July 13, 2018
By Dennis Kaiser
The industrial sector has ridden a hot streak into 2018, following 2017’s record breaking year. Connect Industrial attracted key players from all over the nation to Chicago to explore the drivers and trends shaping the industry. The afternoon of informative panels, networking and cocktails was launched with a discussion titled 2018: The Year of the Entity-Level Deal.
CBRE’s Jack Fraker moderated the panel that also included Elmtree Funds’ David Piasecki, Exeter Property Group’s Jason DeFilippis, IDI Logistics’ Jeff Lanaghan, CenterPoint’s Scott Benedetto, and Hillwood’s Tom Fishman.
The group discussed why consolidations in the industrial space are making this year’s headlines. The limited number of portfolios trading seems to place many large companies in holding cycles, which could be pushing buyers toward purchasing companies rather than portfolios.
Industrial has become the new retail, a glamorous asset class coveted by investors. Fraker noted that it is a “great time for all of us to be in this asset class. Never in the history of industrial real estate have the fundamentals been so strong with real rental rate growth all across the country.”
A deep-dive discussion into big entity-level deals revealed who is selling portfolios, who is buying them, and the strategies at play. Exeter’s DeFilippis says they look for undervalued REITs, but notes there are two buyer sets. That includes the strategic buyer like Prologis that wants to own assets, and foreign capital that wants to own the properties, but needs an operating platform.
Hillwood’s Fishman says there’s two reasons why entity-level deals have become popular. One is the fundamentals. He points to national leasing activity that is “off the charts and construction can’t keep up with demand.” Entity-level transactions lead that activity, and it is being driven by foreign investors over the past three to four years making big bets. They’ve gone from having zero properties to having 80- to 100-million square-foot portfolios. If they can team up with an owner with a local presence, it works, says Fishman.
Investors also like industrial compared to the other main asset classes (office, retail and multifamily) because of capex considerations. They may only need to spend 15-20% of NOI to maintain an industrial building, compared to an office or retail building that has to spend $100 per square foot when a tenant exits to get a new tenant, which quickly erodes returns.
Industrial is simple and easy for investors to get a handle on and understand; the long-term prospects likely holds a relatively safe haven for them. It is also another reason foreign capital likes to invest in the U.S. as a way to eliminate political risk, which is lower in this country.
Elmtree’s Piasecki notes that publicly-traded REITs are likely where the opportunities lie for single tenant net lease portfolio deals. He says they seek investment grade assets.
“We don’t believe in taking credit risk because if you are taking credit risk in business then you’re really not in the long-term net lease business,” he says. “A tenant could go out on you and you’ve basically accepted a long-term net lease return for an operating lease business.”
For the net lease business, the new government accounting regulations actually seems to have increased activity mainly because they’ve provided clarity, both for the investor and for the tenant on the asset side. Now that the rule is more clearly defined, companies see that it isn’t eroding their balance sheets, and there’s quite a bit of sale-leaseback deal flow right now.
CenterPoint’s Benedetto points out sellers are getting value for industrial in a low-yield environment with cap rates where they are. “If you can get an industrial building that’s under construction or vacant, you have opportunity to blend cap rate and push up a little so that deal looks more attractive,” he says. “You can get to that right away, and you’re buying a Class A product.”
He notes that a vacant build right now is worth more than a leased one “because you can project that rent inherently and push values. Institutions like the idea of getting buildings that are rolling over right away or are vacant today, because they can put a lease in they like and really drive that rent.”
For forward sales, IDI Logistics’ Lanaghan says that’s a reason to try to sell a platform with a fairly robust development wing, since there’s ongoing value to be created if you get in at below cost or below replacement cost. He notes you can typically do well by selling forward and get a good return.
But, what qualifies as a forward deal is constantly changing. For some it is a nine-month deal, but for others it may be 18 months and it changes daily.
Yet, what isn’t letting up is demand. The industrial sector must deliver roughly 100 to 125 million square feet each year to keep up with population growth, and another 50 million to meet ecommerce demand. The remaining 50 million of the 200 million square feet of industrial demand per year can be attributed to replacing obsolescent buildings.
Exeter’s DeFilippis notes that since 2014, the country has achieved more than 200 million square feet in annual net absorption. What he says is different about this cycle than the previous one is the lending environment.
The 80% to 100% LTC deals have disappeared, he says. “The most debt you can get now is 50-60% on construction loans.” So the question becomes how much developers are going to do, since they have to put in their own money at risk. He notes that’s helped to taper back some of the development activity, plus there are so many positive indicators leaning against an oversupply.
Hillwood’s Fishman points out that the growth of ecommerce has affected everything. “People want more stuff quicker now, and it is not going to sit in a retail store at $18 per square foot, it is going to be in a warehouse at $4 (psf). Those economics are helping to not have an imbalance with construction and absorptions,” he says.
Elmtree’s Piasecki likens the emergence of the entity-level deals to a production system. “We manufacture $800-million credit- and location-diverse portfolios. Sovereign funds or publicly-traded REITs don’t want to manufacture them. If you can just go out and buy it, you do.” That is a strategy that has worked for them for some time and generates a premium, he says.
Hillwood has found the premiums can be realized by creating homogenous portfolios. In some cases, financing rewards diversification, notes Hillwood’s Fishman, who also says premiums can also bring lots of benefits.
For CenterPoint’s Benedetto, the strategy is to strike a balance between acquisitions and development. The company seeks assets with below-market leases where it can add value. “That’s our value to CalPERS, turning a B property into a B+ and re-lease it at market rates and push value there.”
CBRE’s Fraker concluded the discussion by polling panelists on how long the current cycle might last. He said, “I think personally [this cycle] can go on for quite awhile because of the secular changes such as ecommerce, but we are at the end of typical cycle.”
The general consensus among panelists was to expect another 18-24 months of a strong industrial market. Factors cited for the sector’s positive outlook included the recent tax cut, lack of disruptors on the horizon, growth of ecommerce and those playing catchup to Amazon, the amount of equity counterbalancing the market, and a lack of overbuilding.
Exeter’s DeFilippis says he doesn’t see anything (absent a huge unforeseen event) that would disrupt the current economy. He points out that some of the interest level in acquisition opportunities in the U.S. is because the other alternative investments for countries offer much lower interest rates.
For comments, questions or concerns, please contact Dennis Kaiser