By now, it may not be a surprise that Prologis, Inc. (NYSE:PLD) is one of our favorite real estate investment trusts, or REITs.
We have covered it a lot, as it brings very specific qualities to the table, including fantastic relationships with some of the world’s largest and safest corporations, a keen eye for assets in areas with subdued supply risk, and a balance sheet that most peers can only dream of.
Our most recent PLD-focused article was written on January 19, when we went with the title “Prologis – You May Not Want To Miss The Next Buying Opportunity.”
Here’s a part of our takeaway back then:
“Despite challenges like increased vacancy and declining rent growth, Q4 financials reveal strong performance.
Even better, looking ahead, Prologis maintains a cautiously optimistic outlook for 2024, emphasizing market strengths and strategic initiatives.
All things considered, with a consistent dividend history and promising growth, Prologis positions itself as a compelling long-term investment in a volatile market.”
As it turns out, Prologis just became a better longer-term investment, as its stock dropped to the low-$100 range, pressured by its recent earnings release and ongoing market volatility.
This begs the question:
Is this the next big buying opportunity?
What Just Happened to Prologis?
Prologis isn’t just on our radar because we like this REIT.
No, Prologis is also on our radar because it is one of the best companies to follow when looking for industry intel.
After all, with a market cap of almost $100 billion, the company behind the PLD ticker is the biggest industrial REIT in the world.
- The company has roughly 6,700 customers.
- These customers are served through its network of assets spanning 1.2 billion(!) square feet on four continents (67% in the U.S. – 86% of net operating income “NOI”).
- On these four continents, the company operates in 19 nations.
- Its asset base is so large that it handles products worth 4.0% of the GDP of those nations.
- The entire value of the goods flowing through its network is roughly $2.7 trillion. That’s 2.8% of the global GDP!
In these markets, the company serves some of the largest logistics companies and corporations dependent on reliable supply chains, including Amazon (AMZN), Home Depot (HD), FedEx (FDX), and supply chain giants like DHR, GXO (GXO), and Maersk.
So, yes. Whenever Prologis reports earnings, we listen to whatever it has to say.
Unfortunately, for investors like us, what the company said wasn’t very bullish.
In fact, Prologis warned of a potential shift in its market, as captured perfectly by the headlines from The Wall Street Journal below (October 17, 2023, vs. April 17, 2024):
Now, allow us to throw some numbers at you.
In the first quarter of this year, core FFO (funds from operations) came in at $1.31 per share. These numbers exclude promote revenues (certain incentive fees) and came in according to expectations. That’s up from $1.23 in the prior-year quarter.
The portfolio occupancy ended the quarter at 97.0%, which is slightly down from 97.6% at the end of the fourth quarter. It’s down 100 basis points compared to the prior-year quarter.
Customer retention remained strong in the mid-70% range.
Even better, the net effective rent change was 68%, based on commencements, and 70% based on new signings. According to the company, following in-place increases and changes in market rents, its net effective lease mark-to-market stands at 50%.
Essentially, this represents more than $2.2 billion of rent to “harvest” without any additional market rent growth!
So far, so good.
The problem is that, despite robust economic indicators, leasing activity and net absorption fell short of expectations.
Basically, elevated interest rates and available space coming from pandemic-related capacity have pressured customer decision-making.
To quote the Prologis 1Q24 earnings call (emphasis added):
“The interest rate environment and its associated volatility have weighed on customer decision-making, especially as the 10-year has increased 70 basis points from its level just 90 days ago, and expectations for Fed rate cuts have moved from potentially 6 to now possibly 0.”
The company mentioned something we have increasingly discussed as well, which is that interest rates are likely to be in a “higher-for-longer” state instead of a quick “back to normal.”
As we can see below, consumer price inflation has gone sideways since mid-2023, with recent readings suggesting potential upside momentum. As a result, yields are on the rise again, including the U.S. 10-year (US10Y) and shorter-term bonds, indicating a lower likelihood of a Federal Reserve interest rate cut.
Furthermore, Southern California (“SoCal”) emerged as a particularly challenging market. This market is home to almost a third of the company’s properties.
Generally speaking, SoCal is a fantastic place to be for industrial real estate companies.
- It’s surrounded by the ocean and mountains. This puts tremendous pressure on supply growth.
- California has strict zoning laws, which makes building new assets even harder.
- Despite political issues and migration to “red” states, California is still home to some of the nation’s best universities, the largest industrial base in the country, two massive ports, and the largest consumer base with plenty of spending power.
The data below comes from Rexford Industrial Realty (REXR), a 100% SoCal-focused industrial REIT. As we can see, SoCal’s infill markets have both low supply risk and low vacancy rates.
On a long-term basis, this is highly favorable for pricing. This, too, explains why Prologis still has such a wide mark-to-market opportunity.
Unfortunately, while these longer-term benefits are certainly a factor to be bullish on Prologis, it is currently a headwind, as the economy is just not supportive of operations in the industry.
To quote Prologis again (emphasis added):
“The overall leasing slowdown is most felt in only a handful of markets, Southern California and the Inland Empire being the most acute. In fact, rents in most of our U.S. markets are generally flat. Several are up, and it is mainly elongated downtime affecting near-term occupancy and NOI. While Southern California leasing has been challenging, it has not slowed the tremendous uplift we realize every single quarter from rent change on rollover, which was 120% for the market in the first quarter, with the Inland Empire at 156%, nearly the highest in our portfolio.”
Regarding the company’s post-pandemic supply surge, we see that third-party researchers agree.
For example, in its 1Q24 report, Cushman & Wakefield wrote that:
“The U.S. industrial sector continues to cool off after two years of unprecedented growth coming out of the pandemic. Tenant demand slowed in the first quarter of 2024 but remains positive.”
Moreover (emphasis added):
“New completions (supply) continue to exceed net absorption (demand), causing the overall vacancy rate to trend higher. Still, at 5.8% as of Q1 2024, vacancy remains below its historical average of 7%. Rent growth is also coming back down to earth. In Q1 2024, industrial rents grew 6% annually vs. 10% in 2023 and 20% in 2022.”
This is precisely what Prologis found as well.
The good news is that, using the words of Cushman & Wakefield again, “The future construction pipeline is thinning out quickly.”
After all, elevated rates aren’t just pressuring consumers, but also developers.
As a result:
- Vacancy rates are expected to peak below 7%.
- Rent growth will likely decelerate to the 2-5% range, which would still be highly favorable for an industry benefitting from secular growth in e-commerce, economic re-shoring, and supply chain de-risking.
- 2025 is expected to see a recovery, with rent growth moderating before potentially seeing upside momentum in 2026.
In other words, there is light at the end of the tunnel – and it’s not a train!
Nonetheless, as favorable as the longer-term outlook may be, Prologis had to adjust its shorter-term outlook, as it reduced its average occupancy guidance, now ranging between 95.75% and 96.75%.
This adjustment accounts for a 75-basis point reduction from the midpoint.
Moreover, the company downgraded earnings, core funds from operations ("FFO"), and NOI expectations.
As one can imagine, the comments that even SoCal is weakening on top of weak guidance sent a shockwave through the industry.
The good news is that on top of a good long-term industry outlook, PLD remains in a good spot to withstand economic turmoil.
Despite elevated rates, the company raised $4.1 billion during the first quarter.
This debt was secured at a weighted average rate of 4.7% over a term of 10 years, which is a terrific number in this environment and the result of the company’s A-rated balance sheet.
It now has a portfolio with an in-place rate of just 3.1% and more than nine years of average remaining life on its bonds. It also has $5.8 billion in remaining liquidity, roughly 6% of its market cap.
Shareholder Value & Valuation
The PLD sell-off wasn’t entirely unwarranted nor extremely unlikely. After all, we’re dealing with a highly uncertain economic environment, elevated rates, and sticky inflation.
As “annoying” as this may be for its medium-term performance, it opens up tremendous opportunities.
On top of long-term secular benefits that could lift rent growth substantially in the years ahead, PLD also pays a fantastic dividend.
After hiking its dividend by 10.3% on February 22, it currently yields 3.7%.
This dividend comes with an 86% 2024E adjusted FFO, or AFFO, payout ratio. While this may be somewhat elevated, analysts are upbeat about future AFFO growth, which could bode very well for its dividend – even in this environment.
Using the FactSet data in the chart below, PLD is expected to see a 2% per-share AFFO contraction in 2024. However, 2025 is expected to see 18% growth, potentially followed by 12% growth in 2026.
This also means that PLD is attractively valued. It currently trades at a blended P/AFFO ratio of 23.0x, which is well below its long-term normalized AFFO multiple of 25.7x.
While these numbers are subject to change, they fit perfectly the story we discussed in this article.
2024 will, undoubtedly, be a tough year. However, PLD remains strong and should be able to see a substantial recovery in the years ahead.
This is why we remain so upbeat about PLD, despite our somewhat downbeat view on rates and inflation.
To use Jim Cramer’s words when he discusses certain stocks he likes: “Own it, don’t trade it.”
Takeaway
Prologis remains resilient despite market challenges highlighted by recent earnings.
Despite a leasing slowdown and interest rate volatility, its steady performance underscores its long-term appeal.
While full-year guidance adjustments were made, macro trends suggest a gradual recovery with sustainable growth ahead.
Hence, amidst uncertainty, PLD’s stability shines through, offering long-term investors a compelling opportunity.
In turbulent times, remember: "Don’t trade it, own it."
Pros & Cons
Pros:
- Stability: PLD boasts a resilient portfolio with relationships with industry giants like Amazon and FedEx.
- Attractive dividend yield: With a 3.7% yield and potential for future growth, PLD offers steady income.
- Discounted valuation: Trading below its long-term normalized AFFO multiple, PLD presents a buying opportunity.
- Strength in times of weakness: Despite short-term challenges, PLD remains poised for a significant rebound, reflecting its stability in uncertain times. This is also supported by its healthy balance sheet.
Cons:
- Near-term challenges: The leasing slowdown and interest rate volatility may impact its short-term performance.
- Market turbulence: PLD's stock may face more weakness in light of economic uncertainty.
- Potential earnings adjustments: Further adjustments in occupancy guidance and earnings expectations could affect investor sentiment.
Data Duel
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