2023-10-16 18:38:45 ET
Summary
- The industrial REIT sector has seen a steady increase in interest rates, impacting the spread between cap rates and the cost of capital.
- LXP's cap rate is 6.59%, close to the long-term sector average, but the current cost of capital is 7.44%, indicating a negative spread. Investment recommendation is a hold.
- An increase in re-leasing spreads and a sustained net debt to Adjusted EBITDA of under 6.0x would be positive developments.
Introduction
LXP Industrial Trust ( LXP ) focuses on single-tenant, warehouse and distribution properties most of which are rented out on a net lease basis wherein the tenant bears substantially all the costs such as taxes, utilities, insurance and ordinary repairs. As of June 30th 2023, LXP had equity interests in 116 properties in 20 states largely in the Sunbelt and Midwest. LXP also provides construction financing to merchant builders for speculative properties which may subsequently be acquired by LXP upon completion. LXP enjoys a BBB- rating from Standard & Poor's with a stable outlook.
In this article, we review the performance of the Industrial REIT sector in general and LXP in particular in light of the elevated interest rate environment. For the industrial REIT sector, we look at the historic relationship between 10-year Treasury and the industrial REIT sector implied capitalization rates. For LXP, we look at their current capitalization rate and their cost of capital and opine on the implication of the spread between the two measures in the near to medium term. The cost of capital estimate will require inputs that are directly related to interest rates. We discuss in some detail the inputs used and offer an interpretation against the backdrop of current macroeconomic environment. At the end of the article, a conclusion is offered and an investment recommendation is presented.
Source: LXP Industrial Trust 10-K for 2022 , REITwatch for August 2023, Standard & Poor's Rating Service .
Interest Rates and the Industrial REIT Sector
Please take a look at Table 1 which compares the five-year total return from an equity interest in LXP and the five-year median yield on the Corporate Baa/BBB.
Table 1: Comparison Between Equity and Fixed Income Return | |||
Equity Return | Fixed-Income | ||
Dividend Yield | 6.00% | Corporate (Baa/BBB) 5-year Median Yield | 5.98% |
5-Year Dividend Growth Rate | -6.77% | ||
Total Return | -0.77% |
Source: Seeking Alpha and Fidelity.com at the close on October 13, 2023.
Finance is based on several fundamental precepts, one of which is a balance of risk and return. When you can earn just as much or more on an instrument that has less risk, it may be time to reevaluate the investment thesis for the particular stock. The dividend yield in comparison with the yield on a fixed-income instrument is one area that could prompt equity investors to switch their allocation from the stock to a bond thereby curtailing the stock's appreciation potential.
If an investor is not just interested in buying shares of the business but instead interested in buying the entire business, they might forego the stock versus bond comparison and instead look at the cash flows generated by the business. Let us adopt this perspective.
Let us look at Table 2 that presents statistics that measure the relationship between the capitalization rate, or cap rate, for the industrial REIT sector and the 10-year Treasury from 2000 to 2019. The cap rate uses the net operating income (NOI) as the numerator, which is a proxy for cash flows for real estate assets. The denominator is typically a measure of the asset value.
Table 2: Spread between Industrial REIT Implied Cap Rate and 10-year US Treasury 2000 - 2019, Quarterly | |
% | |
Average Implied Cap Rate | 6.65 |
Average 10-year Treasury | 3.37 |
Spread | 3.28 |
Correlation from 2000 to 2019 | 0.685 |
Q2 2023 Implied Cap Rate | 4.23 |
Q2 10-year Treasury | 4.14 |
Spread | 0.09 |
Source: Nareit T-tracker Q2, 2023 and https://fred.stlouisfed.org . Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis, Percent, Quarterly, Not Seasonally Adjusted.
From 2000 to 2019, we estimate the correlation coefficient between the US 10-year Treasury and the implied cap rate for the Industrial REIT sector to be 0.685 which shows a moderately strong correlation. For the same period, the average cap rate for the Industrial REIT sector was 6.65% and the average 10-year Treasury was about 3.37% which indicates a spread of 328 basis points. One interpretation of this is that the market expects a 328-basis point premium for investing in industrial real estate assets over the 10-year Treasury given the risk profile of the assets. As of Q2 2023, that spread was only 9 basis points. This dynamic has been pointed out by executives in various REITs and is among the reasons some REITs are facing an increasingly challenged environment executing transactions. Sellers have not priced their assets to reflect the current macroenvironment. Tighter spreads imply higher prices.
The relationship between interest rates and cap rates can give us an idea on the relative valuation of a particular REIT sector. Continuing with our interest in the entire business perspective, we now estimate the cap rate for LXP and the cost of capital.
Cap Rates and Cost of Capital
LXP is a spread investor. In essence, LXP leverages their investment-grade credit and access to equity markets to secure funding for the acquisition and development of properties which are then rented out to tenants who takes care of the costs associated with the property. LXP collects rent and profits from the spread between the rental income earned and the cost of the capital used to acquire the real estate. For properties that they develop with merchant builders, LXP is able to leverage their investment-grade credit and offer construction loans, and in exchange, they have a pipeline of properties which could ultimately offer higher returns than acquiring already built, fully-leased buildings.
For an investor contemplating the purchase of the entire business, they would probably want to know the cap rate of the LXP and their cost of capital. The cost of capital can be decomposed into the cost of debt, the cost of equity, the cost of preferred equity and the relative weights of each form of capital employed in the business. If the investor purchases all the debt, all the equity and all the preferred shares they would own the business. If the total cost of capital is less than the cash flow the business generates, there is some basis to consider the deal.
Let us first estimate the cap rate for LXP.
Decomposing the Cap Rate
As mentioned earlier, the cap rate is the net operating income (NOI) divided by the value of the assets. From basic accounting, we know that assets equal liabilities plus equity. So, in estimating our cap rate for LXP, we shall use the NOI divided by long-term debt and the market value of equity and the book value of preferred stock since the preferreds are not as readily traded. Also, we ignore liabilities that are not long-term debt since they are mostly used as working capital. Please take a look at Table 3.
Table 3 : Cap Rate ($ in thousands) | |
Annualized NOI | 267,144 |
Consolidated Debt | 1,495,312 |
Equity | |
Preferred Stock at Liquidation Value | 96,770 |
Equity Market Cap* | 2,464,669 |
Debt plus Equity | 4,056,751 |
Cap rate | 6.59% |
Source: LXP 10-Q for Q2 2023, Q2 2023 Investor Presentation , Q2 2023 Earnings Supplement , *LXP share price at the close on 10/13/2023.
Based on our estimates and adjustments, the cap rate for LXP is at 6.59%. This is close to the 2000-2019 average implied cap rate for the Industrial REIT sector as presented in Table 2 and is a meaningful divergence from Q2 2023 implied cap rate for the sector. It is also close to the estimate provided LXP executives in their second quarter earnings call .
A business that generates a 6.59% would be of interest if we can secure acquisition funding at some rate below 6.59%. That is, for LXP to generate economic profit, the cost of capital used to acquire or develop assets that generate a 6.59% return must be less than 6.59%.
Let us now estimate the cost of capital for LXP.
Decomposing the Cost of Capital
In order to calculate the cost of capital, we have to calculate the cost of debt, the cost of equity, the cost of preferred shares and weigh each in proportion to how much is used in the business. Let us review the capital structure of LXP to see how much of each is being employed in the business. Please take a look at Table 4.
Table 4: Capital Structure ($ in thousands) | ||
Form of Capital | Value ($) | % |
Debt | $ 1,495,312 | 36.9% |
Preferred | $ 96,770 | 2.4% |
Equity | $ 2,464,669 | 60.8% |
Sum | 4,056,751 |
Now that we have the relative weights, let us look at each source of capital and estimate the cost. Please take a look at Table 5 for the cost of equity.
Table 5: Cost of Equity | |
? | 0.82 |
Risk free rate | 4.63% |
Equity risk premium | 4.47% |
Cost of equity | 8.29% |
Source: Yahoo! Finance on 10/13/2023.
There are different methods and philosophies around calculating the cost of equity. We use the Capital Asset Pricing Model (CAPM) in which we essentially add a spread to the risk-free rate and scale the spread by the volatility of a particular stock.
The beta statistic measures the volatility with respect to the market. The beta of 0.82 implies that LXP's stock is less sensitive than the market. Conceptually, this is justified since LXP's revenue stream is secured by counterparties 49.1% of whom are investment-grade tenants. It is for this reason REITs such as LXP are sometimes considered bond-like investments and are frequently classified as a defensive holding.
Moving on to the next statistic, the risk-free rate. I use the 10-year Treasury which is a frequently used proxy for the risk-free rate. Finally, the last input is the equity risk of 4.47 % reflecting the most recent monthly data coming from Aswath Damodoran at NYU . This is well within the historic range. The cost of equity arrived at using this approach is 8.29 %.
Now that we have a cost of equity, let us now estimate the cost of debt. Please take look at Table 6 in which we present the issuer rating for LXP as provided by Standard & Poor's and now include Moody's rating and outlook. It is noteworthy that Moody's has a negative outlook for LXP which we will touch upon later. We use a 10-year horizon to align time periods with the 10-year Treasury used in the cost of equity calculation.
Table 6: Issuer Rating and Cost of Debt | ||
Description | Rating/Yield | Outlook/Time Horizon |
Standard & Poor's Rating Services | BBB- | Stable |
Moody's Investor Service | Baa2 | Negative |
Corporate (Baa/BBB) Median Yield | 6.10% | 10-year |
Source: Moodys.com, Fidelity.com
The tax shield normally included in the calculation of cost of debt is ignored because REITs generally do not pay taxes at the corporate level.
LXP's Series C Cumulative Convertible Preferred Stock ( LXP.PR.C ) has an original coupon of 6.50% which I will use as an estimate for the cost of convertible preferred shares.
Now that we have a cost of debt, the cost of equity, the cost of cumulative preferred and the weights of each in the capital structure, we can calculate the weighted average cost of capital. Please take a look at Table 7.
Table 7: Weighted Average Cost of Capital ( OTC:WACC ) | |
Weight of Debt | 36.9% |
Weight of Preferred | 2.4% |
Weight of Equity | 60.8% |
Cost of Debt | 6.1% |
Cost of Preferred | 6.50% |
Cost of Equity | 8.29% |
WACC | 7.44% |
On a moving forward basis, at least for the near term, LXP has a cost of capital of 7.44% and generates a return of 6.62%. Please take a look at Table 8 for the deficit between the cap rate and the cost of capital.
Table 8: Cap Rate Minus WACC | |
Cap Rate | 6.59% |
WACC | 7.44% |
Difference | -0.86% |
In general, the difference between the cap rate and the cost of capital is usually but not always positive. If the spread is negative that implies that there is an imbalance in the marketplace. In the current REIT investing climate, there has been a steady march upward in interest rates which increases the cost of capital and a lag between when interest rates settle at a higher level and when cap rates correspondingly settle at an even higher level to maintain a positive spread. Investing while this lag is still working its way through increases the riskiness of an investment. If the cap rate is less than the cost of capital then the cap rate will have to increase sooner or later for profitability to be restored. For cap rate to improve there has to be an increase in the numerator or a decrease in the denominator. Let us look at this further.
An increase in the numerator means an increase in the net operating income. One way for NOI to increase is for properties to be re-leased at a higher rate when they are up for renewal. The weighted average lease term for LXP is 6.2 years. In general, in a rising interest rate environment, you would want shorter lease terms if you are the landlord so that you can mark to market the lease more often. LXP's is in negotiations for about 70% of 2024 expirations and expects a mark to market opportunity of somewhere around 20-30% above in-place rents. This could be a welcome development if the numbers pan out. Another way for NOI to increase is when the built-in contractual rent escalators kick in. LXP has an average annual rent escalation rate of 2.6% which is 1.1% short for where the CPI came in in August.
Another way for the cap rate to get back to a positive spread relative to the cost of capital is for the denominator to decrease. For the denominator to decrease then one of two (or both) would have to come down. In our calculation for the cap rate (Table 3), we used long-term debt and equity as the denominator for the cap rate. Therefore, either the long-term debt would have to decrease or equity values would have to decrease. It is the risk of a decrease in equity values that is of potential concern to investors and is the rationale behind why it is risky to invest in a business in which the spread is negative.
Thus far, we have focused on factors that could increase the cap rate as a means of restoring a positive spread. Let us now consider the other side of the equation. It is possible for the spread to get back to being positive if the cost of capital goes down. The cost of capital comprises of the cost of debt, the cost of convertible preferred equity and the cost of equity. The cost of debt is market-driven and closely relates to the level of interest rates. This means that a view that interest rates are on a downward trajectory would have to be incorporated. The next form of capital, the convertible preferred equity, is relatively small given the weight in the capital structure. The last component of the cost of capital is the cost of equity. Let us consider this.
The inputs used to calculate the cost of equity are the 10-year Treasury, the equity risk premium and the beta statistic. The 10-year Treasury and the equity risk premium are exogenous inputs. Not much can be done about it.
The beta statistic is determined by the nature of the business and the amount of leverage used by the business. As a REIT with revenues secured by contractual obligations and counterparties, half of which are investment-grade credit rated, it is not surprising that the beta statistic would be below 1.0, which is the market beta. This lowers the cost of equity. However, leverage could push the beta statistic higher which would increase the cost of equity from 0.82 exaggerating the negative spread. What could lead to the increase?
Please take a look at Table 9.
Table 9: Net Debt to Adjusted EBITDA | ||||
12/31/2020 | 12/31/2021 | 12/31/2022 | 6/30/2022 | |
Net Debt to Adjusted EBITDA | 4.8x | 5.5x | 6.4x | 6.3x |
There has been a steady increase in the net debt to adjusted EBITDA from 2020 to 2022. It is one of the metrics pointed to by Moody's that prompted the change to a negative outlook in May of this year. A sustained ratio above 6.0 would be an unwelcome development.
Conclusion
There are questions that need to be resolved before an investment in LXP can be recommended. A key dynamic that is not exclusive to LXP is that a positive spread between their cap rate and the cost of capital has to be demonstrated. If the spread is negative, it suggests that the opportunity set for investments moving forward is not accretive. If it costs more to fund acquisitions than the cash flow the acquisitions generate then the growth strategy in the near term is not promising.
The recommendation is a hold and not a sell because the stock is already at its 52-week low and LXP has a cap rate that is in line with the historic cap rate for the sector. There appears to be ample opportunity for the NOI to increase meaningfully in 2024 through re-leasing. Also, management has communicated that they are committed to bringing the net debt to adjusted EBITDA down to the 5.0 to 6.0 range. While these are not enough to offset the headwinds, they are probably enough to stem a further material decline in the stock price.
For further details see:
LXP Industrial Trust: Share Price Probably Not Going Anywhere For Some Time