The Buy Thesis
STAG Industrial (NYSE:STAG) has always been somewhere between an industrial REIT and a triple net REIT. Historically, it has accomplished most of its growth through property acquisitions that come with long lease terms and accretive cap rates. This is quite similar to the growth methodology of triple nets and in fact STAG trades at a triple net REIT multiple of 17X forward FFO.
I think this perception of STAG as a triple net is about to change and with it STAG’s multiple can move up toward that of industrial peers. The average industrial REIT trades at about 27X FFO making STAG fully 10 turns cheaper.
We will discuss the key fundamentals that make STAG more like an industrial than triple net but first I want to point out that now is particularly opportunistic entry point into STAG as it is freshly cheap.
Amazon creates an entry point
If you follow the industrial REIT space I’m sure you have heard Amazon’s (AMZN) comment about reducing spend on logistics real estate.
“For the Consumer business, as I said earlier, we currently have some excess capacity in the network that we need to grow into. So we’ve brought down our build expectations. I’d note again that many of the build decisions were made 18 to 24 months ago, so there are limitations on what we can adjust midyear.”
It sent shockwaves throughout the industrial REIT sector and left STAG at a much cheaper level.
Indeed, this was a major topic of discussion in STAG’s earnings call on 5/4/22 and the commentary thoroughly demonstrated it will have minimal impact on STAG, at least directly.
The impact will primarily be in the multistory Amazon specific build to suits as these properties have less fungibility.
STAG’s leases with Amazon are overwhelmingly not-build to suits and are currently leased at rental rates 25% below market. If Amazon in fact leaves, as per their threat STAG can simply re-lease them to a different tenant at a higher rent.
Thus, the drop in STAG’s price over the past month was not matched by a drop in fundamentals which means the new price is more opportunistic.
In fact, STAG’s fundamentals seem to have accelerated in a positive direction. 1Q22, in my opinion, was STAG’s best leasing quarter ever.
36.4% spreads on new leases with 17.9% spreads on renewals for total GAAP rent spreads of 25.1%.
If you recall Prologis’ report, such leasing spreads are not unusual. It has become the norm in the industrial space, but what is unusual here is that in the case of STAG they are coming with a 17X multiple. These massive leasing spreads cause most of the industrial REITs to trade up near 30X.
In fact, there are only three other industrial REITs that trade in the same ballpark as STAG
- Plymouth (PLYM) which is a good company but has an overhang of soon to be issued shares so the above multiple simply isn’t accurate going forward.
- Innovative Industrial (IIPR) is as much a loan company as a property owner. Its rents include substantial amortization of the loan portion of the acquisition price so its organic growth is likely negative
- Lexington (LXP) is a serial underperformer which we discuss more here.
STAG has historically traded at this lower level of industrial REIT because it lacked the organic growth of the rest of the sector.
It was essentially a triple net REIT that dealt in industrial properties. I want to take a bit to discuss the timing on how sale leasebacks work.
When a REIT does a sale-leaseback it usually comes with a long initial term during which the tenant is obliged to pay the contractual rent. During the initial term, the property is fairly irrelevant. It is all about the lease length, contractual rent bumps and tenant’s credit.
In each of these regards, STAG was on par with the rest of the triple net field. Like in other triple nets there is some minor lease attrition with properties acquired at 100% occupancy and over time that trends down to the high 90s.
This attrition caused mediocrity in STAG’s same store NOI that made it look even more like a triple net.
Notice, however, that in recent quarters STAG’s same store NOI is starting to look more like that of an industrial REIT.
It has to do with a particular timing threshold; re-leasing.
See during the initial term of a triple net lease it is quite irrelevant whether the property is retail, office or industrial. However, when that lease comes up for renewal, retail triple nets are looking at flattish renewal as seen by Realty Income’s (O) consistently roughly 100% rent recapture. Office triple nets also tend to get rather flat renewals, but they also have the added burden of a fresh batch of tenant improvement costs for overall less than 100% rent recapture.
Industrial properties, however, are in very high demand allowing STAG to get the 25.1% roll-ups (combination of renewed and new).
So while triple nets grow primarily through external acquisitions, STAG now has an added layer of strong organic growth.
The main change was that STAG is now old enough and big enough that its existing portfolio is now large relative to its acquisition pipeline. As such, while the same store NOI number used to be dominated by the slight lease attrition of the initial term, it is now dominated by the leasing spreads.
As time moves on, the leasing spreads will become a progressively more dominant force in STAG’s growth. It has crossed that threshold from triple net REIT into a true industrial REIT. It is now an organic growth REIT.
Thus, rather than a triple net style multiple of 17X, I think STAG will move up to an industrial style FFO multiple in the mid to high 20s.
FFO/share growth to accelerate
STAG’s FFO/share has grown consistently at a decent pace.
All this growth came with the drag of continuous equity issuance.
STAG was issuing equity for two purposes:
- To fund its external growth
- To reduce debt
In some ways it was successful in both regards. The majority of STAG’s growth over this time period was in fact acquisitions so the issuance was still somewhat accretive on a per share basis even after taking into account the dilution.
Debt was reduced dramatically.
Going forward, STAG intends to stop issuing equity, largely because of how discounted their market price is at 86% of NAV.
Guided acquisition volume is still just over a billion, but it is to be largely funded with debt, cash on hand, and disposition proceeds.
This has three impacts
- No longer a deleveraging drag on FFO
- A new levering up tailwind to FFO
- Reduced acquisition drag on same store NOI
The impact in the figures the market watches will be accelerating same store NOI and accelerating FFO/share growth. I don’t see the slight uptick in leverage as being much of a concern as even at the $1B acquisition volume STAG’s balance sheet will remain conservative.
2023 could be a big year for STAG as it has 11.4% of leases coming due.
This is an opportunity to roll that 11.4% of rent up 25%
Risks to thesis
While Amazon’s reduced capital spend on properties is unlikely to affect STAG directly it could reduce overall demand if other companies follow suit. The worst case scenario would be e-commerce companies collectively recognizing that same-day or same-hour delivery is a pipedream that is not worth investing in.
Such a demand reduction would mean this period of impressive lease rolls might be short lived. It is not my base case outlook, but I think it is within the scope of scenarios one should consider.
As a consolation prize in the event demand turns south, STAG is much better positioned than peers due to valuation. Something like a Terreno (TRNO) with its 35X multiple requires another 5+ years of off the charts leasing whereas at 17X STAG is better equipped to handle a more tepid environment.