Industrial real estate per se is a favored asset class. However, for tenants and investors alike, there are clear lines of demarcation between desirable and undesirable product. A pair of new reports from CBRE Econometric Advisors (CBRE EA) and Newmark illustrates these distinctions. 

“Industrial supply growth has lagged significantly behind robust demand for several years due to factors such as lengthy permitting and zoning processes, site preparation requirements and others,” according to a CBRE EA brief. “As a result, the industrial footprint is aging – three-quarters of the total inventory is more than 20 years old – and often falls short of modern tenant needs for ceiling height, loading dock capacity and other amenities.” 

Although in recent years the combination of extraordinary tenant demand and tight availability concealed these shortcomings, “now the picture is changing,” the brief states. Demand has receded from historic highs while availability has ticked up from the bottom it reached in the second quarter of 2022. At the same time, more than 600 million square feet of new industrial space is under construction. 
 
The result? “Tenants whose leases are rolling over will have abundant, amenity-laden space options, further disadvantaging older, less functional properties.” 

On the subject of lease rollover, it’s no secret that properties with shorter weighted average lease terms (WALT) and below-market rents offer highly attractive mark-to-market potential. However, the benefit has been difficult to quantify in comparison to assets with longer terms in place. A new report from Newmark’s Lisa DeNight and David Bitner starts the conversation around shorter WALTs and investment. 

Key takeaways from the report include the following:  

• In 2022, an observed cap rate delta of 70 basis points between short- and long-term WALT assets implied a 17.5% premium for shorter WALT assets, on average. 

• Industrial sales transactions demonstrated that assets with less than three years left of WALT achieved an average 55% price per square foot, and cap rates appx 70 basis points lower compared to assets with nearly a decade or more left. 

• Assets with shorter WALTs are attractive investment opportunities due how significantly below-market in-place rents are. New owners will have the opportunity to reset rents to market rate when leases roll in the near future.  

• Nationally, the pace of market rent growth has surpassed the rate of rent increases in leases signed years ago; a hypothetical six-year lease signed in 2016 with 2.5% annual escalations would be, on average, 36% below market rent today.  

• Deal metrics shifted in 2022’s second half as the cost of debt rapidly increased. Overall, monthly industrial capital markets activity has experienced double-digit year-over-year declines since August 2022, affecting assets with shorter and longer WALTs alike. While cap rates have risen and pricing has declined across industrial investment asset profiles, there is still an observed premium on short-term WALT assets over long-term WALT.   

• Although near-term WALT assets carry potential for short-term negative leverage, the prospect of securing greater cash flow and refinancing at a lower rate in the future will likely keep this profile of asset competitive in 2023. 

“As lenders become more conservative in the near term, market-specific supply-and-demand fundamentals will become ever more important for investors exploring short-term WALT – or any other – industrial investment opportunity,” write DeNight and Bitner.

For more insights into the industrial market, be sure to register for Connect Industrial Midwest 2023, scheduled for Feb. 22 at Joe’s Live in Rosemont, IL.