STAG vs. Rexford Industrial – REIT Duel between Two Growth Stocks

Vs.

Introduction

I’ve been searching for a growth stock in the Industrial arena for my REIT portfolio. While large pure play Industrial REITs grew revenues between 6 and 11 percent last quarter, I’ve instead been entertaining the possibility of investing in two promising stocks whose growth rates have been more aggressive.

STAG Industrial (NYSE:STAG) and Rexford Industrial (NYSE:REXR) were two of the highlights of the second quarter. Comparing the second quarter of 2015 with the same period last year, STAG’s revenues rose by 27% and Rexford’s by 52%; STAG’s funds from operations (FFO) grew by 22% and Rexford’s by 82%. I chose STAG for the dramatic share price performance, which dropped 29% year to date. As for Rexford, no other pure play Industrial REIT has demonstrated this level of exuberance in terms of revenue growth. For those reasons, these stocks are the subject of this article.

Besides revenue and FFO growth, I’ll be looking at six other metrics for measuring performance: internal growth, investment strategy, balance sheet, distribution growth, room to increase dividends and valuation. The following analysis systematically applies these criteria to see which REIT comes out on top.

But, a heads up! Because they are required to, even growth stocks in the REIT world distribute dividends. There are only a handful of REITs that don’t distribute dividends regularly, and I can tell you right now that their share performance hasn’t been great. Dividends are a strong indication of financial health, so it’s usually wise to stay away from REITs that don’t make distributions. Contrary to stocks in general, in the REIT space it’s hard to find good growth stocks that don’t make regular distributions.

Investment rationale

The investment rationale here is to look for REIT sectors where capitalization rates are compressing but reasonably priced acquisitions remain available. To make a long story short, the higher the capitalization rate, the lower the property value. This means that when cap rates compress, property valuations trend upward.

The “secret” lies in good, experienced management that can purchase or develop high cap rate opportunities in this environment in advance of rapid appreciation. Although we’ve seen compression rates across all types of real estate, Industrials have also demonstrated solid, robust fundamentals. Following years of decline, manufacturing has made a comeback due to increasing labor costs overseas. China shifting gears to become a services-oriented economy rather than industrial is good news as well. In addition, ecommerce businesses have fueled demand for warehouses. These are long-term trends from which Industrials have benefited significantly over the past few years.

Some REITs have also gone a step further and made acquisitions in secondary markets. Investors first search for the low-hanging fruit (more conservative, prime investments), and then as cap rates compress they turn to riskier investments in the secondary and tertiary markets. STAG doubled down on this route, and today 80% of its annualized base rental revenue is sourced from secondary and tertiary markets.

My problem with STAG Industrial

The chart below partially explains why STAG has been punished by the capital markets. While its peers who invested in primary properties have exhibited internal (same store cash NOI) growth rates year-over-year between 5% and 13% (and Rexford grew 8% last quarter), STAG has been stuck at 1%. This is happening even when STAG’s cash-releasing spread was 4%. Rexford’s cash-releasing spread was 7%.

STAG’s Same Store Cash NOI

Rexford’s Same Store Cash NOI

More recently, UBS downgraded its view of the company, and share price plummeted. STAG has been one of the worst-performing stocks in the REIT sector this year, in the bottom 10th percentile.

Differences

STAG and Rexford are two very different companies. STAG invests in single-tenant, net-lease industrial spaces (mostly warehouses) spread over 37 states. STAG has 283 leases for 265 properties, with approximately 50 million rentable square feet. Rexford, on the other hand, invests in multi-tenant industrial spaces of all sizes in Southern California infill markets. Rexford has 1,167 leases for 108 properties, with 10.6 million square feet. Most are either net leases or modified gross leases (mostly of the cost passed through to the tenant).

STAG’s portfolio

STAG leases to large tenants, a significant portion of which are investment grade, with an average lease size of around 177,000 square feet. They purchase properties that are fully occupied, in what the management calls the “binary nature” of their business: these are single-tenant leases, so properties are either 100% occupied or not occupied at all. As a result, internal growth tends to be lower because occupancy can always (and only) go down from a 100% base, as has already happened to acquisitions in previous years. Internal growth is very dependent on the releasing spreads.

STAG's Locations

In contrast, Rexford invests in tenants of all sizes, and the average lease is just less than 10,000 square feet. They are 100% invested in Southern California – the largest industrial area in the country, but also one of the most diverse industrial markets.

Rexford's Locations

Rexford’s retention rate was 52% in Q2, and STAG experienced a 29% retention rate – although STAG’s figure was an odd number for the quarter and shouldn’t be considered the norm from now on.

While STAG’s overall occupancy appears to have stabilized near 95% over the past couple of quarters, Rexford’s overall occupancy in fact dropped to 88% from last year due to acquisition and reposition of properties. That said, Rexford’s same property portfolio occupancy also advanced 280 basis points to 92.6%, whereas STAG’s dropped 60 basis points to 93.8%.

What I like about Rexford

I like Rexford’s investment strategy: scarcity in infill markets intensifies growth. The strategy of being in high-barrier markets with high concentrations of people, jobs, housing, income, wages, and consumption together with competition from other types of real estate makes it harder to find vacant spots or to develop space. This leads to increases in occupancy and releasing spreads which in turn leads to robust internal growth.

Also, Rexford is in the right location at the right time. Rexford is in five well-known counties whose average rents are the highest in the country, some of them highly desired by the company’s REIT peers. Traded REITs in aggregate have little presence in the region.

Similarities

Well, for starters, both companies recently went public. STAG IPOed in April 2011 and Rexford in July 2013, so neither has a long performance history to brag about. Nonetheless, both have grown considerably. Since the IPO, STAG has grown its size in square feet to 3.5 times the IPO base, and Rexford to 2.0 times.

Further, both are small capitalization stocks, and not far from each other in terms of size. STAG’s market cap is $1.2 billion, and Rexford’s is $0.7 billion.

Both companies have raised massive equity to fund their growth in the same proportion as they grew their assets, diluting their share base and discouraging some investors. Both also expect that 2015’s funds from operations per share (equivalent to earnings per share for REITs) will be down.

Debt

Both companies have maintained net debt at acceptable levels of about 5.0 annualized adjusted EBITDA. STAG has been upgraded to investment-grade by Fitch. Rexford’s credit profile is not investment-grade, but the company has nonetheless maintained one of the lowest total debt to total capitalization market ratios, at 26%.

In addition, unlike STAG, Rexford has most of its debt variable in a rising interest rate environment with slightly more than half of it secured, so I’ll have to say that STAG’s debt profile is better.

Entry point

STAG undeniably has the best entry point of the two. Its share price has returned to end-of-2012 levels, when its assets were 40% lower. STAG is currently trading at 12x price-to-FFO, way off its peers’ median. The stock is now yielding at 7.8% for an AFFO dividend payout of 95%.

Rexford’s price-to-FFO is more in line with the median, and so is its dividend yield. Due to dilution, the share price has remained at roughly the price at IPO two years ago. A recent dividend bump of 13% (versus only 4% for STAG) has not been enough to revive the company’s share price. AFFO dividend payout is at 88%, so Rexford has slightly more room to increase dividends.

Summary and verdict

STAG has really been lagging its peers in terms of valuation. I can easily imagine its stock price catching up once the company experiences a wave of good news. Also, the yields are very tempting. However, investor sentiment for REITs has been pessimistic lately, so I don’t see a sharp share price appreciation happening any time soon. Additionally, I’m not a market timer so I’m a specialist in choosing the exact moment to purchase and sell stock.

On the other hand, Rexford presents a more robust investment strategy. You can’t go wrong when you invest in the largest and most diversified industrial park in the country; it’s like investing in the Manhattan of the industrial space.

For these reasons and the reasons listed in the table below, my verdict is for Rexford Industrial.

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Source: STAG Industrial, Rexford Industrial, Fast Graphs

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Disclosure: The author has no positions in any shares mentioned, and no plans to initiate any positions within the next 72 hours.