Prologis Will Be Affected by Elevated Development Deliveries and Softening Warehouse Demand 

Equity Analyst

Suryansh Sharma

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Prologis acquires, develops, owns, and operates industrial facilities that are strategically located in markets characterized by large population densities, growing consumption, and high barriers to entry, typically near large labor pools and extensive transportation infrastructure. The firm's strategy is to leverage the organizational scale of its 1.2 billion square foot portfolio to provide a single point of contact to address the logistical needs of its multimarket clientele. The firm's strategically located global land bank has the potential to support the lucrative development of approximately $35 billion of new industrial projects in upcoming years.

The strategic capital segment, which has around $60 billion of third-party assets under management, or AUM, produces durable, long-term cash flows from unconsolidated co-investment ventures, principally through asset management fees, incentive fees, and property management services. Management has outlined its policies on capital allocation to ensure continuous portfolio refreshment and value creation while maintaining a strong balance sheet and having adequate access to capital. We also welcome management’s focus on Essential’s business where the firm leverages its scale to deliver value to its customers through procurement activities and other innovative solutions related to industrial operations, transport, technology, energy, and labor.

The shift of spending toward goods, a rapid rise in e-commerce, and ongoing economic recovery from the pandemic's effects have led to historically low vacancy rates and very strong rental growth in the industrial sector. Short term, we expect the rental growth to remain strong due to the high mark-to-market before it starts to normalize lower as pandemic-related demand drivers fizzle out and additional supply hits the markets. Long-term, continued growth in e-commerce, overall consumption growth, higher service expectations, and desire for more supply chain resiliency should provide a long growth runway for distribution and logistics facilities, especially given the large amount of space necessary to support online sales compared with traditional retail.

Business Strategy & Outlook

We assign a no-moat rating to Prologis. The development process for industrial real estate is relatively simple compared with other real estate sectors, and the lead time required to build an industrial warehouse is also quite short. Given the substitutes within industrial space, limited supply restrictions in most of Prologis’ key geographic markets, and the relative availability of land surrounding large population centers, we view a large proportion of properties as replicable and, therefore, do not believe that the company has a maintainable competitive advantage.

Market Dynamics (Supply & Demand):

Despite Prologis’ being the largest player in the industry and having a significant global presence, the industry is fragmented and littered with competitors, and we do not see any indicators of competitive advantages for the company. The U.S. contains around 11.1 billion square feet of warehouse and distribution space, and of that space, Prologis’ owned space accounts for around 600 million square feet or 5.4%.

The rapid growth of e-commerce and ever-increasing logistical service expectations continue to be a significant demand driver for additional industrial space as it takes approximately 3 times the amount of warehouse space in e-commerce when compared with traditional retail channels for every dollar of sales. E-commerce's share of total retail sales has grown from 1% in 2000 to around 13% in 2021. If we exclude the categories of retail sales that e-commerce traditionally excludes, such as motor vehicles, gasoline, building materials, and groceries, then e-commerce's share of total retail sales would be approximately 25%. We estimate that e-commerce will be reaching a total share of 45% in the next decade, excluding the previously mentioned categories. We believe that the continued growth of e-commerce is a large structural trend that will benefit owners of industrial space for many years to come.

Although demand for space is increasing rapidly, so is the newly developed construction coming to market every year. In 2022, new development deliveries were expected to exceed 350 million square feet, the highest level recorded. The expected delivery volume in the current year is significantly more than the 130 million square feet delivered during the previous real estate cycle peak in the year 2006. In fact, the delivery volumes and construction pipeline for industrial space have constantly been increasing since the nadir in the year 2010. While vacancies are hovering around historically low levels, the response from increased construction over the past several years has supported our view that any increase in demand for industrial warehouse and distribution space can be appropriately met with new supply.

While location plays a key role in the strength of a portfolio, the massive size of most facilities is such that they are typically located near densely populated areas instead of in them. This makes it difficult for any warehouse to differentiate itself because of the relative abundance of unutilized or underutilized land surrounding large population centers. Additionally, distribution warehouses are a highly commoditized real estate asset class to develop, supporting our view that any outsiders with the financing can enter the market and participate in new construction whenever demand outpaces supply. We traditionally view the ability to effectively rebalance short-term differences in supply and demand as supportive of a no-moat rating in the REIT sector. This dynamic is reflected in Prologis’ inability to charge a premium on its properties on a rent per square foot basis as compared with properties of similar quality and location reflecting the commodified nature of industrial space.

We view Prologis’ facilities as among the best in terms of quality and location, with a concentrated presence that closely aligns with regions representing the lowest capitalization rates in the country, such as Chicago, Miami, Dallas, Seattle, and coastal California. However, while Prologis’ facilities may be newer and well-located, nothing in them is difficult for competitors to replicate. We expect future new developments to remain concentrated in key warehouse locations across the country, especially on the outskirts of densely populated cities.

Having said this, approximately 25% of the company’s net operating income comes from the Los Angeles and San Francisco markets in California, which we view as somewhat competitively advantaged markets. New Jersey, which contributes around 8.0% of NOI, also has some of these characteristics. Prologis obtained its highly attractive position in these markets by acquiring land for industrial use decades ago. These locations represent high-quality facilities with limited competition as the firm benefits from highly restrictive zoning regulations preventing the addition of new supply. California’s arcane and restrictive zoning laws, rampant NIMBYism, and the scarcity of affordable land throttle the addition of economically rational supply, supporting a regulation-based intangible asset moat source for the California business. We would assert that the firm’s California and New Jersey portfolios have some traces of a regulatory intangible asset moat source. Although we see these dynamics in California, we do not think they are present across the remainder of the company’s portfolio. Most cities across the U.S. are typically less restrictive from a zoning perspective and land is more widely available, making land prices lower and new construction easier. Since California is a relatively small part of the overall portfolio, we believe that the company does not have a regulatory intangible asset as a whole. In addition to this, we think that the state of California has incentives to make economically rational changes to zoning and property laws to boost tax revenue and business activity. While these zoning and construction approval processes are often seemingly intractable and difficult to change, we think it is feasible for the regulatory environment to shift more than 10 years out.

Efficient Scale:

Efficient scale is the primary moat source for real estate investment trusts. This moat source refers to situations where companies are effectively serving a very limited market size, and potential competitors have little incentive to enter the market because by doing so, they would lower the industry’s returns to below the cost of capital. We do not see any evidence of these competitive dynamics for industrial space.

First, we think that the market size for industrial and warehouse space in a particular submarket is poorly defined. Industrial space can in some senses be moved to different localities near a submarket as per the availability of land. In other words, the demand for industrial space within a particular locality is not fixed as potential tenants can easily move to nearby localities within a submarket.

Second, the owners of industrial space do not have pricing power because the industry is highly fragmented, with no single entity owning a significant share of inventory within a given geography. For example, despite Prologis being one of the largest industrial space owners in Chicago, we estimate that it owns less than 6% of the total industrial inventory. This limited market share prevents the company from achieving the pricing power necessary to achieve an efficient scale moat source.

Lastly, when assessing an efficient scale moat source, we typically look for a material cost to enter a market and the necessity of a significant market share to make these fixed costs worthwhile. Although large industrial properties can be costly to develop and acquire, no additional barriers are preventing new players from entering a market. Each property can operate on a standalone basis, and the benefits of accumulating properties in a single location are limited. This allows markets to remain fragmented and encourages new entrants when excess returns are to be had.

Switching Costs: 

Industrial real estate tenants typically sign leases that are five to seven years long on average, which does not support a switching-cost moat source. The short length of stay is further complicated by the commoditization of these facilities and the numerous substitutes available in key metropolitan distribution hubs. Some industrial tenants like Amazon can incur significant capital expenditures that are unique to their company after renting an industrial warehouse to support their operation thereby increasing the stickiness of these tenants. However, we think that these tenants form a small proportion of the overall tenant base. The company has a retention rate of approximately around 75%, suggesting the limited stickiness of its client base.

Prologis derives around 11.0% of its net operating income from the strategic capital business segment where it has third-party industrial assets under management and earns asset management fees, incentive fees, and property management-related fees. The strategic capital business is composed of approximately 95% perpetual long-term ventures and has some traces of switching costs. Although the explicit switching costs for managed assets do not seem large, inertia and the uncertainty of achieving better results tend to keep investor money in the same funds for long periods. Additionally, the assets are in private real estate rather than listed securities, which lacks the liquidity of shares traded on an exchange and is thus inherently stickier. The specialized nature of these investments also insulates Prologis somewhat from fee compression prevalent in the industry since its investments are considered more niche and difficult to replicate by investors.

Conclusion:

We use an adjusted return on invested capital, or ROIC, calculation to determine whether a company has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, Prologis has averaged an adjusted ROIC of approximately 230 basis points below our 7.3% weighted average cost of capital. We expect the adjusted ROIC of the company to slightly exceed its WACC by the end of our projected period. For us to award a moat, we need to have both quantitative and qualitative evidence that supports a moat rating. In the case of Prologis, we are not currently confident enough that the qualitative sources of competitive advantage will lead to durable excess returns on capital to justify a narrow moat rating for the company.

None

Economic Moat

Prologis

Prologis, Inc. engages in the provision of real estate investment trust services. It operates through Real Estate Operations and Strategic Capital segments. The Real Estate Operations segment represents the ownership and development of logistics properties and also includes rental revenues, recoveries and expenses recognized from its consolidated properties. The Strategic Capital segment represents the management of co-investment ventures and other unconsolidated entities. The company was founded by Hamid R. Moghadam in 1991 and is headquartered in San Francisco, CA.

Earnings data Q3 2023

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Prologis, Inc. engages in providing logistics solutions and services. It operates through the Real Estate and Strategic Capital segments. The Real Estate segment includes rental operations and development. The Strategic Capital segment represents the management of co-investment ventures and other unconsolidated entities. The company was founded by Hamid R. Moghadam in 1991 and is headquartered in San Francisco, CA.

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