2023-07-20 21:56:53 ET
Summary
- First Industrial reported strong Q2 results, which included another quarter of record cash rental growth.
- Results were also accompanied with positive revisions to expectations for full-year FFO and cash rental growth.
- Despite the strong growth rates, the company appears to be facing little pushback, as assessed through occupancy and retention rates.
- FR also continues to make positive progress in their speculative development pipeline.
- Despite the ongoing strength, I continue to view the stock neutrally and see shares best left on "hold".
Posting back-to-back record rental growth is no easy feat. But First Industrial ( FR ) is making it look easy. Based on the post-earnings share price decline, markets appear skeptical it can last. If markets are correct, FR could be at a greater risk of a pullback in relation to peers due to their higher speculative pipeline.
First Industrial Q2 Results
For now at least, growth rates are exhibiting no signs of pulling back. In the second quarter , FR grew cash rental rates by a record 74.1%. This came at the cost of a slight decline in occupancy and retention levels. Even with the decline however, in-service occupancy still stood at a healthy 97.7%, in-line with expectations .
The strong rental growth contributed to a double-digit increase in same-store net operating income (“NOI”) of 10.8% and a 8.9% YOY increase in funds from operations (“FFO”).
Market Reaction To FR's Q2 Results
Despite the strong quarterly performance, shares pulled back on the day following their release. The decline also coincided with the conference call, which took place on the new trading day. Based on my assessment of the call, the tone was largely positive.
CEO, Peter Baccile, did update on the supply outlook and noted that there would be an uptick in new supply in the next 12 to 18 months. But this wasn’t necessarily a surprise. Baccile also noted that FR is experiencing extended decision-making times from their tenants on completed developments. This in turn resulted in an adjustment to their lease-up assumptions, which ultimately impacted their full-year occupancy guidance. Again, though notable, it’s not exactly new news to investors.
Despite the share price decline on the day, the stock is still up 8% YTD and over the past year. This is roughly in the middle-of-the-pack compared to the sector at large.
Seeking Alpha - FR Basic Trading Data
Key Takeaways From FR’s Q2 Report
Leasing Environment Remains Robust: By all measures, FR is capturing the full benefits of a highly accommodative operating environment. Cash rental rates on new and renewal leases grew 74% during the quarter, a new record. This follows 58% growth in Q1, which marked the previous record.
The increases didn’t appear to be met with significant resistance. Quarter end occupancy was 97.7%. That’s down 100 basis points ("bps") from Q1. But it doesn’t appear as dramatic when considering the rental rate growth over the same period.
Peter Baccile noted that decision timeframes have lengthened. This, however, hasn’t dented the forward momentum. As an example, the company successfully renewed their largest 2024 lease expiration. Retention did dip to 60% from 63% last quarter. But similar to the occupancy rate, the decline doesn’t appear material.
Developments Staying On Track: FR has a large pipeline of speculative developments. While this is a key aspect of their business model, it has been a persistent concern of mine due to its inherent risks.
To date, my concerns have not come to fruition. During the quarter, FR leased 100% of space in two of their properties in South Florida, as well as one in the Camelback business park in Phoenix. In addition, they leased 50% of space in one property in their Seattle market. Collectively, this amounted to 673K SF of signings.
FR even proceeded ahead with two new commencements during the quarter, one in their South Florida market and the other in the Inland Empire. Following the activity during the quarter, they have about +$40M of cap space available. With the cap near full capacity, I’d expect new initiations to pull back for the remainder of the year.
FR Q2FY23 Investor Supplement - Summary Of Availability Remaining In Speculative Cap
Positive Revisions To Guidance: The strong quarterly performance enabled FR to raise their estimates for both cash rental rate growth and full-year FFO.
For 2023, cash rental rates on new and renewal leasing is expected to be in the range of 55% to 60%. This would be up 7.5% at the midpoint from their previously stated guidance in April and 12.5% above their original guidance at the beginning of the year.
Looking more to the bottom line, FFO is expected to land at $2.39/share at the midpoint. This would be up a penny from the previous midpoint. Though early leasing at several development projects is contributing to the increase, delayed decision-making on other projects is negatively impacting their occupancy outlook for the year.
Average quarter-end in-service occupancy is now expected to be 97.5% at the midpoint. This represents a 75bps decrease from their previous target. Despite the decline, this would still be representative of a strongly occupied portfolio.
Is FR Stock A Buy, Sell, Or Hold?
The times are good for First Industrial. Rents are increasing at record rates. Tenants haven’t materially pushed back, as assessed through stable occupancy and retention levels. And the company continues to have success in the lease-up of projects under development.
Why, then, are shares underperforming peers such as EastGroup Properties ( EGP )? Both have comparable state-based footprints. EGP is more pure play to the Sunbelt, whereas FR has Northeastern diversification. But they are otherwise similar. FR is also targeting greater same-store NOI growth.
Yet the stock trades at a few-turn discount to EGP. In addition, the stock has consistently posted weaker returns than those posted by its counterpart. On a YTD basis, FR is up about 8%. This compares to gains of 25% by EGP.
In fairness, EGP does have a strong track of outperformance in relation to the overall peer set. FR’s returns, too, stack up better than others. But I would expect the two to trade more in-line with each other.
In my view, the culprit for the discount is FR’s speculative developments. While the company clearly hasn’t had issues leasing up their projects, the market environment has thus far been accommodative. At some point, however, the market will eventually go through a downcycle. Good times, after all, aren’t expected to last forever.
When this downcycle occurs, there’s a risk that FR could be left with an excess number of vacant properties, which would amplify any deleveraging in rental rate growth. Based on their speculative cap, the company is already near capacity on the number of projects being undertaken.
With the market expected to slow in the back half of the year, I view FR as being at greater risk of a pullback than others, who have less exposure to speculative projects. As such, I view their current valuation as appropriate.
For further details see:
First Industrial: Is It A Buy Following Another Quarter Of Record Rental Growth?