BKM Capital: Industrial Assets Escape Interest Rate Scourge
While prices and the availability of financing have fallen as interest rates remain high, the industrial sector is on a different trajectory, BKM Capital Partners said in a white paper released this week.
By Samantha Rowen, PERE Credit
The industrial sector has so far escaped the brunt of the impact of today’s higher-for-longer interest rate environment, with a white paper released this week from BKM Capital Partners, based in Newport Beach, California, highlighting a rise in pricing and valuations for industrial properties and continued availability of financing.
The industrial specialist’s Multi-Tenant Light Industrial: Maintaining Resilience in Turbulent Economies notes that the sector saw the same financing inputs as other sectors did as the Federal Reserve began a 500-basis point cycle of interest rate increases from March 2022 to July 2023.
But industrial assets have been largely insulated from the pitfalls other sectors have seen, the report found.
“Industrial sale prices have continued to increase during this time, outpacing opposing factors such as a decline in transaction volume, a wave of new supply entering the market and an elevated cost of capital,” the report stated. “Compared to previous monetary policy tightening cycles, this rate hike series has resulted in some of the historically lowest sector pricing and a noticeable slowdown in private equity fundraising.”
Mason Waite, managing director, asset and portfolio management, at BKM, told PERE Credit the firm has observed that the availability of financing for light industrial assets remains strong. This is for both acquisition and development.
“Industrial properties continue to be a favored asset class, thanks to their solid fundamentals and demand drivers. While access to debt financing is still robust, we have seen a tightening in leverage levels, with maximum loan-to-value ratios dropping from 65 percent to the 50-55 percent range,” Waite added.
BKM has also found that banks have also shifted their focus toward maintaining ongoing debt service coverage through stable cashflow, leading to more conservative follow-on capital or holdbacks, Waite added.
“Despite these adjustments, spreads have only increased slightly – up 25-50 basis points over the past year – but remain competitive in the current market,” Waite said. “Hedging requirements continue to be a focus for lenders. Although costs have stabilized, we expect them to decrease as the forward yield curve has dropped significantly, making the financing environment more attractive for borrowers.”
The report also highlighted the fact that valuations have also continued to rise, positing this is happening due to the rapid rent growth seen in the sector over the past three years.
“By May 2024, the average industrial sale price across the country reached $142 per square foot, up 15.4 percent year-over-year and 71.2 percent higher than in 2019,” the report stated. “The national average rate for all in-place leases at this time was also $8 per square foot, a 7.5 percent increase over the past 12 months.”
Dominic DeRose, a managing director at Chicago-based investment manager Cresset Partners, believes there is a growing scarcity premium for well-located, modern industrial assets. The reason is simple – there has not been enough capital available for development allocated to the sector.
“The one thing that is always true about real estate is that development capital is always in short supply, no matter how good or bad the market is. It is the most entrepreneurial and opportunities investment you can make,” DeRose said. “What we are seeing now is something we predicted a year ago, when construction starts tailed off; that there is an upcoming cliff of new supply in a lot of markets.”
There have been about 40 million construction starts each of the last three quarters, a level that is well below average, DeRose said.
“Industrial development in a handful of select markets with good fundamentals is a good opportunity. I think that is the supply side,” he added.
In addition to a scarcity premium, there is also a paucity of high-quality assets. This is becoming an issue for retailers and distributors who are working to adapt to changes in the way goods are purchased, manufactured, transported and fulfilled.
Fifteen or 20 years ago, it was an easier equation for a retailer that wanted to open a distribution center, DeRose said.
“You had a map of your stores, and you put your distribution center in the location that minimizes the cost for that specific store network,” DeRose said. “What we see now is that you can’t send a relatively homogenous shipment of goods from a defined hub and spoke warehouse network to your stores because you need to minimize the cost for an individual parcel from the supply chain to the population center. That has created a decentralized supply chain and the need for more warehouses.”
The firm has seen substantial demand from manufacturers, domestic and international, driven in part by the impact of the Inflation Reduction Act. More companies want to manufacture goods domestically and Cresset Partners is also seeing more onshoring, DeRose added.
Threading the needle
The strong performance of light industrial assets during the recent rate hikes can be attributed to a combination of demand, constrained supply and market positioning, BKM’s Waite said.
“The rate hikes themselves were a direct response to soaring inflation, with the Federal Reserve raising rates throughout 2022. Despite this challenging environment, light industrial properties remained resilient due to strong tenant demand, driven by several key factors,” Waite added.
Rising construction costs limited the development of new supply, which kept existing assets in high demand. At the same time, the tenant base for light industrial properties expanded, particularly in sectors like e-commerce and energy transition, where policies such as the Inflation Reduction Act and CHIPS Act stimulated additional growth and spending.
“Furthermore, many of our tenants were moderately leveraged with fixed-rate financing, allowing them to withstand rising interest expenses. This financial stability enabled them to pass increased costs on to their consumers without significantly affecting their profit margins,” Waite noted.
On the capital markets side, light industrial properties were well-positioned to counteract the impacts of inflation, noted Chris Evans, senior director of portfolio management at BKM.
“With short weighted average lease terms and the ability to adjust rents to market rates, these properties offered a natural hedge against inflation, making them an attractive investment option throughout this period. This combination of limited supply, strong demand and inflation-hedging characteristics has helped the light industrial market retain its resiliency in the face of rising rates,” Waite added.
Outlook
BKM Capital believes the fundamentals for light industrial space remain strong. The sector has been extremely resilient in the period following the global financial crisis and through the covid-19 pandemic, and a hawkish Federal Reserve policy.
There continues to be a supply shortage of small bay light industrial assets, Evans said. This is largely driven by several factors, including high land prices in infill locations, zoning restrictions and the rising costs of development and financing.
“These factors create significant barriers to entry for new developments, keeping the supply of these assets constrained. As a result, demand remains strong, further reinforcing the tight supply conditions in this sector,” Evans added.
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Download and view the white paper here.
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