Thesis: Solid company too expensive
INDUS Real Estate Trust (NASDAQ:INDT) is a small-cap (~$610 million market capitalization) real estate investment trust that owns, operates and develops a portfolio of industrial and logistics properties.
Recently, the REIT’s portfolio has experienced a high degree of sales. More than 10% of INDT’s portfolio has been added just since the start of 2022. There are still some flex buildings/offices and land plots left for sale, which will lead to additional turnover. After adding 520,000 square feet of space to the portfolio in the first half of 2022, management announced plans to add an additional 875,000 square feet in the second half.
Although the company itself is firing on all cylinders, the problem with INDT is with valuation. The share price roughly doubled in the 2.5 years from mid-2019 to the end of 2021 and has since fallen about 25%.
Even so, the INDT still seems overvalued to me.
My conservative estimate of AFFO per share for 2022 is $1.55, which would put the price of INDT at AFFO at around 39.3x at the time of this writing. Meanwhile, analysts give a consensus estimate of $1.76 per share in FFO, which puts INDT at an FFO price of 34.1x.
That’s far ahead of industrial REIT leader Prologis (PLD) with its 25x FFO multiple, despite growing slightly lower than its larger counterpart. In fact, it’s tied with Rexford Industrial Realty (REXR) with its 34.3x FFO multiple, although REXR enjoys much higher growth rates than INDT (largely due to its trophy locations in California du South).
INDT trades at an AFFO yield of 2.6% and an FFO yield of 2.9%, representing a significant premium to its average capitalization rate of around 4%. Although INDT is a solid company with attractive underutilized properties, the stock is still too expensive.
But let’s get into the details of the REIT, and maybe your opinion will differ from mine.
INDUS Realty Overview
Although I normally start by taking a look at a REIT’s real estate portfolio before moving on to performance, this time I want to highlight INDT’s recent performance per share – namely, the growth of AFFO per INDT share by 12.5% year-over-year in the first half of 2022 and 14.7% in Q2 2022.
That’s strong profit growth! He highlights how strong real estate-type industrial assets have been in recent years.
INDT’s portfolio consists of 39 properties averaging 145,000 square feet each. For context, that’s a bit smaller than the average Walmart supercenter footprint of around 180,000 square feet.
The portfolio is almost 100% leased, reflecting not only the particular strength of INDT’s portfolio, but also the low single-digit vacancy rate for industrial properties in most INDT markets.
The portfolio spans the East Coast, with most properties concentrated in Connecticut and Eastern Pennsylvania. But INDT also has a growing presence in central Florida and the Carolinas.
Like other industrial REITs, INDT’s portfolio has significant exposure to e-commerce, with Amazon (AMZN) as its largest tenant by revenue and third-party logistics as its largest tenant by leased square footage.
About a third of tenants by income are classified as investment grade.
But in industry, building specifications and location matter more than tenant credit, as demand is incredibly high for these mission-critical assets.
This demand can be measured by the growth in net operating income of comparable properties. For the INDT, the SPNOI increased by around 11% in the second quarter and by around 8.5% for the first half of 2022.
Although INDT has built in rent increases into its leases that ensure organic rent growth, the main source of NOI growth for the same properties has been rent growth on new and renewed leases, which amounted to on average to about 30% in the second trimester.
As long as this strong lease-to-lease rental growth continues, INDT’s relatively short weighted average remaining lease term of 4.8 years will continue to be a strong asset as renewed leases are expected to continue to produce strong increases in rental income and NOI.
Another feature of INDT is that acquisitions are not the only method of inorganic growth available to it. The REIT also develops properties internally from its sizable land pool.
While most of these developments are on spec (built without tenants in place at the moment), the demand for space in the chosen markets is so high that there is no doubt that space will be to be praised.
Furthermore, the ability to develop is a major asset at a time when the capitalization rate for stabilized buildings is around 4%. This year, INDT has purchased existing properties at capitalization rates of approximately 4% to 4.5%, while it has the ability to develop new properties from scratch at projected capitalization rates of 6, 1% to 6.6%. This two-point difference is equivalent to millions of dollars of value creation.
Given the ongoing development projects and the likely acquisition pipeline, INDT’s geographic diversification should increase over the coming quarters.
In some ways, INDT could be considered the East Coast version of REXR (albeit much smaller), which is focused on the West Coast and specifically Southern California.
Like the portfolio, INDT’s balance sheet exudes quality and strength. The REIT is too small to have a credit rating, but the balance sheet certainly exhibits investment grade characteristics.
Although the debt to annualized EBITDA for Q2 2022 looks rather high at 7.6x, this is a function of portfolio turnover, which translates into a large cash position that has not yet been reinvested. Cash is currently at 12.5% of INDT’s market cap. Q2 net debt to annualized EBITDA is well below 4.1x.
Long-term debt to gross real estate assets (at cost) sits at 23%, while debt to enterprise value is just under 22%.
Apart from a short-term construction loan maturing in 2023, the INDT has no debt maturities before 2027. And this construction loan, upon stabilization of the property in question by a lease, should easily be replaced by a mortgage or equity issue.
High G&A costs
The biggest red flag I see with INDT is the company’s high general and administrative costs, which investors might consider management fees.
G&A as a percentage of total rental revenue was 23% in 1H 2022, decreasing slightly to 20% in Q2 2022. Compare this to G&A revenue percentages for PLD of around 6.5% and REXR of around 10% .
Admittedly, PLD and REXR are much larger than INDT and therefore benefit from more economies of scale. But even look at Plymouth Industrial REIT (PLYM), which is only slightly larger than INDT by market cap (~$815 million). PLYM’s G&A ratio to revenue is approximately 9%. Similarly, LXP Industrial Trust (LXP), with a market cap of just under $3 billion, has a G&A earnings ratio of around 10.5%.
More than half of this high G&A comes from employee and executive cash compensation. Cash compensation alone represented 13.8% of revenue in 1H 2022 (vs. 11% in 1H 2021) and 13.3% in Q2 2022 (vs. 11.3% in Q2 2021).
Perhaps the development arm of the business requires a larger team and therefore more compensation expense which is worth it due to the value creation that internal development brings. Even so, the G&A expenses and especially the cash compensation seem too high to me.
Despite high G&A costs (perhaps from an overpaid management team), INDT strikes me as a solid REIT with the balance sheet strength and portfolio quality to continue delivering high single-digit growth until mid-teens by AFFO action for the foreseeable future.
The problem is that all of this optimism is amply reflected in the stock price, which even after a drop of around 25% since the start of the year still shows an FFO multiple of 34x and an AFFO multiple of 39x. That’s a pretty rich valuation, even for a solid company!
I haven’t even mentioned the dividend yet. Indeed, the annualized dividend of $0.64 gives a yield of 1.07%. The payout ratio is only about 41% AFFO and about 36% FFO, leaving room for the dividend to grow from here at a slightly faster rate than AFFO per stock.
Even then, it would take significant dividend growth (unaccompanied by a multiple expansion) to produce a dividend yield that would catch the eye of most dividend growth investors.
INDT will be on my radar in the future, but I find other options in industrial real estate much more appealing. For example, STAG Industrial (STAG) may not have the same portfolio quality or growth rate as INDT, but its base FFO multiple of 14.6x and dividend yield of 4.6% are much more attractive to me than the 34x FFO multiple and its 1% dividend yield.