STAG Industrial: A Solid Industrial REIT – At The Right Price

Thesis: Industrial Real Estate Supply May Blunt Rent Growth

“The cure for high prices is high prices.”

This economics slogan may be trite, but it’s basically true. High prices are a signal for producers to increase supply, and it’s a signal for consumers to pull back and look for alternatives. Gradually, as high prices spur market actors to increase supply and decrease demand, prices come down (or at least stabilize).

The same holds true in the world of commercial real estate. Over the past few years, a huge spike in demand for industrial space along with constraints in the ability of developers to deliver new industrial buildings has created the perfect setup for falling vacancy rates and rising rent growth.

This environment allowed single-tenant net lease industrial real estate investment trust STAG Industrial (NYSE:STAG) to generate cash leasing spreads of 13-15% and same-property cash NOI growth of 5-5.25% in 2022 – the strongest for both metrics in company history.

A BMO analyst recently initiated coverage of STAG with an “outperform” rating, expecting same-property cash NOI growth of 5.3% in 2023, driven by 25% cash leasing spreads as well as 2.5% contractual rent bumps.

But I think these assumptions will prove a bit too optimistic. All-time low vacancy rates and double-digit rent growth characterizes the current situation, but a likely 2023 recession along with around 1 billion square feet of new warehouse space scheduled for delivery in the coming months will likely normalize the industrial real estate market.

STAG currently trades at a 4% dividend yield, but given my assumption of forward average annual dividend growth of 4-5%, I think STAG would be a much more compelling “Buy” at a 4.5% dividend yield or higher. That sets my “buy under” price at $32.50.

STAG’s Outlook: Optimistic, But Not Pollyannish

STAG isn’t your average industrial REIT targeting the most institutional quality Class A properties in primary markets.

Instead, STAG is the value investor in this space, typically acquiring properties with some element that makes them undesirable to the big institutional investors and REITs. These may have shorter remaining lease terms, non-investment grade tenants, redevelopment opportunities, or may simply be vacant.

This allows STAG to acquire properties in the 5-6% stabilized cap rate range rather than the 4-4.5% territory of its peers.

Most of STAG’s real estate are large warehouses or logistics facilities in secondary markets. Though location quality is mediocre, demand for industrial space like STAG’s is so high that keeping a high occupancy rate has not been a challenge. At the end of Q3 2022, STAG’s portfolio occupancy sat at 98.2%.

Around 40% of STAG’s portfolio is directly associated with e-commerce activity, which should provide a sustained boost in demand for big box properties like STAG’s going forward.

Moreover, as inventory levels normalize going forward, utilization of STAG’s properties should also increase, making them even more mission-critical to tenants.

Over the last several years, STAG has undergone a long transformation process to elevate the quality of both the portfolio and balance sheet, and that process appears to be virtually complete. The portfolio has grown while transitioning to fully industrial (as opposed to 1/5th in flex/office space), with nearly a quarter of space in multi-tenant properties (generally less risky than the binary nature of single-tenant properties).

Contractual rent escalations have likewise grown from 1.25% at STAG’s IPO to 1.75% at the end of 2015 to around 2.5% today.

And notice below that STAG’s financial side has significantly improved. Net debt to EBITDA shrank from nearly 8x at the IPO to 5x today, while secured debt went from 100% to virtually 0%.

Meanwhile, STAG’s cash generation has really picked up as well, going from zero free cash flow to about $75 million and from a payout ratio in excess of 100% to about 78%.

Probably shareholders’ biggest complaint has been STAG’s crawlingly slow dividend growth rate of less than 1% annually. This was a purposeful decision by management to maintain a technical dividend growth streak while also steadily lowering the payout ratio and prioritizing deleveraging.

Going forward, I would assume STAG’s dividend growth would be more in line with its FFO per share growth rate, which I estimate to fall in the 4-5% range.

On the subject of the balance sheet, it’s important to keep in mind that STAG’s historical reputation as a “lower quality” REIT are outdated. STAG enjoys a BBB credit rating, 99.7% unsecured debt that is 94.5% fixed-rate, 5.9x fixed charge coverage, and exceedingly little debt maturing before 2025.

Moreover, the weighted average interest rate on debt maturing in the next two years sits at 4.3%, which is much lower than STAG’s other debt. If this debt is refinanced with new issuance, interest costs may rise, but not to a painful degree.

Beware The Wave of New Supply

The recent BMO analyst coverage initiation shows rent and same-property cash NOI growth going even higher in 2023 than it did in 2022. While I as a shareholder would of course welcome this, I think it might be a bit too optimistic.

Why?

First, notice that both cash and straight-line rent growth appear to have already peaked and begun a slow process of declining.

Blended Leasing Spreads	Cash Rent Growth	Straight-Line Rent Growth	Square Ft Leased
Q3 2022	13.6%	12.5%	2.8M
Q2 2022	14.1%	21.9%	3.2M
Q1 2022	15.2%	25.1%	3.1M
Q4 2021	16.0%	22.6%	3.6M
Q3 2021	8.0%	14.7%	3.7M

Click to enlarge

Double-digit leasing spreads are nothing to sneer at, and surely this implies years of embedded rent growth as expiring leases are reset at the (higher) market rent rate. But the trend appears to be downward, especially for cash rent growth.

Second, the huge rent growth from the past few years spurred a big wave of industrial real estate development, and many of those new properties are coming online this year.

A January CBRE report puts this wave of nearly completed warehouse space at around 1 billion square feet nationwide. This new supply, combined with an estimated 10-15% decline in leasing due to softening economic conditions, should cause the vacancy rate to tick up a bit and rent growth to slow.

At the same time, construction starts of new warehouses is expected to drop to a 7-year low in 2023 due to high cost of capital and construction costs, which means that the relief to the industrial real estate market could be short-lived.

Bottom Line

It’s important to note that even amid the strongest backdrop for industrial real estate in STAG’s history, including all-time low vacancy rates and double-digit rent growth rates, STAG’s core FFO per share increased “only” 7.1% in the first nine months of 2022.

Now, 7.1% core FFO/share growth is respectable, but the point is that STAG isn’t turning in the same double-digit FFO per share growth rates that the premier industrial REITs are.

For example, for the full year of 2022, Prologis (PLD) turned in core FFO/share growth of 24%.

For the first nine months of 2022, EastGroup Properties (EGP) turned in FFO/share growth of 16%, while full-year 2022 FFO/share (just reported as this article was being written) grew 14.9%.

First Industrial Realty Trust (FR) is guiding for FFO/share growth of 13% in 2022.

Thus, you can’t really compare STAG’s price to FFO multiple of 16.3x to industrial REIT peers’ FFO multiples in the mid-20s and proclaim it cheap. Every REIT needs to be valued in relation to its own growth rate, not the average growth rate of its peers.

Moreover, I think the 7-9% FFO/share growth STAG should achieve last year won’t be easily repeated going forward, for the reasons stated above.

At a dividend yield of 4.5%, STAG would be valued at an FFO multiple of 14.5x, which strikes me as a far more compelling entry point for the REIT.