Online Retail Gives Industrial REITs a Lift

Posted on June 15, 2016

Investors in recent years have been ho-hum about online shopping’s potential as a growth engine for companies that own warehouses and distribution centers.

Now Wall Street is giving that a rethink.

Shares of real-estate investment trusts that own industrial space have soared 17.3% this year, compared with 6% for all equity REITs and 1.7% for the S&P 500, according to Green Street Advisors.

In 2015 and 2014, by comparison, industrial REITs underperformed the real-estate market by 0.6% and 9.1%, respectively, Green Street Advisors says.

Analysts believe that internet retail accounts for much of the increase in demand for industrial space. At the end of 2015, tenants in the top 47 markets occupied 101.7 million more square feet than they did at the beginning of the year, according to data firm Reis Inc. That is up from 93 million in 2014.
This year’s exuberance partly reflects the strong first-quarter earnings posted by industrial REITs such as Prologis Inc. and Duke Realty Corp. But the rally also is a sign that investors are recognizing that online retail is going to have a deeper and longer lasting impact on demand for industrial space than previously expected.

One big reason: Processing goods for online distribution is proving to be more complicated and requires more space than processing goods for bricks-and-mortar stores. Prologis, the country’s largest industrial REIT, estimates that every dollar of online sales needs three times more distribution-and-warehouse space than one dollar of bricks-and-mortar sales.

“Even if retail sales in the economy stay constant, just a shift from stores to e-commerce is going to grow industrial demand,” said Hamid Moghadam, chief executive of Prologis, which controls 667 million square feet of industrial space world-wide.

The growing appeal of industrial REITs contrasts sharply with the pain that online shopping is inflicting on other parts of the retail world. Major retail companies such as Macy’s Inc. and Sears Holding Corp. are getting hammered as consumers increasingly shop online.

Last year, 7% of U.S. retail sales were online, compared with 3.9% in 2009, according to a Green Street Advisors analysis of U.S. Census Bureau data.

Meanwhile, an April report on the industrial sector by Green Street Advisors pointed out that U.S. inventory levels have been rising faster than sales since 2011.

Analyst Eric Frankel said that is partly because e-retailers have needed to keep more inventory on hand as they promised customers shorter delivery times.

“People are saying ‘I want my shipment in one or two days,’” Mr. Frankel said. “That has an impact on inventory.”

E-retailers also require more inventory space because moving their goods tends to be less efficient than moving inventory for stores. “If you look at major retailers like Wal-Mart, warehouses are set up to send truckloads of goods to individual stores,” said James Connor, chief executive of Duke Realty. On the other hand, online distribution centers “are set up exactly the opposite,” he said. “Everything goes out in onesies and twosies.”

As online retail has grown, few expected industrial REITs to be hurt. But it hasn’t been clear how much they would benefit.

Many believed retailers would be able to store both online and bricks-and-mortar inventory in existing distribution facilities.

Also, the industrial sector suffered a severe space glut in the aftermath of the 2008 crash. Investors became painfully aware of how easy it was for new space to be built, and many remained wary of industrial REITs during the current recovery.

But so far in this cycle, many industrial REITs have restrained their urge to develop a lot more new space. For example, Duke has preleased 79% of the $650 million worth of new space it is developing.

In 2008, only 15% of Duke’s space under development was preleased, Mr. Connor said.

“We haven’t all gotten together and shot ourselves in the foot by overbuilding the market,” he said.

Mr. Moghadam believes that as online shopping grows, retailers will have to shift from traditional distribution facilities to those structured around “parcels instead of pallets.” The change would take place more quickly if retailers weren’t already committed to current leases, he said.

Analysts and executives at industrial REITs caution that all is not smooth sailing ahead for the sector. A slowdown in the economy and consumer spending would push vacancy higher and rents down.

What’s more, e-retailers are still in the early stages of figuring out new methods for delivering goods from distribution facilities to households. It isn’t clear how demand would be affected throughout the supply chain if there is a big push to convert relatively small downtown buildings into distribution facilities.

Mr. Frankel points out that demand for industrial space also may decelerate as internet distribution becomes more efficient. He notes that a huge online retailer like could “curb overall demand” by greatly increasing its offering of its logistics services to smaller retailers.

Mr. Moghadam said he isn’t concerned about a threat from Amazon, partly because companies like Prologis are going to benefit as long as shopping shifts from bricks-and-mortar retailers to e-commerce.

“If you take the same number of goods and stack them in pallets, and take the same number of goods and put them in boxes ready for [online] shipping, it’s going to take more space,” he said.