REITs: Tides of Trade - Remain bullish on Industrials
Sector: Industrial REITs

What's Incremental To Our View

Net-net: We remain bullish on industrial fundamentals through 2017 due to: 1) expected favorable lease mark to market profiles (up to 20% on new leasing, see Figure 18), 2) continued strong demand growth from E-commerce (at least 30bps of net new demand, our assumption-unchanged since 2011), 3) relatively low/stable GDP growth of ~2% and 4) disciplined new supply growth.

Remember, there is a 71% correlation between changes in container traffic and changes in industrial demand, with container traffic leading industrial demand by 3 qtrs. And similarly, there is approximately a 77% correlation between changes in trucking volumes and industrial demand, with a 3 quarter lead via trucking volumes. U.S. container traffic decreased -2.2% YoY in Sept versus +0.8% YoY in Aug. When excluding empty containers, volumes actually increased +2.3% in Sept versus +3.5% in the previous month. Following the Hanjin Shipping (10% of Long Beach TEU traffic) bankruptcy last month, we may see lingering results, as West Coast ports reported a -5.8% decline in volumes in Sept vs. +3.2% increase in the eastern ports (Houston leading the way). Trucking tonnage: +5.0% YoY Not Seasonally Adjusted (NSA) in August vs. prior month’s +0.3% YoY (77% historical correlation to industrial demand growth).

Based on regression model (GDP/trade regression, plus layering in our estimate of e-commerce contribution, 30bps per year or 40msqf), we estimate industrial demand (occupied sqf) to grow roughly 1.6% over the next year; this is in addition to 2015’s (estimated) 2.1% increase in demand (according to CBRE; 253msqf,). With supply expected to grow 1.3% in 2016 and 2017 (CBRE), we continue to view favorable supply/demand dynamics in the industrial space. While the growth rate in demand (relative to supply) may peak post 2016, this does not mean an immediate return to low net absorption environment necessarily or no rent growth.

Other leading indicators:

Trucking tonnage: +5.2% YoY Seasonally Adjusted (SA) in August vs. prior month’s +0.3% YoY.
Rail: -1.0% in Aug YoY vs. -9.2% in July
Air Cargo: Global traffic +3.5% in August YoY vs. +4.6% the prior month, North America Air cargo traffic increased +4.6% YoY vs. +1.3% the prior month.
ISM Index: 51.5 in Sept vs. 49.4 the prior month; New Orders (the most forward looking) are at 55.1 for Sept, up from 49.1 the prior month.
Case-Shiller 20-Price Index: +5% in July YoY vs. +5.1% the prior month.

CBRE – 3Q16 Market Snapshot

Based on CBRE’s latest 3Q16 industrial market snapshot, the industrial market picked up an additional +20bps of occupancy to reach 91.2%, quarter over quarter and +80bps YoY. Overall, the demand-supply equation remains favorable for the industrial sector, with lowest vacancy level for some markets in decades. Specifically, markets such as New York (-240bps YoY), Detroit (-250bps), Tampa (-200bps), Boston (-180bps), and Philadelphia (-150bps) had noticeable decrease in vacancy.

REITs – Things we are thinking about as we head into 2017

Approximately, 25% of the $4.5 trillion Federal balance sheet matures by the end of 2019. The quantitative easing program is not a single shot program, it is a treadmill, and as the securities mature the Fed will have to decide to rollover the debt (by buying another $1.1 trillion in debt, or let some portion of the debt mature and thereby roll back the original scope of the QE program.)

There are a couple of opposing forces: 1) At this junction, inflation is a slightly growing concern in the U.S. as CPI has increased noticeably and wage growth has accelerated. This is in contrast to countries like Japan that is facing deflationary pressures, where maintaining aggressive QE is more understandable. 2) One of the problems with rolling back QE relates to the interest expense (6% of annual spend) the treasury has been paying to fund the US government. This has been quite low, at 1.7% (2.3% if including intergovernmental debt) on $19.5 trillion of debt. But with constant budget shortfalls, we think the government has to remain on the treadmill for the most part and likely maintain a larger balance sheet at the fed.

Our early opinion is that, there has been significant focus on what the fed will do with the fed funds rate, but not enough focus on decision the fed will make with the $4.5trillion inflated balance sheet. And if this becomes more topical in the future, we see increased volatility for REITs. We see moderate risk the fed decreases the size of its balance sheet due to inflationary pressures. We do not pretend to know what is going to happen, but it’s the unknown that creates risk that may impact the REIT market. At the end of the day, budget deficits, interest expense concerns, and the fear of yield spikes are likely to pressure the fed in maintaining a large balance sheet (QE program), for the longer haul.