Keeping Up with Industrial in a ‘Wildcard’ Year
As the Fed holds back on interest rate cuts, investors keep a close eye on market trends and tailwinds
Uncertainty around interest rates, slowed transactional volumes, and a future of unknowns has left investors in the industrial sector watching trends closely.
“This year has been a bit of a wildcard,” says Jason Patterson, senior vice president of investments at W. P. Carey. “People constantly speculate about what the future holds regarding interest rates, and we also saw a bit of softening on the lease demand side at the end of 2023.”
As uncertainty persists, understanding a few key trends can help the industrial sector track what’s next as it moves closer to a new normal.
Cost of Capital Challenges Persist
As 2024 began, forecasts predicted multiple interest rate cuts; however, the Fed has held rates unchanged to date. Recently, it adjusted the previous forecast from three expected rate cuts in 2024 to one, against the backdrop of persistent inflationary concerns. Volatility around rates has also led to investor hesitancy in making long-term commitments, further impacting transaction volumes.
“There is also a long and continuous trend toward e-commerce,” says Patterson. “In the near term, there has been a bit of volatility due to overbuilding in certain markets, and there is a bit more vacancy that needs to be absorbed. These shorter blips are relative to what seems to be a long-term trend toward higher value in industrial real estate.”
Despite ongoing challenges, opportunities still exist for the industrial market, and understanding some existing tailwinds can help investors capitalize on these.
Shift to Onshoring
Onshoring is a continued tailwind for the industrial sector, especially on the manufacturing side according to Patterson. “It seems there is bipartisan agreement around a movement to onshore, as sentiments trend toward increased American manufacturing.”
Upticks in high-tech chip manufacturing and transitioning the auto fleet to electric are also drivers of long-term industrial demand, says Patterson. While electric cars accounted for only 2% of vehicles in 2018, that number jumped to roughly 18% of all vehicles sold in 2023. A push toward more sustainable vehicle technologies could further drive long-term industrial demand, but Patterson cautions that continued growth could depend on the outcome of the election.
Strategic Positioning and Access to Capital
When operating in a market with many unknowns, a good place to start is focusing on what’s within your control, suggests Patterson.
“Factors such as interest rates are out of the hands of most folks,” says Patterson. “We focus on sticking to our competitive advantage, which is underwriting sub-investment-grade long-term lease opportunities.”
Agility is also key, as is working with partners who can support the market’s need for increased flexibility. According to Patterson, “This is a time when having a reputation for strong performance and access to capital is very valuable. At W. P. Carey, we are well positioned to execute with significant liquidity and capital, enabling us to be nimble in the current environment.”
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The Appeal of Industrial Sale-leaseback Transactions
Let’s start with the foundation: if you’re unfamiliar with the term sale-leaseback, you should go here- The Ins And Outs Of Sale-Leasebacks| W. P. Carey. For a more focused explanation relating to industrial properties, let’s turn to Erik Foster, principal with Avison Young and head of the firm’s industrial capital markets practice. “A sale-leaseback is when a user of real estate who owns their premises chooses to monetize that real estate. They stay in [the property], occupy it for a long term and sell it to a third-party owner who becomes the landlord, and the occupier becomes a tenant,” Foster told LoopNet. According to Foster, sale-leaseback transactions for industrial assets have been surging over the past several years, with interest in North American industrial properties emanating from across the world. “It’s truly become a global marketplace,” Foster said. This interest in industrial real estate is neither new nor particularly surprising. As Foster noted, the sector has been experiencing record low vacancies amid historic levels of investment activity. And these factors, which have intensified during the pandemic, have created what Foster described as “a very exuberant investment atmosphere.” And industrial users are increasingly taking note of this enthusiasm. Historically, industrial users have been more apt to own their facilities than their office or retail counterparts. Where most office and retail properties are typically developed with the expectation that multiple tenants will occupy the property, some types of industrial properties are more commonly utilized by a single user. Moreover, industrial properties are often heavily customized to meet the manufacturing or specialized logistical requirements of a particular business. But industrial users are beginning to realize that they may be able to possess their proverbial cake and consume it too. “Industrial users are finding that they can reap the rewards of the sale of their building at record pricing, but still maintain occupancy and the use, so nothing really changes for them,” Foster said. Of course, few things in commercial real estate are without caveats. To gain a better understanding of the industrial sale-leaseback phenomenon, LoopNet spoke with Foster — as well as Gino Sabatini, head of investments and managing director of W. P. Carey — and they walked us through the attributes and challenges of this process for both users and investors. An Opportunity for Industrial Users to Acquire Capital and Flexibility According to Foster, for the industrial user, most of the advantages of a sale-leaseback transaction can be reduced to two concepts: working capital and flexibility. Foster noted that most industrial users that own their property have some kind of financing tied to the building. Perhaps they have a loan that represents 50%, or even 60% or 70% of the building’s appraised value. This loan provides them with operating capital to reinvest into the business — for the purchase of equipment or materials, for instance. Through a sale-leaseback transaction, a user can derive 100% of the value of their property, and reallocate that capital to other aspects of their business. Depending on the company’s accounting structure, this could vastly improve their balance sheet. “You can pay down debt, you can reinvest into your business,” Foster said. Meanwhile, the company in question retains use of the asset. The user “gets a ton of capital out of the real estate and continues to use [the real estate] the way they always have,” Foster added. The industrial user also enhances their flexibility in the process, trading their real estate asset for “a leasehold obligation. It’s not an illiquid asset,” Foster said. Between record-setting industrial investment activity and equally historic low interest rates, this can seem like the ideal moment for industrial users to relinquish ownership of their facilities. “W.P. Carey, and most other sale-leaseback and net-lease buyers, operate on a spread over interest rates,” Sabatini said. This means that as interest rates potentially rise in the near(ish) future, cap rates could climb alongside them. Currently, Sabatini said that cap rates range from 4% to 7%, depending on the location and nature of the facility (more on that in a moment). Foster said that he was even “hearing about sub-3% cap rates on the coasts.” All of these factors may make an industrial sale-leaseback transaction seem like a “best of both worlds” scenario for the user, but it’s not quite that simple. For one thing, as most industrial users are typically real estate novices, they need to make sure they carefully consider all potential suitors. “The user needs to make sure that they don’t talk to the first person that knocks on the door,” Foster said. According to Foster, taking the property through a traditional investment sales process generally garners terms that are more beneficial to the user — both for the sale and the subsequent lease. “When we go out and we make a market for assets like this, we’re amazed at how the terms continue to become better as we work through the process. Foster mentioned that it’s also important to find the right investor match for each particular industrial user. “Sometimes this is their only location and its critical to the [tenant/seller], so having an owner who doesn’t have any forethought or care about the user is an issue too, so you’ve just got to find the right match.” Industrial users also need to be comfortable with the control they’re surrendering by entering into a sale-leaseback transaction. For users that are accustomed to having sole authority over their premises, that adjustment could potentially be challenging. And, as frenetic as the industrial sales market is at the moment, there are reasons to believe that prices could continue to rise. “With the shortages in the commodities markets and the difficulty in getting steel and lumber and other materials, there’s a bit of a governor on the amount of development that can happen. So, the supply of assets is also muted, which is continuing to drive scarcity pricing,” Foster said. Ultimately, the viability of a sale-leaseback transaction for an industrial user will come down to that particular company’s priorities and whether they value working capital and flexibility over control and security. For investors, the calculus is a bit more fraught with risk, but potentially equally rewarding. Conducting Due Diligence on an Industrial Sale-Leaseback Opportunity It’s probably fair to say that W.P. Carey has more experience in industrial sale-leasebacks than any other property owner; after all, that’s been the firm’s primary focus since it was founded in 1973. As Sabatini described it, “Sale-leasebacks of industrial buildings for sub-investment grade companies is really our bread and butter.” When LoopNet asked what made these investments so appealing to W.P. Carey, Sabatini explained, “The facilities are often very critical to the company that is doing the sale-leaseback, and that’s very important for us; because we’re a long-term holder and we want to own something that the company is planning on using for a long period of time.” In an ideal scenario, Carey [Note: have requested that they change to Sabatini] said that W.P. Carey’s investment thesis is relatively simple. “We’re making a bet alongside the equity investors in that company that the company is going to be successful for a long period of time. If we’re correct, then we’ll collect rent for a 15- or 20-year primary lease term for starters, and potentially [execute] renewals as well.” But what happens if they're wrong? According to Sabatini, that depends largely on the market and asset in question. A highly customized property, one that will be challenging to adapt for a new tenant — such as a food or biotech manufacturing facility — represents a greater risk than a relatively generic property, like a last-mile fulfillment center. That risk expands in smaller markets and is somewhat ameliorated in larger markets. In terms of how Sabatini approaches the due diligence process, he said that the first portion of his methodology involves elements that are fairly consistent across any real estate asset class or deal type. He advised that prospective investors commission an environmental phase I study (and a phase II study if the initial report reveals any areas for concern); have an engineer walk the property to appraise its structural integrity; and review the property survey and title. “Make sure you’re purchasing a clean piece of real estate,” Sabatini said. After that, you need to undertake what Sabatini says is often the more challenging facet of the process: reviewing the company who will first sell you the property and then become your tenant. Sabatini likens this phase of due diligence to the process credit organizations like Moody’s undertake when they’re rating companies. “You try to understand the industry, the company’s position within it, as well as any threats to either the company or the industry,” he said. “You really need to dig into the credit and understand why the building is important to the company, and what the company’s financial prospects are in the short-term, the medium-term and the long-term.” Sabatini also said that it’s important to carefully review the company’s balance sheet. Specifically, you should assess their attitude towards leverage and how they have fared during downturns. As this process illustrates, in many respects a sale-leaseback transaction isn’t a simple real estate deal; it’s more analogous to the creation of a (hopefully) long-term, mutually beneficial partnership.
Is the Net Lease Industrial Market Still "Red Hot"?
The single-tenant net lease industrial market has been on fire in recent years. Buoyed by e-commerce growth, industrial properties were seeing record low cap rates and record high competition from investors following the COVID-19 pandemic. However, the sector has not been immune to recent macro-economic volatility. Search -In fact, quarterly transaction volume fell more than 46 percent in the first quarter of 2023, making it the slowest quarter reported by the net lease industrial sector since mid-2017. Does this mean that the industrial market is losing its steam? While some investors are waiting on the sidelines, trends including onshoring, supply/demand dynamics and rising interest in sale-leasebacks will help bolster the industrial market in the long term. Here’s why: Impact of onshoring Supply chain issues during the pandemic have been a major catalyst for onshoring in the industrial market. Having manufacturing facilities overseas meant accessibility was limited (or in some cases, completely restricted), which had a major impact on companies’ ability to get their product to consumers. As a result, more companies have focused on bringing their facilities back to the U.S., which has only been supported by lower labor-related costs, better automation technology and an accessible highway and interstate system. Technology companies have largely been leading the onshoring charge, with companies like Intel, Micron and Texas Instruments committing to building large manufacturing plants in the U.S. This has led to a steady rise in demand for warehouse and industrial spaces from U.S. companies, with notable growth seen in the Southeast. Supply/demand dynamics After several years of growth post-COVID, warehouse construction is on the decline due to higher interest rates, a slower economy and Amazon’s reduced spend on new facilities for 2023. 6,700 warehouses are expected to be built in 2023, a 35% reduction compared to the 10,000 built in 2022. Despite this, e-commerce growth is expected to keep demand for warehouse space strong, with rents anticipated to increase over the next year. The good news for investors is that cap rates are also on the rise – Search -up 35 basis points from record lows in 2022. As the buyer-seller price gap continues to close, more investors will likely jump back into the market, strengthening transaction volume in 2024. Uptick in sale-leaseback interest The volatility in the capital markets environment has certainly been challenging for companies, with cost of capital rising considerably given increasing interest rates. Alternative forms of financing such as sale-leasebacks have come to the forefront as companies look for ways to unlock capital. Sale-leasebacks offer a “naturally accretive” funding source, particularly for companies that own fungible, mission-critical real estate and are willing to sign a long-term lease. Industrial facilities have inherent criticality which makes them uniquely attractive to investors, making owners of these types of facilities great candidates for sale-leasebacks. While inflation is starting to cool, experts predict that the Fed won’t start cutting interest rates until 2024, which will encourage more industrial companies to pursue a sale-leaseback. With more opportunities likely coming to market and investors poised to execute (particularly all-equity buyers), we believe industrial will maintain its position as the “darling” of net lease for the foreseeable future.
What’s Next for Net Lease?
The effect of rising interest rates registers in many ways around the real estate world, but perhaps the starkest impact can be seen in the investment volume differential in one of CRE’s most popular sectors. Net lease investment volume decreased roughly 35% year over year in the third quarter, according to Jason Patterson of W. P. Carey. The VP of investments at one of the largest diversified net lease REITs notes the Fed’s impact on market players has been far-reaching. “Net lease volume prior to the Fed moves had been near or at record levels so the run-up in rates certainly impacted people getting on the same page with the value of real estate or what they were willing to commit to on a cap rate basis,” Patterson said. “A high level of volatility in a space where people are making long-term investments is not the ideal environment.” A Debt Market in Disarray Call it a pause, a disconnect, or total debt market disarray, 2022 has brought major headwinds to a CRE industry and net lease sector that have gotten accustomed to cheap capital. Yet, Patterson reports still seeing a lot of attractive opportunities in the market. “Private equity-backed sellers or tenants continue to use sale-leasebacks as an attractive form of unlocking tied-up capital in their acquisitions, a counter-inflationary move that in some cases has been beneficial to us,” he said. “They’re viewing it more and more as a regular, very attractive component of the capital stack, which I think is good from a broad industry perspective.” Unencumbered by rising capital costs, equity investors have certainly found more room to work within the net lease market “The current environment favors people in a high certainty or all-cash type of capital structure like W. P. Carey,” Patterson said. “We’ve seen increased focus on certainty of close as levered buyers signed up for deals maybe in the early part of the summer and then with rising debt costs their assumptions didn’t pan out. You see deals come back to market as more investors have to reevaluate pricing in this period of volatility.” 2023 Outlook Citing the first half 2022 industrial deal volume exceeding more than 50% of the STNL market, Patterson forecasts that industrial product will continue to be a very attractive investment target. He added though that not all industrial product types are created or viewed equally. “Rather than just lump everything into broad industrial, we’re looking for real estate that is extremely critical to operations for our tenants,” he said. “Maybe we’re willing to give up a little bit in terms of fungibility for increased certainty that tenants are going to renew and keep paying rent for the long term. Asset classes such as cold storage and food production are extremely important to users and they don’t have a ton of alternative options available.” A $75 million sale-leaseback W. P. Carey completed in the second quarter embodies the above trends. The 25-year net lease for six mission-critical specialty manufacturing facilities totaling approximately 1.1 million square feet in three countries is backed by private equity. “There continue to be more and more deals getting done with private equity sponsorship, and we’d expect that to largely continue in 2023,” Patterson said. “The trend, a positive one for the industry, really is private equity ownership looking toward sale-leasebacks.”