Industrial REITs: Amazon Cuts Deep
This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on May 22nd.
REIT Rankings: Industrial
Industrial REITs – a perennial performance leader in recent years – have been slammed over the past month with declines of 20-30% after e-commerce giant Amazon (AMZN) announced plans to cut costs in its logistics network, pumping the brakes on its aggressive pandemic-fueled footprint expansion amid rising transportation costs and slowing consumer spending, seeking to reduce overcapacity through sublets and renegotiated leases. The downbeat Amazon report followed an otherwise stellar slate of industrial REIT earnings reports highlighted by incredible 30% rent growth, record-low reported vacancy rates and overshadowed several major M&A developments. In the Hoya Capital Industrial REIT Index, we track the thirteen industrial REITs which collectively total nearly $160 billion in market value.
Led by sector stalwart Prologis (PLD), industrial have consistently delivered dividend and FFO growth near the top of the REIT sector over the past decade, but Amazon’s somewhat surprising report seemed to call into question the “extreme competition” for logistics and distribution space noted in the prior quarter. But while the e-commerce giant is indeed the largest industrial REIT tenant, Amazon still comprises just 3-5% of total occupied space. As a percent of NOI, REIT-specific exposure ranges from a low of 1% at EastGroup (EGP) to a high of 8% at Industrial Logistics (ILPT). For industry insiders, Amazon’s plans to scale back its expansion were not unexpected. Supply chain consulting firm MWPVL International estimates that Amazon increased its square footage by nearly 400% between 2016 and 2021 – and doubled in 2020 and 2021 alone – and had forecasted a moderation in its expansion plans in 2022 and 2023. Despite this major push, Amazon still represented a relatively modest 14% of incremental absorption in 2021 and 7% YTD so far this year.
These much-discussed overcapacity issues appear to be company-specific as broader industrial vacancy rates remain at record lows. 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, riding similar compelling structural tailwinds of low supply and robust demand as the U.S. housing industry. Robust demand for logistics space has been driven by dueling trends of the “need for speed” in both business-to-consumer and business-to-business goods delivery and, more recently, by the critical need for enhanced supply chain resiliency. Brokerage firms CBRE and JLL each separately reported that industrial vacancy rates declined to record-lows below 4% in Q1 2022 despite robust levels of new development and weaker demand from Amazon.
Encouragingly, responding to the Amazon reports and questions this week, Prologis reiterated its full-year demand outlook and expect rent growth of over 20% and record-low year-end vacancy rates of 3.3% this year, citing “clear constraint on supply” and noting that “logistics market conditions are still defined by historic low vacancy, constraints on new deliveries, and pent-up demand.” Prologis commented that it is “watchful on rising levels of consumer stress and modeled -5% real growth in retail goods sales in our Q1 2022 earnings call” but noted that “space is effectively sold out” with record-low vacancy rates. Prologis estimates that the market is experiencing more than 800 million square feet of pent-up incremental demand even with this pullback, but only 375 MSF will come online in 2022 to meet this demand.
Industrial REIT Earnings Recap
As analyzed in our REIT Earnings Recap, six of the seven REITs that provide guidance raised their full-year FFO growth outlook including Prologis, First Industrial (FR), and Duke Realty (DRE) which all reported a remarkable surge in rent growth and raised their full-year outlook. PLD noted that its average rents on existing leases are 47% below market, equating to $2 per share of embedded earnings growth as these leases renew at current market rates. Rexford (REXR) was also an upside standout, raising its full-year FFO growth outlook to 13.4%, driven by an incredible 71% jump in renewal spreads. On average across the industrial sector, GAAP renewal spreads surged more than 35% in Q1 while cash spreads rose nearly 20% – each the highest quarterly rent growth on record.
A pair of emerging mid-cap industrial REITs also reported impressive results as Terreno (TRNO) recorded cash spreads of 34.8% in Q1 while increasing occupancy to record-highs at 96.9% while EastGroup (EGP) recorded leasing spreads of 33.5% and raised its FFO growth of 10.8% in 2022 – up 190 basis points from its prior outlook. Even Americold (COLD) – which has been among the worst-performing industrial REITs amid operational challenges in its services-heavy business model – boosted its full-year property-level outlook which now calls for a 2.0% increase in NOI. Unlike other industrial REITs that simply rent the space, COLD feels the supply chain disruptions directly and noted that it continues to face “very challenged” conditions across the global food supply chain. Net lease-focused STAG Industrial (STAG) is also slowly but surely starting to see positive mark-to-market rent growth effects as its long-duration leases come up for renewal.
While the property-level metrics remain stellar, some industrial REITs are still figuring out how to get out of their own way. LXP Industrial (LXP) still expects a decline in full-year FFO growth of nearly 15% as it seeks to sell its last remaining office assets as part of its transition to become a pure-play industrial REIT. LXP also announced that it is no longer pursuing a sale of the company, citing “the significant changes to macroeconomic, geopolitical and financing conditions since it commended the process in early February. Another smaller industrial REIT, Industrial Logistics (ILPT) reported disappointingly slow progress in its plan to reduce its debt by selling assets from its recently-acquired Monmouth portfolio and an FFO drag from its bridge loan being used to finance the deal.
Industrial REIT External Growth
On that note, while some smaller industrial REITs are facing challenges with portfolio repositioning, several mid-cap REITs are enjoying a fertile and active M&A environment. Earlier this month, Prologis proposed to acquire Duke Realty in an all-stock deal at a 29% premium to Duke Realty’s closing price on the same date. Duke subsequently rejected the offer, noting that it was “virtually unchanged” from prior proposals and is “insufficient,” but remains “open to exploring all paths to maximize shareholder value.” Prologis has been far and away the most active acquirer over the past half-decade with major acquisitions of DCT Industrial in 2018 for roughly $8B, Industrial Property Trust in 2019 for $4B, and Liberty Property Trust in 2020 for $13B.
Prologis has been actively pursuing Duke for at least six months and Duke previously rejected two proposals – the first one coming on November 29th. Under the terms of yesterday’s proposal, Duke Realty stockholders would own 19% of the combined company. The Prologis offer for Duke – which we believe would benefit both companies if completed at the right price – came two weeks after another major industrial real estate acquiror – Blackstone (BX) – scooped up PS Business Parks (PSB) at $187.50 – a 12% premium to its prior closing price. For Blackstone – which oversees a massive conglomerate of real estate investment vehicles including the largest non-traded REIT – the deal is the fifth since last June following acquisitions of residential REITs American Campus (ACC), Preferred Apartment (APTS), Bluerock Residential (BRG), and data center REIT QTS Realty Trust (QTS).
Industrial REITs continue to see significant value-add opportunities in ground-up development 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 other property sectors including data centers 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. 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 REIT Stock Price Performance
On the front lines of the historic supply-chain shortages, Industrial REITs outperformed the broad-based REIT Index for the sixth consecutive year in 2021, but have uncharacteristically lagged in early 2022 in the wake of the Amazon report and amid a broader growth-to-value rotation within the REIT sector. Industrial REITs are now lower by more than 26% so far on the year, trailing the 17.3% decline from the broad-based Vanguard Real Estate ETF (VNQ) and the 16.4% decline from the S&P 500 ETF (SPY).
These declines, however, come after recording a remarkable sixth straight year of outperformance in 2021, a streak that trails only the manufactured housing sector, which has delivered an unprecedented nine-straight years of outperformance. The carnage this year has been widespread across the sector with every industrial REIT lower by more than 20% YTD with the exception of PS Business Parks. Small-cap REITs have been slammed particularly hard with Plymouth and Industrial Logistics each dipping roughly 40% – a sharp reversal from last quarter in which these smaller-cap names were among the sector leaders on the year. As noted, however, the brutal year follows one of the strongest for industrial REITs as twelve of the thirteen industrial REITs delivered positive total returns in 2021 with Americold as the lone exception.
Deeper Dive Into The Industrial Sector
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) – a trend that has been further accelerated by the pandemic.
Supply chain disruptions came as inventory levels were already historically lean amid a shift towards “just-in-time” inventory management. Resilient supply chains will require substantial investments in logistics space with Prologis pegging the number at 800 million extra square feet just to reach equilibrium. Prologis noted last month that the utilization rate edged up into the mid-85 percent range in November and December and while utilization is below its historic high of 87 percent, the inventory-to-sales ratio is more than 10 percent below pre-pandemic levels and there is no “shadow space” to absorb inventory right-sizing.
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 and increasingly by Walmart (WMT), Target (TGT), Home Depot (HD), and Lowe’s (LOW). 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 shortage of industrial space itself has driven investments into logistics technologies that could eventually lead to higher levels of space efficiency, higher utilization rates, and eventually could marginally reduce the need for physical space.
Industrial REIT Dividend Yields
Appreciated more for their dividend growth than their current yields, industrial REITs pay an average dividend yield of 2.7%, 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 nearly 10% per year since 2014, significantly higher than the REIT sector average of roughly 4%. 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 four “Yield REITs” at the top of the chart pay an average current yield between 3.5%-9.4% but have seen their dividends grow at slower rates. On the other hand, the remaining eight “Growth REITs” pay an average dividend yield of around 2.3% but have seen their dividends grow by an average of 10% per year over the past five years.
Takeaways: Opportunity In Amazon Carnage
Industrial REITs – a perennial performance leader in recent years – have been slammed over the past month with declines of 20-30% after Amazon announced plans to cut costs in its logistics network. The largest industrial REIT tenant, Amazon still comprises just 3-5% of total occupied space. These overcapacity issues appear to be company-specific as broader industrial vacancy rates remain at record lows. The sour Amazon report followed an otherwise stellar slate of industrial REIT earnings reports – highlighted by incredible rent growth averaging over 30% – and overshadowed several major M&A developments. We had trimmed our industrial REIT exposure prior to this sell-off given the previously lofty valuations, but the recent carnage is an opportunity to double-down on several dividend champions. We believe that premium valuations are warranted given the secular tailwinds of limited supply and robust demand which should persist into the back half of this decade.
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