of acquisitions and organic same store NOI growth. The ample price of PLD at 25X current year FFO makes equity capital very cheap which in turn makes acquisitions highly accretive.

The incremental FFO/share from acquisitions stacks summatively with the incremental FFO from rent growth.

Source: SNL Financial

Same-store NOI growth has been quite impressive but you can see that it has slowed a bit. That, in my opinion, is the impact of the growing supply of industrial properties. It's harder to push rents when there are competing properties opening up.

For the next few years, supply growth looks to be balanced out by equally strong demand growth so I would anticipate NOI growth to continue at a pace of about 3% annually.

This pace of growth, in my opinion, justifies the relatively high 25X FFO multiple at which PLD trades. The piece that pushes me into being bullish is PLD is better than peers positioning for when the downturn eventually comes.

The regular warehouses that are basically just 4 walls and a roof will likely have to cut rates in a downturn as they will be competing with each other to maintain occupancy.

In comparison, there will be relatively few warehouses fully decked out with robotics and solar, so these will be facing far less competition and will likely have better pricing power to maintain rental rates.

For the value conscious

Prologis is a solid investment, but I think STAG Industrial (STAG) offers an even better reward to risk ratio. At just 16.2X FFO STAG has a much higher cash flow yield and its growth is not priced in. Prologis is clearly the leader in robotics, but relative to the size of the company STAG’s solar outlay is actually ahead of PLD’s. I would expect to see the solar improvements adding incremental FFO to STAG in the near term.

Analyst’s Disclosure: I am/we are long STAG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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