Avoiding the Herd Mentality in Buying Industrial

In a competitive acquisition market for industrial, it pays to be selective. That approach puts you in good stead from the standpoint of meeting your returns target for an asset, and not overpaying to add it to your portfolio. One investment veteran with a great deal to say about smart buying is ElmTree Funds CIO David Piasecki. Here, he shares some of his insights with Connect readers—but he’ll have even more to tell the audience at Connect Industrial, slated for July 11 at Sunda in Chicago.

Q: Both your own background and ElmTree’s investment strategy point to net lease. Aside from the predictability of cash flow, what are some of the other attractive aspects of net lease from an investment standpoint?

A: Net lease, as a sub-set of overall commercial real estate investment, presents an excellent balance of risk versus reward. We would generally say that the risk range of net lease is core to core plus, but the demonstrated returns are more to the value-add or opportunistic spectrum.
The investments, while not totally passive, require less oversight and asset management than operating real estate. Depending upon lease structure, most, if not all operating expenses are borne by the tenant. Depending on length of the lease, much of the predicted returns come from contractual cash flow, versus projected reversionary value. Most net lease investors prefer 10-year or longer lease terms, thus realizing a majority of the projected IRR comes from contractual cash flow.

Q: Conversely, investors such as ElmTree Funds do well by being choosy with acquisitions. What are some of the factors you and your team consider when determining which investments to make and which ones to leave to others?

A: Our acquisition goals are credit based (a high % is investment grade), and long-term leases (weighted average initial term goal is 13-15 years). We would prefer the majority to be industrial, however we also do office, healthcare and data centers. We don’t do retail by choice, believing that market is well-served by other competitors, and that the space (credit and space needs) are challenged by forces (e-commerce, spending trends and demographics) which are hard to assess and predict.

To supply discipline to the process, we developed a Deal Score system which quantitatively assesses the key components of a deal’s valuation. We don’t use “Deal Score” for Yes or No, but it is a tool for rationing the pricing sanity of a given deal.

Finally, and maybe most importantly, all deals go through an elaborate pre-screen process before we issue a Letter of Intent. Put simply, we want to be sure we want the customer to say yes before we ask them to say yes. This puts value to an ElmTree LOI, which means it can be relied on. Even further, ElmTree has an integrated platform of construction professionals that help in the due diligence process.

Q: The industrial market is extremely competitive, which clearly has an effect on pricing. How does ElmTree avoid overpaying for assets?

A: The proprietary Deal Score system we have developed helps us immensely. Pricing is rationed in such a way that all the key components are valued on a weighted basis, so that, simply put, we reserve our best pricing for the deals with the highest scores. This avoids deal fever, which can creep into one’s thinking. That said, overall, cap rates continue to compress in industrial, thus defying logic about the impact of increased interest rates.

As an old-school contrarian by nature, I try to avoid herd mentality and generally believe that if everyone thinks the same thing, it is usually wrong. We look for ways (we call it holes in the market) to add value. For example, we’ll do a longer lease in a smaller primary market. We’ll do some added TI in an industrial deal where the pricing will support a TI amortization, whereas pure industrial space buyers may avoid it due to an increased price per square foot.

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