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Morningstar | No-Moat Duke Realty Delivers Strong 2Q Results

Duke Realty delivered another satisfying quarter of growth, as demand for industrial warehouse space continues to outpace supply, but we do not see lasting changes to our investment thesis, so we will maintain our $29.20 fair value estimate and no-moat rating. Second-quarter funds from operations increased 3.1% from 2017's second quarter to $0.33 per share, a result of strong same-store net operating income growth at 3.9% from the same period. Duke Realty’s FFO beat our estimates by a penny, driven by 6% higher-than-expected rental revenue growth.

The revenue growth was a result of encouraging e-commerce demand delivering favorable rent conditions and somewhat faster-than-expected occupancy growth, as occupancy for in-service leased properties is up 60 basis points year to date, as well as a front-loaded lease-up of acquisitions. Duke Realty appears to be front-loading its acquisitions for the year; we estimate year-to-date acquisitions are around 70% of our full-year predictions, but full-year guidance is still well within our estimates. The company estimated that the stabilized yield on acquired properties would be around 4.4%, which we see as reasonable but still 10 basis points below our forecasts and much less attractive than the stabilized yield for developed properties, which we estimate to be about 7%.

Overall, we see this as another strong quarter of growth for Duke Realty, but we are wary because the company is rapidly expanding its portfolio in a declining cap rate environment, even though we recognize that such expansion is somewhat necessary as the company has a relatively small land bank to develop.

Management raised its FFO guidance by 2.9%, and our annual estimates now are slightly below the lower end of that outlook, but we believe that our conservatism is justified by the long-term competitive dynamics of the warehouse industry. Since warehouse space is a relatively undifferentiated and low-barrier-to-entry product, we are seeing supply ramp up with new construction, which raises concerns regarding future rent growth potential. Additionally, the company’s 10 largest customers make up 19.6% of annual gross effective rents and some customers, such as Amazon, have demonstrated the capacity to develop their own warehouses, which we believe will hurt Duke Realty’s bargaining position when tenant leases come up for renewal. We will watch Duke Realty’s growth with caution, because we believe new supply will hurt industrial real estate investment trusts’ pricing power and we notice Duke Realty accepting falling yields on acquired properties while recognizing it is necessary, given the firm’s smaller land bank.