Publications

- July 1, 2017: Vol. 4, Number 7

How to Invest in Industrial Real Estate

by Steve Lekki

Industrial properties have become the new darling of real estate investors. Significant global capital is pouring into the buildings where goods are created, stored and shipped. Take a look at the numbers and it is not hard to understand why: record rental income, strong demand and mass disruption from e-commerce calling for new product.

First, let’s look at cash flow. Leasing rates for industrial properties are at record highs across the United States, while availability is near a 16-year low, according to CBRE Econometric Advisors. As a result, investors in industrial properties have the upper hand in most lease negotiations. Many tenants understand the market and are more interested in strategic location than price. High demand for both new construction and existing locations alike can take credit for high rents.

These strong fundamentals are yielding returns for investors. In fact, industrial total returns as reported in the NCREIF Property Index have outperformed all other major property types on a one-, three- and five-year basis. These numbers speak for themselves, explaining the strong interest from global and domestic investors alike.

INDUSTRIAL REAL ESTATE DISRUPTED

For investors, it is critical to understand that this is a market in flux; disruption is changing nearly everything about the industrial real estate market. Several factors — a long-term demographic shift in population to cities, advances in logistics and supply chain management, and the rise of e-commerce — are driving retailers to rethink the ways their products reach customers’ hands.

Retail and industrial real estate strategies are integrated to keep up with evolving consumer buying habits. In this new world of omnichannel marketing, a customer might shop online from a computer or mobile device and pick up items from a brick-and-mortar store, or might make in-store purchases to be delivered from warehouses. As a result, retail concepts are being reconceived to include smaller storefronts with warehouses nearby to restock and deliver goods quickly.

The shift in demographics to more upscale consumers in cities further drives demand for high-quality infill industrial product, creating opportunities for investors. But even with these solid demand drivers, success requires a clear understanding of distribution, demographic trends and commercial real estate.

EVERYTHING OLD IS NEW AGAIN

In fashion, trends always seem to return decades later for a new generation of buyers. The same phenomenon is playing out in industrial real estate today. A century ago, multi-story buildings in city centers served as warehouses, so the goods stored there could reach stores quickly. That changed when the post-war expansion of international trade and the highway system resulted in a network of single-story warehouses in outlying areas near highway interchanges, rail lines and airports. Fast forward a couple decades, and the advent of just-in-time production in the 1970s and lean manufacturing in the 1990s transformed industrial real estate markets again. Today, in addition to large, single-story massive distribution centers, companies are also seeking smaller spaces with more truck bays to enable faster inventory turnover.

The rising tide of e-commerce is prompting the industrial property sector to retool once again. Ironically, some of the changes bring the industry full circle, as leading e-commerce companies build multi-story facilities for regional distribution and seek smaller spaces near city centers in order to deliver high-traffic goods to businesses and consumers within hours of ordering. Despite the similarities, however, this is not your great-grandfather’s industrial property business. Advanced automation and radio frequency identification (RFID) systems for reading bar codes are allowing customer orders to be fulfilled more quickly by machines/robots.

Additionally, more than ever before, companies are intensely focused on supply-chain logistics as a way to reduce cost, manage risk and enhance customer service. To maximize these benefits, they are increasingly outsourcing parts or all of their distribution function to third-party logistics firms — a key reason behind a surge in leasing activity from firms in this sector.

WHAT’S YOUR RISK APPETITE?

Industrial real estate opportunities offer a wide range of options that may be right for institutional portfolios, family offices or private investors with varying risk tolerances. At the lower end of the risk spectrum would be a large single-tenant building with a long-term lease to a single user. A company that needs capital for growth will often sell its property and lease it back from the buyer. These deals are often considered as an alternative to bond investment, but contain a healthy yield premium to cover risk factors like having to backfill space or make capital improvements.

For higher returns, industrial investors look for opportunities to add value. Multi-tenant properties with shorter term leases in place can produce higher returns if market rents rise, but they can also cause investors to lose money if occupancy levels fall. Investments in this category have risk and return characteristics more in line with those of equities, but require active leasing and management from the investor or a third-party adviser to achieve these higher yields.

Development deals also offer higher yield opportunities with corresponding levels of risk. A build-to-suit deal developed to the specifications of a credit tenant offers the certainty of a signed lease, but with the tradeoff of construction risk. A forward commitment works the opposite way: the investor agrees to buy a speculative or partially pre-leased building upon completion, thus taking leasing risk but no construction risk. Investors with industrial expertise in-house or through an adviser can aim for even higher returns with speculative development on previously entitled land. And those with the highest risk tolerance can buy raw land and go through the process of zoning and entitlements prior to development.

It is important to note that development deals only start producing cash flows after construction and lease-up. Calculations of total return must take this lag time into account. The good news is that an industrial building can be constructed on zoned land in less than a year, compared to two or three years for office or apartment properties of similar size.

MATCHING OPPORTUNITIES TO INVESTORS

Although industrial offers viable investments for a wide range of investor types, some opportunities are better suited to institutions than private investors, and vice versa. Large e-commerce hubs and bulk distribution facilities requiring significant upfront capital tend to make great investments for institutions looking for stable long-term cash flows and willing to settle for moderate yields. On the flip side, private investors and family offices can be very competitive for multi-tenant, small-bay buildings that require more active management. Some manufacturing businesses also lease space in smaller buildings that offer good opportunities for private investors.

Flex and research and development (R&D) buildings are often considered industrial properties, although they actually accommodate a range of office, research and industrial assembly uses. Both institutional and private investors can do well with these properties, but investors need deep pockets due to the higher tenant turnover at bulk facilities and a need for specialized build outs. Flex/R&D investment carries higher buildout costs on an ongoing basis than their warehouse and distributor counterparts.

Institutional buyers have several options in industrial investment, including direct investment of existing properties, forward commitments on properties under development, portfolio acquisitions and participation in commingled funds. Commingled funds managed by institutional-level advisers often include industrial properties as one component of a broader commercial real estate play. The stability of the industrial property sector helps to balance out the highs and lows of more volatile property types. Plus, as we have seen in recent years, industrial can produce yields in excess of other property types.

No discussion of industrial property investment would be complete without some mention of real estate investment trusts (REITs). Large publicly traded REITs offer a simple way for any type of investor to move capital into and out of the industrial space. Two big advantages of public REITs are diversification — if one property sits vacant, the impact on the REIT’s performance is negligible — and liquidity. However, REITs can be more volatile and are highly correlated to the equity stock market.

A SOLID INVESTMENT PLAY

Industrial development is never a slam-dunk investment, even today when the market is on a roll. Smart investment requires in-depth market knowledge and an understanding of where business and consumer trends are leading, in addition to strong leasing and management skills. When all the pieces are in place, however, the rewards are worth the risk.

 

Steve Lekki is senior vice president, portfolio manager, in the San Francisco office of Bentall Kennedy.

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