How to Invest in Industrial Real Estate

The industrial sector is arguably the least glamorous commercial real estate asset class. There are no elaborate architectural design features, resort-like amenities or high-profile addresses. Instead, industrial real estate is intended to provide practical and efficient space to users that prioritize function over form. Industrial buildings are suitable for a variety of uses such as manufacturing, R&D and the storage and distribution of goods.

Over the long run, industrial properties are steady performers, which is why they merit inclusion in real estate investment portfolios. The average annual total return for industrial properties over the past 20 years is 10.6%, which is slightly ahead of the average return of 10.2% across all property types, according to the National Council of Real Estate Investment Fiduciaries (NCREIF) Index.

In this article, we begin with an overview of the industrial asset class, discuss demand drivers as well as changes in use and conclude with thoughts on how to use this information in making informed investment decisions.

Asset Class Overview

The three main categories of industrial real estate are manufacturing, warehouse and Flex/R&D, which are defined as follows by the National Association of Industrial & Office Parks (NAIOP):

Manufacturing: A facility used for the conversion, fabrication and/or assembly of raw or partly wrought materials into products/goods. These properties tend to have less than 20% office space and can be further classified for a heavy or light industrial use.

Warehouse: A facility primarily used for the storage and/or distribution of materials, goods and merchandise. These buildings tend to have less than 15% office space, and modern facilities have high clear ceiling heights that allow for more cubic storage space. This category also may include specialty facilities, such as cold or freezer storage for food.

Flex/R&D: These industrial buildings are designed to give its occupants flexibility in use of the space. Sometimes referred to as flex/tech space, these buildings are an office-industrial hybrid that can have 30% to even 100% office finish.

Because they require a lot of acreage for wide building footprints, low-density parking, and truck turning, industrial buildings are almost never found in the CBD.  Therefore, it is rare to hear them distinguished according to anything other than use.

Demand Drivers

There are a number of factors to consider when analyzing industrial investment opportunities. Chief among those factors are location, proximity to customers and workers, transportation, access to land and financial incentives that can offset building costs.

Transportation: Industrial real estate depends on easy access to major highways and interstates; intermodal rail; ports; and air freight and, as a result, serves as a significant driver for industrial demand. Louisville, for example, is home to a major shipping hub for UPS, which has helped to attract dozens of e-commerce and retail firms such as Amazon, Columbia and Guess, as well as manufacturers such as GE.

E-commerce: E-commerce acts as a substantial demand driver for industrial real estate, particularly in larger format buildings. For example, according to Costar, since 2010, one-third of all industrial leases over 500,000 square feet have been for e-commerce purposes. As for market size, Forrester Research projects that U.S. e-commerce sales will surpass $400 billion by 2018. Correspondingly, the demand drivers of e-commerce are omnipresent and only gaining momentum.

Incentives: Locating large industrial facilities often involves working closely with local city or state agencies to negotiate incentives that can influence location decisions. Large industrial properties such as a manufacturing plant, distribution center or data center can have a big tax benefit, and cities and states compete aggressively for bigger projects that will boost their tax base with jobs and property taxes. Those bidding wars include offers of tax rebates, low-cost loans and even free land that can have a big impact on a project’s overall cost and ROI for investors.

Changes in Industrial Use

The use of industrial real estate has evolved substantially over the last twenty years. The following are just a few highlights of how uses have changed.

Early Suppression Fast Response (“ESFR”) Fire Sprinkler Systems: For warehouse users, fire protection is a major issue, considering that warehouse fires are difficult to suppress and can be devastatingly costly. In years past, a common practice was to augment standard sprinkler systems with an additional “in-rack” system that snakes sprinkler heads through the warehouse rack system. As you might imagine, in-rack systems are costly to install, prohibit further alteration of the warehouse rack system after installation and are prone to operational issues.

The drawbacks of in-rack sprinkler systems have led to the rise of ESFR sprinkler systems. ESFR sprinklers detect and respond to fire much faster than a conventional sprinkler head and spray far greater quantities of water.  For example, while a conventional sprinkler head outputs 25 to 30 gallons per minute, an ESFR sprinkler head can output up to 100 gallons per minute. These performance differences enable industrial users to obtain the same or greater level of fire suppression of the in-rack system while foregoing the high cost of installation and ongoing headaches of operation.

Taller Clear Heights: Over the last 30 years, industrial buildings have grown taller to address demand for increased warehouse efficiency. As recently as the 1970s, most buildings were built with clear heights below 20 feet. As modern warehousing practices spread throughout the country, many tenants demanded more “cubic” space in their facilities, which led to the construction of buildings with 24-, 28-, 32- and now even 36 foot clear heights.

A building’s clear height is defined as the usable height to which a tenant can store its product on racking. While the height of a pallet of goods varies, the most common pallet size is 64 inches, estimated to be used approximately 50 percent of the time. That means 32-foot clear facilities can rack between four and six pallets. By jumping up to a 36-foot clear height building, a user will usually be able to rack one pallet position higher, which increases capacity by 10 to 25 percent with the same footprint.

While more efficient, the cost of developing a building to the 36-foot clear height is much than lower clear height buildings. The net result is that 32- and 36-foot clear height buildings are the new class of A buildings, while 20- to 24- foot clear height buildings are usually now considered Class B (for more information on asset classes please see our recent article “Making the Grade in Real Estate: Understanding Class A, B and C”) . It is important to note that many warehouse tenants do not require 32- or 36-foot clear heights, which enables them to lease highly functional Class B space at a substantial discount to Class A building rents.

Distribution vs. Fulfillment: Logistics is becoming an increasingly important factor in the use of industrial real estate. Traditionally, distribution involves the storage and shipment of goods to stores in large batches. Fulfillment is a fundamentally different type of use that involves the shipment of products to consumers in small batches. Distribution can function in semi-rural locations where land is cheap and plentiful. Fulfillment, however, requires proximity to major MSAs and/or transportation hubs to facilitate fast deliveries to end users.

The shift in consumer behavior due to e-commerce is changing the use of certain types of industrial real estate as fulfillment has different locational requirements and functional needs such as greater parking ratios. Particularly, as e-commerce retailers are racing for the prize of same day delivery, the fulfillment center is emerging as its own subset of industrial use.

Synthesizing the Information

Similar to the conclusion of our recent article, “How to Invest in Office Real Estate”, assembling the above information into a useful set of tools to evaluate potential industrial investment opportunities boils down to relevancy. When thinking through industrial real estate, it’s helpful to take a macro to micro approach. First, consider what is happening at the metro level in terms of how it uses industrial real estate, which metros are offering incentives to developers and how market demands are changing uses within those metros. From there, look to the submarkets within the metro that possess the best access to key modes of transportation as it is those markets that will attract the most tenants. Finally, when drilling down to the asset level, consider the asset’s ability to serve the needs of the modern industrial tenant. As we mentioned at the outset, those needs are almost purely functional, so the asset needn’t be pretty. Instead, a viable asset offers things such as competent fire suppression, adequate clear heights for its intended use and good ingress and egress. While not perfect, if you can gain comfort at each level as you conduct a macro to micro analysis, you likely have a winner.

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