With industrial having recently achieved the status of a close rival to multifamily in terms of investor interest, the subject of financing for transactions in this marketplace comes into focus. What that financing looks like can vary widely depending on the product type and the sponsor’s business plan. Connect Commercial Real Estate spoke with two industrial finance experts at Meridian Capital Group: New York City-based Morris Betesh and Southern California-based Seth Grossman, both senior managing directors with the firm.
Q: Seth, you are more focused on the West Coast whereas Morris, you work primarily on the East Coast. Do you see any differences in priorities between East and West Coast borrowers?
Seth Grossman: While each borrower conveys to us the priorities that matter most with regards to debt terms and execution, I’ve seen no easily identifiable differences tied to what those priorities are based on borrowers’ geography. Priorities generally center around leverage, recourse, structure, rate, term, reliability and sometimes timing or asset management. One of those categories may be the sole driving force for execution and loan sourcing with one borrower, while another borrower may ask us to demonstrate how the lending landscape shifts if those metrics are traded for one another. The ultimate execution is always tied to an owner’s specific priorities, but I don’t believe region is the driver.
Morris Betesh: While I don’t think there are many differences between the coasts, there are definitely geographic distinctions elsewhere. The primary difference with industrial properties as compared to other asset classes is that they vary widely depending on their location. There are core locations that service large urban centers, like Northern New Jersey in the New York metropolitan area, in addition to similar core markets up and down the East and West Coasts. In these locations, there are high barriers to entry as well as limited supply and tremendous demand. Once you start moving into less densely populated parts of the country, supply is more robust, land is less expensive, and the cost of putting up these industrial structures is lower. They aren’t 20-story skyscrapers; these are one-story boxes. So, they are relatively affordable to put up—it’s more a question of the cost of the land and strategic location relative to major access and urban centers. In the coastal markets, there is also a very similar thesis around industrial properties. So you don’t get the same rent growth in the Midwest that you would see in Northern New Jersey.
The other key distinction is that industrial is a broad term that doesn’t just encompass logistics and distribution centers. There are many pockets of industrial properties, including manufacturing facilities, varied types of storage, and other specialized uses. Currently, everyone is chasing the coastal logistics centers.
Q: Have lenders become more stringent or more relaxed as demand for industrial has increased?
MB: Generally speaking, if we were marketing an industrial property two or three years ago, it would contain private companies or non-credit tenants with short-term leases. Many of these tenants are on three- or five-year leases and have been in place for 20 years. Convincing lenders that they would continuously renew and that they didn’t need to worry about their credit was a difficult task, so those deals would require recourse or heavy structure around lease rolls.
Today, lenders are confident that if any given tenant blows out, a replacement tenant is available. Every lease expiration is a value-add opportunity, because if the tenants are on three-to-five-year leases, those leases were signed at a point in time when rents were lower. This means the underwriting rigors and covenants that lenders require have loosened considerably, and pricing has tightened substantially. Bridge loan pricing on industrial is as low as 3.00% to 3.75%. Six months ago, I’d say that was 4.50% for vacant spec industrial, and 12 to 18 months ago it was significantly more expensive.
Over the past 18 months, coastal markets—New York, L.A., San Francisco, D.C., Boston—have been adversely impacted by COVID in all sectors, including multifamily. Industrial distribution was the only asset class that investors could play in, at least in markets they understood geographically. That is the only area where there was rent growth, that was the only area where there were no issues with collections.
SG: Deals are assessed case by case and there is no such thing as one size fits all, no lender that bids everything. Especially because industrial product varies so greatly across markets and sub-property type; whether it’s flex, distribution, manufacturing, last mile, etc. Each lender is going to pursue what fits their mandate and risk-return profile, but we have also observed that the typical strike zone for each lender has expanded dramatically this cycle and simultaneously pricing has compressed. Initially, that trend gained momentum over the last several years due to the continued growth of e-commerce providers’ and distribution needs, and that momentum then increased exponentially once the pandemic began.
Q: Just as transactions are not one size fits all, does that also apply to the types of financing solutions that you steer clients toward?
SG: No question. On some deals, you can go out to a very small subset of lenders, and on others, your outreach must be extremely broad. But no matter what you do, you have to bring different options to the table. Even if an operator thinks they want a very low-leverage bank deal, we’re doing them a disservice by not bringing back a higher-leverage debt fund option to better educate them on what is available. Conversely, someone may be convinced they want higher leverage, but we can say, “Here are a variety of financing options for the property; just to show you, we brought back a bank bid, which is lower leverage, but you’ll notice it’s 100 basis points tighter.” It is surprising how often people pivot to something that they didn’t think was available or that they weren’t interested in until they see it in front of them and then realize that it may be a more favorable capital solution or allow them to achieve different objectives.
MB: We structure and negotiate financing depending on the client’s business plan. Some clients are buying existing occupied properties and clipping their coupon for 10 years. Other buyers are looking to buy vacant properties, lease them up in 12 months, and sell them. Some buyers have syndicated high-net-worth capital, while some use their own money. There is often a trade-off between pricing and proceeds, recourse and non-recourse. But generally speaking, the most important thing is understanding the profile of the buyer: what their business plan is, what their hold period is, etc. We advise and tailor the financing around that.
There is no industrial deal that can’t get done in the market today. Even the specialized uses will get done, and even sale-leasebacks with private companies with challenging financials can get done. We have clients buying at 7.00% and 8.00% cap rates and financing them at 3.50%, generating tremendous cash-on-cash returns.
Q: Are you hearing about concerns or pain points that borrowers keep bringing up, especially as the market becomes more competitive?
MB: Acquisitions are definitely competitive, and a lot of industrial properties require environmental diligence. With respect to other asset classes out there—retail, office, multifamily—environmental is usually just a checked box. With industrial, it can be much more than that.
One issue is prior use; these little industrial submarkets in urban areas have historically been areas of environmental contamination. Sellers have tremendous demand for their properties; they’re dictating contract terms that are very aggressive—but environmental diligence on these assets is critical. Sometimes people are going hard without diligence, sometimes the diligence is murky, but for the most part, professional industrial buyers know what they’re dealing with and how to handle it. It’s the folks who are first deciding to get into the industrial space who might be out of their league on environmental diligence.
SG: The hurdles in the industrial space are far smaller than it feels like they are in any other asset class, other than maybe multifamily. You always have the typical transaction hurdles, whatever they may be. But if you have a retail center, an office building, and an industrial product all with very similar near-term tenant rollover situations, you’re going to see more lender forgiveness and attempts to solve the problem in the least painful way possible for an industrial property.
People are not just being blindly optimistic about industrial; there’s a reason for it, because the e-commerce boom already had tremendous momentum before the pandemic hit. The “do everything from home environment” brought on by quarantining and the pandemic poured more fuel on the fire, but we’re still nowhere near full utilization of what’s going to happen with online shopping, the need for last-mile distribution, the need for third-party logistics space, and the need for production facilities and storage for these products.
Q: We’ve heard a lot about last-mile facilities within city limits. Is this a highly sought-after asset class, and what is the underwriting like on those types of properties?
MB: The rent growth is enormous. Amazon has leased several sites in industrial pockets of the Bronx, Queens, and Brooklyn, and paid upwards of $28 per square foot to lease properties that previously would have rented for $10 to $12 per square foot. Every last-mile site seems to get gobbled up, but there are not that many tenants in the market. Some of Amazon’s competitors—UPS, FedEx, even Target and Walmart—are not as aggressively taking on space the way Amazon is. Target and Walmart may view their existing real estate as quasi-distribution centers, as opposed to Amazon, which doesn’t have the brick-and-mortar presence already embedded in communities.
It’s going to be very interesting to see how it plays out and evolves. You’re going to see a lot of repurposing of retail real estate—the real estate exists, it’s just a question of the use.
SG: “Last mile” has become a buzzword this cycle that looks great in committee books but is often very loosely defined and used. It can describe a one million square foot 3PL (Third Party Logistics) site offering pick and pack services directly off a major freeway exit within an hour drive of two million residents. It can also mean an eighty thousand square foot, final-stop distribution center within a small city’s limits that services only residents within a few square miles. The idea behind last mile that both lenders and owners love, and the reason it is so sought after, is that it defines a site that is mission-critical to tenants in what is typically a supply-constrained market. Those two forces generally yield good real estate. Capital markets will then dictate where the economics shake out for that real estate (and loan). But limited supply coupled with users that need to distribute product quickly to consumers makes for what most consider a far lower-risk investment than many alternatives.