(By
Todd Lukasik, CFA) Earlier
this year, we downgraded our moat assessments for industrial property
landlords ProLogis Trust and AMB Property Corporation as stand-alone
businesses to none from narrow. Recently, these firms merged, creating ProLogis Inc. (
PLD),
a worldwide behemoth owning industrial property in markets that
represent roughly 80% of the global economy. Still, the expected
benefits of the merger are not sufficient enough for us to change our
outlook on the newly combined firm's moat.
We look at a number of operating and financial metrics when assessing
moats among landlords. We think landlords with competitive advantages
should be able to post solid operating metrics across a complete real
estate and economic cycle and generate returns on real estate assets
that exceed their costs of capital. By our reckoning, industrial real
estate investment trusts ProLogis and AMB Property failed in both areas
as stand-alone companies.
The most common operating metrics we consider when assessing moats
among landlords are re-leasing spreads and portfolio occupancy rates,
which drive same-property net operating income (NOI).
Re-leasing spreads measure the change in rental rates on new versus
expiring leases. In the last six years, both AMB and ProLogis
experienced periods of rent roll-downs (negative re-leasing spreads),
where the new rents were lower than the expiring rents, resulting in
lower revenue.
This negative pressure on rents is unlikely to change in 2011.
AMB recently has said that it estimates it is roughly 10% "overleased"
(in-place rents on existing leases are 10% greater than current market
rates) across its portfolio. We think ProLogis is in similar shape, if
not slightly worse, given its recent relative performance.
Occupancy rates at stand-alone AMB and ProLogis also suffered
recently, as tenants reduced their demand for industrial space in the
wake of the financial crisis and a sharp decline in global commerce. The
situation was magnified at ProLogis because it completed a slew of
speculative development projects as demand cratered, resulting in high
and persistent vacancies. But even ProLogis' adjusted occupancy rate,
which excludes the negative effect of its poorly leased completed
developments, fell meaningfully in the downturn.
Rental rates and occupancy are two main drivers of landlords'
profitability. As rental rates and occupancy fall, so does revenue, and
with a number of fixed operating costs, profits are squeezed.