Industrial Real Estate Investment

Industrial real estate is a massive industry and yet it is not particularly well understood. When people discuss “commercial real estate” more broadly, they often talk about multifamily, office, retail, hospitality and land development. Sometimes, people forget about industrial real estate entirely.

At least, that was the case until recently.

 

Today, industrial real estate is booming. Demand for specific types of industrial properties is at an all-time high, driven in large part by the need for warehouse buildings in “last mile” locations – i.e., near consumers who are increasingly purchasing goods of all kinds online.

While industrial may have been overlooked in decades past, that will certainly not be the case moving forward. The availability of industrial real estate (or lack thereof!) has a major impact on the overall economy. Real estate investors, large and small alike, are taking note and beginning to add industrial properties to their portfolios with record speed.

In this article, we provide a high-level overview of industrial real estate for any investor who is considering following suit.

 

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What Does Industrial Real Estate Include?


Industrial real estate generally refers to commercial properties that have large, open floor plates. Buildings have flat floors, high ceilings, and easily accessible loading docks that allow for raw materials, goods and other products to be loaded, unloaded and easily stored.

Municipalities will usually require property to be zoned specifically for industrial use in order for a property to be utilized as industrial real estate.

Types of Industrial Real Estate

Industrial real estate can be broken down into a few sub-categories, including:

Manufacturing: These are facilities used for the assembly, production or manufacturing of raw, semi-raw and finished materials. Manufacturing can be further subdivided into “light” and “heavy” manufacturing, depending on the nature of the products being made – and by extension, the processes by which these products are made.

Warehouse: A warehouse is a specific type of industrial property used primarily for the storage of inventory, usually on a long-term basis. The primary functions of warehouse facilities include internal shipping and receiving, storing inventory, and organizing and categorizing inventory. They tend to be used for internal operations and do not act as or interface with shippers forwarding products directly to consumers. Warehouses features include very high ceilings, rows of racks, and multiple loading docks.

Distribution: Many people conflate warehouse and distribution space, assuming the two are one in the same. However, they are decidedly different product types. Unlike a warehouse, very little product actually stays within a distribution center for a long period of time. Instead, distribution centers, or “DCs”, act primarily as shipping and fulfillment spaces in which inventory from various locations is consistently shipped out to nearby consumers.

Distribution centers tend to feature advanced technology such as temperature-controlled areas that allow for the short-term storage of perishable goods. Distribution centers will often utilize various supply chain management tools and software that have built-in capabilities to help forecast product demand, which by extension, allows businesses to lower their storage time (and by extension, costs). Distribution centers are thought to be “consumer-centric,” meaning that they are located in areas that allow businesses to quickly deliver products to the end user.

Flex Space: These are industrial properties used for purposes other than manufacturing or warehousing. Flex space may include laboratory space, showrooms (e.g., car dealerships), or some combination of light industrial/warehouse and office space.

Specialized Industrial: This is a “catch all” term for other types of industrial property, including self-storage facilities, recycling facilities, and data centers – properties that otherwise don’t fit cleanly into the other industrial descriptions. 

Examples of Industrial Real Estate

Industrial real estate can take many forms. Even within each of the sub-categories above, properties can vary drastically.

For example, “big-box,” bulk industrial is currently one of the most highly sought-after types of industrial property. This includes regional distribution centers that are often leased to companies like Amazon, Walmart and Target.

There are even subsets of big-box distribution, such as smaller, “mid-bay” distribution buildings. Whereas a regional DC might have 1 million square feet of space leased to a single tenant, mid-bay distribution centers tend to be 100,000 to 250,000 square feet in size and are subdivided in 25,000 increments and then leased to multiple industrial tenants.

Both big-box and mid-bay industrial properties can be sited with either front-load configuration or rear-load configuration. With the former, the industrial property is positioned toward the back of the lot and trucks load at the front of the building. Rear-load configuration refers to the opposite: the property generally sits closer to the road with parking and loading occurring at the rear of the building.

Another subset of industrial real estate is smaller-bay infill buildings. These properties tend to be older, second-generation Class B product built on the outskirts of major economic hubs.

Light industrial, multi-use logistics business parks are another example of industrial real estate. These properties will often have multiple industrial buildings occupied by a range of tenants (usually smaller tenants). The buildings will have varying degrees of finish levels, which can range from 15% finished space on the low end to 60% finished on the high end. Many of these industrial properties were built in the 1970s or 1980s and are now looked at as infill industrial development sites as businesses look for properties located closer to their end users.

 

Industrial Real Estate REITs

Real estate investment trusts, or REITs, are companies that own or finance income-producing real estate. REITs can invest in all different types of commercial property. Industrial REITs, as you might imagine, are those that own and manage industrial facilities that are then leased to industrial tenants. Some industrial REITs will be focused on a subset of industrial property, such as warehouses or distribution centers. Others will be more agnostic toward the industrial property type, opting instead to invest in all kinds of industrial real estate.

Industrial Real Estate Leases

Industrial real estate leases are generally long-term, ranging from seven to ten years with an option(s) to renew. This is especially true for those leasing larger industrial properties, such as big-box distribution centers.

One of the reasons industrial tenants look to lease space on a long-term basis is that their set-up costs tend to be very high. The build-out and infrastructure needed to run a large industrial property can be expensive. Relocating to a new facility can therefore be cost-prohibitive.

Moreover, industrial businesses make their site selection decisions very carefully; their facilities tend to be mission-critical in terms of getting products to their customers in a timely fashion. Therefore, moving is often not an option. Industrial tenants are therefore referred to as “sticky” tenants given that they tend to “stick” around for some time.

Industrial properties also tend to utilize triple-net (NNN) leases. This means the tenant is responsible for all maintenance, property taxes, their fair share of insurance costs (on a pro rata basis), etc.

Multitenant properties, or smaller buildings that have been subdivided into smaller leasable areas, may utilize shorter leases (e.g., 5-7 years) to provide tenants with more flexibility. In some cases, a startup company may want to sign an even shorter lease (say, 3 years) given they are still unsure of their business’s growth trajectory. These shorter-term leases are often utilized at light industrial properties and multitenant industrial parks. Regardless of lease duration, these leases will still be structured as triple-net.  

What Drives Demand for Industrial Real Estate?

At a macroeconomic level, there are two primary drivers that have been fueling the expansion of industrial real estate: e-commerce fulfillment and the burgeoning direct-to-customer business model. Both are driving demand for big-box distribution and e-commerce fulfillment centers. This then trickles down into higher demand for last-mile distribution and even more localized fulfillment centers. 

The importance of e-commerce cannot be overstated enough. The shift to e-commerce was already happening pre-Covid, but the pandemic accelerated things at rapid speed. For example, a decade ago, roughly 8% of retail sales were made via e-commerce. Today, that number is rapidly approaching 20%. For every percentage growth of e-commerce, another billion square feet of industrial space is needed. Industrial development simply isn’t keeping pace with the rapid rise in demand.

On a more localized level, there has been a migration of traditional Class A and Class B office users seeking space within industrial business parks. This has become especially prominent in the wake of Covid, where tenants no longer want to be sharing elevators, bathrooms and other amenities with other users. Instead, they want their own private spaces like those found in industrial business parks. 

What is the Future of Industrial Real Estate?

The future of industrial real estate is bright. Some have gone so far as to call it the new “darling” of commercial real estate. Individual and institutional investors alike are clamoring for industrial real estate.

This is because demand for industrial real estate is at all-time highs and is anticipated to be for some time. Big-box industrial will continue to expand given the continued shift toward e-commerce. How long this can continue at its rapid pace remains to be seen. At a minimum, there will likely be sustained demand for older buildings that can be recycled and repurposed for newer distribution centers in key strategic locations.

The future for multi-tenant industrial parks is equally as bright. A look at the rent roll for these properties shows that they tend to be leased to a wide variety of users, ranging from carpenters to auto repair shops. These businesses are fundamental to any local economy and will not be going away any time soon. Industrial buildings that are leased to a well-diversified tenant base will continue to perform well into the future.

It’s worth noting that small businesses compromise 44% of U.S. gross domestic product. As long as the nation retains its entrepreneurial spirit, these businesses will need industrial spaces to grow and expand. This provides tremendous downside protection for investors looking to add industrial real estate to their portfolios. 

Is Industrial Real Estate a Good Investment?

Given the positive outlook for industrial property, experts tend to agree that industrial real estate is a good investment. Some industrial product types are better positioned than others. For example, older manufacturing properties may be outdated and need substantial renovation to remain competitive.

Meanwhile, other types of industrial property, like multi-tenant light industrial, are positioned to thrive. This is because land prices and construction costs are far outpacing where rents need to be in order to justify the risk of building these projects on a speculative basis. Therefore, although the industrial building stock has grown by 2.7 billion square feet since 2007, only 178 million square feet of desperately needed light industrial has been built during that same time.

In recent years, the fundamentals of industrial real estate have only gotten better. In a supply-constrained environment like we have today, both occupancy and rents should continue their upward climb which bodes well for investors both now and into the future. 

How to Invest in Industrial Real Estate

There are a few ways for individuals to invest in industrial real estate, including:

Direct Ownership of Industrial Real Estate:

This requires an investor to be actively involved in the operations and management of a property. Only those with significant time, capital, and experience will want to pursue this active real estate investment approach. 

Invest in a REIT:

Individual investors can purchase shares of industrial REITs just as they would buy any other stocks or bonds. This is one way for someone to gain exposure to industrial real estate while preserving their liquidity (vs. investing in industrial real estate directly). However, it is important to note that when someone invests in a REIT (industrial or otherwise), they are buying shares in the company that owns the real estate—not the real estate itself. It is just like buying shares of Apple or Google stock. REIT investors do not reap the same benefits as they would if they held direct ownership to industrial property (e.g., depreciation and other tax benefits).

Co-invest in a Real Estate Syndication or Fund:

Those looking to gain a direct ownership stake in industrial real estate will want to consider investing in a real estate syndication or fund. In either case, an adept real estate sponsor will acquire, renovate and manage the industrial property on investors’ behalf. With a real estate syndication, the sponsor generally raises capital from limited partners that is then pooled and invested in a specific industrial asset. With a real estate fund, individuals invest more generally in a fund that acquires and manages a portfolio of industrial properties. In both cases, the passive investors gain access to institutional-quality real estate that they would not otherwise be able to access on their own. 

Conclusion 

Industrial real estate may have been overlooked in decades past, but it’s arguably one of the hottest asset classes as of late. This is not a fluke, and its growth will not be short-lived. American consumers are now more comfortable purchasing goods online than ever before—and businesses must respond by investing in the warehouse, logistics and distribution centers needed to fulfill this demand. 

 

As more people add industrial to their portfolios, we can expect cap rates and yields to compress. That said, there is still tremendous opportunity for those looking to invest in industrial real estate. Those who do so now will be well-positioned to reap the rewards of rising rents and higher property values in the years to come.  

POSTED BY

ChrisRising

CHRIS RISING

Chris Rising manages the day-to-day business activities of Rising, while also serving on its Investment Committee.

He received his J.D. Law, Real Estate from Loyola Law School and his B.A. in History and Political Science from Duke University.