2023-07-26 14:22:49 ET
Summary
- The first half of 2023 was marked by an increase in the S&P 500.
- A handful of stocks drove the gains. I now expect REITs to take over.
- Here are three I'm avoiding and one I like a lot.
Written by Sam Kovacs.
Introduction
The rest of the year will provide investors who missed out on the gains of the first half the opportunity to profit greatly if they know where to look. The Fed is still raising rates, market pundits are still cautious about a recession, certain stocks are falling despite beating on earnings and revenues.
Yet, I believe that the market will continue to power on for a while, but you can profit only if you know where to look.
At the end of the first half of 2023, I shared with our members our outlook for the next few quarters.
I noted that the S&P 500's (SP500) strong performance has been driven by its gains in tech, communication services, and consumer discretionary.
In other words, tech, because its communications service exposure is heavily tilted towards Alphabet (GOOG) and Meta Platforms (META), while its consumer discretionary exposure is heavily tilted towards Amazon (AMZN) and Tesla (TSLA).
It is no surprise that these stocks led the recovery; the big name, big tech stocks are now often the first to signal broader market movements.
The power behind the bull market that resumed in March is being led by the Magnificent Seven and their stellar performance in 2023: Alphabet ((GOOGL)) +31%, Microsoft ( MSFT ) +39%, Amazon ((AMZN)) +48%, Apple ( AAPL ) +51%, Meta ((META)) +136%, Tesla ((TSLA)) +149% and Nvidia ( NVDA ) +195%. Putting things in perspective, without the big gains of the gunslinging gang, the S&P 500 would be slightly underwater for the year.
I told our members that what I expect to follow is a slowing in tech gains, broader gains in consumer discretionary, a reversal in REITs and Financials, and continued gains in industrials.
In the past month, we've seen all of this start to happen.
Financials, Real Estate, and Industrials have all outperformed tech, and within consumer discretionary, TSLA has started to trend down, AMZN is flat, while LOW, HD, DRI, and WSM have all increased by at least 4%.
In an article outlining our sector outlook for the next 6-18 months I said that:
So from a business cycle perspective, we've got some emerging factors of an early recovery (Tech, Industrials materials up, energy, utilities down) But we still have some looming elements of the recessionary phase: financials down, real estate not yet staging a recovery,
So we're somewhere in that transition from a recessionary phase to an early recovery phase IN THE MARKETS (this is leading economic movements).This is consistent with data showing declining inflation (led by declining energy, which is the leading variable for inflation on the way up and down) and a strong job market that just won't quit being strong.
Well, both financials and REITs have started to bounce, and we've seen breadth start to establish in Consumer Discretionary stocks as well.
But does that mean you should just go out and buy any stock in these sectors?
No, of course not.
Understanding differences within sectors
While stocks within a sector are usually quite closely correlated, it is important to understand that there are many industries within sectors which share fundamental differences.
These differences can be so strong that while a whole sector is doing well, a certain sub sector is failing to gain any traction.
Let's take real estate investment trusts, or REITs, which will be the focus of this article.
All REITs are similar because they lease some form of property to a tenant, property which is financed by equity and debt.
When rates go up, all else held equal, the spread between rents and financing costs goes down, as REITs pay more in interest payments.
This has pushed virtually all REITs down severely over the course of the past year.
But it is important to understand that while the cost of capital is similar for REITs (adjusted for credit ratings of course), the nature of the property and the nature of the tenants isn't.
Let's compare an office REIT with an industrial warehousing REIT.
The former has places where people will go to work, presumably with a phone and a laptop. The latter has places where people will go to process and store goods which must at a later point be shipped to a client.
The nature of the property is, therefore, fundamentally different.
And while you can't have Amazon's employees warehousing goods from home, you can have Amazon's marketing team working from home, as every home is equipped with a phone and a laptop.
This is a classic business school case of Porter's 5 forces, in particular the threat of substitutes.
For those of you not familiar with Porter's 5 forces, it is an elegant framework which analyzes the competitive forces in an industry.
Work from home is effectively a threat of a substitute for office REITs, which weakens the attractiveness of office REITs.
Offices which see reduced footwork question whether they need as much space. They realize they don't, so they downsize, relinquishing their space. This reduced demand tilts the market into oversupply, which increases the bargaining power of buyers (tenants).
This subsequently reduces the amount that REITs can charge their clients when they go to renew their leases.
It is not surprising, then, to see that the likes of Boston Properties, Inc. ( BXP ) are renewing leases with cash spreads of 0.81%
This is well below the firm's 10 year CAGR of same store net rents of 3.1%.
And it is alarming, because it is a phenomenon which will last for years as vacancy rates in key markets like Boston and Manhattan are at all-time highs.
Office clients in these markets where BXP operates will usually lock in long-term leases.
This shelters the REIT for some time, but as leases expire, the difficult discussion of renegotiating the rent enters.
So it is clear to see how a REIT is only as strong as the robustness of its demand, and the constraint of its supply.
BXP operated in markets with constrained supply on the basis that demand would always be there.
We're now seeing that isn't the case. We haven't returned to pre-pandemic levels, and have to question: will we ever?
Does this mean BXP's stock won't do well in upcoming months?
No, of course it could do well. In fact, as REITs as a group rise, it isn't unimaginable to see BXP rise as well. The rising tides lift all boats, as they say.
But because of the foreseeable struggles in office REITs for years to come, I prefer to pick other stocks.
Industrial REITs: a more attractive asset class, with a caveat.
Industrial REITs own and manage a variety of industrial properties, primarily warehouses, distribution centers which cater to e-commerce, manufacturing and transportation businesses.
Prologis: the elephant in the room.
The biggest stock in the industry is Prologis, Inc. ( PLD ) with a market cap of $112bn.
It currently yields 2.75%, slightly above its 10 year median yield, and has been growing its dividend at a 12% CAGR for the past decade.
The industrial REIT industry in the U.S. as a whole is composed of 11 players and worth about $165bn, making PLD worth 67% of the industry.
If we're going to talk about industrial REITs, we cannot ignore the elephant in the room.
The company recently reported great Q2 results , with the CFO noting that:
The continuation of record operating results is a testament to Prologis' premier global portfolio and the enormous, embedded mark-to-market upside that will provide industry-leading, predictable growth for years to come.
Let's unpack this: office cash spreads on industrial REITs are huge, as the demand for industrial properties has increased at a rate which has exceeded the supply of new industrial space.
As the share of ecommerce continues to climb throughout the next decade, there will naturally be more demand for industrial warehousing.
How high can Ecommerce go as a percentage of retail sales? It is currently around 20%.
If we look at other countries, like South Korea for example, where the penetration rate of Ecommerce is already 35%, it is clear there is still room to grow.
This is a natural tailwind for the next decade.
But what about supply?
It is no surprise that the large increases in rents of industrial have attracted investors to create more supply of such properties.
Nationwide, there is a large amount of construction forecasted over the next 5 years.
But this construction varies massively depending on geographies.
In fact, we're already starting to see certain key markets which have attracted a lot of new supply, like Dallas and Atlanta, have releasing spreads which are lower than the national average.
And this, is the very reason that I question the second part of PLD's statement: " that will provide industry leading growth."
Let's turn to the company's research which it generously shares to give us further understanding of the dynamics of the industry.
In 2023, bucking the trend of 21 and 22 where demand for new industrial locations outstripped the supply of new locations, we're now seeing large deliveries coming to the market, which should push vacancy rates up.
It should be noted that this increase in supply and a slowdown of demand is set to increase the vacancy rates to 3.6%-4% from 3% in 2022. This is still well below the historical vacancy rates, and the true months supply of 25 (the time it would take to absorb all new supply) is still well below historical TMS of 36. A reduction in deliveries in 2024 could see the vacancy rates stabilize at around 4% for the next two years.
Now it is important to understand that not all industrial markets are made the same in the U.S.
Investing in the likes of Prologis means being exposed to multiple states. Not all the states are good. With PLD you're picking up a bag of little of everything, and some in Europe, Mexico, China and Japan. It makes the analyst work more difficult, and removes the edge from selecting submarkets.
Some have talked about potential supply gluts in the industrial warehousing subsector, and those cannot be ignored. But they are localized risks.
Or, should I say, there are localized markets, which are not at risk.
Because of its size, I don't believe PLD can get enough exposure to the right geographic locations to have the industry leading growth it promises for years to come.
EastGroup Properties: Questionable sunbelt exposure.
Another Example of an industrial REIT which has considerable exposure to markets with supply risk is EastGroup Properties, Inc. ( EGP ), an $8bn market cap industrial REIT which operates in sunbelt markets.
While the company has 20% exposure to SoCal, it has considerable exposure to Florida, Texas, Arizona as well as Charlotte.
Now if we go back to our graph highlighting the difference between rent in place and new rents in the key markets, we can see that EGP has exposure to markets with lower spreads than the national average (if we exclude its California & Miami exposure, which account for only 23% of rent).
EGP's strategy has been to focus on sunbelt markets, as the belief was that with the ongoing trend of onshoring of warehouses, states like Texas, Florida and Arizona would be winners as companies would choose these low tax markets to operate their warehouses.
While this premise makes sense on the demand side, it is flawed because it fails to consider the fact that a market is based both on supply and on demand.
And if supply can increase exponentially to absorb the new demand, then the dynamics of supply and demand do not favor massive rent increases.
We previously saw that Phoenix, Dallas, Houston and Charlotte represent a large part of the industrial construction in progress, and the leasing spreads in these markets have been below national average.
These markets are going to continue to see supply pressure in upcoming months and years, which will put a halt to the huge renewal spreads EGP has seen.
Now, cash spreads of 32% are nothing to be ashamed of.
These are amazing spreads, and a testament to the current environment where outsized demand allows industrial REITs to command higher rents.
They are lower than the 48% spreads that PLD is getting, and less than the 75% cash spreads the final REIT I like gets, which I'm about to present.
Furthermore, relative to its dividend, EGP trades at a fair price. Sure it could continue to do well, but you're not buying something historically undervalued, just like PLD.
Rexford Industrial: Eat your cake, and have it too.
Rexford Industrial Realty, Inc. ( REXR ) is an industrial REIT focused solely on Southern California Infill.
Los Angeles, Inland Empire, and Orange County all have the peculiarity of having strained supply, while SoCal is the largest U.S. market, and the 4th industrial market worldwide, if we considered it a country!
As you can see, I highlighted in green the average spreads realized in the markets in which REXR operates, and in red those where a lot of new supply has come online.
And Rexford owns high quality and newer assets within this positive submarket. While SoCal has had negative net absorption in Q1 2023, Rexford's has remained positive, and its rent growth outpaces their markets.
And while PLD's CEO claims that they have industry leading performance, REXR demonstrates that it is not the case.
Net operating income growth and dividend growth have been double that of its peers, and well above PLD.
The cash leasing spreads of 75% in this quarter are out of this world.
What's more, REXR's Inland Empire exposure doesn't have the same vacancy threats as the rest of the market, which is one of the only areas in SoCal where significant construction is still happening.
By focusing on facilities of an average of 29,000SF, it is avoiding the vacancy rates and supply risk faced by the larger 100K+SF properties.
This has allowed REXR to have positive net absorption in the past 4 quarters while SoCal has seen vacancy rates increase slightly. REXR's occupancy remains at 98.1% of its properties.
The stock currently trades at $56 and yields 2.7%. This is significantly above its 10 year median yield of 2.1%.
A reversion to the 10 year median yield would suggest a price of $73. My price target for REXR is $75 over the next year, but I believe it could be a $100 stock by 2026.
There is nothing compelling to suggest that REXR won't be able to grow its dividend by at least 15% per year for the next 3-5 years.
Industrial REITs are one of the best industries within REITs right now. REXR will still be a great stock even when other markets get displaced by new supply.
Conclusion
Buying stocks which do well is a function of: picking the sectors which will likely do well in the next 6-18 months. finding the industries within them with the strongest fundamentals; and finding the stocks within that industry with even better fundamentals.
Then you need to hope you can get the stock at a great price.
This is the case for REXR.
Of course, you can do well just by being overweight the right sector, but why not go the extra mile to really knock it out of the park?
For further details see:
3 REITs I'm Avoiding And 1 REIT I Love For H2 2023