Kwarkot
Industrial Logistics Properties Trust (NASDAQ:ILPT) has dramatically underperformed the Real Estate Select Sector SPDR ETF (XLRE) this year, as it has plunged 85%, much more than the 25% decline of the ETF. Consequently, Industrial Logistics Properties Trust has sunk to a fresh historic low. As the stock is currently trading at an extremely low price-to-FFO ratio of 3.0, many investors are likely to conclude that the stock has become extremely cheap. However, the market rarely offers the opportunity to buy stocks at such depressed valuation levels without a good reason. In this article, I will analyze why Industrial Logistics Properties Trust is highly risky.
The good
Industrial Logistics Properties Trust is a REIT that owns and leases industrial and logistics properties throughout the U.S. In March, the REIT performed a major acquisition. It acquired Monmouth Real Estate Investment in a cash deal of about $4.0 billion and thus it now has 413 properties. The company generates approximately 28% of its annual revenues from its 226 properties that are located on the island of Oahu, Hawaii, whereas the other 187 properties are located on the U.S. mainland.
Industrial Logistics Properties Trust enjoys a strong tailwind in its business, namely the shift of the U.S. retail industry from stores and shopping centers to online sales platforms. This shift has significantly increased the demand for industrial and logistics properties. As this trend is only in its early phases, it is likely to provide a tailwind to the business of the trust for many more years.
Moreover, Industrial Logistics Properties Trust exhibits some strong performance metrics. It has an occupancy rate of 99.2%, which is one of the highest occupancy rates in the REIT universe, while it generates 78% of its revenues from investment grade tenants. FedEx, Amazon and Home Depot lease approximately 40% of the total rentable square feet of the REIT. These characteristics render the cash flows of the REIT somewhat reliable.
Furthermore, due to the collapse of its stock price, Industrial Logistics Properties Trust is currently trading at an extremely low price-to-FFO ratio of 3.0. This is far lower than the average FFO multiple of 12.5 of the stock over the last four years. Therefore, it is only natural that some investors wonder whether the stock has become a screaming bargain.
The bad
Whenever a stock trades at such depressed valuation levels, investors should make sure they understand the reason behind the cheap valuation. Otherwise, they may find out the reason after having incurred devastating losses.
In the case of Industrial Logistics Properties Trust, the game changer was the gigantic acquisition of Monmouth Real Estate Investment in a transaction of about $4.0 billion in cash. This acquisition added 126 new properties to the asset portfolio of Industrial Logistics Properties Trust and thus greatly enriched its asset base. To provide a perspective of the transaction value, the current market capitalization of Industrial Logistics Properties Trust is only $255 million. In other words, the amount paid by the REIT is more than 15 times its current market capitalization.
The consequences of the size of the acquisition were clearly reflected in the latest earnings report of the REIT. In the third quarter, the trust nearly doubled its revenues over the prior year’s quarter, primarily thanks to the contribution of the new properties. However, its FFO per unit plunged 50%, from $0.46 to $0.23, due to a steep increase in the operating expenses as well as in interest expense. Both of these expenses skyrocketed due to the immense acquisition. To be sure, operating expenses nearly doubled year-over-year while interest expense jumped nearly 10-fold, from $9.1 million to $89.7 million. As a result, the REIT missed the analysts’ consensus by $0.09 and the stock plunged 9% after the earnings release.
The stock would have plunged more but the market realized most of the consequences of the acquisition when the trust nearly eliminated its dividend, in July. Management reduced the dividend by 97% in July in an effort to preserve funds for the acquisition. The stock plunged 24% on the announcement, even though management stated that it intended to restore the dividend close to its previous level next year. Obviously, the market is skeptical about the ability of the REIT to restore its dividend due to the high debt load that has resulted from the acquisition of Monmouth Real Estate Investment.
The ugly
Due to the aforementioned major acquisition, the balance sheet of Industrial Logistics Properties Trust has become extremely weak. To be sure, in the last 12 months, interest expense has exceeded operating income by a wide margin ($216 million vs. $109 million) while net debt (as per Buffett, net debt = total liabilities – cash – receivables) stands at $4.2 billion. This amount is about 16 times the market capitalization of the stock and 34 times the annual FFO before the acquisition (in 2021). Therefore, Industrial Logistics Properties Trust undoubtedly carries an excessive debt pile.
Even worse, due to the surge of inflation to a 40-year high, the Fed is in the process of raising interest rates aggressively in order to cool the economy and thus put a lid on inflation. Rising interest rates exert huge pressure on heavily indebted companies, as they greatly increase interest expense. As mentioned above, interest expense already exceeds the operating income of Industrial Logistics Properties Trust by a wide margin. If interest rates rise further, they will exert even greater pressure on the REIT. This helps explain why the market does not believe management, which has stated that it will try to restore the dividend next year.
Due to its huge debt pile, I believe Industrial Logistics Properties Trust will probably have to dilute its unitholders to a great extent at some point in the future. This is a great risk, which should not be underestimated by investors.
Final thoughts
Industrial Logistics Properties Trust has plunged 85% this year, to a new historic low, and is now trading at only 3.0 times its annual FFO. However, I believe the stock is highly risky due to its immense debt load and the strong headwind from rising interest rates, which are likely to increase the interest expense of the REIT even further in the upcoming quarters. Highly indebted companies may sometimes offer great short-term returns but they usually offer poor long-term returns. The dramatic underperformance of Industrial Logistics Properties Trust vs. the S&P 500 since the formation of the former in early 2018 (-84% vs. +44%) is a testament to the risk of the REIT.
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