2023-10-25 14:41:34 ET
Summary
- First Industrial shares have fallen due to rising interest rates, supply pressure, and a slowdown in tenant leasing.
- Operating results remain strong with mark-to-market rent increases driving NOI higher.
- The company is poised for continued growth from same-store NOI growth and development projects, with potential for a 60-75% upside in shares.
Shares of First Industrial ( FR ) have been battered, having fallen nearly 13% year-to-date, and are now down 37% from their all-time high due to rising interest rates, supply pressure, and a slowdown in tenant leasing. While the share price has suffered, operating results have remained strong as mark-to-market rent increases on its portfolio have driven NOI higher - a trend which is likely to continue over the next several years.
At today's price, First Industrial trades at a 6.7% implied cap rate (using 2024e NOI) and just 16.2x 2024e FFO. Moreover, the company is poised for continued strong growth from both same store NOI growth as leases roll/are repriced and as the company completes development projects. Looking out to 2027, I see 60-75% upside in the shares.
Current Results - Embedded growth
While headlines lament surging supply and waning tenant demand, as you can see below, First Industrial has continued to deliver exceptional rent growth as leases are repriced.
Importantly, this trend has continued despite a slowdown in the industrial market -as noted above, cash rental increases for leases set to roll in 2024 are up 38%. Importantly, in addition to the immediate increase in cash rents, like other industrial landlords, First Industrial has negotiated higher annual escalators (3.8% for 2023 expiries) into its leases. The combination of soaring rent upon lease renewal and strong annual escalators have driven exceptional same-store NOI growth over the past few years.
Moreover, looking beyond 2024, we should continue to see meaningful rent increases into 2025-26 as most of these leases which were signed in 2020/21 (outside of new development most of First Industrial's leases are 4-6 years) are well below current market rents. Rising rents on lease expirations coupled with 3+% escalators on in-place leases should drive 5+% same store NOI growth in 2025-2026.
Creating Value Through Development
As shown below, First Industrial has been a prolific developer of industrial real estate, having placed ~20 million square feet of real estate into service at a 7% cash yield since 2016.
First Industrial has just over 2 million square feet of development in progress and another 2 million feet which has been completed and is in the process of being leased-up. In total these projects are forecast to add another $40 million, or 8% to NOI. Beyond current, in process development, First Industrial maintains a large land bank for development with the potential for another 15 million square feet (22% of current portfolio) over the next 4-5 years.
Like other real estate sub-sectors, rising interest rates and construction costs coupled with softening demand, tighter lending standards and a pullback by regional banks is curtailing new industrial development projects. While the market appears concerned about the overall level of industrial development pipeline and the prognosis for leasing these projects at attractive returns, it is important to highlight that overall development starts for industrial real estate have plummeted nearly 50% over the past nine months (as shown below).
At the end of 2Q23, industrial real estate occupancy is strong with vacancy across the overall industrial landscape was below 4% (sub 5% taking into account development pipeline). While the balance of power in leasing for the next 6-12 months is likely to favor tenants, the dramatic decline in development, looking out one year, this space is expected to be absorbed by underlying demand growth. As recently noted by industry leader Prologis, by 2025, the balance of power should again favor industrial landlords.
Valuation
As we sit today, First Industrial trades at an implied cap rate of ~6.7% on 2024e NOI (adjusting GAAP rent to cash). To an extent, this actually understates the implied cap rate due to the ongoing mark to market expected to occur in 2025-26. While cap rates have increased from the high 3s seen during the near-zero interest rate period of 2020-21, recent deals, such as P rologis' purchase of a Blackstone portfolio have been in the 5-6% range (on a stabilized, mark-to-market basis).
I estimate a 2027 NAV of $70-$72 for First Industrial assuming 5% same store NOI growth (3+% from escalators, remainder from mark-to-market) and applying a 5.5% cap rate. Factoring in dividends, this suggests a 17% annualized shareholder return for First Industrial shareholders over the next four years.
Conclusion
A demand slowdown, rising interest rates, and a construction overhang have hurt First Industrial shares. However, with a low valuation and a well-positioned portfolio set for meaningful NOI growth, I see First Industrial as an attractive opportunity for conservative, long-term shareholders.
For further details see:
First Industrial: Embedded Growth At A Discount