Opportunity arises when the fundamental value moves disparately from the market price. In somewhat chaotic markets like what is happening in the first month of 2022, it is quite common for good companies to get caught up in the sell-off and unfairly punished. I think this happened at Plymouth Industrial (PLYM).
In order to capture such opportunities, I constantly monitor price changes and compare them to fundamentals to see if they make sense. Below are the 5 worst performing REITs in 2022 in terms of year-to-date price change.
The first 4 suit me. RVI declared a special dividend of $3.27, so the stock naturally fell $3.27 when the dividend was paid. Innovative Industrial (IIPR) and Safehold (SAFE) trade at extreme valuations relative to their property values and cash flows, respectively.
With interest rates rising and inflation so high, such valuations no longer make sense, so I think it’s okay for the market to bring its valuations back in line.
Seritage (SRG) has real fundamental challenges ahead as shopping centers continue to struggle to find their place in the economy. It’s possible that SRG could reallocate its space to another function, but that’s speculative and risky and not something I would want to own in this environment.
Plymouth is the baby thrown out with the bathwater.
17% is a huge drop in less than a month and what seems really out of place to me is that the fundamentals have turned strongly positive. Towards the end of 2021, there was perhaps concern that industrial REITs that have had tremendous success in raising rental rates were approaching a point of rate hike fatigue.
Perhaps after years of increasing rates for renters, there would start to be some pushback leading to more moderate renting in the future.
However, data released so far in 2022 suggests that there is still a long trail of rapid growth ahead. With properties located in smaller cities compared to large industrial REITs, PLYM’s rental rate growth has been more moderate. Here are the numbers from their latest earnings report:
Leases commencing in the third quarter of 2021 totaled 1,538,268 square feet, of which 1,428,068 square feet are associated with leases with terms of at least six months. The Company will experience a 10.8% increase in cash rental rates as a result of these leases. Leases commencing in the first three quarters of 2021 totaled 4,746,898 square feet, of which 4,454,043 square feet are associated with leases with terms of at least six months. The Company will experience a 9.7% increase in cash rental rates as a result of these leases.
A 10.8% increase in leases on 3rd quarter and 9.7% over the 9 months is solid, but slightly lower than that of competitors like Rexford (REXR), Terreno (TRNO) and Prologis (PLD), which are running at more than 30%.
It makes sense that coastal locations were hit earlier by the wave of rent increases, as their tenants have no other options. Places like the Port of Los Angeles don’t have enough land available to build competing warehouses, so tenants have to pay what the REIT wants to charge.
However, there is growing evidence that rental rate increases will spread to smaller towns. Rent is such a small component of a tenant’s overall logistical expenses that rate increases don’t seem to be on their list of concerns.
In small communities, like the ones PLYM owns, labor is the main problem. It can be very difficult to find labor for a new warehouse in a new location and much of the workforce depends on public transport to get to their work in the warehouse.
This entrenches tenants in their existing warehouses where they already have workers who already have transport processes in place. The labor disruption alone would be a bigger blow to the warehouse operator than simply having to pay higher rent, so PLYM can raise rents with minimal churn.
PLYM’s rent is among the most affordable among warehouse REITs at approximately $3.68 rent per square foot. The rent in place is in many cases an inherited rate from when the lease was signed. Given the changes that have taken place in warehouses and industrial properties since then, I suspect rental rates are at least 20% below market.
In fact, in 2022, PLYM released some of the earlier 4Q21 information, revealing that rental rates on Q4 leasing jumped 22.1% on a cash basis.
A significant advantage of PLYM over its peers who focus on Class A industry is that PLYM is not really impacted by new supply.
It has been known for some time that logistics space would be in high demand, so developers are starting to ramp up production, but newly developed properties are almost always built as high-end Class A properties; the guy who would bring in up to $10 a square foot in rent.
PLYM operates at a different price and competes for a different pool of tenants, so it is less sensitive to the arrival of supply. As such, its rent increases came later in the cycle but are expected to continue longer in the cycle.
I suspect that the 22% lease renewals seen in 4Q21 will start to spill over into most of the portfolio as leases expire. This is starting to really hit the bottom line with significant expiration volume in the coming years.
So basically what has happened so far in 2022 is a dispersion between price and fundamentals.
- PLYM’s rental announcement, along with general trends in the industrial space, point to strong growth ahead
- PLYM is down 17% since the start of the year
Better than expected growth and a much lower price. This is the birth of opportunity.
Strong value proposition
With prices falling, PLYM is now trading at a significant discount to NAV. Specifically, it trades at 94.6% of NAV while other industrial REITs trade at 115% of NAV.
Beyond the discount, I think there are more upsides to its net asset value as its cap rate has not yet been compressed like the rest of the sector.
Popular coastal industrial properties are being bought at cap rates of around 3.5%, while PLYM properties are still in the works for 6% and above. As growth becomes more evident in their rental rates, I wouldn’t be surprised to see cap rates drop to 5%-5.5%.
From a cash flow perspective, PLYM also presents attractive value.
The FFO consensus estimate for 2022 is $1.92, which means PLYM is trading at around 14x the FFO. By comparison, the industrial REIT sector trades at an average and median of 28.5x and 28.6x, respectively.
That’s a pretty massive discount for a business that’s growing well. Consensus estimates call for steady growth through 2026.
If the consensus is nearly correct, PLYM is a slam dunk on its combination of value and growth. That said, my estimates differ quite significantly from the consensus.
- I think the current FFO is much lower.
- I think the growth rates are significantly faster.
The reason is that PLYM has somewhat atypical titles and different FFO accounting. Note that FFO is a non-GAAP number, so a company can really define it however they want, and in public documents PLYM is clear on how it defines it.
Below is the reconciliation of their 10-Q.
It should be noted that preferred dividend expenses would normally be taken BEFORE the FFO line. Almost all REITs present FFO as a figure net of preferred dividends. So, comparing PLYM to other FPIs, we should start from the CORE FFO line rather than the FFO line.
Additionally, certain accrual charges related to legacy funding are functionally an expense but not technically an expense and therefore do not appear in these figures.
As such, I consider current actual FFO to be significantly lower than consensus estimates, but I also believe growth will be significantly faster.
The majority of PLYM’s expenses are fixed; Thus, as rental rates increase, the increase in revenue should be passed on to the bottom line with a high additional margin.
As leases expire and are re-let at rates that I expect will be 20% higher, this increase in revenue will result in a significantly larger increase in FFO/share. All other things being equal, a 10% organic increase in PLYM revenue translates to an increase in FFO of approximately $0.40 per share.
So if the leases go as I expect, the potential for growth is quite significant.
So while I think the 2022 to 2024 consensus numbers are a bit ambitious, I think the longer-term numbers are entirely achievable in a base case scenario.
At the freshly cheap market price of $26.60 per share, PLYM looks significantly undervalued to me.