As inflation continues to rage, real estate is often a great way to play it. Rising real estate prices often translate into higher rents, and Prologis (PLD -1.57%) has benefited as one of the premier players in the logistics space.
Increased e-commerce spending has helped the company, and it is now benefiting from another major corporate trend involving how much inventory companies hold. These factors have contributed to rising rents, which bodes well for Prologis' earnings.
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A leader in logistics real estate
Prologis is a logistics real estate investment trust (REIT) that is a global leader in warehousing space. The company owns and operates logistics spaces in high-barrier/high-growth markets.
If you drive along any major interstate, you will see these massive structures with what seem like dozens of truck bays. These are typical of Prologis properties. It concentrates on facilities next to major metropolitan hubs, and many e-commerce companies and brick-and-mortar retailers use these buildings to store inventory close to its final destination.
Ever since the 1980s, corporations have focused on "just in time" inventory management, which means that inventory should be kept at low levels, which saves costs. Improvements in inventory-management software and communications helped push along this process.
During the pandemic, many companies found out the downside of this philosophy: It left them vulnerable to disruptions in the supply chain. So these companies are rethinking their inventory management and choosing to hold more of it in order to meet demand surges. This change in corporate philosophy should help drive earnings and be a tailwind for the entire sector.
Capacity in the logistics space remains limited
Prologis just reported second-quarter earnings, which beat Wall Street expectations, and raised guidance for full-year 2022. The company is benefiting from rising real estate prices and rents, while many of its competitors struggle with rising land and construction costs.
Those higher costs mean that competitors need higher rents to earn a decent return, which makes competing with Prologis difficult. Capacity in the logistics space remains tight, and Prologis reported a 97.6% average occupancy rate for the quarter, up from the 96% average in the same quarter last year.
Look for big rent increases
Higher occupancy usually indicates a tight market, which would imply higher rental rates. During the second quarter, the company reported that its net effective rent (which takes into account promotions like a free month's rent) rose 46%.
During the recent earnings conference call, chief financial officer Tim Arndt said that the average mark-to-market on its leases was 56%. This means that when a lease expires, the new rent will increase by about 56%. This increase will translate into over $2 billion in additional net operating income over the next several years as these leases reset to market levels, management says.
Late 2021 and early 2022 were periods of abnormally high demand for the industry. CEO Hamid Moghadam joked on the earnings call that the end of 2021 and the first quarter of 2022 were something like a 13 on a scale of 1 to 10.
Even today, management is still assessing demand at a 9.5 to 10, which would equate to the top 5% percentile over the past 40 years. Investors have been nervous about Amazon's comments regarding capacity, as well as statistics that imply plenty of capacity is coming on line. As Prologis points out, though, much of this planned capacity is going to ramp up slowly as labor constraints and construction costs remain high. This should support continued growth in funds from operations.
