2023-07-07 17:20:29 ET
Summary
- New supply is impacting occupancy globally, but REXR's redevelopment are projects contribute to lower reported occupancy.
- Additional vacancy in Southern California is relatively small and does not significantly impact overall vacancy rates.
- REXR's strategy of redevelopment and acquisitions contributes to growth in AFFO per share.
- REXR's leasing performance in Q2 2023 is strong, potentially setting a new quarterly record.
- Market rent growth and smart management are expected to drive additional value for REXR.
Executive Summary
Rexford ( REXR ) went on sale. We reexamined our thesis and found it remains accurate.
Weaknesses:
- Southern California weakened a little bit, from all-time record strength.
- There’s some general negative sentiment around California. That seems to be spilling over to industrial REITs.
Neutral:
- Treasury yield correlation doesn’t explain the dip.
Strengths:
- Fundamentals are good. Consensus projections are up.
- Cash leasing spreads have been great. Mid-quarter update has REXR on the road to new record leasing spreads.
- New supply is weighing on occupancy globally. PLD details projections. Many new properties are being completed, but very few are being started. Higher supply over the next few quarters, then lower supply.
- REXR’s occupancy was down slightly, but it looks worse because REXR put many properties into redevelopment at attractive returns.
- 3 million square feet of extra vacancy in southern California sounds bad. It’s roughly the difference between 1.35% and 1.50% vacancy.
- Like REXR, PLD also is having a monster second quarter on fundamentals. We don’t have numbers yet for TRNO.
- Issuing equity can look bad but isn’t a good predictor of success when used in isolation. Development projects are boosting NAV per share and boosting future AFFO per share.
- E-commerce uses more than 3x more industrial space (than retail) per $ of sales.
- If all leases were adjusted to market rates overnight, REXR’s projected FFO for 2023 would go from about $2.135 (consensus estimate $2.15) to $4.035. That would create a vastly lower multiple.
- We expect growth in market rents and smart management to drive additional value.
We'll cover some those points in greater detail.
Fundamental Growth
Did we make a mistake in evaluating the fundamentals underpinning industrial REIT growth? If the projected FFO and AFFO per share is falling, that could mean a mistake on Wall Street projections or a mistake in our estimates. We’ve been adamant about projecting strong average annual growth rates for industrial REITs. We expect REXR to have one of the very highest average growth rates measured over several years.
I pulled the consensus projections for FFO and AFFO per share for several REITs around late January / early February 2023. Before the Q4 2022 earnings results. We can compare the projections from that point with the projections today. There are three scenarios:
- Projections up: We can’t blame projections for weaker prices.
- Projections flat: We still can’t really blame projections for weaker prices.
- Projections down: Time to double-check why the projections fell.
The result is:
- Projections up. This is not the problem!
Here are the charts, starting with FFO:
We have modest increases to FFO per share projections. About 2%, with a bigger increase for 2025. That’s certainly not a negative development.
How about AFFO?
Those are some pretty big increases. So, it’s not AFFO per share.
Treasury Rates
There’s been some volatility in Treasury rates:
Can we blame the activity on Treasury rates? It would seem that way in the first two months, but that connection didn’t last. I set up two charts to cover roughly the same period. It’s a bit rough, but the result is obvious enough that greater precision would be pointless:
We can wipe out that theory. We should’ve seen a negative correlation in those charts, but we didn’t.
So, what else is happening?
Cash Leasing Spreads
One of the most important metrics for the overall health of the market is shown through leasing spreads. There are a few kinds of leasing spreads, but we tend to prefer using cash leasing spreads. Cash leasing spreads are:
- Easy to understand. It’s the change in rent between expiring and new leases.
- Does not involve any revenue smoothing, which would favor longer leases.
- Reported by many REITs.
Those are some big benefits. The biggest weakness is that a REIT may have acquired some properties where rent was exceptionally low or exceptionally high. If that happens, the renewal of that lease might push the averages for the quarter. Regardless, as long as you’re looking at multiple quarters, you’ll be in good shape. These are the cash leasing spreads for the three industrial REITs we’ve tracked closest.
You can see that the values remain strong. Prologis ( PLD ) is seeing some huge gains in this area, but REXR and Terreno ( TRNO ) remain very strong. This isn’t a good explanation either.
New Supply Impacting Occupancy and Rates with PLD
We have a better explanation here, though it’s still not great. There was a big increase in development starts over the last few years. That leads to additional supply hitting the market, though some markets make it very difficult to build new supply.
Fortunately, the biggest developer of industrial real estate is one of the REITs. PLD has the most industrial real estate and the biggest development program. Consequently, we could even use the rate of change in PLD’s development activity as a proxy for the sector. PLD also provides some nice metrics for guidance, which really help with evaluating the sector.
You’ll notice PLD reduced their development starts in 2020, then increased them rapidly in 2021 and 2022. In 2023, they slashed new development.
The reduction in new development starts will impact the supply growth rate in future years. In the near term, we have some extra completions.
PLD already projected this would weigh on occupancy. They are projecting 2023 average occupancy between 97% and 97.5%:
That would be lower than their recent level of 98%.
If the average dropped to 97%, it would suggest ending occupancy at around 96%. However, I should mention that PLD has been vocally predicting a recession as part of its base scenario. I think a recession is likely, but the point is that PLD’s guidance is already baking that in.
Looking at PLD’s Q4 2022 earnings call , management stated:
However, they also projected reduced development (where they are a major developer) leading to less supply coming to market around the end of 2023 or in 2024:
That’s positive for shareholders in any of the industrial REITs.
The trend was confirmed in PLD’s Q1 2023 earnings call when management said:
Later, they added:
REXR Occupancy
Turning back to REXR, we see a dip in occupancy during 2022.
Occupancy dipped but remains pretty strong. The “Same Property Portfolio” (green box) is usually the ideal measurement tool here. An investor could argue for the orange box instead, but I wouldn’t. REXR often buys properties where the lease expires soon. If they're going to lease the property again without redevelopment, it would be included in the orange box but not in the green box.
Infill Southern California
REXR has a focused portfolio. While most REITs own real estate across the country or across the globe, REXR owns industrial real estate in Southern California. That’s where we have the ports to handle importing tons of junk from China. To be fair, we import it from some other countries as well. However, much of it comes across the Pacific Ocean.
Remember how occupancy dipped a bit for REXR during Q1 2023? If we use the same property portfolio, it was a minor dip going from 96.1% to 96%. It was a bit bigger if we just exclude repositioning/redevelopment projects, going from 97.9% to 97.4%.
REXR had 14.7% of their leases set to expire during the full year of 2023:
A disproportionate share of leases were expiring in Q1 2023, as the remaining expirations already fell:
While more space in REXR’s portfolio was expiring than being leased, they were putting a significant chunk of the real estate into their redevelopment program:
That’s why total occupancy is down. Because REXR has quite a few redevelopment projects underway. Higher cash rents drive higher AFFO, but turnover costs reduce AFFO in the present year. Consequently, more of the benefit comes in the following year.
Likewise, putting more real estate into redevelopment will hurt AFFO per share today, but it will drive higher rents and greater AFFO per share in the future. We actually want those leases to expire because each expiring lease is an opportunity to dramatically increase rents.
Conclusion
REXR remains a great investment. Investors focusing on AFFO per share in this year are ignoring how much higher AFFO per share will be over the next several years. I picked up additional shares twice in June. Once at $51.22 and again at $51.39.
Prices are only slightly higher today (at $51.63 when I finished preparing the public release) and REXR remains a great choice.
We provided an e xtended version of this article (paywall) on The REIT Forum. This is a great example of the kind of equity REITs we like to pick. REITs that deliver strong long-term results, even if the dividend yield is lower. We can always enhance the portfolio's yield by including preferred shares and baby bonds. There's no need to give up great long-term investments just because the yield is lower today. Each position should function as part of the portfolio.
For further details see:
What Happened To Rexford?