Equity Investors Pull Back on the Industrial as Returns Dim

Investment in commercial real estate has become more difficult over the last year. This is true even for industrial property, which investors consider one of the most important asset classes. According to Al Pontius (senior vice president, national direct for office, industrial, and healthcare at Marcus & Millichap), lenders are taking a more cautious approach to industrial deals due to higher interest rates and fears about a possible recession. Pontius says recent investment sales figures in the industrial sector show the effect of higher equity requirements as well as higher interest rates. They are currently at 6.0 percent on average, compared with a range of 2.0 to 3.0% a year ago.
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According to MSCI Real Assets real estate data, the U.S. industrial sales volume was $137.6 billion for the year through November. This is a 3 percent decrease from the same period 2021. The sector's average cap rate was 5.4 percent. CBRE's third quarter capital markets report estimated that industrial sales volume fell 23.6 percent from a year earlier to $31.4 billion, from $41.1 billion.
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The single-asset sale of industrial properties dropped by 25.7 percent to $19.5 billion. Sources of capital The market for industrial deals still has a wide range of equity sources, including institutions, high-net-worth individuals and small investors. Stephanie Rodrigues is the national director of industrial services at Colliers. They are now taking less risk than they did previously
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Due to rising interest rates and weakening economic conditions, traditional commercial real estate debt sources like banks and life insurers have seen their leverage levels decrease. Jim Koman is the CEO and founder at ElmTree Funds in St. Louis, a private equity realty firm. Pontius reports that today's loan-to-value ratios (LTV) are typically between 65 and 75 per cent depending on the asset location, lease structure and physical condition. This is compared to 70 percent to 80 percent last year.
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Investors are turning to more costly, alternative funding sources for equity and debt coverage. Koman says that preferred equity and mezzanine investments are more in demand today than they were in the past. These sources offer higher LTVs than traditional sources of lending, but at a higher price.
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The terms and cost of mezzanine or preferred equity financing can vary depending on the deal's characteristics and risk profile. "Mezzanine and preferred equity investments must be evaluated on a case by case basis in order to ensure that they are accretive to the transaction. The use of mezzanine and preferred equity to finance development projects has become more popular as construction costs continue to rise across the globe, according Jeff DeHarty (senior vice president of debt and equity at Northmarq). Pontius says that mezzanine financing is now available to institutional investors if their lending vehicle allows it. It offers a comparable investment option to equity financing and a higher yield at 11 to 14 percent with a lower risk.
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Koman says that many equity and debt funds focusing on the industrial sector are actively raising capital due to increasing demand. They tend to focus on logistics real property assets, particularly last-mile hubs. However, equity fundraising has been slowing as advisors adjust their return expectations and invest strategies to reflect changing market conditions. Chris Riley, president at U.S.
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CBRE's industrial and logistics capital markets. He says that while fundraising is still ongoing, he recommends focusing on smaller raises and giving more time to secure capital. Pontius says equity fundraising is currently difficult for many reasons.
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Investors should also remember that real estate reports can be two to six months behind what is actually happening in the market, Pontius states.
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Instead of industrial property prices remaining stable and a 30-to-40-basis-point increase at capitalization rates, as was reported recently, he claims that values are down 7.0 to 15.0% from a year ago and cap rates have risen 75 to 150 basis points. The higher cost of debt and lower prices are also decreasing potential returns for people who want to sell assets. As rents rose across the sector, net operating incomes (NOI), and cash returns increased in 2022, Riley says. Those who purchased assets at cap rates 30-50 percent higher than the peak were able to get better returns.
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"Many well-located new speculative delivery in desirable target markets have seen greater market rent appreciation than caprate expansion, which has provided an acceptable stabilised return on costs. The lower exit pricing means that total returns are not as high as in the first quarter 2021 or 2022. Pontius says that there are still many investors who are interested in investing in industrial properties because of the strong supply/demand fundamentals. However, not everyone is being selective.
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If the cap rate on the deal is higher than the debt rate, investors won't buy. "If the income stream will be flat for many years, the cap rate must not exceed 6.5 to 7.0% to transact. Deals with upside potential in the short term are an exception. Assets with a cap of 4 to 5 percent are still attractive if the lease expires within the next two year. This allows the buyer to increase rents to the market rate.
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A recent Newmark report shows that overall monthly industrial capital market activity has seen a double-digit decline year-over-year since August 2022. Limited data indicates a rise in cap rates and a decrease in pricing for short- and long term weighted average lease terms (WALT) assets. However, the latter are still subject to higher premiums and lower caps rates. Riley says that there was an increase in investor demand at the end 2022, stronger than the third quarter, primarily due to assets with below-market rents and short WALTs.
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Newmark's analysis of industrial sales transactions for 2022 revealed that assets less than three years old in WALT received an average premium price per square of 55 percent. Cap rates and ft. that were about 70 basis points lower than those for assets with almost a decade left in WALT.
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Cap rate delta is a difference of 17.5 percent in the average value between short-term and long-term WALT assets. The report also noted that the SOFR (Secured overnight Financing Rate), which was at 4.31 percent at January's start, and further interest rate rises possible, means that acquiring near-term WALT asset carries the potential for negative leverage but offers the possibility of greater cashflow and refinancing at lower rates in the future. Korman says that private and institutional investors who have a long-term investment plan, such as pension funds and family offices, are the most in demand.
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Riley states that buyers who aren't dependent on leverage or use low levels of leverage to close deals are more active. This includes separate accounts, open core funds, family offices, and private buyers that can keep their assets indefinitely. Private investors should view the current market, he says, as an opportunity to buy large returns at lower prices than replacement cost pricing. This is an attractive combination. Stephanie Rodrigues is the national director of industrial services at Colliers. She also says that groups looking to reinvest their tax money are actively seeking out opportunities.
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Riley says that investment vehicles in redemption queues, such as non-traded REITs or open-end funds, are the least active on both the buyer and seller sides. They sell or finance assets to raise capital.