The U.S. economy has suffered through two consecutive quarters of gross domestic product declines, which is an unofficial measure of a recession. Amazon.com (AMZN 3.43%) and FedEx (FDX 0.12%) have both announced plans to pull back, notably with regard to the size of their distribution networks. That's led to steep declines in warehouse real estate investment trusts (REITs) like Prologis (PLD 0.69%). There's a very important reason why dividend growth investors might still find this warehouse giant attractive.
Is the sky really falling?
Wall Street has a bad habit of overreacting to news. So when retailer Amazon announced that it was going to be shutting some of its distribution centers, subleasing them to others, investors got it in their heads that the demand for warehouses was set to decline. That negative view got compounded by news that shipping giant FedEx was closing locations amid a decline in shipping demand.
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REITs like Prologis that own warehouses, key pieces of the global distribution network, have been slammed. Prologis, the largest company in the property niche with one billion square feet of space across four continents and 19 countries, has seen its stock fall over 35% so far in 2022. On some level that makes sense, given that Amazon and FedEx are both customers.
In fact, they are Prologis' No. 1 and No. 2 customers. Combined, they account for around 9% of the REIT's revenues. That sounds pretty terrible until you step back and consider that Prologis has a massive portfolio with locations in the most vital global distribution hubs. These aren't the types of locations that most customers want to get out of.
Notably, Prologis' occupancy at the end of the second quarter was 97.7%, and management hinted that it was still heading higher. Moreover, strong demand has led to strong rental rates, which gets to the really big story for Prologis.
The future still looks bright
In the second quarter, the average net effective rent change for the REIT was 45.6%. That's a huge figure and probably not sustainable. Indeed, rents could actually come down if demand falls, leading to a drop in that number.
However, there's a deeper story here. Prologis leases out its warehouse space for multi-year periods. As those leases end, the lease either gets renewed at a market rate or leased to a new tenant at the market rate. The net effective rent change figure is so large because old leases at notably lower rates are rolling over to current rates. That's a process that will take time to flow through the entire portfolio. And the spread between old and new rates will remain material even if there's a pullback in rental rates, given the still-strong demand trends noted by management.
Prologis goes further than that when it explains the issues that will affect demand. For example, the cost to replace a warehouse is more than the cost of an existing facility. So it makes sense to keep leasing an existing asset. And, not surprisingly given the replacement cost issue, the supply of warehouse space is historically low, which supports rent growth.
Moreover, many of the largest users of warehouse space, including FedEx, aren't actually walking away from warehouses. They have openly explained that they are simply being more careful in how they allocate their cash. As the United States, and perhaps the world, teeter on the brink of a recession, that makes complete sense. But it doesn't negate the rent rollover trends built into the Prologis portfolio. At most it might mitigate, to some degree, the rent increases the REIT can achieve. And, given Prologis' well-located portfolio, it could actually benefit if key partners place a higher value on the properties in its portfolio.
Not a screaming buy, but...
The deep decline in Prologis' share price has pushed the dividend yield over 3%. That's probably not a screaming buy for income-focused or value investors, but the yield is back into a more normal historical range. That suggests Prologis is fairly valued right now.
However, if you are a dividend growth investor, Prologis' dividend growth has averaged around 10% a year over the past decade, which is huge for a REIT. And given the company's still-strong fundamentals, there's no reason to believe that strong dividend increases will suddenly stop. Dividend growth investors, then, will probably find Prologis attractive today despite the moves being made by customers like Amazon and FedEx.
