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Net Lease Trends
More net leases inked for industrial, manufacturing properties

In the lease-finance business, giant deals for retail and restaurant chains get the most attention, followed by office deals. But there are opportunities in industrial properties, too—opportunities that may be more rewarding than in more competitive markets.

AIC Ventures, an Austin-based sale-leaseback investor, recently purchased New River Cabinet & Fixture Inc.'s two facilities in Fort Lauderdale, Fla. for its first investment in a new $300 million fund. The two facilities, which total 82,847 square feet, serve as New River’s corporate headquarters and house design and production for its custom cabinetry. 

The deal had plenty of positives – quality real estate in a good location within a tight industrial market, says Meredith Hardy, managing partner of AIC Ventures. Plus, the company had a strong track record, reasonable growth projections and a contract with HCA Inc. to provide cabinetry for the hospital operator's many facilities.

"We really like industrial properties – we like the re-tenanting risk because we feel that there's always going to be what I like to call 'widget makers' out there looking for space," Hardy says. However, she acknowledges that industrial net leases can be more complex and involve companies with "smaller" credits and unique balance sheets. "Industrial properties just don’t look the same on paper as office or retail net leases."

That’s why a lot of investors have historically avoided the industrial net lease market to focus on other sectors even though the industrial sector is considered to be more stable and less cyclical than the others. But, as investors fight over office and retail net lease properties, more and more institutional and private buyers are rethinking their attitudes about industrial assets.

"There are a lot of industrial and manufacturing companies in this country with functioning space that provide a long-term rental steam with strong unleveraged risk-adjusted returns," says Mark Carroll, vice president of STAG Capital Partners, a Boston-based firm that targets industrial net leased properties with returns of 8.5% to 10.5%. "If you can underwrite the risk for industrial, you should be able aggregate a higher yielding portfolio than you would with office or retail."

More industrial activity

As of mid-March, the average cap rate for net lease industrial properties was 8% compared to 7.27% for retail properties and 7.64% for office properties, according to the most recent Boulder Net Lease Funds LLC Net Lease Market Report. The average price per square foot for industrial properties was $69.36.

Over the past 12 months, there's been a huge increase in the number of industrial net lease deals. During the first quarter of 2007, 2,112 net leased industrial properties sold, a whopping 240% increase over the 620 properties that sold during the same period in 2006, according to Boulder's report.

Currently, about 18% of the overall $52 billion net lease market is comprised of industrial properties with a total value of $11.5 billion versus $4.8 billion last year. In the U.S. alone, there's a 26 billion square feet of industrial real estate, and 65% of that real estate is owned.

For industrial clients, sale-leasebacks can give a little relief from the margin crunch imposed by international competition. "They're leveraged to the max, and the ones that are surviving are the ones that are embracing sale-leasebacks," says Ed LaPuma, managing director of W.P. Carey.

New York-based W.P. Carey recently completed a $42 million sale-leaseback deal with German manufacturer Görtz+Schiele for three manufacturing facilities in Germany and the U.S. The company uses the facilities to supply automotive manufacturers with engine blocks and cylinder heads.

Even industrial companies that have bullet-proof balance sheets are considering sale-leasebacks today. "We're seeing record valuations on the sale price, and the most favorable lease terms we've ever seen in the sale-leaseback industry," says Andrew Sandquist, a senior vice president with CB Richard Ellis' Capital Markets Group – Sale Leasebacks and Net Leased Properties. "So a lot people are taking advantage the market."

Additionally, Sandquist notes that many companies are doing sale-leasebacks to "proactively transfer residual value risk" for facilities in less desirable locales. For example, he and his partner Bob Brennan, brokered one of the largest manufacturing sale-leaseback deals in the U.S. in 2006, selling a 24-building, 4 million-square-foot portfolio of older manufacturing facilities in tertiary and rural markets for $158 million. The tenant, Milwaukee, Wis.-based Rockwell Automation markets, committed to leases ranging from five to 15 years. The portfolio generated 45 offers from both institutional and private investors.

More complex than other sectors

Industrial still remains the smallest net lease category because it presents a host of complex issues that office and retail assets don't. "If you have a sporting-goods retailer who goes dark, there are number of retailers that would be happy to be in that space," LaPuma points out. Finding a new industrial tenant may not be so easy. (That's less true for logistics and warehouse facilities, experts say.)

To do well in industrial property a net-lease investor needs to understand the underlying business. "You really do have to dive into complicated issues with outsourcing in manufacturing," Carroll says. "When we do a deal, we're making a bet on that company's ability to compete in the long term."

With that in mind, STAG often underwrite its deals with a re-leasing period for anywhere two to four years. The company's newest fund is set to acquire $1.5 billion worth of net leased office and industrial properties over the next two to three years. Recently, it purchased a 443,493-square-foot manufacturing and distribution facility in Streamwood, Ill., as part of a 20-year sale-leaseback transaction with Duraco Products, a manufacturer and distributor of injection-molded plastic and polyurethane garden products and related accessories.

Distribution centers have their own unique challenges, says John Maher, executive vice president of Colliers Corporate Solutions. He points out that distribution facilities are occupied not only by companies that manufacture products, but by suppliers and third-party logistics providers. That means that vendor contracts to supply goods and to manage the supply chain are very important.

"When the strength of the tenant is contingent on contracts, you're also underwriting the other company upstream," says Eric Ogden, senior vice president with Chicago-based brokerage firm HSA Commercial Real Estate.

AIC Ventures' Hardy says that a tenant with a short-term contact with a single customer is significantly less attractive than one that has a long-term contract or multiple contracts, especially when it comes to investing in non-primary markets. "We don't think being in a primary market is critical for industrial like it is for office and retail," she says, adding that many industrial tenants are moving to secondary markets because of the affordable rents. "But, if the asset is too far off the beaten path, there could be a lot of risk if the tenant loses the contract."

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