If you read the news, it almost seems inevitable that we're heading toward a recession. With inflation running rampant, the Federal Reserve has no choice but to raise interest rates rapidly. Most market watchers believe this will undoubtedly cause a recession. That would be likely to cool off the red-hot market for industrial real estate.
However, those headlines don't match the current reality. That's clear from the evidence provided by Prologis (PLD 0.17%) on its second-quarter conference call. Here's what the leading industrial real estate investment trust (REIT) is seeing in the market.
Market conditions aren't slowing down but shifting direction
Prologis CFO Tim Arndt led the industrial REIT's quarterly conference call. He noted the second-quarter results "were strong and ahead of our expectations with occupancy, leasing, and rent change all at record highs." Arndt also pointed out that fellow industrial REIT Duke Realty (DRE) -- which Prologis is in the process of acquiring -- recently reported results that "tell a similarly strong story."
The CFO then stated:
That said, the macroeconomic environment is making it difficult for investors to fully assess the state of our industry. There's frankly a stark difference between what one reads in headlines versus what is actually happening in our business. Accordingly, we find ourselves focusing more on our own proprietary metrics and real-time feedback from our customers to build a forward-looking view of our markets and demand.
He then dove deeper into those metrics to give investors more insight into what's happening in the industrial real estate market. Arndt pointed out that they had proposals for 52% of its remaining available capacity at the end of the second quarter, up from an average of 38% before the pandemic. That shows how active prospective tenants are in their search for more space, and the company's limited available capacity after occupancy improved to 97.6% in the quarter. Meanwhile, the company has already preleased or started negotiations on 71% of leases that expire within the next year, up from its 56% average before the pandemic.
The CFO noted that while the urgency to secure space has worn off, it's still seeing healthy demand with little downtime. While they're seeing less demand for space from e-commerce companies these days, "overall occupancy and leasing have continued to grow with take-up coming from a broad set of users, most notably transportation, healthcare, and auto," according to Arndt. He noted that they're seeing the emergence of supply chain resiliency as an incremental demand driver. While an economic downturn could delay this trend in the near term, Prologis sees it lifting demand for years.
What does this mean for Prologis?
Given how healthy demand remains and how low vacancy rates are in its markets, Prologis is increasing its rent growth forecast this year. The company boosted its overall market rent growth forecast to 23% globally and 25% in the U.S. That's up from its prior forecast of 22% in the U.S. and 20% globally because of a very strong first half where rents were up 14% globally and 16% in the U.S.
Prologis isn't capturing all the rent growth at once because of the long-term nature of its leases. The company noted that the rent increase during the second quarter pushed the spread between current market rents and the average lease rate across its existing portfolio to 56%. That implies the company is sitting on $2 billion of net operating income (NOI) upside as expiring leases roll over to market rents, a significant number for a REIT that generated $3.6 billion of NOI over the last 12 months. The company noted that this indicates it can grow its same-storage NOI by more than 8% annually through 2025 with no further increase in market rents. That's an incredible amount of built-in organic growth for the company.
There's additional upside potential to that number if rents keep rising, which Prologis believes will happen because of the incremental demand from supply chain resiliency and continued e-commerce growth. Add to that its development pipeline, with the company starting $2.7 billion of development projects this year, and it has lots of growth ahead. Meanwhile, its Duke deal will enhance its growth prospects. It will provide an immediate earnings boost and long-term upside from higher rents because of Duke's equally large spread between current lease rates and market rents and its development pipeline.
The disconnect looks like an opportunity for investors
Shares of Prologis have tumbled nearly 30% from their recent high because of growing fears that demand for industrial real estate is slowing down. However, Prologis isn't seeing any evidence of this as demand remains robust. The REIT's sell-off looks like a great buying opportunity given the growth it still has ahead.
