Many data points indicate that we are headed into a downturn and stock markets have recently reacted as such. This thesis does not in itself rely on an imminent economic downturn but is strengthened by the prospects of it.
Investment Thesis Part I - Drivers of Outperformance, Especially during Downturns:
The 3 factors that demand attention when evaluating REITs that are positioned to drive value during any type of economic downturn are: property sector, balance sheet health, and development pipelines.
Property Sector: Downside risk in the real estate world is a function of operating margins, sensitivity of demand to the economy, and lease duration. Generally, REITs that participate in end-markets with consistent demand, exhibit strong margins, and lock in leases that extend through downturns without significant concessions are rewarded and demand attention when alpha generation becomes difficult.
Balance Sheet Health: Prudent capital allocation is crucial as one of the growth strategies in REITs is asset expansion at a sufficient spread between cap rates and cost of capital. Strong balance sheets provide REITs with the luxury of flexibility - allowing them to acquire real estate during downturns at attractive entry points or the liquidity to execute on other strategies, such as asset improvements to drive higher lease rates.
Development Pipelines: While developing new supply can yield impressive results, it is unwise to have sizable development pipelines when cost of capital is in flux.
Investment Thesis Part II - Yesterday vs. Today
In the '08 downturn, the top 5 performing sectors were Net Lease, Healthcare, Storage, Industrial, and Strip Center REITs respectively. According to Green Street Advisors, a leading real estate research firm, each sector's total return from 12/2006 - 6/2009 were ~-3%, ~-6%, ~-12%, ~-15%, and ~-17% respectively. Based on these precedents, EGP has traded down along with the S&P500 (-3.43% and -5.59% YTD, respectively as of 2/24/16), though many questions begin to arise whether EGP's underperformance relative to public storage (NYSE:PSA YTD of +0.9%) and net lease (NYSE:O YTD of +15.27%) REITs is warranted.
Several key factors differentiate the industrial REITs today than the industrial REIT in '08. First and most importantly, as eCommerce continues to grow in scale, demand for industrial properties are beginning to rise in tandem. The most valuable industrial properties are ones that are close in proximity to major population centers. These properties are usually light industrial buildings, or simply warehouses, which serve as central distribution points for retail and eCommerce stores. EGP's currently portfolio is focused on major population centers with ~81% of its portfolio based on sq. ft. dedicated to business distribution space.
Secondly, REITs in general today, have strengthened their balance sheet and are better poised to weather economic downturns. EGP in particular, currently has an interest coverage of 4.0x vs. Industrial REIT (comprises the following companies: EGP, DCT, DRE, FR, LPT, and PLD) average of 3.7x and has a weighted average cost of debt of 3.8% vs. Industrial REIT average of 4.3%.
Lastly, while some REITs including EGP have concerning leases rolling over in the near-term (~14.9% of base rent expiring in 2016), re-leasing spreads have been extremely attractive indicating that demand is robust (11.9% increase in rental rates for leases that expired in 2015).
EastGroup Properties is an equity REIT organized in 1969 and is focused on the development, acquisition, and operation of industrial properties in major Sunbelt markets throughout the U.S. with an emphasis in the states of Florida, Texas, Arizona, California, and North Carolina. The Company currently owns 324 industrial properties and 1 office property as of 12/31/15. As of 2/16/16, the portfolio is 96.9% leased and 95.7% occupied. Approximately ~39% of the portfolio (based on sq. ft.) is developed by EGP, and ~81% of the portfolio is dedicated to business distribution space. The remaining 15% is dedicated to bulk distribution, and 4% is dedicated to business services.
Business distribution space (81% of sq. ft.): Typically multi-tenant buildings with building depth of 200 ft. or less, clear heights of 24-30 ft., office finish of 10-25% and truck courts with depths of 100-120 ft.
Why the Stock is Cheap:
EGP currently trades at a valuation discount relative to peers due to its recent departure of long-term CEO David Hoster and its exposure to Houston and its oil-centric economy. We believe EGP's valuation discount is unwarranted, and upside is bountiful. Management has stated that it intends to slowly dispose of its Houston assets (currently ~20% of NOI) in the coming year, and is projected to be offloaded at premiums to EGP's current valuation ratios. This is strongly convincing given that EGP currently trades at a ~6.6% cap rate and Houston Industrial Assets are trading at ~6.0% nominal cap rates.
On valuation: Based on a 2016E Average Consensus AFFO basis, EGP trades at 17.4x as of 2/24/16 vs. industrial REIT averages of 19.3x - excluding LPT, which has significantly underperformed, industrial REIT average 20.2x 2016E AFFO. On a cap rate basis, EGP's properties are valued at ~6.6% vs. industrial REIT averages of ~6.5%. Excluding LPT, which has significantly underperformed industrial peers, on an implied cap rate basis peers average ~6.2%. EGP also trades at a large discount to NAV of -17.6% vs. industrial REIT average sans LPT of -8.6%.
Based on EGP's sector leading balance sheet, light g&a load (0.44% of assets vs. industrial peer average of 0.51% of assets), and high quality portfolio in growth markets other than Houston, we believe this large discount to peers is unwarranted. The Company exhibits all of the traits to weather any economic downturn - a shift in consumer behavior indicates that EGP's current portfolio's end markets are reclusive to economic downturns, its strong balance sheet, and low development pipeline as % of Gross Assets (8.9% vs. average of 11.1%) should be enough justification for it to perform better than its peers.
What We Think is Upside / Conclusion:
So far, we have postulated that:
-Industrial properties of today are different from the ones of yesterday
oThey are crucial building blocks of successful eCommerce ventures
-EGP has sector leading Balance Sheet health
oInterest Coverage of 4.0x vs. Peer Average of 3.7x along with one of the lowest G&A loads (0.44% of Assets vs. Peer Average of 0.51% of Assets)
-EGP has a smaller development pipeline as a % of Gross Assets
o8.9% of Gross Assets vs. Peer Average of 11.1%
With this, we first calculate an IRR over a 2-year holding period assuming current depressed valuation metrics:
-We assume that we are exiting the EGP investment in 2018E at the current 2015 AFFO Multiple of 19.3x
-We use Green Street's 2017E AFFO/Share of $3.45 for our exit date of 2/2018; with this, the implied exit price is ~$66.62/Share
-Based on MRQ annualized dividend payouts of ~$2.40/Share, we collect this in 2016E and 2017E
-We assume we enter the investment at a share price of $53.70, which is the closing share price as of 2/24/16
-The total IRR during this time period is: ~15.6%
If valuations were to come in-line with its Industrial REIT peers over the course of the investment, we get an exit price of ~$79.18 for an IRR of ~23.6%.
Risks to our thesis are mostly in the Company's assets in Houston which currently comprise ~20% of NOI. If the Company does not sell this down or sells it down at unattractive multiples, the stock price can see decline. This initiative is also pegged to the credibility of the new CEO, Marshall Loeb, among other initiatives Loeb plans to continue executing that exiting CEO David Hoster was known for.
I intend to have a long position in the stock within the next 3-5 business days.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EGP over the next 72 hours.