Co-produced by Austin Rogers.
In the post-pandemic years of 2021 through 2023, commercial real estate (with the exception of the office sector) enjoyed an almost uniformly strong environment characterized by rising occupancy and strong rent growth.
At the tip of the pyramid in terms of strength is industrial real estate.
According to a December 2023 report by CommercialEdge, in-place rents for industrial real estate rose 7.4% year-over-year, while the national vacancy rate of 4.6% remained unchanged from November.
That is the highest level of rent growth and lowest vacancy rate of any major sector of commercial real estate!
The strongest region of the country has undoubtedly been Southern California, where rent growth still registered in the low double-digits in December, while the Midwest saw the lowest level of rent growth at 3-5% YoY.
This year is not expected to be as strong as 2022 or 2023, but industrial still remains arguably the hottest sector of CRE. Here’s an excerpt from that CommercialEdge report:
“In 2024, rental rate growth will cool, and vacancy rates will climb, with the impact of record levels of new supply working its way through the market.”
However, despite record levels of new supply being delivered, it’s important to realize that this surge in supply is a temporary phenomenon. Developers started a big wave of industrial projects in 2021 and 2022 during the period of high rent growth and low interest rates, but in 2023, construction starts plummeted.
To quote CommercialEdge again:
The new supply pipeline will continue to slow this year. Deliveries peaked in 2023 following a historic ramp-up in starts that only ended when interest rates began to climb in the latter half of 2022. Despite the deceleration of new development, long-term demand drivers for industrial assets remain positive, industrial property outlooks indicate.
Between continued e-commerce growth and a few key manufacturing sectors reshoring in the U.S., long-term tailwinds should persist for industrial real estate for many years to come. Meanwhile, as you can see from the chart above, low construction starts in 2023 and 2024 should result in a drop in deliveries in 2025 and 2026.
As such, industrial should have a decent year in 2024, but an even better few years thereafter.
That gets us excited about a few industrial real estate investment trusts (“REITs”) (VNQ) that have been largely overlooked by the market. They not only enjoy strong fundamentals, they also offer attractive discounts to their closest peers.
What’s more, they also pay dividends on a monthly basis, making them even more appealing.
STAG Industrial, Inc. (STAG)
STAG has historically been the value investor in the industrial space, targeting value-add properties such as vacant buildings, older buildings, or short remaining lease terms. Plus, their target markets are secondary and tertiary ones, especially in the South and Southeast.
But in the past decade, STAG has taken great strides to improve both its portfolio and its balance sheet.
Today, STAG’s performance metrics are only slightly less impressive than its blue-chip industrial REIT peers. Vacancy is low, while rent growth has tracked in the double digits for years now.
In 2023, cash rent growth was over 30%, while straight-line rent growth (including future rent escalations) was over 40%. Meanwhile, the vast majority of tenants with expiring leases chose to renew their lease, with retention increasing from Q3 to Q4.
This kind of strength is remarkable and exemplifies how significantly STAG’s portfolio has improved over the years. These are low-risk, high-value properties capable of generating strong, organic revenue growth.
Moreover, STAG’s balance sheet has significantly improved as well. A decade ago, STAG’s net debt to EBITDA was in the high single-digits. Today, it has dropped to 4.9x, while fixed charge coverage of 5.7x implies huge interest expense coverage.
Notice also that the vast majority of STAG’s debt is fixed-rate at a weighted average interest rate of 3.7%, while very little debt matures this year. The $50 million that does mature already sports the highest interest rate of any STAG debt. Thus, refinancing maturing debt this year should not result in a meaningful increase in interest expense.
Moreover, now that STAG’s payout ratio has dropped from about 90% to settle in the low 70% territory, the REIT can soon begin to increase its dividend at the same pace as its cash flow growth.
And yet, despite the improvement, STAG continues to be valued at a significant discount to industrial REIT peers:
|EastGroup Properties (EGP)
While a slight discount may be justified, we think that the size of STAG’s discount to peers is unwarranted.
We see at least 15% upside from multiple expansion on top of STAG’s nearly 4% dividend yield and mid single-digit growth, which should easily result in double-digit total returns going forward.
Modiv Industrial, Inc. (MDV)
While STAG is a mid-cap stock, MDV would be considered a micro-cap stock at a market capitalization of about $185 million.
But that isn’t the only difference between these two industrial REITs.
While STAG focuses on warehouse/logistics properties with shorter lease terms that allow for more frequent rent resets, MDV focuses on manufacturing properties with very long lease terms.
Notice from the illustration below that MDV’s 44-property portfolio boasts a weighted average remaining lease term of about 14 years, along with average annual rent escalations of ~2.5%. This means that even if there are zero acquisitions (which is unlikely), MDV’s current $40 million annual base rent should turn into $41 million in a year’s time.
While STAG’s short lease terms are useful for frequently resetting rents at the higher market rate, MDV’s long lease terms and triple-net lease terms greatly minimize maintenance and capital spending, making cash flows highly stable and reliable.
When it comes to the portfolio, MDV focuses on stable, essential industries of permanent value to the economy, such as infrastructure, automotive, aerospace & defense, medical products, and technology hardware.
Although MDV targets private, non-investment grade industrial tenants, management is highly selective about the businesses and industries with which they work. They focus on growing companies with long histories of operating at the properties MDV owns.
On the balance sheet side, MDV may seem to be highly leveraged at a net debt to EBITDA of 6.7x. But that will naturally come down as MDV finishes its portfolio recycling (selling the last few non-industrial properties) and rent escalators kick in overtime.
Also, MDV has virtually no debt maturing until its $250 million term loan matures in January 2027.
Likewise, both its Costco and OES property mortgage debt should be eliminated within the next year as the last of the OES principal is paid and the Costco property is sold.
While MDV’s payout ratio currently sits at around 90%, that should also come down over time as the portfolio recycling ends and the balance sheet gradually deleverages. This makes MDV’s ~7.7% dividend yield appealing and likely safe.
Best of all, MDV’s management team is highly aligned with shareholders after frequent insider open-market share purchases over the last year. While shareholder alignment isn’t a silver bullet, it does indicate that management is incentivized to act in shareholders’ best interest.
Industrial real estate is cooling from “red hot” down to merely “warm” this year, but it remains arguably the strongest and most desirable form of real estate for investors. Moderating demand and rising supply deliveries in 2024 should make for a middling year this year, but the lack of further supply deliveries in the pipeline for 2025 and beyond bodes well for future rent growth.
For investors seeking both high monthly income and high upside, STAG and MDV look like strong picks in the sector.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.