Prologis (NYSE:PLD) is one of the world's largest owners of industrial real estate, and it just inked a $12.6 billion deal to buy competitor Liberty Property Trust (NYSE:LPT). This isn't unique in the real estate investment trust (REIT) industry -- acquisitions have been big news lately. There are two notable trends underpinning the moves by Prologis and others. Current shareholders might like what they see going on, but investors looking to put cash to work should think twice before buying today. Here's what Prologis' recent acquisition says about the broader REIT space.
The big deal
In late October, Prologis announced that it was buying Liberty Property Trust, paying $12.6 billion including the assumption of debt. An all-stock deal, Liberty investors will get 0.675 shares of Prologis for each Liberty share they own. This news comes after activist shareholder Jonathan Litt pushed Liberty to sell itself.
On the surface, this is a solid deal. Prologis and Liberty own similar assets. The deal is expected to be accretive from day one based on the prospects for $120 million in cost savings. It is projected to increase Prologis' core funds from operations (FFO) -- like earnings for an industrial company -- by $0.10 to $0.12 a share. As Liberty's growth projects come on line and planned asset sales of around $3.5 billion work through the system, that benefit could reach as high as $0.16 per share. That would represent a nearly 5% boost in Prologis' core FFO (based on its 2019 FFO projections), which is a worthwhile jump for a REIT.
But there's more to this deal than meets the eye. And it highlights a couple of trends in the REIT space to which dividend-focused investors will want to pay close attention.
A tale of two REITs
Prologis' stock is near all-time highs. Its yield at around 2.4%, meanwhile, is near all-time lows. And its price-to-core-FFO ratio is roughly 26, based on the company's 2019 projections for core FFO. This industrial REIT does not look cheap. And that's a general theme throughout the REIT space. For example, net lease bellwether Realty Income (NYSE:O) also has a high price, a low yield, and a lofty valuation, with a price-to-adjusted-FFO ratio over 20. AvalonBay (NYSE:AVB), one of the largest apartment landlords, follows the same trend. Go through every REIT sector, and with just a few exceptions (notably the mall REITs), you will find companies trading at lofty valuations.
Lofty valuations are not the norm for REITs, which are generally bought by dividend-focused investors looking for reliable income and slow and steady dividend growth over time. But this is a massive opportunity for REITs. This corporate structure is specifically designed to pass income through to shareholders, with a mandate to pay at least 90% of earnings as dividends (which allows REITs to avoid corporate-level taxation). That leaves little in the way of cash to fund growth spending and acquisitions. So REITs generally have to tap the capital markets to fund such efforts. With some companies benefiting from lofty share prices, the cost of equity capital today is very low.
The all-equity structure of the Liberty deal is a big reason why Prologis pulled the trigger. Others, like Realty Income, are simply selling shares to the public to fund sizable acquisitions. Even AvalonBay, which has been trying to fund growth internally, has been selling more individual properties than it's buying. Through the first nine months of 2019, it jettisoned $427 million in assets and only bought $285 million. It is using the proceeds to help fund a number of construction projects because it views building from the ground up as a better use of capital today. However, management noted in the third-quarter conference call that cost of capital is very low -- a function of both a low interest rate environment and a historically high stock price.
But what's most interesting about AvalonBay's comments is the time period highlighted. According to Chief Investment Officer Matthew Birenbaum, "Our cost of capital is down quite a bit over the last two or three quarters." A key piece of that is the stock price gains that REITs have seen in 2019. To put some numbers on that, REITs in general are up around 20%, using Vanguard Real Estate Index ETF as a proxy. (Though it is worth noting that Prologis is up twice that amount.)
And yet a broad index is always made up of winners and losers. There are some companies that don't look as richly valued. Litt pushed Liberty to sell itself because he believed it was underpriced by as much as 25%. Realty Income recently agreed to buy a portfolio of 415 properties for $1.25 billion at a roughly 7% cap rate (higher cap rates are better for buyers). This is notable because roughly 60% of the portfolio is investment-grade quality and, according to the company's third-quarter conference call, those assets tend to trade at cap rates of 5% to 6%, with non-investment grade between 5% and 8%. In other words, it looks like Realty Income got a good deal for these properties. They were sold by a non-public REIT, which by design wouldn't benefit from the investor enthusiasm for public REITs.
So there's a disconnect going on to some degree, with some REITs benefiting from lofty valuations, and other REITs (and some individual assets) looking relatively cheap. That suggests that now is a great time for richly valued REITs to be net buyers, or at least to put capital to work (for companies with a penchant for building over buying, like AvalonBay). This, in the end, is pretty good for shareholders, who benefit from the growth that's being funded by equity and low-yield debt issuances.
The fly in the ointment
The problem here is that it may not be a great time for investors to buy REITs. First, most investors shouldn't buy any company just because they expect it to be acquired. You need to think carefully about "cheaply" priced REITs, since there's likely a reason for the low price and a buyer may or may not materialize. The REITs benefiting from lofty valuations, meanwhile, are by definition expensive, so buying today doesn't make much sense. That's doubly true if you are investing for income since a high price basically means a low yield. Many of the biggest and best positioned names are priced for perfection right now, and as value investing legend Benjamin Graham has noted, a great company can be a bad investment if you pay too much for it.