Industrial Logistics Properties Trust Is Cheap But Risky (NASDAQ:ILPT)

Art Wager/iStock Unreleased via Getty Images

A couple of weeks ago I started a position in Industrial Logistics Properties Trust (NASDAQ:ILPT) in my real estate only portfolio. Since then, the company’s shares have continued to drop. In this article, I will go over the company and highlight its main strengths and weaknesses.

Strengths

Hawaiian Properties

In the company’s latest 10-K, it mentioned that approximately 52.9% of the company’s annualized rental revenues come from its Hawaiian Properties (approximately 34% after the acquisition of Monmouth). Most of the properties of the company are located on O’ahu, which is the third-largest Hawaiian island and this is where Honolulu is located. ILPT’s properties are located near the island’s central business district, which makes them very interesting for a lot of companies that are doing business in Hawaii.

A picture of one of ILPT

Sand Island Buildings Honolulu, HI (ILPT)

Another potential advantage of the Hawaiian properties is that they are leased on a triple net basis, meaning that the tenants are responsible for most costs. This substantially lowers costs to the company and means that they are less influenced by rapidly rising costs. Additionally, the Hawaiian leases are subject to periodical rent resets to fair value. The fair value of the rents is determined through one of the following two ways: negotiation between ILPT and the tenant, or an appraisal of the land, based on the highest and best use of the land unencumbered of the lease. This can be a positive or negative as most of the rents do not have an annual escalator built in the rent, but historically this has been a positive for the company.

The last thing that makes the Hawaiian properties a strength is the fact that Hawaii has a limited amount of space, and unless they are going on the Dutch tour (adding new land, by draining the lakes and the seas), there won’t be any new land. As developers aren’t able to build logistics properties on all pieces of land, the value of the land that can be used (and the logistics properties on them) will only become more valuable over time, which is very favorable for investors.

Investment-grade tenants and long leases

After the acquisition of Monmouth, the company’s tenant base consists of 77% of investment-grade tenants and the Hawaiian ground leases and although that is no guarantee for success, it significantly lowers the overall risk of the company.

An overview of the industrial logistics properties trust annual base rent divided by investment grade and non-investment grade rated tenants

ABR Divided by Investment-grade and Non-investment-grade (Investor Presentation)

The company’s top 3 tenants are FedEx (FDX), Amazon (AMZN), and Restoration Hardware (RH). For 2 out of the 3 warehouses and logistics properties are essential to run the business (for RH they are important, but they also have stores). This increases the likelihood of continued payments even further. Additionally, the company’s weighted average lease term was 9.2 after the merger. This means that cash flows should remain relatively stable in the foreseeable future.

Weaknesses

External management

Most REITs that are externally managed are trading at a discount compared to peers that are internally managed and ILPT is no exception. The company currently trades at an NTM P/AFFO of 11.6, which is lower than Prologis (PLD), PS Business Parks (PSB), STAG Industrial (STAG), and Plymouth Industrial (PLYM).

An overview of Industrial Logistics Property Trust

ILPT NTM P/FFO vs Competitors (TIKR.com)

The terms of the agreement between ILPT and its external manager The RMR Group (RMR) have some terms that could be negative for shareholders. First of all, RMR gets paid a fee of 0.5% on the lower of gross historical costs or market capitalization, while the first $250 million has a fee of 0.7%. Secondly, the company earns 3% of collected rents and 5% of construction costs, and last but not least, the company earns 12% of the outperformance against the MSCI US REIT/Industrial REITs over a three-year period (capped at 1.5%).

The main thing that could influence shareholders is the 3% of gross collected rents and 5% of construction costs. This could potentially destroy value as the company might look for adding properties that are of less quality or overpay for good-quality properties. One portfolio that was acquired at a high price was the Monmouth portfolio. Some investors might think this was a good deal for the company, but in my opinion, the company paid too much and I wouldn’t be surprised if this happens again in the future to boost the earnings of RMR.

Large dependency on top tenants

After closing the Monmouth acquisition the company receives around 30% of its annual base rent from FedEx (20.7%) and Amazon (9%). Even though both parties are investment-grade rated, they will have a lot of bargaining power when extending their leases. In the future, this could lead to significantly lower rents as they could use properties of other landlords as a bargaining chip to drive down future rents and/or rent increases. Even though it shouldn’t be impossible for ILPT to find a new tenant, 29.7% of ABR is a large amount and could make a huge dent in the financial strength of the company. Therefore, investors should monitor this situation carefully.

An overview of the top 10 tenants of Industrial Logistics Property Trust by annual base rent

Top 10 Tenants by ABR (Investor Presentation)

Valuation

In order to value a REIT, I like to combine two methods. First of all, I like to use a discounted AFFO, as normal cash flows do not properly represent REIT earnings and thus a discounted AFFO is a better alternative. Additionally, I like to use a forward P/AFFO based on the discounted AFFO.

To get ILPT’s AFFO I used the company’s FFO, made the adjustments mentioned in the annual report, and took out maintenance CAPEX. The adjustments as a percentage of FFO have been used to estimate the adjustments for the coming years. The growth rates of FFO in the base case have been collected from TIKR and are based on the average of analysts. The bull and bear cases are based on the base case.

An overview of the assumptions of FFO growth for ILPT in the coming 5 years

ILPT FFO Growth Assumptions (Author, TIKR, 10-K)

In order to discount the future cash flows, we need to estimate the company’s WACC. The WACC that I estimated was based on the cost of debt over the past 2 years, the company’s beta, and my required rate of return (10%).

An overview of the assumptions used to estimate the company

WACC Estimation (Author, Yahoo Finance)

Based on the aforementioned assumptions, the calculated price target based on the discounted AFFO was $24.30. For the P/AFFO I assumed a re-rating of the company’s P/AFFO to 13 (which is its 5-year mean), and this led to a price target of $27.88.

If we combine these two methods I get a price target of $26.09. This is approximately $8.62 or almost 50% higher than yesterday’s closing price.

Risks

As with all investments, ILPT comes with risks. At the moment of writing I view the following risks as having the most impact and being the most likely:

  • Bargaining power of tenants

  • Alignment between shareholders and the external management

  • Higher borrowing costs due to interest rate hikes

  • Increased chance of natural disasters in Hawaii

Conclusion

Industrial Logistics Properties Trust is a REIT with some great properties in Hawaii and a strong tenant base. Unfortunately, the company receives almost 1/3rd of its ABR from its top two tenants which gives its tenants strong bargaining power. Furthermore, the company is externally managed and this usually leads to a discount. The company is undervalued by over almost 50% based on my estimation of fair value, but the fact that it’s externally managed and that its top tenants count for such a large percentage of ABR makes it a risky investment and for those reasons, I would advise investors to limit their exposure in ILPT.