Last July, a collection of Class-A industrial properties outside of Baltimore came to market with bids projected just north of $67 million. Both the seller, UPS, and brokerage agent Trammell Crow believed that the 94% leased property was worth $50 per sq. ft. That was an aggressive target, since at that price it would have represented one of the East Coast's strongest industrial deals of the year.
No sweat. The 1.3 million sq. ft. Marshfield Business Park properties received nearly three dozen offers of $67 million — or $53 per sq. ft. — in less than five weeks. Among the bidders were private investors, wealthy families, REITs and pension funds. In fact, Dallas-based Lincoln Property Co., acting on behalf of Oregon State's pension fund, ultimately won the property with its $71.9 million bid.
“We certainly exceeded our pricing expectations. The pension funds all want this sort of product,” says Bruce Strasburg, senior vice president at Trammell Crow's investment services group. Lincoln's $71.9 million bid will generate an initial annual yield of roughly 8%, according to Strasburg.
The Marshfield deal illustrates the diverse pool of bidders that is driving a hot industrial seller's market around the nation. New York-based research firm Real Capital Analytics reports that cap rates on institutional-quality industrial assets dropped by about 100 basis points to roughly 8% in the first half of 2003 alone. Heated demand and limited supply have fueled a seller's market where property fundamentals and values are somehow disjointed, though the incongruity isn't scaring away buyers.
Even with record high industrial vacancy and depressed rents, demand for industrial real estate is outstripping supply. Practically every investor class is looking to buy industrial properties. And with encouraging third-quarter earnings being reported by major U.S companies, buyers will underwrite far more optimistic assumptions while accepting lower initial yields.
With the London Interbank Offered Rate (LIBOR) trailing well below 10-year Treasuries since the end of 2001, some leveraged buyers are gambling on floating-rate debt. That adds an element of risk to the equation.
But an interest rate hike would simply erode demand from leveraged private buyers, if these buyers find that the numbers just don't work. If cap rates start to climb, however, there may be even more institutional money ready to jump in.
The question, in the meantime, is why are so many investors hungry for industrial product now?
“There's a simplicity with this product,” says John McDermott, regional manager at Irvine, Calif.-based Sperry Van Ness. “It has a low price per square foot relative to other property classes, and it's low maintenance. Tenants have a high tolerance for problems with the space, and institutions love industrial parks.”
McDermott, who calls industrial assets a “safe harbor investment,” also believes that investors like the long-term net leases that anchor most industrial properties. “If the economy contracts even more, these are great properties for investors pulling out of Class-A or -B office space.”
By the Numbers
There's more to the story than strong demand. Sector fundamentals, which vary from market to market, are incredibly weak. In fact, national industrial vacancy has risen for 11 consecutive quarters through the end of September, reports CB Richard Ellis subsidiary Torto Wheaton Research. What's worse, last quarter's 11.7% national vacancy represented a high-water mark for the industrial sector.
Asking rents, which typically lag the market by a few quarters, remain soft. By Grubb & Ellis' count, the average warehouse-distribution rent is $4.43 per sq. ft. annually, while flex space averages $10.93 per sq. ft. The averages have dropped 8% and 6%, respectively, between June 2002 and 2003.
One positive sign is that industrial vacancy may have peaked, according to Boston-based Property & Portfolio Research. Though P&PR finds national vacancy essentially unchanged from March, it predicts that vacancies will decline slowly, dropping to 9% by the end of 2004. Pointing to historically low inventory-to-sales ratios, P&PR also expects that the decline will be driven by action from pent-up demand and new demand from an improving economy.
Few would dispute that there is an abundance of pent-up demand among buyers for industrial product. In fact, demand may be overriding some investors' typical strategy and driving them into lesser-quality assets. “It's tough to find product, especially product that makes sense,” says Kevin Shannon, a senior vice president in the Torrance, Calif., office of Grubb & Ellis. The shortage is so severe, he adds, that institutional investors are willing to buy Class-B and -C product where they formerly would buy only Class-A properties.
There are several theories as to why so few owners are putting their properties on the market. Shannon believes that some are holding out for higher prices, while other owners assume they will not be able to find replacement properties. That makes sense, but the irony is that reluctant owners are ensuring that ready and willing sellers of Class-A properties fetch top dollar for their assets.
Institutions Battle Small Investors
While many investor classes are vying for industrial property, a smaller circle is actually closing deals. Brokers report that wealthy individuals, private partnerships and 1031 exchange buyers account for the majority of investment deals. Insurance companies, pension funds and REITs are equally eager, but the lack of appropriately priced institutional-grade properties has stymied their efforts.
“Pension funds are still aggressively buying industrial property. What they are largely buying are leased, state-of-the-art facilities though,” says Douglas Poutasse, chief investment strategist at Boston-based real estate investment advisor AEW Capital Management. He sees core investors on the pension fund side paying all cash for assets, with a smaller number using leverage. He also is seeing plenty of levered private investors pursuing industrial assets.
|2Q 2003 Vacancy Rate*||2Q 2003 Rental Rate**|
|Long Island, N.Y||6.6%||$6.00|
|Grand Rapids, Mich.||6.9%||$3.34|
|*Data refers to general industrial, warehouse-distribution, R&D, flex and incubator buildings.|
|**Warehouse-distribution space, quoted on a triple-net basis|
|Source: Grubb & Ellis|
Down the road, Poutasse believes that pension funds' real estate portfolios will remain heavily weighted toward industrial, especially in key markets such as Northern New Jersey and greater Los Angeles (see chart above). Chicago, which Poutasse says has been a favorite industrial market among pension funds, is suffering from high vacancy (11.4% at mid-year by Grubb & Ellis' measure). Construction around Chicago's I-55 Corridor remains brisk, too.
Meanwhile, coastal markets such as Los Angeles have benefited from a steady rise in retail imports across both the Atlantic and Pacific. There's also the scarcity factor to consider, says Poutasse: “It's hard to get, so you naturally buy it when it's for sale.”
Of course, buyers have run into plenty of competition recently. Robert White, president of Real Capital Analytics, says he's seeing local private users closing the lion's share of deals these days. White calculates $6.1 billion worth of industrial sales through the end of September, which is 30% higher than sales volume at the end of the third quarter of 2002.
“Investors employing leverage have a competitive advantage they've never had before,” argues James Carpenter, executive director of investments for Chicago's First Industrial Realty Trust. “Their cost of equity is a lot lower than that of institutional investors, who use their own money and have to maintain certain levels of return. As prices go up, cap rates go down, and we can't afford to buy if cap rates drop below a certain level.”
In a $15.8 million sale-leaseback, for instance, First Industrial landed Whirlpool Corp.'s 657,000 sq. ft. distribution center in Atlanta. The reason? It had the cash on hand, enabling a quick close under competitive circumstances.
“There were other competitors bidding on this property, including other REITs,” says Sam O'Briant, First Industrial's vice president of development and acquisitions. O'Briant says that the property initially was shopped around only to a handful of investors.
For Whirlpool, the issue was speed. “The seller wanted someone who could move fast. If it had gone to market, we probably wouldn't have been able to buy it. The price would have gone too high,” says Carpenter.
Another advantage for institutional investors is the ability to buy under-performing properties and turn them around. “Leveraged investors can't buy buildings with very high vacancy because they need to start servicing their debt fast,” Carpenter points out. “We can be more competitive.”
Case in point: First Industrial purchased a 750,000 sq. ft. industrial park from a Japanese insurer anxious to dump its last U.S. asset. Bought for $40 million with an expected return of 6.9%, the greater San Diego property was 31% vacant. First Industrial bought it at a 7% cap rate. By carefully marketing the remaining space in the property over the next two years, Carpenter believes that with lower vacancy the property will produce 11% returns for First Industrial.
Bill Maher, LaSalle Investment Management's director of North American research and strategy, says that private buyers using leverage are bidding at cap rates as low as 7% for industrial assets. He also sees institutions bidding in the 7.5% to 8% range for well-leased assets. But there's a problem: they aren't winning with these bids, he says.
New Pools of Capital Emerge
Smaller investors have an edge because most available properties are too small or in the wrong markets to interest institutional buyers. Sperry Van Ness' McDermott says 70% of industrial transactions are under $5 million, and 50% of current investment transactions occur in metropolitan areas with fewer than 1 million people.
But new investment companies have sprung up to enable small investors to pool their buying power and compete for larger deals. For example, San Juan Capistrano, Calif.-based Argus Realty Investors provides opportunities for investors seeking 1031 exchanges. The partnership, which has $500 million to spend on industrial acquisitions, recently closed the $15 million purchase of a 250,000 sq. ft. flex building in Dallas.
Another category of active buyer is the owner-user. McDermott believes that owner-user interest is peaking, and says that activity in his market is primarily driven by businesses looking to buy their own properties.
Regardless of which market an investor chooses, Carpenter of First Industrial cautions against buying solely on the basis of cash return. “Chances are a building with a stabilized rent roll has many leases signed at yesterday's higher rents,” he says. “If you buy based on current returns, what happens when those tenants move out and you have to rent at lower rates?”
McDermott of Sperry Van Ness predicts that the current development slowdown combined with population growth and increasing demand to convert urban industrial sites to “higher and better” uses will boost demand and force values higher. That bodes well for the industrial market in the future.
In regard to land, McDermott notes that markets such as New Jersey, Phoenix, Denver and Las Vegas still have large tracts available, but in many other areas the only options are to redevelop existing sites. That usually means switching to higher-rent uses, or looking for property at the fringes. He says Southern California is particularly tight, with new development heading to Riverside-San Bernardino rather than Los Angeles-Orange County as in the past.
Barry Hibbard, vice president of industrial and commercial marketing for Tejon Ranch Co. in Kern County, Calif., says Southern California development is beginning to spread north of Los Angeles. IKEA and Target Corp. have both built giant distribution centers in Tejon Ranch Industrial Complex. IKEA built a whopping 1.65 million sq. ft., while Target built 850,000 sq. ft. Hibbard says Kern County's 25% to 30% rise in land prices in two years is being repeated in many outlying markets across the country.
Jones Lang LaSalle's Maher has urged his clients to consider the retail-industrial connection that has made markets such as Los Angeles so strong. But he believes that most investors have been drawn to industrial for another reason: “It's historically been less volatile than office.”
That pattern may hold true, but it seems it's a moot point if investors can't get their hands on a property now. As Carpenter of First Industrial puts it, “The only way to find deals in today's market is to use your competitive advantages and work your tail off.”
John McCloud contributed to this article.