EastGroup Properties Is Well-Positioned To Benefit From The Upcoming Market Shift

Investment thesis

While the industrial property sector is facing some headwinds, the market presents us with some attractive opportunities. With the signs for the upcoming market shift towards a more favourable supply-to-demand relationship, I believe EastGroup Properties (NYSE:EGP) is well-positioned to benefit from the potential improvement of the market conditions as it has:

• a strong position within high-potential sunbelt markets
• a strong balance sheet with a fixed-rated debt structure, low indebtedness, and outstanding fixed charge coverage
• solid business metrics marked by a relatively high occupancy rate, the ability to secure significant rent growth on new leases or renewals, and a top-tier tenant diversification structure

On top of that, EGP offers dynamically growing and well-covered dividends, as well as a potential for multiple appreciation (it may be considered a margin of safety). That is a “buy” from me – I am bullish on EGP.

Introduction

The industrial property sector continues to face some headwinds related to the oversupply and a relatively dormant transactional market due to the noticeable disparity between buyers’ and sellers’ expectations. Since mid-2022, the sector has been accompanied by high new supply coming to the market with a demand heavily weakened after the previous post-COVID surge, which resulted in a still present unfavourable supply-to-demand relationship. The continuously high net completions totalling over 100m sq. ft. for a 7th consecutive quarter (since Q3 2022) combined with a relatively low demand drove the vacancy rate to the highest record since 2015 – 6.2% in Q1 2024.

After the largest industrial REIT in the world – Prologis (PLD) published its Q1 2024 results, which reflected the continuous character of the headwinds mentioned, the market sentiment towards the sector deteriorated. Moreover, the Company’s CFO, Tim Arndt provided some more color on the situation during the Q1 2024 Earnings Call:

Net absorption in the US, for example, was very low this quarter at just 27 million square feet. So while the macro landscape and supply chains continue to generate a need for space, we think it’s prudent to expect continued headwinds on overall absorption over the next few quarters.

Therefore, the unfavourable supply-to-demand relationship is expected to be upheld in the upcoming quarters. This insight was the main reason why the market sentiment deteriorated, leaving many of its representatives discounted.

Let’s investigate whether EGP is worthy of a place in a well-structured portfolio. Enjoy the read!

EastGroup Properties: Overview

Business metrics

EGP concentrates on sunbelt markets, which are accompanied by positive value drivers, which according to the Clarion Partners are derived from:

• high share in the total population
• dynamic population growth
• pro-business tax levels and regulations
• strong job market, GDP and wage growth
• the growing force of tourism

The Company focuses on last-mile e-commerce and multi-tenant properties with a competitive edge due to its locations – specifically shallow bay industrial properties, which have a history of relatively low vacancy rates. As the sector occupancy rates declined (consistently to the higher vacancy rates), EGP still holds a relatively solid metric of 98% leased and 97.7% occupied as of March 2024. For reference, the occupancy rate stood at:

When evaluating the quality of a REIT’s portfolio and the predictability of its cash flows, I often refer to the entity’s ability to secure long lease terms. EGP is certainly capable of securing impressive lease terms, as the weighted average lease term (WALT) on its acquisitions realised during Q1 2024 and FY 2023 amounted to 6.2 years and 8.0 years, respectively.

EGP has an outstanding tenant diversification, with its Top 10 tenants generating ~7.8% of rent – during the Q1 2024 Earnings Call, the Company’s CEO, Marshall Loeb, claimed that to be the best metric across the whole industry. Moreover, the Company holds substantial pricing power as it increased its rental rates on new leases and renewals by 57.8% on average during Q1 2024. EPG has been able to deliver such an impressive increase as the market rates have been growing at a more dynamic pace than EGP’s rents, resulting from contract-embedded rent escalators. Therefore, the above tendency is likely to continue upon upcoming rent terminations.

Regardless of the slower rent growth derived from rent escalators than the market rent growth, these contract-embedded growth drivers are one of the leading growth drivers for REITs as the (generally) low single-digit rent escalators tend to add up over time and heavily impact the bottom line.

Dividends and Balance Sheet

On May 23, EGP declared its 178th consecutive quarterly dividend of $1.27 per share. The Company has increased or maintained its dividend payments for 31 years, and the DPS marked an impressive CAGR of 13.1% during the 2019 – 2023 period (with 2018 as a base year). The dividends declared in 2024 stand for an annualized $5.08 DPS; however, I expect another dividend increase in the upcoming quarter. The dividends not only exhibit impressive growth but also remain well-covered with the forward-looking AFFO payout ratio equal to ~77.8%.

The Company has a safe financing structure with 100% of its debt at a fixed rate of a weighted average of 3.37%. As of 3/31/2024, its debt was equal to 16% of its Enterprise Value. As of March 2024, EGP had a reasonable maturity schedule with 10% of its debt maturing in 2024 and 8.6% and 8.3% maturing in 2025 and 2026, respectively. As mentioned during the Q1 2024 Earnings Call, EGP’s fixed charge coverage increased to 10.4x, which is an outstanding level when compared to its peers. For reference, the fixed charge coverage ratio stood at:

• 5.5x for STAG Industrial (STAG)
• 7.6x for PLD
• 4.4x for FR
• 7.2x for TRNO

The Market Conditions Are Shifting

Yes, the industrial property sector is facing some headwinds, and it will probably continue to do so in the upcoming quarters. However, there are already visible signs of a potential market shift towards a more favourable supply-to-demand relationship as new construction starts are shrinking. After the peak in Q3 2022 when the new industrial properties construction starts totalled ~175m sq. ft., it has declined ever since and reached ~40.8m sq. ft. in Q1 2024 (down from over 100m sq. ft. on a year-over-year basis). The above will result in sharp completion drops in the upcoming years, as indicated within PLD’s Investor Presentation.

The decline in the supply combined with positive growth drivers of the demand (especially within the sunbelt markets) resulting from population growth, further GDP growth, and the growing significance of e-commerce sales will lead to a turnaround in the market conditions. While the market is currently oversupplied, we may soon observe it shift more and more towards the undersupply, which will cool the vacancy rates and improve the landlords’ negotiating positions.

The Company’s CEO has also provided a comment on this matter, providing even more colour, during the latest Q1 2024 Earnings Call:

As always, we ultimately follow demand on the ground to dictate pace. Based on the decision-making time frames we’re seeing, I expect our stocks to be more heavily weighted to the second half of 2024. Within this environment, we are seeing two promising trends. The first thing, the decline in industrial starts. Starts have fallen six consecutive quarters with first quarter 2024 being over 70% lower than third quarter 2022 when the decline began.

Assuming reasonably steady demand, the markets will tighten later in 2024, allowing us to continue pushing rents and create development opportunities. The second trend is the rise in investment opportunities with developers who’ve completed significant site prep work prior to closing and need capital to move forward. This allows us to take years off our traditional development time line and materially reduce site development legal risk.

Risk Factors

Naturally, there are risk factors to be considered, as in the case of each investment. Prolonging high-interest rate environment could hurt EGP’s financial performance by forcing it to refinance at a higher cost. Also, the lack of a potential market shift, which I mentioned above, could also negatively impact EGP’s business leading to higher stock price volatility.

Any tenant issues could translate into the financial performance of EGP – depending on the instance, however, this risk remains limited due to the well-diversified tenant structure. Any other material adverse changed could lead to worse financial results and higher stock price volatility.

Valuation Outlook and Key Takeaways

As an M&A advisor, I usually rely on a multiple valuation method that is a leading tool in transaction processes, as it allows for accessible and market-driven benchmarking.

With the noticeable drop in EGP’s stock price YTD, the valuation has detached from the business fundamentals, especially given the state of the business and the attractiveness of the sector. For reference, please review the forward-looking P/FFO multiple for selected entities:

• 20.4x for EGP
• 20.5x for PLD
• 18.2x for FR
• 24.8x for TRNO
• 14.7x for STAG
• 21.4x for COLD

Given EGP’s:

• strong position within high-potential sunbelt markets
• strong balance sheet
• dynamically growing dividends, which are well-covered
• solid business metrics
• operations within an attractive property sector, which is setting the stage for further growth despite some temporary headwinds

I believe EGP’s P/FFO multiple has some room for appreciation in the 21.5x – 22.5x range. Therefore, there’s currently an attractive risk-to-reward opportunity to lock in the ~3% dividend yield with further double-digit growth prospects supported by a valuation safety margin. That is a “buy” for me.