Challenging, uncertain, unnerving… a few characterizations of the global economic environment as investors grapple with a confluence of factors affecting investment decisions. Top of mind are geo-political risks such as the Russia and Ukraine war, a resultant energy crisis, incremental risk of food insecurity as well as the varying stages in which countries are attempting to transition out of the Covid-19 pandemic. Acting within these parameters, policymakers face a herculean task of determining ‘appropriate’ interest rate policies to counter historically high inflation levels whilst achieving the fabled ‘soft-landing’- an elusive as well as increasingly illusive endeavour as odds of a recession remain on the rise. Take a deep breath as we pass the half-way mark of 2022.
Venturing into the second half of the year, vigilant while anticipating no shortage of unforeseen macro and political blindsides, Catalyst finds comfort in our detailed bottom-up process and sharp focus on underlying company and sectoral fundamentals. Currently, a wide-angle view of the listed real estate sector displays well capitalised balance sheets, staggered debt maturity profiles, high quality property portfolios and generally adept management teams. This combination may enable some companies to play both defence and offense through full market cycles. Additionally, growth in a variety of niche real estate sub-sectors (such as single-family rental housing, manufactured housing, industrial logistics etc.) and their increasing share of investable listed real estate, tilts the sector composition to one that exhibits healthy fundamentals and reasonably strong pricing power. While supply and demand maintain a favourable balance for landlords in most property types, there will continue to be pockets of oversupply relative to demand, and in these cases, certain companies may be ill-equipped to navigate persistently high inflation and/or a potential economic downturn.
In June of every year the National Association of Real Estate Investment Trusts (NAREIT) hosts their REITweek conference in New York City, and the fact that this was the first in-person conference in three years provided a most welcomed semblance of normality. Catalyst was as per usual in attendance, embracing the opportunity to engage with 80+ global management teams across c. 20 property sub-sectors, and interact with fellow industry participants. Having recently adjusted our assumptions and outlooks for various sub-sectors leading up to the NAREIT event, the key takeaways from the conference re-affirmed our views and outlook for the real estate sector.
Despite general concerns surrounding the macro-economic environment, and specific focuses on tightening interest-rate policies, less accommodative debt markets and elevated inflation, the tone that emerged from the conference was cautiously optimistic. Across the spectrum, the sub-sectors that are enjoying the most favourable supply and demand fundamentals include industrial, single-family housing rentals, apartments, and storage. Traditional sectors such as offices, retail and net lease continue to encounter particularly strong demand headwinds while the performance outlooks of these assets have the highest uncertainty and are most at risk of further negative surprises.
One sector that has garnered heightened interest from investors and attracted a disproportionate amount of our time interrogating and refining our assumptions has been the industrial logistics sector. In April, Amazon reported its first quarterly loss in seven years, citing slowing online shopping as well as inflationary and supply chain issues. The company announced that they will be looking to offload some of their excess capacity by cancelling uncommitted warehouse developments and sub-leasing a portion of existing space, most likely for a period of one to two years.
How did they get to this point? The behemoth’s historical take-up of industrial space has been seasonal, with a year of highly active leasing typically balanced by a successive year of more modest take-up. An accelerated shift of consumption to online channels during the pandemic exposed fragilities in supply chains as bottlenecks prevented exceptional demand from being met. Amazon subsequently made the deliberate decision to increase capacity and not let a lack of industrial space constrain their business, altering this pattern of seasonal uptake. Their insatiable appetite to grow their footprint has resulted in two years of elevated take-up, which has now been met with some digestion pains.
The expected amount of space to be sublet by Amazon could be up to 30m square feet, which equates to c. 20% of their cumulative openings in 2020 and 2021. According to Greenstreet Advisors, new supply in the Top 50 US markets is expected to be nearly 400m square feet in 2022, representing approximately 2.6% annual supply growth. At the beginning of the year the total inventory of industrial logistics warehouse space in these markets was estimated to be 16 billion square feet. To put this into context, the amount of space that Amazon is expected to sublease equates to 0.2% of total industrial inventory and would increase available supply growth from 2.6% to 2.8% in 2022. While this seems immaterial, one must not flippantly dismiss the impact as inconsequential. Amazon has been a major source of industrial take-up to date and may grow at a slower pace in the future, which at the margin will affect demand for industrial warehouses.
What gives us comfort that this decision represents Amazon taking its foot off the pedal and not slamming on the brakes, is the fact that these sub-leases will mainly be for a term of one or two years whilst they retain optionality to take the space back once they’ve digested their excess capacity. However, this move has attracted scepticism that e-commerce penetration is perhaps closer to maturity than previously thought, having implications for future industrial space demand. Admittedly, this view is not unfounded, however as the incumbent and most dominant global e-commerce company in the world it would logically follow that they would be first to reach maturity in terms of extracting supply chain efficiencies and saturating their home market. We believe that most other e-commerce companies are still in the early stages of this process, many of which would have been crowded out by Amazon’s breakneck pace of expansion over the years.
Facts aside, we have become increasingly attuned to the market’s ‘shoot now, ask questions later’ approach to fear-invoking headlines. Following Amazon’s announcement, the selloff in global industrial real estate companies was indiscriminate and excessive. Having dissected the news and considered the impact to market rental growth for our universe of industrial stocks, we arrived at earnings revisions akin to a gradual descent from a peak, in contrast to falling off a cliff as share price performance would have suggested. Evidently, in times where growth is questioned, companies whose shares are low yielding and whose earnings are projected to grow at high growth rates, tend to be most punished. Ironically, some of these companies’ growth outlooks are expected to be amongst the most insulated to a slowdown in Amazon’s leasing activity.
The selloff was also not confined to the US as Amazon’s home market, but was rather broad-based, flowing through to the UK and Europe as well. While some credence can be given to the market’s concern for a slowdown in US industrial demand off the back of Amazon’s news, the repricing of industrial stocks becomes increasingly difficult to justify as it pertains to the UK and Europe in particular. There are strong reasons why Europe should be less impacted from both a slower pace of leasing as well as risk of a slowdown in the growth rate of e-commerce penetration.
Below are two illustrations provided by Greenstreet Advisors. The first shows the vast divergence of Amazon’s presence globally, with certain European markets proving to be a rounding error in comparison to the US. The second illustration further shows how much lower e-commerce sales per household is in European countries in comparison to the US. This is both a function and a result of the relatively early stage in the e-commerce growth cycle that these countries find themselves in compared to the US, which is further along the e-commerce growth cycle. The average US consumer is also typically in better financial health with a higher propensity to spend money on goods online.
Source: Greenstreet Advisors
Source: Greenstreet Advisors
Taking stock of current fundamentals, supply remains manageable relative to robust levels of demand from a variety of users of industrial space. Given a lack of land availability, zoning and entitlement complexities as well as rapidly rising replacement costs, the ability to bring on new supply is encountering increasing resistance, but development profit margins do remain attractive. However, in certain nodes within high-barrier, urban-infill locations it is exceptionally difficult and infeasible to undertake ground-up development without already owning developable land. Here we expect the lowest levels of new supply as well as strong occupier demand. Adding impetus to demand is the decision by tenants to hold additional safety stock to build resilience into their supply chains, where normalised stock levels are anticipated to be 10%-15% higher than pre-covid levels. This favourable supply and demand dynamic places landlords in a position of strong pricing power.
In the US, market rental growth for warehouses increased by 11% in 2021, and according to Prologis (the largest listed global industrial landlord) market rental growth in 2022 should accelerate to 22% in the US, and 20% globally. These eye-popping numbers beg the question “is such high growth sustainable?” Over the long-term market rental growth should converge to inflationary-type growth. However, over the near-to-medium term the answer is ‘it depends’ with instances of both a decisive ‘yes’ and an emphatic ‘no’.
Real estate rental still only constitutes less than 5% of a tenant’s total supply chain costs, while labour and transportation can account for 70%-75% of total costs. Therefore, it seems realistic that a tenant would prioritize their real estate footprint with a key focus on proximity to densely populated locations and highly efficient buildings to minimize transportation costs and secure necessary and increasingly scarce labour. Given that the non-real estate cost component has arguably grown at a faster rate than market rents, it is conceivable that above-inflation market rent growth is achievable for an extended number of years. However, due to affordability constraints this will not be broad-based. In fact, the divergence in performance across location and the quality spectrum of assets is likely to widen going forward. Only the highest quality assets run by best-in-class operators will be able to capture double-digit market rent growth in the near-to-medium term.
All considered, given our revised outlook for the industrial sector and companies within it, we believe that the selloff in industrial shares was indiscriminate and disproportionate to the probable impact on fundamentals and share values. Indeed, in times of panic opportunities present themselves and we have used this magnified selloff as an opportunity to increase certain positions within the sector. As many of our companies under coverage report earnings updates this month, we will have an opportunity to re-evaluate and fine-tune our assumptions to increase conviction on our outlook for the listed real estate sector and its constituent sub-sectors and companies.
At Catalyst we have a long-standing, robust investment process that has been tested over numerous market cycles and periods of dislocation. During times of heightened uncertainty, volatility, and weakness in the market our process is invaluable and tends to show its true mettle. As active, specialist listed real estate investors we are likewise fortunate to have an extensive opportunity set spanning a variety of sub-sectors and companies with unique underlying economic drivers. While these will not be entirely immune to the ebbs and flows of the broader economy and stock markets, it does provide us with the tools to construct portfolios for varying economic conditions to better enable the management of risk and return over the long-term. For investors with a similar long-term time horizon, the sector appears fairly valued with more attractively priced opportunities for astute active managers to generate superior risk-adjusted returns.