The overall stock market has performed quite well in 2023, but the real estate sector is a big exception. Rising interest rates tend to put pressure on income-focused stocks, as well as commercial real estate valuations in general, and real estate investment trusts, or REITs, are paying the price.
While nobody likes watching their stocks go down, the recent underperformance in the REIT world has created some excellent opportunities for long-term investors to add industry leaders to their portfolios at a rare discount. One such company is leading industrial REIT Prologis (PLD 0.69%), which I'm finally planning to add to my portfolio after years of watching from the sidelines.
What does Prologis do?
Prologis is a real estate investment trust, or REIT (pronounced "reet"), that specializes in industrial properties. The company refers to its properties as "logistics" real estate, with warehouses, fulfillment centers, and other properties that help businesses store and move products around the world. Amazon (NASDAQ: AMZN) and its massive fulfillment centers are an example of a Prologis tenant, and other top tenants include FedEx (NYSE: FDX), Walmart (NYSE: WMT), Home Depot (NYSE: HD), and UPS (NYSE: UPS), just to name a few.
The company is a massive enterprise. It is the largest REIT of any kind and has about 1.2 billion square feet of logistics real estate in 19 countries around the world.
Staggering rent growth
As mentioned, industrial real estate has been an extremely hot real estate subsector recently, fueled by pandemic-era growth in e-commerce that created favorable supply vs. demand dynamics.
Just to illustrate this, in the third quarter, Prologis reported a staggering 54.2% cash rent change on new and renewal leases, an all-time high. Think of this as if your apartment lease was expiring and your landlord raised the rent by over 50% due to strong demand -- that's essentially what is happening in industrial real estate right now.
Not only has rent growth been extremely high, but the market is absorbing it. Prologis retained more than three-fourths of its tenants with expiring leases, and the portfolio is more than 97% occupied.
Here's one key point to keep in mind. The average Prologis lease term is nearly six years in length. This means that most of the tenants currently in place signed their leases before the recent surge in market rent, so the elevated rent growth will remain for years to come. In other words, there are a lot of lease renewals that need to work their way into the company's earnings.
Why now?
Prologis has been beaten down despite a red-hot industrial real estate market, mainly due to interest rate pressures -- not anything wrong with the business itself. In fact, Prologis' size and financial flexibility give it an advantage over rivals, especially in an environment where the cost of capital is significantly higher than it was a couple of years ago.
To be sure, at roughly 18.6 times the expected 2023 funds from operations, Prologis certainly isn't the cheapest REIT you can buy. But it's important to keep in mind that, as mentioned earlier, there's a lot of embedded rent growth that will take years to truly be reflected in the numbers, so it's cheaper than it looks. With a top-notch leadership team, numerous competitive advantages, and a hot industrial market that should remain so for the foreseeable future -- not to mention a 3.2% dividend yield -- it seems like an excellent time to finally add this forever stock to my portfolio.
