Prologis (NYSE:PLD) stock has enjoyed a strong start to the year despite continued interest rate increases by the Federal Reserve. Hence, I think the company has largely realized its short-term potential. That said, I believe any weakness in the shares can be seen as a buying opportunity, given the strong growth pipeline and stable funding profile.
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Prologis primarily manages logistics buildings spanning 1.2 billion square feet. The company operates in four regions – the U.S. at 86.3% of total net operating income (NOI = rents and other revenue minus operating expenses), Europe at 7.9% of total NOI, Other Americas at 3.9% of total NOI, and Asia at 1.9% of total NOI.
Operational Overview
Prologis delivered core funds from operations (known as core FFO, a cash-flow metric used by REITs) of $1.24 per share in Q4, up 10.7% from the prior-year quarter. On an annual basis, core FFO was $5.16/share in 2022, up 24.3% from 2021.
Additionally, occupancy increased by 0.5% year-over-year to 98.2% in Q4.
Meanwhile, same-store NOI jumped by 7.7% in Q4 year-over-year, and NOI growth has been consistently above 7% for the past 12 months.
Issuance in Q4 consisted of $1.1 billion of debt with a weighted average interest rate and term of 3% and 7.5 years, respectively. However, thanks to hedging, its overall weighted average interest rate is below current market rates, at 2.5%, with a weighted average term length of 9.1 years.
Still, a red flag regarding Prologis’ funding strategy is that the company is focusing on issuing short-term debt with a lower interest rate. While this strategy can help PLD increase its core FFO, it also exposes the company to future increases in interest rates. For reference, the yield on its 4.375% 2048 USD bonds is now about 5.1%.
Prologis’ Implied Capitalization Rate
It is always important to consider the capitalization rate (the rate of return on a real estate investment property based on its expected cash flows) of a REIT you invest in and not just the yield based on core FFO. Usually, to increase returns, REITs borrow from banks and other lenders. This often results in a high core FFO yield.
However, if the REIT needs to sell a property on the market, the buyer will consider the capitalization rate as it encompasses all cash flows of the property to equity and debt holders combined.
Prologis gets variable income from asset management aside from the rent income it gets from buildings. Thus, a true market-implied capitalization rate is hard to come by. Nevertheless, a good approximation would be to combine its core FFO forecast and interest expense and divide the sum by the company’s enterprise value.
In 2023, core FFO should be about $5.1 billion and interest expense about $0.7 billion. Against an enterprise value of about $138 billion, the market-implied capitalization rate is about 3.85%.
2023 Outlook
Prologis expects to grow Core FFO by about 5.6% to $5.40-$5.50 per share, a deceleration from 2022. Further, occupancy is expected to decrease by 1.2% to 96.5%-97.5%, mainly due to deliveries in the development pipeline.
Thus, the only bright spot is same-store NOI which is seen growing at about 8.5%, an acceleration to 2022.
2024 and Beyond
Looking further ahead, the company is facing two offsetting forces. On the one hand, further NOI growth of about $2.9 billion is to be expected post-2023, as noted on the conference call. The company’s CFO stated, “Given these assumptions, we believe our lease mark-to-market will be sustained or even increased over 2023, ending the year between 65% and 70%, and providing visibility to an incremental $2.9 billion of NOI after the more than $300 million that will become realized over the course of this year.”
On the other hand, the company has to refinance its debt over time, increasing its interest expenses due to higher rates. If we assume average interest rates rise 1% to 3.5% (above current short-term borrowing rates but below prevailing long-term rates), this will result in an extra $0.3 billion of interest expenses.
Netting the two effects, the long-term current capitalization rate can be seen at about 5.6%. You can view this rate as the yield Prologis’ properties will deliver if old low-rent leases expire over time and the company re-lets the properties at the current prevailing market rent.
Bearish Interest Rate Trends to Consider
Aside from company-specific factors, I want to highlight two near-term events that may prompt a rise in interest rates. Firstly, the U.S. dollar index is down about 10% from its peak in September last year. Dollar depreciation may push up inflation and limit interest rate cuts by the Federal Reserve in the near term.
The other factor to watch is whether raising the debt ceiling in the U.S. prompts a torrent of debt issuance, pushing interest rates higher. Current issuance is abnormally low, and the U.S. treasury is using its cash reserve at the Federal Reserve to make up the difference.
While neither factor should affect Prologis in the long term, a near-term correction could be in the cards, given the interest-sensitive nature of the company.
Is PLD Stock a Buy, According to Analysts?
Turning to Wall Street, Prologis earns a Strong Buy consensus rating based on 12 Buys, two Holds, and zero Sell ratings. Additionally, Prologis stock’s average price target is $138.71, implying 7.3% upside potential.
The Takeaway
Prologis is a high-quality company that is well-appreciated by the market. Thus, I would argue there is limited upside in the shares, given the strong year-to-date performance.
That said, due to its appealing long-term growth prospects, any correction in the shares can be seen as a buying opportunity. Alternatively, investors already owning the shares can use them to generate income via the selling of covered calls, a popular options trading strategy.
