Market analysis by our public securities expert, Geoff Shaver
April 3, 2020
Industrial REITs: Who Is Best Positioned for Growth, and Who’s Feeling the Heat?
by Geoff Shaver
Director of Public Securities
In spite of recent trade and supply chain disruptions – caused first by tariffs enacted with China in 2019 and now more recently the COVID-19 pandemic – the industrial sector within the public real estate investment trust (or “REIT”) market continues to show strong resilience. Largely mirroring the market movements of other REITs in the immediate weeks of the market selloff, industrial REITs have now begun to outperform other sectors. The industrial REIT sector has generated a -17.6% performance on a year-to-date basis (as of 4/1/20), substantially outperforming the broader FTSE NAREIT All Equity REITs Index, which tallied a -32.6% return over that same period(1). The sector’s relative outperformance is highlighted even further when compared against the performance of hospitality (-54.4%) and retail (-53.7%) over the year-to-date (as of 4/1/20)(1).
Let’s take a look at two factors that could benefit industrial REITs: demand and leverage. Over the past three years, eCommerce sales have averaged a growth rate of 14.5% and just eclipsed 16% of total retail sales in 2019, or $601.75 billion(2). A CBRE Research study found that for each incremental $1 billion in growth in e-commerce sales, there needs to be an additional 1.25 million square feet of distribution space to support the channel growth(3). As eCommerce continues to increase its market share, industrial space will continue to be in high demand moving forward.
Next, let’s look at leverage, or the use of debt to buy assets. Since the financial crisis of 2008, industrial REITs have prioritized deleveraging their balance sheets. We believe industrial REITs have positioned themselves to withstand potential declines in both asset values and cash flow. Over the last five years, industrial REITs have lowered their Debt/EBIDTA ratios by anywhere from 20% to 35%(5). Outside of data centers, industrial REITs have the lowest Debt/EBITDA ratio of any REIT Sector(5).
Now that we’ve explored some factors that work in industrial REITs’ favor, let’s look at three potential headwinds: tenant industry concentration, tenant size, and geography.
Tenant industry concentration risk can lead to different default probabilities across each industrial REIT’s portfolio. Industrial tenants are linked to their products and the creditworthiness of their underlying customers. In particular, industries such as construction, automotive, and transportation pose the heaviest risk for tenant default, as their underlying customers could become cash constrained for the foreseeable future.
In response to the rapid growth of eCommerce, industrial has shifted its focus from overall square footage to the cubic size of their facilities. By maximizing space efficiency, tenants are able to store more product and reduce their occupancy cost per square foot. New developments have now shifted towards higher clear heights of at least 36 feet, wider column spacing at 50 to 60 feet, and a high number of dock doors. For example, clear heights since the eCommerce Boom have increased by 18.1%(14). However, over 75% of the existing industrial supply was built prior to the eCommerce boom and does not meet the evolving needs of many industrial tenants(13). Portfolios with a high exposure to pre-2000 vintage product could face significant rollover and re-tenanting risk, as these building designs lack the efficiency that warehouse and logistics tenants demand.
Another potential headwind is tenant size. Smaller tenant sizes generally correlate to smaller scale businesses and shorter-term leases. With a higher level of rollover and higher tenant default risk due to the limited balance sheets of small businesses, portfolios with smaller tenant sizes could face immediate risk.
Lastly, there’s simple geography. Certain markets are tied directly to single industries, and, as a result, are more susceptible to economic downturns than cities with a more diverse workforce. With oil prices dropping to as low as $20 per barrel and tourism and theme parks at a virtual standstill, markets such as Houston, Orlando, and Las Vegas will be affected more than gateway cities. Similarly, secondary and tertiary markets pose additive risks based on their limited pool of tenants and lack of barriers to entry. Smaller markets typically have fewer tenants and businesses that can backfill vacant, rolling, and speculative space. This risk is further exacerbated if companies delay future expansion plans due to economic uncertainty. In addition, there are fewer barriers to entry for new supply with ample developable land, fewer regulatory hurdles, and a lower replacement cost. These factors, if not carefully monitored, can create oversupply issues.
Who’s Well Positioned, and Who’s Feeling the Heat?
We believe that Prologis (PLD), Duke Realty (DRE) and Terreno Realty (TRNO) are relatively well positioned within the industrial sector, largely due to strong relative balance sheet health, balanced tenant exposure and geographically diverse footprints within growth markets.
Prologis, Duke, and Terreno share many of the same fundamentals that have positioned them for resilience and growth. All three REITs are comprised of diverse portfolios from both an industry concentration and geography perspective, with PLD and DRE being two of the top five largest industrial owners in the world. Their portfolios are located across high demand markets, such as Southern California and New York, that position them to service a diverse tenant base and capture the tailwinds of eCommerce demand(6-8). Even with significant transaction activity over the past 24 months, all three REITs are among the lowest in Debt/EBITDA ratios across the industrial sector(5).
Despite broader industry tailwinds, we believe that Industrial Logistics Property Trust (ILPT), Stag Industrial (STAG) and PS Business Parks (PSB) have some headwinds to weather due to outsized exposure to markets like Hawaii and Houston. They also have leverage issues to contend with and aren’t as well positioned to take advantage of the growth opportunities within the eCommerce segment.
With approximately 40% of their portfolio in Hawaii, ILPT has significant geography concentration risk in a market that receives over 70% of its statewide GDP from lodging, tourism, and entertainment. With tourism halted for the foreseeable future, their highest concentrated market could be the most adversely affected in their portfolio. STAG has approximately 11% of its tenants concentrated in the automotive industry, with an additional 9% in air freight and logistics. In addition, over two thirds of the STAG portfolio is located in secondary and tertiary markets. With many automotive companies furloughing employees and a high exposure to non-gateway markets, STAG has considerable industry concentration and geographical risk. Lastly, in PSB’s portfolio, 72% of their tenants and 30% of their net rentable area is leased by tenants, with an average size of 2,164 square feet. In addition, approximately 35% of the PSB portfolio consists of flex and office space that has low ceiling heights and lacks the spatial efficiency for warehouse and distribution. Though PSB has a strong balance sheet with no debt, their portfolio is exposed to considerable default and rollover risk.
No sector, company, or market will be untouched by COVID-19 and its economic effects. However, we believe that strong market demand and balance sheet fundamentals of the industrial sector, coupled with diverse tenant and geographic exposure, will position these industrial REITs for resiliency near-term and strong long-term growth.
(2) - https://www.digitalcommerce360.com/article/us-ecommerce-sales/
(3) - https://www.cbre.com/real-estate-services/real-estate-industries/omnichannel/omnichannel-hub/e-commerces-impact-on-industrial-real-estate-demand?article=30bbefb0-42be-4ba2-8000-18b3ed42b2a4&feedid=a0bdebdf-c63a-448b-8284-0e88e726a5a3
(4) - GreenStreet-REIT-IndustrialSectorReport-20200326.pdf
(5) - https://www.reit.com/sites/default/files/reitwatch/RW2002.pdf
(6) - https://s22.q4cdn.com/908661330/files/doc_financials/2019/q4/updated/Final-Q4-2019-Supplemental.pdf
(7) - https://investor.dukerealty.com/static-files/eee16847-0d88-4769-8b03-3ae92ea6778d
(8) - https://investors.terreno.com/Cache/IRCache/6a2b0a75-3de1-665e-36dc-9b854b3c77da.pdf
(9) - https://s22.q4cdn.com/903350330/files/doc_financials/2019/q4/v2/ILPT-2019-Q4-SUPPLEMENTAL.pdf
(10) - https://ir.stagindustrial.com/files/doc_financials/2019/q4/Q4-Supplemental-Information.pdf
(11) - https://d3nywy8xhihhjs.cloudfront.net/wp-content/uploads/2020/03/Company-Update-March-2020.pdf
(12) - https://www.bea.gov/system/files/2020-01/qgdpstate0120_2.pdf
(13) - https://irp-cdn.multiscreensite.com/8dcfb692/files/uploaded/Clarion%20white%20paper-%20US%20Warehouse%20Boom.pdf
(14) - https://www.us.jll.com/en/views/snapshots/industrial-clear-heights-rising-with-e-commerce-gifts
Director of Public Securities
Geoff leads the construction and monitoring of the public real estate securities portfolios available in our Path by Origin app. Prior to Origin, Geoff spent the last 12+ years researching and investing in public REIT securities at both Duff & Phelps Investment Management Co. and J.P Morgan Asset Management.
Geoff Shaver and clients of Path by Origin, LLC own DRE. Neither Mr. Shaver nor Path have a business relationship with any company whose stock is mentioned in this article.
Path by Origin, LLC (“Path”) is an SEC registered investment adviser. Mr. Shaver is the Director of Public Securities of Path. The views expressed herein are subject to change, and no forecasts can be guaranteed. The comments provided are for educational purposes only and may not be relied upon as recommendations, investment advice or an indication of trading intent. In preparing this document, the author has relied upon and assumed, without independent verification, the accuracy and completeness of information available from public sources. The stocks mentioned in this article have been highlighted based on some reported news, quality or characteristic and do not necessarily represent all of the securities recommended for a particular portfolio. Path is not soliciting any action based on this communication. Investments involve risk, including the possible loss of principal and fluctuation of value. Past performance is not indicative of future results. Mr. Shaver and Path disclaim responsibility for updating any information herein. In addition, Mr. Shaver and Path disclaim responsibility for any third-party content.