Rising interest rates have been a headwind for companies in the real estate investment trust (REIT) sector. Commercial real estate issues have bedeviled office and retail properties. Commercial property prices have been falling, and rolling over debt has been a problem for many developers. The logistics sector has been largely immune to the pressure, as capacity is limited and demand is strong. Prologis (PLD 1.04%) just announced strong earnings. Is the stock a buy?
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Prologis is a massive logistics REIT
Prologis is one of the biggest global logistics REITs. The company has a massive footprint, with 5,563 buildings with 1.2 billion square feet of space in 19 countries. If you drive along the highway close to major metropolitan areas, you will probably see these massive facilities with dozens of truck bays. These facilities generally store inventory for retailers and manufacturers.
Corporate America is reevaluating its investment in inventory
Since the COVID-19 pandemic began, corporate America has reevaluated its perception of inventory. Ever since the 1980s, corporations have worked to minimize inventory. Inventory ties up capital, and the cost of financing can affect the bottom line. This has been a one-way trend for decades. However, the COVID-19 pandemic exposed the cost of that strategy. Clogged supply chains caught many companies off guard, and companies have been increasing investment in inventory ever since.
Inventory levels have yet to recover to pre-pandemic levels
You can see the effect in the chart below, which shows inventory divided by sales. The higher the number, the more inventory is being held. In the immediate aftermath of the pandemic, the number dropped as companies sold inventory and were unable to replace it quickly. Since then, companies have been rebuilding their inventory stocks, but we are still a long way from pre-pandemic levels. Given the memories of supply chain issues, we could see inventory go back to levels we saw in the 1990s, which were about the levels of the 2020 peak when retailers were largely shut down.
U.S. Retail Trade Inventory/Sales Ratio data by YCharts
This adjustment in inventory is one of the biggest long-term drivers for Prologis's business. Prologis has been running at close to full capacity, with occupancy averaging 97.5% in the second quarter of 2023. Rental inflation has been robust, with net effective rents on new leases rising 78.5% in Q2 2023. Rental inflation was incredibly strong in 2021 and 2022. However, market rent inflation is slowing to more normal levels.
Prologis is guiding for 2023 funds from operations (FFO) to come in between $5.56 and $5.60 per share. REITs prefer to quote income as funds from operations instead of net income as calculated under generally accepted accounting principles (GAAP). This is because depreciation and amortization is a big expense under GAAP. However, it is a non-cash charge, which means that net income under GAAP tends to understate the company's cash flow generation ability.
Great stock, but not cheap
At current levels, Prologis is trading at 22.2 times 2023 guided FFO per share. This is on the high side for a REIT, but Prologis is a market leader and has been growing at a rapid clip. The annual dividend of $3.48 is well-covered by FFO per share. However, the yield of 2.9% is miserly for a REIT. This is largely because Prologis is plowing funds back into the business, but the stock also has a high multiple. Investors who like the long-term inventory story and are comfortable with a lower dividend yield might find the stock intriguing.
