Industrial real estate investment trusts (REITs) are seeing huge demand today. Supply chain upheavals from the coronavirus pandemic and supply chain security issues driven by geopolitical concerns are both net positives for REITs in the niche. However, Industrial Logistics' (ILPT 5.08%) stock is down 80% over the past year. What's going on?
Where the story really starts
So the end of the story is that Industrial Logistics made a poorly timed acquisition. But that's not really the important part of this tale. To understand what's going on here, you need to understand what Industrial Logistics is. While it is an industrial REIT, which means it owns and rents out industrial properties, it is also an externally managed REIT. That means that it pays another company to run its day-to-day operations. In this case, the external manager is The RMR Group (RMR 0.22%).
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This isn't a small thing, noting that the CEO and CFO of Industrial Logistics both work for RMR Group. RMR Group, meanwhile, oversees roughly $37.3 billion in assets under management across the industrial, office, hotel, life sciences & medical office, retail, and senior living sectors. Of that total, $30.9 billion falls into what it calls Managed Public Real Estate Capital. That's basically a collection of five publicly traded real estate companies.
External management in and of itself isn't necessarily a bad thing. However, it does bring with it some important risks. In the case of Industrial Logistics, one of those key risks is the way in which RMR gets compensated.
A look at the risks section of the REIT's annual 10K includes this warning:
Our property management fees are calculated based on rents we receive and construction supervision fees for construction at our properties overseen and managed by RMR, and our base business management fee is calculated based upon the lower of the historical costs of our real estate investments and our market capitalization. We pay RMR substantial base management fees regardless of our financial results. These fee arrangements could incentivize RMR to pursue acquisitions, capital transactions, tenancies and construction projects or to avoid disposing of our assets in order to increase or maintain its management fees...
Now for the troubled deal
So, to sum things up a little, RMR gets paid more as Industrial Logistics gets bigger. And the purchase of Monmouth REIT for $4 billion in 2022 quickly increased the size of Industrial Logistics. That said, it was a complex deal that was largely paid for with debt. The plan was to sell assets to pay down the leverage it took on.
That process has run into some important snags, notably a swift increase in interest rates. That has made it more difficult to unload properties because the costs for potential buyers have materially increased. In July of 2022, Industrial Logistics basically admitted the depth of the problems it faced when it cut its dividend to a token penny per share per quarter. For an individual dividend investor, that's basically akin to eliminating the dividend since the only purpose of the payment is to allow institutional investors with dividend mandates (such as insurance companies and pension plans) to continue to own the stock.
As of the fourth quarter of 2022, the company was continuing to struggle on the disposition front. To be fair, the property portfolio is highly occupied (99.1%), and Industrial Logistics is doing a good job of increasing rents (18.7% increases). Only the property portfolio isn't really the problem; the balance sheet is.
Specifically, the "mortgages and notes payable, net" line item on the balance sheet increased from roughly $646 million in 2021 to $4.2 billion in 2022. The interest expense line item on the income statement, meanwhile, rose from $35.6 million in 2021 to $280 million in 2022, and that was only a partial year of interest since the deal for Monmouth closed at the end of February 2022.
Not worth the risk
RMR took a risk when it bought Monmouth. If interest rates hadn't gone up so far and so fast, that risk may have played out just fine for investors. But that's not what happened, and investors in Industrial Logistics got burned. A key problem in all of this is that the way RMR is compensated seems to incentivize this type of risk-taking. Most investors will probably be better off looking elsewhere. Indeed, until it can start unloading a material number of properties, the headwinds here aren't going to change.
