Summary: ILPT is a busted REIT spin/IPO with high-quality assets trading at a 31% discount to NAV. As a recent spin, ILPT has limited coverage and buy-side recognition. The company’s assets, which are located in Hawaii and the Mainland US, are 99.9% leased with an average lease duration of 11.2 years, and contractual rent-resets provide a clear pathway for modest organic growth. ILPT’s leverage of 2.6x net debt/EBITDA is less than half the peer median of 5.3x, and it’s 6.1% dividend is double the peer group median and conservatively covered by cash flow. ILPT is cheap on a nominal and relative basis, trading at only 12.9x 2018E FFO vs an industrial REIT average of 23.1x, as well as a deep discount to NAV. At the current price you’re essentially buying the Hawaiian assets at a fair price and getting the Mainland logistics assets for free. We believe the stock will return 37% over the next 12 months in our base case, with nearly 100% upside in our bull case based on the recent PLD/DCT transaction, and 15% downside in our bear case.
Industrial Logistics Properties Trust (ILPT) is an industrial/logistics REIT that spun-out/IPO’d on January 12th, 2018. ILPT owns two sets of assets: Hawaiian and Mainland US. The company has owned the HI assets since 2003, and occupancy at those properties has never dropped below 98% during that time. The mainland assets were primarily purchased in 2015 and are 100% leased with Amazon as the largest customer. The company’s assets were formerly owned by Select Income REIT (SIR), who continues to own 69% of ILPT common stock. As many of you likely know, SIR and ILPT are RMR managed REITs, not exactly a compliment in the REIT world. The RMR family of REITs is managed by the Portnoy family, who had a very pubic and nasty fight with Corvex and Related over Commonwealth REIT. The rub on the Portnoy family of REITs was that they were vehicles to enrich the family while not doing much for outside shareholders. We believe the risk of this happening at ILPT is largely mitigated by the company’s compensation structure, which only really pays off for management if ILPT outperforms the REIT index by a significant margin. The idea behind the ILPT spin was the high-quality Hawaiian and Mainland assets would get a premium valuation compared to the legacy SIR office assets. With little in the way of leverage, management could continue to acquire high-quality mainland logistic assets at ILPT. As the company acquires mainland logistics assets, coupled with contractual rate increases at the legacy properties, NOI and the dividend will grow over time.
The ILPT IPO could not have come at a worse time, which is one of the reasons we like the set-up from a structural angle. SIR got the ball rolling on the spin in late September of 2017, which coincided with the beginning of a stretch of drastic underperformance by REITs relative to the S&P 500. In the months leading up to the spin, the IYR underperformed the S&P 500 by 15%. The original IPO range for ILPT was set at $28-$31, but ended up pricing at $24 and closed its first day of trading at $23.35. The stock languished after the IPO with the broader REIT group, trading down to ~$20, roughly where it trades today.
ILPT owns 266 properties, leased to 243 different tenants, comprised of 28.5M square feet. The assets are 99.9% leased with an average remaining lease term of 11.2 years. The company reports results in two segments: Hawaiian and Mainland. The HI properties represent 59% of square footage and 61% of revenue, with Mainland representing 41% of sq. ft. and 39% of revenue. An interesting point to note is that because the Hawaiian rents only reset every ~10 years, the current HI portfolio is currently underpriced by ~30% compared to market rents. Thus, ILPT is severely under-earning on its HI assets.
The Hawaiian assets are located on the island of Oahu, primarily between the Honolulu airport and the downtown business district. [Side note: there are no active volcanoes on the island of Oahu]. The vast majority of the Hawaiian assets were purchased in 2003. Due to a lack of land supply and significant government land ownership, there is a very limited amount of industrial real estate on the island. To that point, since 2003 the Hawaiian assets have never dipped below 98% occupancy, including during the financial crisis. The assets are currently 99.9% occupied and have an average remaining lease term of 13.4 years. One unique aspect of the HI properties is rents typically reset every 10 years, as opposed to annual rent escalators. The average rent-reset increase since taking ownership of the assets has been ~33%, although in 1Q18 that figure was 46%. In 2019 a significant portion of the properties are due for a reset. 20 properties, representing $10.9M of annual rent, will reset. We estimate a 35% rent increase for these properties, which represents $3.8M of revenue growth, all of which should fall to the bottom line.
The Mainland assets are comprised of 40 properties in 24 states. Made up of 90% logistics assets and 10% industrial, the mainland properties are 100% occupied with an average remaining lease term of 8.3 years. The assets are high quality, for example in Colorado Springs and Salt Lake, but not in the hottest markets such as Northern NJ, San Francisco or DFW. The overall mainland portfolio is in the A to B range. It also has high quality tenants, as Amazon represents 10% of total ILPT consolidated revenue. Logistics properties such as ILPT’s have seen an increase in demand over the past few years as the e-commerce boom has accelerated. ILPT purchased the bulk of the Mainland assets in 2015 at a cap rate of 5.9%. On average the mainland contracts have a 1.5% rent escalator.
We calculate NAV by valuing the Hawaiian and Mainland assets separately. First, we use two different methodologies to derive the Hawaiian asset value: 1) Price per square foot based on the most recent Colliers Oahu report, and 2) on a consolidated cap rate basis. The Colliers Oahu Valuation Analysis provides a price per square foot range for each location on the island. ILPT also breaks down its assets into these same buckets, and therefore we can layer over the Colliers estimates on ILPT’s percentage of square footage in each location. This analysis, provided below, indicates that ILPT’s Hawaiian assets are worth ~$1.5B.
Alternatively, we value the Hawaiian assets based on a consolidate cap rate. This method is inherently subjective. However, based on historical occupancy and growth trends we believe ILPT’s HI assets are on par if not better than the premier US mainland industrial assets in areas such as San Francisco, Southern California, Seattle and New Jersey. These areas demand cap rates in the 3.9%-5.0% range, and so we use a 4.8% cap rate to derive a valuation for ILPT’s HI assets.
This analysis also implies a valuation for the Hawaiian assets of ~$1.5B. Moreover, as noted above, the current EV for ILPT is only $1.74B, which ascribes only $159M of value to the mainland assets. The mainland assets, which we know to be high quality based on a range of factors, generate $54.2M of annual NOI, which implies they are being valued at a ~35% cap rate, i.e. essentially zero. To value the mainland assets, we employ a simple scenario analysis using a range of cap rates. Keep in mind, ILPT purchased these mainland assets in 2015 at a 5.9% cap rate, and logistics assets have appreciated since that time due to the increased in e-commerce activity. Also note the recent Blackstone/GPT transaction price implies a 5.9% cap rate for the consolidated GPT portfolio, which includes a significant amount of lower quality office real estate.
Using the above analysis as a guidepost, we believe the mainland assets are worth $875M. Combining the valuation of the two assets yields a NAV of just north of $2B, or $31.44 per share. ILPT’s current share price of $21.60 represents a 31% discount to NAV.
One pushback on ILPT is the RMR management structure. We believe the risk of a negative outcome due to this arrangement is mitigated by the terms of the contract. The management fee to RMR is split into two buckets: 1) A base management fee, and 2) an incentive fee. The base management fee is equal to roughly $9.2M, and is well below its peer group average as a percentage of assets, revenue and AFFO. The incentive fee which can be earned by RMR only pays-out if the Total Shareholder Return (TSR) of ILPT exceeds the TSR of the SNL US REIT Equity index and is calculated based on the percentage of outperformance. The TSR must be positive, i.e., outperformance with a negative TSR at ILPT does not garner a pay-out. Moreover, there is a bonus pay-out if the TSR of ILPT exceeds the REIT index by greater than 12%. There is also a penalty if ILPT underperforms the index by greater than 500bps, and a cap to how large the incentive fee can be on the upside. We feel this arrangement aligns the interests of outside shareholders with those of management, and mitigates the potential for abuses of power.
ILPT is on the small side relative to the industrial/logistics REIT peer group, with a current EV of ~$1.74B. The company has by far the lowest leverage, the highest dividend yield and is significantly cheaper on a multiple basis. We believe this is due to structural issues, i.e. ILPT is a recent busted spin/IPO, and that the valuation discrepancy will close as investors become aware of the story, and it becomes eligible for REIT ETF/index inclusion.
ILPT is trading at a deep discount to NAV, 31% by our estimation. And, while US public REITs are currently trading at a 10% discount to NAV on average, industrial REITs are currently trading at a slight premium to NAV. This is in large part due to PLD’s recent acquisition of DCT, but nonetheless indicates investor are willing to pay a premium for industrial/logistics REITs compared to the broader REIT group.
Our base case implies a 37% return over the next twelve months. We derive this by beginning with a NAV of $31.44. We apply a 5% discount to NAV based on a blended NAV discount relative to the average public REIT, while also considering the average industrial REIT is currently trading a premium to NAV. We then apply an additional 5% discount based on the RMR management structure. This incremental RMR discount equates to $97.5M of equity value. We then add the $1.32 dividend an investor will receive over the next 12 months. This analysis implies a 37% return over the next 12 months.
Our bull case implies a return of ~100%. The upside case is based on an acquisition scenario, using the recent PLD/DCT transaction as a guidepost. As previously noted, the e-commerce boom has resulted in increased demand for logistics warehouses. The DCT deal gives PLD more exposure to this trend, specifically in the US. While DCT is larger and has greater scale than ILPT, the two are fairly similar and actually share two of each other’s top three customers, Amazon and FedEx.