Class B Industrial - Bubble waiting to explode - please prove me wrong.
Real estate GP (development/value-add) returns - 15+ net IRR target in a HCOL city.
TLDR: low-clear height buildings will see significant rent declines in the next 5 years.
Too many new “industrial people” speculating and driving up the price of what actually is obsolete industrial space.
We haven’t bought a deal since March 2021. It’s been boring.
Like everyone else, we love value-add industrial with low-site coverage etc.
Unlike everyone else, we’ve been doing industrial since 2007.
We have people in our markets buying 18ft clear height buildings at 60% site coverage, with 80 foot truck-court depth for +$330PSF.
My argument is this: if it’s manufacturing, fine - likely a specialized building with binary risk which I don’t want. If it’s light manufacturing/ warehousing, like most of my market is - no sophisticated company can afford to pay $20PSF on low clear height buildings for extended periods of time. I have seen hundreds of these companies balance sheets, at $6psf rents, they were at 7-14% GROCs. I’m seeing it now and we’ll continue to see it - there aren’t enough companies than can utilize low clear height buildings and pay the freight. The math just doesn’t work.
Thank you
Based on the most helpful WSO content, the concerns about Class B Industrial properties and the potential for a market correction are not unfounded. Here are some key points to consider:
Clear Height: As you've pointed out, clear height is a significant factor in the functionality and desirability of industrial properties. The trend is towards higher clear heights, with Class-A bulk buildings now having at least 32' clear, and a preference for 36'-40' clear. Buildings with lower clear heights, like the 18ft you mentioned, are less versatile and may not meet the needs of modern logistics companies, which could lead to rent declines as you've suggested.
Market Trends: There's a shift towards more efficient, higher clear height buildings in industrial real estate. This is driven by the need to accommodate modern logistics practices such as vertical storage and advanced material handling equipment. As new developments cater to these needs, older buildings with lower clear heights may become less competitive.
Tenant Needs: The ability of tenants to pay higher rents is contingent on their operational efficiency. If a building's specifications, such as clear height, do not align with the tenant's requirements for efficient operation, it will be challenging to justify higher rents. This is especially true in high-cost-of-living (HCOL) cities where the pressure on margins is greater.
Speculation Risks: The influx of new investors speculating in the industrial market can drive up prices temporarily, but if these investments are in properties that do not meet modern standards, there is a risk of a market correction. This speculation can lead to a bubble, as you've indicated, particularly if the properties being acquired are functionally obsolete.
Investment Strategy: Your strategy of not buying deals since March 2021 and focusing on value-add industrial with low-site coverage is prudent given the current market dynamics. It shows a disciplined approach to investment, favoring long-term functionality and tenant demand over short-term speculation.
In conclusion, your argument about the risks associated with low-clear height buildings in the industrial sector is supported by current trends in tenant preferences and market developments. While it's impossible to predict the future with certainty, your insights align with the broader industry observations that prioritize functionality and efficiency in industrial real estate.
Sources: Industrial Properties - What are the key things to know?, Value creation in different RE property types, "Why was it built this way?", General Real Estate Discussion, Has the Wooden Skyscraper Revolution Finally Arrived?
As a fellow class-b industrial value-add guy, I feel your pain and I cannot agree more. I have been on the investment side for 10+ years between working for a firm and doing my own deals with partners. Over the last few years, I've watched all sorts of multi-family syndicators, house flippers, etc move into industrial and pay more for a shitty class C building in the middle of nowhere with a local credit tenant and likely no demand to backfill it should they go out, than I would pay for a prime location, class B industrial building with all the right attributes and a wide array of tenants to backfill the space. It'll make for a somewhat amusing fallout when it occurs and may offer plenty of opportunities then, but it sure sucks sitting on my hands in the meantime.
Any idea what kind of leverage these buyers are using? I used to work in retail, sort of similar risk in terms of a single tenant or just a few tenants, cap ex, length of time to acquire a new lease, etc. We used 50-55% leverage. Since you are referencing people who moved from the residential side to industrial, I would assume it would be high leverage?
Yup, we sell these big metal dumpster buildings like hotcakes where I am. No way can it last forever.
This has been my concern as well. The story we continue hearing is that the tenants in this Class-B product just don't have an option besides going out of business or paying the rent since all of the new product has been mega industrial sites on the outskirts of town and not infill, smaller suite that matches to the Class-B sized tenants. We have been trying to avoid this product given the potential fall out could be huge vs. the upside is probably limited at this point. Talking with tenant rep brokers, it sounds like there are still only rare occurrences in which a tenant can't afford to pay the higher rents, but in my opinion it still begs the question of how high can we really go? I've said that many times in my career though and have continually been wrong (how high can housing prices in West LA go back in 2016? How high can rents in Texas really go in 2019 before tenants are priced out? Continually the answer has been "a lot higher than you thought").
We have found the best way to continue playing in this space is to make sure it's super infill in high population growth cities so that we feel good we can eventually continue finding the tenants to pay higher rents given supply in these markets is non-existent and probably nearly impossible going forward, with the added bonus that a few of these plays should eventually turn into a covered land play as the cities continue to grow and we flip them to a multifamily developer or someone that wants to convert them to more flex/trendy retail (breweries, restaurants, etc.). However, that also means most of the stuff we're looking at is already more flex product by nature (mostly distribution uses, 5,000 sf to 20,000 sf tenants)
Yeah, the counter-thesis here is that this schlocky stuff simply doesn't get built anymore. It's typically the same zoning designation as true industrial (or even data center in some cases), and every bank and LP would rather write a check for a 32' clear class A building under the guise of e-commerce. Lack of new supply will always keep an upward pressure on rents. And frankly I would argue that the WFH revolution has and will stimulate demand in this space, both because of engineering type firms who don't necessarily need dock space but are embracing a hub-and-spoke office model and need to find little pockets of suburban space, and because household formation increases the need for your landscaping firms, HVAC vendors, kitchen/bathroom showrooms, etc. who want direct suite access and the ability to load into box trucks.
Good thread OP.
I’ve been interested in this asset class as well. Have a half baked investment thesis that when prices crash, there could be potentially an opportunity to buy these assets and raise the clear height of the building via roof lifting, curious to see if this could potentially be profitable.
Definitely doable for some buildings, have looked into it. Generally need scale to get the $PSF numbers to make sense.
Also need truck court depth
What materials were you looking at for pricing? Interested in doing a case study on a property in my area and having trouble estimating construction costs.
Interesting thought.
like everything, it depends I would say. I’ve seen folks pile into older product near urban cores where it could serve as a CLP and converted to a higher use once the path of residential progress nears it. These seemed like a smart play while rates were low and construction costs were manageable but will be interesting to see how those sagas unfold now.
Another question is what happens to bulk product with sub-32 clear heights at roll? No one seems to want a 1M SF building with 24-28 clears when there’s 36+ at the next exit down.
Adding additional feet via clear high is not super expensive for industrial guys. Looked at this when trying to redevop Class B Flex Office.
Depending on the market, think Class B will be strong, but there is evidence for the cyclicality of rents in class B
Not saying it won’t be strong / there aren’t value add options. I’m just saying the people buying at super high basis looking for 5% rent CAGR to stabilize at +6.50%YOC are out of their minds.
I don't think you're wrong overall, but there is still a lot of runway left, just because those lower clear height buildings are taking up space still.
There are also still a boat load of tenants that can't / won't even rack over 18'. I've walked into so many 28'+ clear buildings where this is the case.
Tides are definitely changing though, and now is a perfect time to buy newer, better clear product for WAY less of a premium than it should be.
Pros
Cons
Overall, for those buying crappy, Class-C, they will get hurt. However, Class B seems viable for the short-to-mid term as there just isn't supply coming online (at an affordable price point). FWIW, we have built Class A Flex industrial over the past few years. In our market, Link (i.e. Blackstone) owns Class B industrial and they charge nearly the same rents as us. If this isn't supportive of Class B, I don't know what is..
I'm a multifam broker but have worked on industrial in a prior role in my career. I'm in a major port city and been looking into add industrial brokerage to my belt. Not sure if anyone has any thoughts about that but multi has been absolutely hammered with political issues in my market.
Plenty of pushback from municipalities to new industrial development. To your average layman, the thought of industrial buildings goes back to some industrial plant from the 80s spewing out toxic waste. Can get pretty cartoonish.
If you're quoting $20 rents on 18' clear buildings that's two markets, NNJ or inland empire. Inland is going through some pains right now but NNJ is still rocking for small space. Given how difficult it is to develop new product in NNJ with even as of right sites my bet would be long on any dry 20+ clear functional buildings.
So far down the east coast in Charlotte, Atlanta, Jacksonville and NNJ infill class B is very strong while Class A bulk has taken a beating.
Same in the Rocky Mountain West. Class B warehouse still strong. Albeit, a slight price decrease. Class A feeling the pain.
What’s NNJ?
Northern New Jersey
We’re seeing those numbers in some of Boston’s submarkets
Anyone ever look at PLYM? Mostly Class B with some A in what they call the Golden Triangle (Basically Chicago, Cleveland, Columbus, Indy, St. Louis down to Memphis, Atlanta, Jacksonville, Savannah etc.). Trades at just under 8% implied cap rate, they make the argument above that supply is much less for Class B and that these markets benefit from onshoring given the strong manufacturing bases etc. Just curious, equity generalist intrigued the convo here.
Industrial acquisitions guy here at a Owner/Operator. I've traded PLYM back and forth in the PA and listened to a few earnings calls as they are our closest public comparable.
They carved out a good niche initially but started overpaying for stuff going into later half of 21 and 22 so not super confident in the management and recently its just traded as a interest rate play more than anything (like the rest of the REITs). I think its starting to look attractive again but I'm fairly certain you'll be able to buy cheaper over the next 12 months. FWIW you definitely wouldn't be able to buy their portfolio on the private side at the implied pricing of 8% cap, but not sure I'm quite getting an 8% based on the Q3 NOI math (closer to a 7%).
To address OP's original question, this is extremely market to market dependent. There likely is a bubble in Tier 1 markets just given the capital chasing the space but in secondary / tertiary markets especially at this point in time pricing has become a lot more attractive compared to 12 months ago. We can only play the greater fool game for so long, real estate needs to cash flow at the end of the day.
Pulled the 7.8% implied on consensus forward NOI on FactSet so that is part of the difference but regardless that is helpful commentary. Thank you!
What are the untrended cap rates that the overconfident buyers you're referring to are buying at?
Untended 5%-6%.
Rents for class B are the same as new builds at the moment, I think that’s going to change as supply finally catches up.
I would say you are ascribing return expectations for a very narrow market (select infill primary markets) to an entire asset class. In the markets I work, Class B industrial is a 7%+ cap rate. I for one really like Class B industrial - no one is building more of it, the gap between Class A and Class B rents is wider than historicals, and I haven't seen much of a drop in demand even with higher interest rates / rents. The biggest issue that I have in Class B is you are competing with owner users who can always pay more than an investor.
Agreed and I think this problem extends beyond the low clear heights, high site coverage buildings you describe that would be more Class C than B profile. Not an industrial guy so I'm hypothesizing here and haven't dug into the data, would love somebody more informed to tell me why I'm wrong.
There was such a huge surge in new supply during COVID with an increase in demand for same/next day delivery and many companies moving from just in time to just in case inventory management and thus requiring more space. This fed both speculative small-time buyers and massive funds pouring money into the space due to the newfound undersupply driving up rents at unsustainable rates.
People have been buying industrial at absurdly low, negative leverage cap rates on the thesis that they're buying at a good PSF value and can move that up by rolling rents to market as rents continue to surge. Companies like Amazon were gobbling up prime space and forcing smaller companies to overpay on rent for crappier, less optimally located buildings driving up rents like crazy in lower quality assets. We've already seen some of the larger players start to scale back their warehousing post-pandemic, and I'm now hearing stories about ghost tenants with warehouses sitting empty or filled with overstock that see limited to no activity. At least in Canada new development starts have dropped massively and rent growth has gone from 20-30% to sub-10% (not that this is poor rent growth, but would imagine that's just the start). Cap rates have begun to expand as well.
We're starting to see institutional buyers become much more selective in their industrial investments accordingly, but there are a ton of unsophisticated investors still throwing money at the non-core stuff thinking the bull run is surging forward. Think there's going to be an ugly time to come for these folks.
Don't get me wrong, I still think the macro tailwinds for industrial are absurdly strong and for people looking to invest in core/develop-to-core real estate it's got the greatest go-forward prospects in the industry today, but I'm in agreement with OP that the dated, lower quality product is in trouble.
It's been eye-opening diving into the nitty-gritty of the industrial real estate scene, especially when we're talking about those older Class B and C properties with their low er ceilings and packed sites in high-cost living areas.
IMO, the convo here really painted a vivid picture of a market at a tipping point, where bets are being placed left and right on properties some might call outdated. Yet, there's this undercurrent of, dare I say, HOPE - that with the right moves, these old spaces could be turned into gold mines.
Stepping into the future of industrial real estate feels a bit like walking a tightrope while having in a B-Plug. On one side, you've got the sheer need for spaces that can keep up with the online shopping craze and all the logistics that come with it. This means we're all eyeing properties that can stack up higher and stretch out further. But then, there's this whole other area of the market, particularly those spots right in the middle of everything, that could really shine with a bit of creativity and elbow-giz grease.
The smart move seems to be looking at this with a bit of a split vision. It's about being careful not to get caught up in the hype and overpay for something that's not really up to snuff anymore, while also being on the lookout for those diamonds in the rough. Thinking about how to lift those roofs, spread out those cheeks and sites, or even completely switch up what these places are used for could really pay off. Whether it's turning them into hubs for quick deliveries, spots for small-scale manufacturing, or even mixed-use spaces, there's a lot to be excited about.
Everyone's feeling the squeeze when it comes to the rents and prices of these smaller, cramped properties, but there's also a sense of some excitement about what COULD be if we're willing to roll up our sleeves, get on our knees, and reimagine these spaces. It's all about doing your homework, thinking outside the box, and really committing to making these places work not just for now, but for the future too, in a way that's smart and sustainable.
So, we're at this interesting point with industrial real estate where it's a bit of a challenge, sure, but it's also filled with possibilities. For those of us ready to think long-term and really consider how our investments can make a difference, there's a path forward teeming with chances to make a real impact and see some solid, hard, and throbbing returns.
You mentioned "diamonds in the rough" that can be found by finding entirely new uses for the class B, infill spaces. I think that's a huge opportunity for someone that can do it right. Was in Boston this summer and spent a lot of time at the Seaport - a lot of old, mid-size industrial spaces that have been repurposed into breweries, restaurants and even one that was being converted into loft-style apartments right on the water. Obviously Boston is a major city, but there's so many smaller (but quickly growing) cities in places like the Midwest that want that kind of trendy, mixed-use focused growth that still feels "authentic," and I think repurposing some of those smaller class B sites could be a way to do that. Here's an article talking about how a rising elderly population and declining birth rates is leading to a younger, child-less population that wants walkability and neighborhood amenities rather than the traditional suburban subdivision - I think it kinda underscores the class B thesis.
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