The Big Myth About Industrial REITs

Several of the industrial REITs have significant exposure to southern California. Rexford (REXR) is entirely invested in the region. Prologis (PLD), Terreno (TRNO), EastGroup (EGP), First Industrial (FR), and STAG Industrial (STAG) also have exposure to the area in different amounts.

This leads to some concerns for investors. I want to quickly address those concerns.

Remote Jobs

California is declining as office jobs go remote. True, but that doesn’t actually hurt industrial real estate. Office real estate in the central business district tends to be tall buildings because the cost per square foot of land is so high. Further, those office properties don’t have the necessary parking or street access to be industrial real estate. They will not be converted into industrial real estate.

To the extent residential rents are pressured by office workers leaving, it would be favorable for the industrial workers. Likewise, to the extent traffic is reduced by the decline of office, it’s favorable for industrial workers (who must commute) and for truck drivers who want to use the freeways.

The decline of office is a net benefit for industrial real estate. The biggest negative impact for industrial that I foresee is that plunging office real estate values may decrease property taxes on office buildings, which could trigger other tax battles. Likewise, a slight decrease in population may reduce the need for “last mile” facilities. However, the e-commerce growth rate will dramatically outweigh the impact of a slight reduction in population.

The Walmart Narrative

This story seems to be hitting the airwaves from a few angles. Walmart (WMT) plans to reduce its total headcount in industrial staff by 2,000 workers. That’s basically a rounding error. Even if they were all in Southern California, it would be less than 1% of the industrial workers there. How many of the jobs are actually in Southern California? Zero. Walmart’s job cuts are in Texas, Pennsylvania, Florida, and New Jersey. Yet, those cuts are referenced to create support for a false narrative.

Bloomberg (paywalled link) ran a story about the decline in industrial real estate. They dramatically oversold the issue with terms like “an ominous sign for California.” While stirring up fear, they also mentioned Walmart’s announcement as cuts “across the country.” They did not mention that all of the cuts were more than 1,000 miles away from the areas they were discussing.

They also neglected to mention that Walmart was paying the employees for 90 days to find jobs at their “new high-tech e-commerce distribution centers.” That seems like an important detail.

Further, industrial jobs and industrial real estate are not equivalent. Walmart is actually making a point of highlighting the increase in their e-commerce capabilities, as CFO John David Rainey said on the latest earnings call:

Somehow Walmart’s move into newer and better facilities was construed as a negative sign for the industry.

Automation

Warehouse jobs should become significantly more efficient over time with dramatic increases in automation. Warehouse work is physically demanding, and that is precisely where automation shines.

There wasn’t as much incentive to automate warehouse positions before because there were far fewer warehouse employees. Automating an industry with fewer employees produces less savings. Therefore, there’s minimal investment in automation. As the total cost rises, the appeal of automation increases.

The following chart was provided by Bloomberg to support the doom and gloom scenario:

The data reflects about 150,000 jobs at the start of 2020. Now it reflects about 200,000 jobs. However, due to a peak of around 215,000 jobs, this is seen as plunging jobs. Of course, no data is perfectly accurate. There’s always some weakness in data collection.

It might be good to consider that while it appears there was a 7% reduction in the reported (or estimated) workforce, occupancy remains around 99%. I think occupancy is the more valuable metric here. Further, that occupancy is high despite dramatic increases in rental rates. Which metric do you think matters more?

Conclusion

Given the strong occupancy and strong rent spreads we’ve continued to see, along with guidance for strong rent spreads to continue, we’re not concerned by the report of a modest dip in the reported (or estimated) number of employees. The fundamentals driving demand remain excellent, and the attempts to create a negative narrative simply do not reflect reality.

Improvements in automation may result in a significant difference between the number of industrial jobs and the volume of square feet needed. The development of that automation was not practical several years ago because the industry was smaller. However, the growth of e-commerce is providing greater economies of scale for investments in automation.

Automation benefits industrial real estate because reducing labor costs per dollar of sales increases the incentive for selling more online. That leads companies to further emphasize online sales. Since online sales require significantly more space (no retail store to hold inventory), each dollar that moves to e-commerce contributes to greater demand for industrial real estate.

We are long PLD, REXR, TRNO, and EGP.

Using today’s prices, I think PLD, REXR, and TRNO are nice bargains and I’m reiterating a bullish outlook on those three REITs.

While industrial REITs command higher AFFO multiples (and lower dividend yields) than other types of REITs, they also have dramatically more embedded rent growth as many leases are still dramatically below market rent.

Since supply remains constrained and demand growth is fueled by the shift to e-commerce, I expect market rents to be materially higher in five years than they are today. That allows these REITs to generate growth from leasing properties at current market rates, plus further growth in market rates. That combination leads to dramatic growth in revenue, which fuels growth in AFFO per share.

Some investors will continue to hate this call because industrial REITs have such low dividend yields. That’s their choice. However, REITs are not only a tool for yield. They can also provide substantial growth. Many of the most valuable companies in the world have no dividend or a very small dividend. It would be wise to consider some of the REITs with lower yields and dramatically stronger growth.