(Hoya Capital Real Estate, Co-Produced with Colorado Wealth Management)
Riding the e-commerce revolution - 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. Industrial REITs recorded the strongest earnings and dividend growth of any real estate sector in 2020, powered by the "need for speed" in consumer goods distribution and more recently, the urgent need for supply chain densification. In the Hoya Capital Industrial REIT Index, we track the thirteen industrial REITs which account for roughly $150 billion in market value.
Out of Stock? From the inability to find toilet paper and PPE to the blockage of the Suez Canal and surging lumber prices, the coronavirus pandemic has exposed the extreme fragility of global supply chains across essentially all goods-producing segments of the economy. Costing U.S. businesses hundreds of billions of dollars in lost revenues, order delays and bottlenecks have further worsened amid the global economic reopenings, frustrating both businesses and consumers alike. Goods-selling businesses report historically low inventory-to-sales levels, and demand for industrial real estate space remains insatiable as businesses scramble to invest in logistics resiliency.
Underscored by another impressive "beat and raise" quarter this week from logistics giant Prologis (PLD), businesses are increasingly understanding the critical need for investments in their supply chain - particularly in the types of goods storage and logistics facilities owned by industrial REITs. PLD boosted its full-year guidance across the board and noted that net effective rents (releasing spreads) surged 27.0% in Q1, driving an expected rise in same-store NOI growth of nearly 5% this year. Prologis CEO Hamid Moghadam commented that demand is as "strong as I have seen in my career as global supply chains are pushing to keep pace with accelerating economic activity and retooling for faster fulfillment and resilience."
Industrial development has increased significantly over the past five years, but it hasn't been nearly enough to relieve upward pressure on rents, which have roughly doubled since 2015 in the United States. Prologis expects that structural trends are expected to drive further demand for prime logistics real estate and believes that the future of supply chains is larger, faster, more resilient, and closer to end consumers. The shift from "just-in-time" to "just-in-case" supply chains could drive inventories up by more than 5-10% which would create more than 100 million square feet of additional logistics demand per year over the next five years without accounting for a rise in sales.
These "just-in-case" trends are additive to the pre-existing "need for speed" trends which continue to be driven most prominently by e-commerce giant Amazon (AMZN). The pandemic significantly accelerated the penetration rate of e-commerce, which requires up to three times more logistics space than sales through traditional brick and mortar sales. A potential double-edged sword for industrial REITs, the "retail apocalypse" does put further pressure on their brick and mortar-based tenants and has driven investments into logistics technologies that could eventually lead to higher utilization rates and marginally reduce the need for physical space.
For now, robust demand for logistics space from these dueling trends of speed and resilience should more than offset the near-term impacts from these potential risk factors. 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. The IBI Index rose for the eighth consecutive month in the most recent January report amid an intense US-led rebound in economic activity even as order delays and lack of inventory remain an ongoing headwind.
Sharing similar supply/demand dynamics as the housing sector, industrial REITs continue to enjoy some of the strongest property-level fundamentals across the real estate sector. Stellar fundamentals rarely come cheap and industrial REITs are priced for perfection, but investors that have been willing to "pay-up for quality have been rewarded. The "essential" property sectors - housing, logistics, and technology - have been an "oasis of growth" throughout the pandemic as eight of the thirteen industrial REITs boosted their dividend last year, and we've seen another four raise dividends thus far in 2021.
As we'll analyze in more detail below, fourth-quarter earnings reports confirmed that fundamentals were actually made stronger by the pandemic. Industrial REITs recorded the strongest FFO ("Funds from Operations") growth rates among major property sectors last year at nearly 10% compared to the roughly 20% declines in these metrics from the REIT sector at large. Incredibly, all six industrial REITs that provided 2020 FFO guidance before the pandemic ultimately ended the year with growth rates above their initial estimates and the momentum appears likely to continue throughout this year.
Driven by these stellar property-level fundamentals, industrial REITs rallied back from declines as steep as 30% at the lows during the initial coronavirus outbreak in late March to finish 2020 with total returns of 12.2% compared to the -8.0% decline from the FTSE NAREIT Equity REIT Index. The vaccine-driven sector rotation has pressured some of the highest-flying REITs over the past several months, but industrial REITs are still higher by another 12.0% so far in 2021, slightly underperforming the 13.2% gains from the broad-based Vanguard Real Estate ETF (VNQ).
Consistent with the trends across the REIT sector during the "Reopening Rebound," many of last year's losers have been this year's winners. PS Business Parks (PSB) and Plymouth Industrial (PLYM) - the only two REITs with negative total returns in 2020 - have led the gains so far this year. Since the start of 2015, industrial REITs have been the second-best performing property sector. Trailing only the manufactured housing REIT sector, industrial REITs have produced average annual total returns of nearly 20% compared to the 6.1% average annual returns on the broad-based REIT Index.
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. Robust demand for space over the past decade has been driven by a relentless "need for speed" arms race as retailers and logistics providers have invested heavily in supply chain densification and physical distribution networks.
Prologis segments industrial real estate assets into four major segments: Multi-Market Distribution, Gateway 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 due to scarcity of permittable land. 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 has been further accelerated by the pandemic.
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. 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), Lowe's (LOW), Target (TGT), and Costco (COST) have been among the fastest-growing industrial REIT tenants.
As noted, for industrial REITs, the "retail apocalypse" could be a double-edged sword. Investors shouldn't forget that while e-commerce-focused firms like Amazon are 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. Several of the more 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.
One of the largest property sectors, industrial REITs comprise between 10% and 15% of the broad-based Core Equity REIT ETFs. 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 13 REITs as well as self-storage REIT Life Storage (LSI), small-cap diversified REIT One Liberty Properties (OLP), and cannabis REIT Innovative Industrial Properties (IIPR), which we discussed last week in Cannabis REITs: Still Flying High.
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. Leasing spreads also topped 15% in Q4, on average, indicative of a substantial and continued shortage of industrial real estate space and substantial pricing power. Since the start of 2015, industrial REITs are tied with residential REITs for the strongest average annual same-store NOI growth at roughly 4% per year.
Importantly for cash-based metrics like Net Operating Income, rent collection has remained a non-issue for the industrial sector. Industrial REITs have maintained collection rates above 98% since the start of the pandemic, led by near-perfect collection rates from the logistics-focused firms including Duke Realty (DRE), Rexford (REXR), and Prologis. By comparison, rent collection has averaged only around 75% for mall REITs since the start of the pandemic and roughly 90% for shopping center REITs, which has been the driving force behind the sharp declines in NOI for those sectors.
In addition to robust organic growth, industrial REITs continue to benefit from the added tailwind of external growth which we expect to pick up again in 2021 as the "animal spirits" have started to come alive across the REIT sector. After years of relying on ground-up development to fuel external growth, industrial REITs were on a "buying spree" before the pandemic, getting back to doing what REITs do best: using their equity as "currency" to fund accretive acquisitions. After a lull during the early stages of the pandemic, acquisition activity again picked up in late 2020 as industrial REITs acquired nearly $4B in net assets in Q4 which was two-thirds of their haul for the entire year.
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 that 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.
Industrial REITs operate with some of the most well-capitalized balance sheets across the real estate sector which is especially important for REITs with large development pipelines which can be a source of "shadow leverage." The eleven largest industrial REITs all operate with debt ratios below 35%. Five industrial REITs command investment-grade credit ratings including Prologis and PS Business Parks which own the coveted "A-rated" long-term bond ratings. The better-capitalized logistics-focused REITs including Prologis, Duke, Rexford, and Terreno (TRNO) have delivered some of the strongest performance of any REIT over the past two years.
Industrial REITs pay an average dividend yield of 2.4%, which is below the REIT average of roughly 3.2%. However, it's important to note that Industrial REITs have grown both dividend distributions and FFO by an average of nearly 9% per year since 2014, significantly higher than the REIT sector average of 4% and 3%, 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 thirteen industrial REITs where the "tradeoff" between high current yield and long-term dividend growth becomes quite apparent. The five "Yield REITs" at the top of the chart an average current yield of 4.5% but have seen their dividends shrink or stagnate over the past half-decade years. On the other hand, the remaining eight "Growth REITs" pay an average dividend yield of just 2.0% but have seen their dividends grow by an average of over 10% per year over the past five years.
Six of the thirteen REITs offer preferred securities including three issues from Rexford (REXR.PA, REXR.PB, REXR.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 11 securities pay an average yield of 5.17% - a notable premium to the average common stock dividend yield - and trade at a 7% premium to par value.
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.
Below we outline five reasons that investors are bullish on industrial REITs
Below we outline five reasons that investors are bearish on industrial REITs
From the inability to find toilet paper and PPE to the blockage of the Suez Canal and surging lumber prices, the coronavirus pandemic has exposed the extreme fragility of global supply chains across essentially all goods-producing segments of the economy. Demand for industrial real estate space remains insatiable as businesses scramble to invest in logistics resiliency. 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 throughout this decade for the industrial real estate sector.
These REITs are certainly not risk-free, however. While not an immediate risk, the consolidation of the retailing industry into fewer and more power goliaths like Amazon could erode pricing power over time. Additionally, the combination of high levels of new supply and tech-driven efficiencies to industrial space usage could become a more pronounced issue when demand growth begins to normalize. Stellar fundamentals rarely come cheap and industrial REITs are priced for perfection, but investors that have been willing to "pay-up" for quality have been rewarded.
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Disclosure: I am/we are long HOMZ, AMT, ARE, AVB, BXMT, DRE, DLR, EFG, EQIX, FB, FR, MAR, MGP, NLY, NHI, NNN, PLD, REG, ROIC, SBRA, SPG, SRC, STOR, STWD, PSA, EXR, AMH, CUBE, ELS, MAA, UDR, SUI, CPT, NVR, EQR, INVH, ESS, PEAK, LEN, DHI, HST, AIV, MDC, ACC, PHM, TPH, MTH, WELL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. Nothing on this site nor any published commentary by Hoya Capital is intended to be investment, tax, or legal advice or an offer to buy or sell securities. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and should not be considered a complete discussion of all factors and risks. Data quoted represents past performance, which is no guarantee of future results. Investing involves risk. Loss of principal is possible. Investments in companies involved in the real estate and housing industries involve unique risks, as do investments in ETFs, mutual funds, and other securities. Please consult with your investment, tax, or legal adviser regarding your individual circumstances before investing. Hoya Capital, its affiliate, and/or its clients and/or its employees may hold positions in securities or funds discussed on this website and our published commentary. A complete list of holdings is available and updated at www.HoyaCapital.com.
REIT Terms Defined:
REIT (Real Estate Investment Trust): A company that owns, operates, or finances income-generating real estate. REITs must distribute 90% of taxable income to qualify. REITs are exempt from corporate income taxes, but distributions are generally taxed at ordinary (not qualified) income rates.
FFO (Funds From Operations): A standardized measure of REIT operating performance, used in place of Earnings. FFO adds back depreciation to Net Income and adjusts for gains/losses on property sales.
AFFO (Adjusted Funds From Operations): A non-standardized measure of recurring/normalized FFO after deducting capital improvement funding and adjusting for “straight line” rents.
NOI (Net Operating Income): Typically reported on a “same-store” basis, NOI is a calculation used to analyze the property-level profitability of real estate portfolios. NOI equals all revenue from the property minus property expenses.
NAV (Net Asset Value): An estimated market value of a REIT's net assets based on estimated private market valuations of similar assets, assuming immediate liquidity and zero transaction costs.