2023-11-09 09:59:39 ET
Summary
- EastGroup Properties is a mid-cap REIT that develops, acquires and manages industrial buildings in the Sunbelt States.
- The company's current occupancy rate is 97.9%, down slightly from the previous quarter, but it has been able to increase rents on rollovers by an average of 55.4%.
- Guidance has been raised twice this year, by 6.0% so far, and the company will likely exceed the high estimate.
- While cap rate expansion in Q3 has lowered REIT values across the board, EastGroup's shares remain slightly elevated, though closer to an entry point.
EastGroup Properties, Inc. ( EGP ) is an industrial REIT that is a component of the S&P Mid Cap 400 . It is an internally managed company with a very focused product: industrial distribution buildings between 80,000 to 150,000 square feet, in the Sunbelt, and divisible into multi-tenant configurations with 15-25.0% office space. I have written previously about EastGroup and am updating my analysis because third quarter results were recently presented, and for the second time in a year, the company increased its guidance. The current estimate for FFO is $7.73-$7.77 per share, but on the recent conference call, management indicated that it would likely beat this number. The initial estimate for the year was $7.30-$7.50, about 6.0% lower. Recent trends of note from the third quarter conference call are:
- New acquisition opportunities are arising as the market slows and cap rates increase.
- Industrial construction starts in the market have dropped by 2/3.
- Developers are finishing site work and selling on, an opportunity for EastGroup.
- The company focus has switched from development to acquisitions. It has reduced its holdings in Houston and increased them in Las Vegas. Austin and San Diego are targets for more buying.
Another factor has changed since I last wrote about EastGroup: industrial cap rates increased in the third quarter by another 54 basis points. Using the new information for Q3, I thought it would be appropriate to revalue the company's shares. It is on my watch list and I previously estimated its fair value at about $168.00, when shares were priced at $176.87. At that time, I found it to be fully valued by the market. But many REIT prices are down of late and according to Morningstar, the sector dropped 7.2% in the third quarter . There have also been a handful of REITs that have cut their dividends lately, though these have been mostly office-based. So I also wanted to look at the safety of the dividend.
Shares of EastGroup are currently priced at $168.50. As I noted previously, the recent peak was $227.95 in December 2021, so they are down 26.1%. The current dividend is a relatively low 3.0%, so investors are likely looking for share price appreciation here. Per the 2023 Investor Presentation , the 20-year compound annual return was 13.7%, while the five-year return was 14.7%.
The Third Quarter Portfolio Added Another 1,581,000 SF
Currently, the company owns 59.0 million square feet of industrial space, an increase of 5.4% over the year-end 2022 number of 56.0 million . EGP specifically targets infill sites in undersupplied industrial markets and about 34.0% of the company's net income is generated in the state of Texas. The buildings in the portfolio are primarily multi-tenant, and as of the third quarter they averaged 94,000 square feet in size. The current occupancy rate is 97.9%, down slightly from 98.7% in the last quarter. EastGroup currently has about 500 industrial properties and three of its largest credit tenants are Amazon.com, Inc. ( AMZN ) with 2.0% of annualized base rent ((ABR)), FedEx Corporation ( FDX ) with 0.70% of ABR, and Trane Technologies plc ( TT ) with 0.77% of ABR.
During the third quarter, EastGroup made several important acquisitions. It continued to expand in Las Vegas with the acquisition of Blue Diamond Business Park. This property had two buildings with 254,000 square feet and was acquired for $53,000,000, or $208.66 per square foot. The buildings are 100% leased and increased total Las Vegas holdings to 1,165,000 square feet.
EastGroup also purchased the McKinney Logistics Center, a newer 193,000 square foot distribution building for $26,000,000 or $134.72 per square foot. This building in suburban Dallas is 100% leased. During the third quarter 2023, the company acquired land for future development, including 20.3 acres in Denton, Texas and 43.8 acres in Tampa, Florida.
EastGroup completed the development of six industrial buildings totaling 1,134,000 square feet this quarter. These buildings were in Greenville, Charlotte, Atlanta, Charlotte and Dallas-Fort Worth. They were all 100.0% leased except for Greenville which was 72.0% leased. All were valued by EastGroup with a 6.8% cap rate. The company also began construction on three new industrial buildings with 793,000 square feet.
Market Vacancies are Rising, but so are Rents for Now
Industrial vacancies are still relatively low; however, the rate has risen to 5.0% nationally in the third quarter, from 3.59% in the third quarter last year. According to Colliers Q3 industrial Market statistics, "record new supply and normalizing demand pushed the US industrial vacancy up for the fifth consecutive quarter." The south experienced the largest vacancy increase to 5.9% this quarter up from 4.1% in Q3 last year. This is EastGroup's primary market. However, vacancies when broken down by industrial building size, show that they have only increased slightly, from 3.1% to 3.3%, for properties between 25,000 and 100,000 square feet. This is EastGroup's product segment. The largest increase in vacancies has been in big box warehouse distribution properties.
Despite rising vacancies in the market, EastGroup is reporting that it has been able to increase rents on average by 55.4% on rollovers in the third quarter. So, industrial leases signed only 5-10 years ago are still significantly below current market rates when they expire.
According to Colliers, the national average industrial rent is $9.52 per square foot. EastGroup reported that its average rental rate per square foot was $7.06 in 2022 (the most recent average released). Hypothetically, if all the leases rolled over with a 55.4% increase, the new average rent would be $10.97. According to Colliers Industrial Market Outlook for the second quarter 2023, warehouse distribution rents in the south averaged $8.22 per square foot triple net; while in the west they were $9.30 per square foot. EastGroup's new average rent won't be released until the 2023 annual report comes out, but it appears there is more room for it to grow from a low base of $7.06.
The company's typical lease is triple net for five to ten years, with annual increases in rent. In the past these were 3% per year, but in the third quarter investor call, EastGroup noted that it has been able to increase rents by 3.5% to 4.0% per year in the current market.
New Construction is Slowing but so is Absorption
Space is still tight in the industrial market, but according to Colliers, there is still 546.0 million square feet of industrial space under construction across the US, down two-thirds from last year. Four of the five submarkets that have the largest amount of industrial space under construction are those in which EastGroup operates. These are Dallas, Phoenix, Los Angeles, and Atlanta. It is important to note that the absorption of industrial space is also down; it was 47.8 million square feet in the third quarter, a 63.0% decline from last year, again per Colliers Industrial Market Statistics. While the rate of construction has dropped considerably, I think the declining absorption rate will lead to higher vacancies in the future.
Revaluing EastGroup's Shares Given New Data
Now that we are in the third quarter, the company has updated its guidance. The current estimate for FFO is $7.73-$7.77 per share. In the recent earnings conference call , East Group said it usually beats its annual consensus, and expects to do so this year, so I will use the number of $7.85 for valuation purposes. Previously, in its Second Quarter 2023 results, EastGroup estimated that FFO would be $7.58 to $7.68 per share. If it reaches $7.77 in 2023, FFO will have grown at a compound annual rate of 11.8%.
EastGroup's current share price is $168.50, which at a projected 2023 FFO of $7.77 is equal to a price/FFO multiple of 21.7. In order to value the shares, I have updated the price/FFO multiple of various other industrial REITs as of the end of the third quarter. AFFO numbers would have been useful as a crosscheck, but only a few industrial REITs publish this number and EastGroup does not. Prologis, Inc. ( PLD ) and Rexford Industrial Realty, Inc. ( REXR ), which have similar products, do not publish AFFO numbers.
For the comparable REITs, the current average multiple is 18.42 for the FFO group and 15.70 for the AFFO group (excluding EastGroup's numbers). These are down considerably from the multiples in mid-September, the last time I did this survey. Then the multiples were 21.66 and 22.99, about 15.0% higher. Again, FFO is projected to be $7.77 per share in 2023, but I am using the $7.85 number. Thus I calculate the preliminary value of East Group's shares as 18.42 X $7.85 or $144.60. Valuations are down across the REIT sector through multiple compressions as interest rates rise. I want to note here that, on or about On October 23, shares were actually trading as low as $154.28, so much closer to their fair value.
I have used an industrial market cap rate as a cross-check to the FFO valuation. Lee & Associates publishes cap rate statistics in their Q3 2023 North American Report . The national US index cap rate for industrial properties is 6.9% - this is up considerably from 6.0% in the first quarter. I have also looked at CBRE's third quarter cap rate survey, presented below, which included data specific to the south. These ranged from 4.75% or 5.0% to 5.25%, so let's use 5.25% as a cap rate. Then this calculation becomes $7.85/.0525 = $149.52, making the current share price about 12.0% overvalued. I believe the FFO multiples are a lagging indicator and that cap rates from investor surveys may be a little more current, so I am concluding at a fair value of $150.00 per share, down from $168.00 in the previous quarter, given cap rate expansion in the market and an overall repricing.
The Dividend Still Looks Safe
EastGroup's dividend was recently increased by 1.6% from $1.25 per quarter to $1.27. The company has increased its dividend in each of the last 12 years. I calculate the compound annual growth rate as 4.1% from 1987 to 2023, or about even with inflation over this time frame. The current payout ratio as of the third quarter 2023 is an easily sustained 64.0% of FFO as illustrated below.
At today's prices, the new yield will be 3.0%. Comparing this to the yield of EastGroup's peers, the company is on the lower end of the spectrum for industrial REITs. I have updated a table of yields below. If we rule out the extremes of Innovative Industrial Properties, Inc. ( IIPR ) and Industrial Logistics Properties Trust ( ILPT ) the average yield is 3.43%, a bit above EastGroup's. Even Prologis, Inc. ((PLD)), STAG Industrial, Inc. ( STAG ) and Rexford Industrial Realty, Inc. ((REXR)) have higher yields.
Risks to Outlook
I think the primary risk to my $150.00 value estimate is another interest rate increase from the Fed. Rate increases accelerate cap rate expansion and lower valuations across the board. A 0.5% change in the average industrial cap rate would lower values by 10.0% mathematically. A downturn in the economy could also weed out tenants and lower occupancy rates. However, the type of product EastGroup acquires and builds, with spaces between 20,000 to 100,000 SF, and buildings averaging 93,000 SF, puts it in a sector where vacancy rates are around 3.3%. Smaller tenant spaces in multi-tenanted buildings are less of a challenge to lease than a large, single-tenant industrial building which represents a larger commitment from a single tenant.
Conclusion
I continue to believe that EastGroup is an appealing company because of its simple business model of developing and acquiring multi-tenant distribution buildings in upscale industrial parks. The FFO estimate has been increased twice this year and will likely be $7.77 or higher. This was the 12th consecutive year of FFO increases and the portfolio is currently leased to 98.5% with 97.9% occupied. Because of the tight industrial market, EastGroup was able to achieve substantial rent increases on new leases and renewals. I expect this to continue in 2024. But I still believe the market is overpricing EastGroup shares and I estimate that a strong entry point is at or below $150.00. While it seems the company is frequently overvalued by the market (shares are currently $168.50), it is important to note that they were trading below $150.00 between September and December 2022, and varied from $142.00 to $145.00 per share during that time. In October 2022, they went as low as $138.16, so the price can get to a strong entry point, but a lot of patience is required from investors.
For further details see:
EastGroup Properties: Guidance Raised Again In Q3, But Wait For Better Price