As the U.S. enters 2023, fears of a recession are building after the Federal Reserve aggressively hiked the federal funds rate to get inflation under control. The Fed's tightening cycle was one of the most aggressive in history, and aggressive cycles usually trigger recessions. In a recession, consumer spending generally falls, which is bad for the retail sector. It also will hurt sectors that support retail, especially the logistics industry. It looks like activity is falling in the logistics market, which could be a red flag for Prologis (PLD -1.69%).
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Prologis is a leader in logistics real estate
Prologis is an industrial real estate investment trust (REIT) that specializes in warehousing and distribution. If you drive down a major U.S. interstate, you will probably see these huge facilities with dozens of truck bays. These are the typical facilities that Prologis operates. These logistics spaces are mainly used for inventory management. A big-box store will keep a certain amount of inventory in-house and then access the logistics facility when it needs more.
During the COVID-19 pandemic, e-commerce business surged because many stores were closed. This created additional demand for warehouse space, and Prologis saw record occupancy numbers and rapidly rising rental rates. Supply chain issues during the pandemic also created problems for retailers and manufacturers. For the past 40 years, corporate America has focused on maintaining as little inventory as possible. Inventory requires payment up front, and it may take months until the goods are sold and the costs recouped. In the meantime, inventory ties up working capital, which is inefficient and raises costs for a company.
The pandemic exposed the risk of extended supply chains
The pandemic exposed the flaws in this mindset as supply chain bottlenecks caused shortages. Retailers and manufacturers realized that extended and lean supply chains had a cost, and they built up inventory in response. This inventory build is looking played out, and according to some studies, warehouse leasing activity is down compared to the third quarter of 2022. Vacancy rates are ticking up, from 3.1% to 3.3%, which is historically still an extremely low level.
Some of the decline in activity comes from two giants -- Amazon.com (AMZN -1.14%) and FedEx (FDX 0.11%), which both said they would take steps to reduce warehouse capacity after overcommitting during the pandemic years. For example, Amazon.com more or less doubled its fulfillment network. It probably overshot. On the third-quarter 2022 earnings conference call, Prologis Chief Executive Officer Hamid Moghadam reassured investors that this appears to be a non-issue for the company. Amazon has not sent any notices to lower capacity, and FedEx's changes affect air operations, which could actually benefit ground-based logistics and help Prologis.
Prologis has record occupancy rates
In the third quarter of 2022, Prologis reported an occupancy rate of 98.6%, which is about as close to maxed out as you can get. This is a record for Prologis, so abnormally low vacancy rates were probably unsustainable and represented the "catch-up" phenomenon described above. Even if demand for warehouse space declines, the rate increases on new leases are still high. The bottom line is that even if vacancy rates rise, rents are still going up. Prologis benefits from having attractive locations next to major metropolitan areas, so any vacancy issues will probably come from some of the more marginal players.
Prologis has forecast 2022 funds from operations (FFO) to come in between $5.12 and $5.14 per share. REITs generally use FFO instead of net income as reported under generally accepted accounting principles (GAAP), like most other companies. This is because of depreciation and amortization, which is a big cost but doesn't actually represent a cash expense. GAAP net income tends to understate the cash flow generation capacity of a REIT.
At current levels, Prologis is trading at 23.7 times projected funds from operations per share, which is high for a REIT. That said, Prologis is a market leader and is outperforming the competition, at least if you are looking at vacancy rates and occupancy. The dividend yield is 2.6%, which is low for a REIT. The company is a top performer but will be subject to multiple compression (i.e., falling price-to-earnings ratios) if investors sense that retail is struggling.
