Investment Analysis

Industrial's New Image

Investors clamor for the functionality and simplicity of warehouse properties.

By Trey Hollingsworth |

Long stigmatized as the asset type of old dirty factories, industrial real estate has ascended to prominence in private investors' portfolios. No longer is the big-box warehouse a distant cousin from the bright, colorful retail center or the tall glass office tower. Today industrial real estate has stepped into the limelight as a product that demands consideration for its simplicity of management and its long life of functionality.

From manufacturing plants to the more-common large distribution warehouses, industrial real estate has several compelling factors that are driving the higher allocation by individuals and institutions alike.

Easy to Manage
As investors cast geographically wider nets to find acquisitions that meet their criteria, post-closing ease of management has become a critical issue. Single-asset industrial acquisitions tend to have fewer tenants, significantly fewer common area expenses, and often much less common area space - limiting maintenance and tenant disputes. With single-asset acquisitions, owners have fewer checks to process, less reconciliation effort, and fewer management headaches. In addition, the process of re-leasing single-asset industrial space tends to be much simpler since tenant needs are more uniform.

In the early 1990s, most companies organized their distribution networks around many smaller distribution centers located around the country, but the trend now has shifted as more companies favor fewer, larger distribution centers in strategic locations. This shift has led to more single-asset product as the higher square foot requirements allow developers to build single-tenant facilities with the scale advantages that once only applied to multitenant facilities.

Chasing the Elusive Yield
With capital abundantly flowing into real estate, the search for yield has pushed many investors into the single-

tenant category. Typically, the single-tenant facility is the highest level of tenant risk an owner can take, and that higher risk translates into higher levels of yield for the investor. With all else being equal, at one time single-tenant properties added 50 to 100 basis points in returns over multitenant properties, according to Stan Johnson Co., one of the largest net-lease brokers in the country. As a sign of the growing demand for single-tenant properties, the yield spread over multi-

tenant comparables has narrowed to just over 10 basis points as of 3Q06, according to Real Capital Analytics.

With myriad investors clamoring for product, the safer, multitenant office buildings are transacting at very low capitalization rates and more investors are turning to single-tenant assets to garner higher yields. In fact, retail and industrial happen to have the most single-tenant assets in real estate.

A Cleaner Image
A sharp, dramatic pullback from industrial assets occurred in the early 1990s when environmental regulation, litigation, and lawsuits hit their peak. When a few investors saw their assets exposed to huge environmental liabilities, anything associated with industrial real estate suddenly was subjected to a risk premium for potential environmental problems.

Since then, regulation has softened and better techniques for assessing and quantifying environmental risk have been developed. Portfolio managers no longer demand a premium for considering industrial assets. The vast majority of today's industrial product - warehouses - present very little environmental concern as they are merely stopover points for finished goods going to the consumer or products on their way to a manufacturing facility.

A Longer Life
Investors seeking assets that they can hold long term are turning to industrial because the buildings tend to stay functional and attractive longer. Retail corners go out of style, architecture changes for office buildings, and hotels quickly reveal their age, but industrial tends to stay functional for much longer, an especially important fact when considering the initial depressed yields available in the market. No doubt industrial does decay in its functionality; for example, clear heights have gone from 24 feet in the 1970s to 32 feet in the 2000s - but the obsolescence curve is much flatter, and tenants tend to be much less particular in the aesthetics compared to retail or office.

The market one invests in determines much of industrial product's functional life and whether buying older product yields more than new product. Often, the biggest determinant in the trade-off between old and new is the cost of new product construction. If the cost of new construction is high - due to regulatory involvement, materials costs, and land shortages - then older product retains an ability to command a higher lease rate despite its age. If the ease and cost of new construction is relatively lower, then older product will be unable to maintain its lease rates and will lose value to new construction much more quickly.

Factors to Consider
Part of the investment boom in industrial acquisitions has arisen naturally because more distribution space is being constructed than ever before. More developers themselves are recognizing this asset class, and many factors, from globalizing trade flows to just-in-time supply chains, are driving increased demand from tenants for warehouse space. As a result of an increased supply, more industrial product is finding its way into the hands of investors.

Of course, therein lies the classic "the chicken or the egg" conundrum. As more investors purchase industrial real estate, cap rates over Treasuries compress, causing more developers to focus on the class, which will in turn deliver more product to the investment market.

Unlike many asset classes, warehouses located in smaller markets are just as attractive to users and investors as those in the major markets. According to several prominent studies, location in a major metropolitan area does not demand a premium - and sometimes is discounted - by industrial tenants. Major population centers present problems for warehouse users such as heavy traffic that slows shipments, labor competition that drives higher wages, and regulatory issues, depending on what the tenant's product is.

As the competition intensifies in large markets, investors are going to secondary and tertiary markets in search of the right deals for their portfolios. Exit pricing is the primary concern of investors when purchasing tertiary-

market properties as those locations often prove more difficult to sell to institutions. However, there is almost no discernable yield difference for comparable product on lease terms longer than five years, according to Real Capital Analytics.

With abundant capital flowing through the veins of the real estate industry, many investors are finding industrial is the answer to their real estate asset needs.