2024-01-05 06:00:11 ET
Summary
- First Industrial Realty Trust's revenue and funds from operations have shown positive growth, with strong lease renewal activity driving net operating income growth.
- With imports and e-commerce activity picking up, demand should strengthen in 2024.
- Despite some challenges, such as inflation in operating expenses and slower leasing of new space, the company is well-positioned for continued growth and has the potential for increased FFO margins.
Shares of First Industrial Realty Trust (FR) have surged over the past two months to move solidly into positive territory over the past year. While this has lagged the broader market, FR has fared better than many other real estate-oriented stocks in this period of rate volatility. With favorable long-term trends, I view shares as attractive, even amidst a moderate demand slowdown.
First Industrial is an owner of logistics real estate, similar to Prologis (PLD), though on a smaller scale. About 58% of the company's real estate is coastal exposed, serving as important warehouse infrastructure for international trade, with particularly large presences near California's critical West Coast ports as well as in the state of Florida. Reflecting strong rent renewal rates, in the company's third quarter , revenue rose by 11% to $155 million. Management also raised full-year guidance by a penny to about $2.40 in 2023 funds from operations (FFO).
In the third quarter, FFO rose by 3% to $0.62, more modest than revenue growth. Operating expenses rose nearly 20% to $42.6 million as the company faces inflation in property taxes, insurance, and labor. These forces should moderate in 2024 with real estate valuation growth slowing. FR is controlling its own expenses well as G&A was roughly flat at $8.4 million. Given higher rates, interest expense rose by 50% to $20 million with debt of $2.2 billion, up $140 million year. With the Federal Reserve likely done its rate-hiking cycle, we should not see further material interest expense increases, though we will not see declines back to 2022 levels either.
While expense growth has offset much of the revenue growth, property-level earnings growth has been solid, though we have passed the peak. Same store net operating income growth should be about 8.25% in 2023. However, we are seeing deceleration. FR generated 7.4% same-store NOI growth in Q3, and I expect Q4 to be in the 6.25-6.75% range. This is still a robust level-down from 10.1% in 2022, but above the 4.5-5% prior 5-year trend.
Strong lease renewal activity is the primary driver of NOI growth. Many of its leases run 5-10 years, and given the growth in e-commerce and companies choosing to hold a bit more inventory after COVID-related supply chain shortages, lease rates are substantially higher now than when these contracts were signed. As a consequence, FR has delivered cash rental rate increase of 60% this year. Critically, on 2024 expirations, it has resigned 40% of those leases already at 38% increases, with management expecting the final 2024 rate to be higher than 38%. Many of these contracts also have 3+% annual inflation escalators. As you can see below, leasing activity has been strong with the company seeing large gains on new and renewing leases.
While the rate of NOI growth has slowed, the net rate FR secured in Q3 of $11.22 rose from the $10.89 full year level, indicating a still-healthy level of rental demand. One challenge for margins is that while FR has been able to re-sign existing tenants, it is taking longer the company to lease new space. As such, occupancy fell 2.3% sequentially to 95.4%. Excluding just-completed developments, this would be 97.1%. Management is guiding for occupancy to decline to 94.5% at year-end as it expects new completions to not have leases signed until 2024 as prospective tenants have been " deliberate " about adding space.
If FR can sign this incremental space in 2024, we should see room for FFO margins to improve, particularly with interest expense increases set to slow. Combined with higher renewed lease rates, that should be a combination for upper-single digits growth to continue. I see several reasons why this is likely to be the case. First while FR has had space come to the market, it is the exception. Higher rates in 2023 caused a 54% drop in new logistics construction, meaning there will be relatively little supply hitting the market over the next 18 months.
As such, if demand return, FR has the space to exploit this. With its coastal exposure and granular tenant base (its top 20 tenants are just 26% of the portfolio), FR has the properties and relationships to take advantage of that demand. Moreover, just a few months ago, many were fearful of recession or higher rates. With a soft landing appearing more likely, tenants should be more willing to sign leases.
Additionally, FR and the warehouse sector saw a spike in demand in 2020-2022 as trade picked up and e-commerce rose. Both of those trends reversed a bit over the past year, a headwind to their demand, but are now moving back in the right direction. First, e-commerce companies obviously need more warehouse space than traditional retailers. As you can see below, COVID caused a surge in e-commerce penetration when brick and mortar retailers were forced to close.
When they reopened, e-commerce took a step back. Essentially, e-commerce has been in a secular bull market for two decades, but it grew too far above its long-term trend, leading to a natural pullback. However, we now appear to be back on a growth footing. This should be supportive of warehouse demand in 2024.
Additionally, with its coastal markets, First Industrial is exposed to international trade flows. Imports spiked to records after COVID as consumers used stimulus checks to buy large quantities of heavily-imported goods like apparel. As this consumer demand stagnated, we saw imports decline over the past 18 month. However, here we are also seeing a return to growth.
Even with these two trends moving against the company over the past year, First Industrial is renewing leases at double-digit gains, which speaks to the quality of its footprint, as well as the pent-up inflation in its business. Because leases are 4-10 years, when rents rise substantially, there is significant cash flow to come just by bringing leases to market levels. Whereas apartment REITs can do this in 12-18 months, it takes logistics REITs much longer. These long-term contracts provide revenue certainty, during downturns, but also mean that upturns can last for several years.
Even if we see rental growth rates slow to mid-single digits with the potential to improve occupancy by 150-275bps over the next year as demand comes back, we should see upper-single digit top-line growth. With that top-line growth, I expect 2024 FFO growth to be 6-8% $2.55-$2.65 in FFO.
FR is well positioned to use that FFO growth to reward shareholders. Its 2023 dividend coverage is about 1.88x, a very strong level, which means dividend growth should at least match FFO growth, if not slightly exceed it. That is why FR has a 5-year dividend growth rate of 8%.
That strong dividend coverage also gives FR the flexibility to fund its growth efforts. It retains about $160 million in cash flow and is running about a $300 million net cap-ex program, meaning it self-funds about 50% of projects. That reduces its needs for debt-financing, which is why its own construction activity has been less rate-sensitive than the sector as a whole.
It has a 5.1x debt/EBITDA leverage ratio, but it has pushed maturities to limit near-term refinancing. Eventual Fed rate cut will also reduce interest on its line of credit. This is why I expect interest expense to remain around Q3 levels, after its large year-over-year increase.
Given favorable supply/demand dynamics and long-term leases, I view the biggest risk to First Industrial as an investment to be macro-oriented. If you compare shares to long-term treasuries (TLT), they exhibit a close correlation, which is true of many real estate stocks. Long-term rates have fallen a lot from two months ago, and so tactically, if you expect rates to rise again, there could be a better entry point in shares than today. However, if rates keep falling, shares could rally further.
Ultimately, interest rates are hard to predict, and out of FR's control, or investors' control. I do think given the rate move, investors should be selective in real estate investments. In some cases, the recent rally can provide an opportunity to exit at much better levels, as I recommended with Extra Space Storage (EXR). In First Industrial's case, I am still comfortable with the valuation given the fundamental factors described above.
In this rate environment, I continue to believe investors should target 10+% required returns. With its strong dividend coverage and my expectation for 6-8% FFO growth, I expect dividend growth of about ~8% in coming years as we see the benefits of renewed leases and incremental occupancy. As such, I see fair value for shares to the mid-$60's for a 2% dividend yield and 4% FFO yield. That provides for about 20% upside to fair value.
I would view the biggest risk to this price target a rise in 10-year treasury yields above 4.5%. A recession would also likely reduce demand for its space, slowing rental growth rates, though this impact would be mitigated if associated with a decline in interest rates. Given the potential return opportunity and stability offered by its strong dividend coverage and lease contract lengths, I view these risks as manageable, and I recommend buying FR.
For further details see:
First Industrial Is Positioned For A Strong 2024