The End of Inexpensive Debt and a Return to Basics Should Elevate Industrial Assets

Industrial real estate emerged in the past decade as the darling asset classes to rival multifamily, with tailwinds evident to those observing current economic trends. E-commerce and the increased sophistication of logistics technology have brought the terms “same-day delivery” and “last-mile distribution” into common usage. As big-box retail traffic has declined in recent years as a result of this E-commerce shift, warehouse and distribution centers have benefitted greatly as consumer spending increasingly shifts online.

Supercharged rent growth, supply-constrained markets and two years of historically low debt costs have been beneficial for industrial real estate owners, however the conditions are clearly shifting in the wake of changing economic factors.

Changing tides

At the midway point of 2024, inexpensive debt has not been available for nearly two years, and worries of a recession is causing doubt as to whether the recent trend of rising rents will continue. Capital Providers of all types are widening spreads and becoming increasingly more stringent.

Active buyers are weighing the option of using less accretive debt or waiting for prices to come down, resulting in fewer bids on actively marketed assets.

The industrial real estate sector stands to benefit from a move toward onshoring, a slow-moving but encouraging reaction by corporations that were hit hard by the breakdown of just-in-time overseas supply chains. The August 2022 passage of the Creating Helpful Incentives to Produce Semiconductors (CHIPS) and Science Act includes $52.7 billion to support chip manufacturing and research in the U.S., further inducing motivation to ramp up manufacturing efforts on U.S. soil.

This massive push towards domestic high-tech manufacturing, coupled with the continued strength of E-commerce, bodes well for the industrial asset class. But with higher interest rates and less access to capital, growth may start to experience decline In notable sub-sectors. Industrial property owners may need to upgrade Class B and C assets as demand starts to soften in order to maximize property values while capitalizing on current market fundamentals.

Value-add strategy

Industrial real estate owners can no longer sit passively while rents tick up, vacancy rates shrink toward zero and per-square-foot values increase every year. In this new environment, some of the challenges facing owners may include upward pressure on expenses due to rising energy costs and higher overall inflation.

There also may be increased lender adherence to (and enforcement of) debt-yield ratios, debt-service-coverage ratios, cash sweeps and lockbox covenants. Other possible impacts may include more complex and dynamic tenant goals and needs, which may result in a flight to Class A assets that more closely meet their specifications.

To help combat some of these issues, owners must have space that can be easily reconfigured to accommodate a large variety of tenant uses in addition to upsizing, downsizing or consolidating. Since individual industries and tenants are not affected equally in recessions, the value of diversified tenant rent rolls and all-inclusive space offerings become critically important in mitigating risk.

Jonathan Gray, President and Chief Operating Officer at Blackstone, stated on an earnings call this past April that “in an inflationary environment, the importance of owning things where cash flow can grow is super important.” He further added that real estate sectors with “good fundamentals and short-duration leases have pricing power.”

Experience matters

Light industrial and multi-use logistics assets typically have 20,000 to 200,000 square feet of space, often having a diverse base of warehousing, manufacturing, research and development, distribution and showroom tenants. Many assets are legacy buildings located in dense infill submarkets, often requiring consistent capital injection to maintain competitiveness in the market.

An experienced operator that can take advantage of low vacancy rates — and has the skill set to make intelligent updates and reconfigurations — will maximize efficiency. Cap rates for these existing properties are generally higher than for conventional warehouse and distribution assets, and they are priced well below estimated replacement costs, making them a good choice for investors who can deploy a smart value-add strategy.

During an economic slowdown, some small businesses downsize their footprints while others will close their doors entirely. Onshore production and e-commerce demand have kept multi-use logistics properties occupied, but a slumped market reduces occupancy rates. A highly diversified rent roll provides stability as market forces cause various industries and businesses to expand or contract. Successful operators will respond by allowing existing tenants to reduce their space while attracting new tenants that are downsizing to take the remainder.

All signs point to the industrial sector retaining its status as a premier asset class. Higher cap rates and the ability to resize spaces may result in multi-tenant industrial properties being favored over multifamily investments if the economy sours and rents level off. Turning 15,000 square feet of distribution space into three 5,000-square-foot warehouses is relatively inexpensive, a unique characteristic not seen in many other asset classes.

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Rising mortgage costs and increased underwriting standards are putting pressure on transactions. Lenders are stressing net operating incomes by demanding more equity at the closing table. As a result, operators need to raise more equity and returns may be tighter.

For originators and developers, success in this climate will come down to market expertise, a deep knowledge of the tenant base, deployment of a strong value-add strategy, and the placement of a moderate amount of debt. Knowledge of real estate fundamentals will favor the most talented originators and operators, helping to steer them through this uncertain period.