Soaring Demand Drives US Industrial Market to New Heights

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1 Soaring Demand Drives US Industrial Market to New Heights Capitas (DIFC) Limited I June Issue: 2017 THIS ISSUE COVERS: The Amazon Factor a seismic shift in the way people shop Industrial real estate hitting new highs as the US economy continues to grow The continued chase for cash on cash returns and what it means in terms of asset quality Long-term NNN leases to single tenants as a secure investment A Growing Economy, Coupled with a Transformation from Traditional Retail to E-commerce, Has Pushed the Industrial Sector to New Highs in Terms of Occupancy and Rental Rates Although the US Economy is growing at a slower pace, 0.7% as of Q , it continues to grow, outpacing the UK and much of Europe US population reaches a milestone 325 million people as of May 2017, growing at 0.8% annually 1 Evolving demand requirements for industrial space in e-commerce and traditional platforms continue to require space to meet consumer demand and requirements for goods to be produced, stored and shipped Tenants are demanding more modern buildings and higher clear heights, a requirement coming from industrial users that store goods for retail / e- commerce purposes with a focus on cubic footage US industrial market reaches supply and demand equilibrium - CBRE Due to the increased competition in industrial real estate, average US industrial cap rates have compressed to 4.9%, and total investment into industrial real estate has dropped $14.4 billion (-31.1%) from 2015 to With record low vacancies of 4.8%, and the largest amount of supply coming on board since 2008, Q projections show 44.9 million (nearly a 0.4% increase this quarter) square feet 2 of new space is coming to market; there is opportunity for investors but considerations need to be made regarding asset quality, location and strength of tenant US Industrial Snapshot (JLL) 1 US Bureau of Economic Analysis 2 JLL Q42016 Industrial Investment Outlook 1 P a g e

2 THE AMAZON FACTOR Demand for Real Estate is Shifting from Retail Space to Industrial Due to The E-commerce Boom In the last decade, the US retail market has suffered from what author William Wise dubbed the Amazon Factor, which details the demise of retail giving way to e- commerce, led by Amazon. For example, 20 years ago, Borders Bookstore was a 1.6-billion-dollar retail giant, yet dissolved in 2011 as consumers decided to seek online resources to meet buyer needs. Traditional retail space is converting to serve last-mile delivery options as infill industrial becomes more valuable. Not to mention, industrial space is becoming more sophisticated and tenants may require modern cross-docking capabilities and ever increasing clear heights (36 is the new 24 ). In the year 2000 about 20% of Americans shopped online. 3 Now that number is up to 80%. Shopping online consists of everything from electronics to clothes and even groceries and other day to day items. 8.5% of US shopping is online, growing 16% per year. This shift in the way people shop changes the traditional need for retail to industrial space. Additionally, driving this boom for industrial real estate were logistics companies. For example, UPS and Fed EX saw a business boom, with more shipments than ever and requirements for more new and big facilities. Nearly 20% of all leasing activity for big box transactions (over 500,000 square feet) from 2010 to 2016 centered around e- commerce - JLL States added 2.2 billion jobs and achieved real economic growth as seen by the increase of GDP by 2.1% 43. In April of 2017, the unemployment numbers fell to 4.4%, better than the predicted level of 4.6%. More jobs mean more production and consumption, which leads to further demand for industrial space for both traditional and e- commerce uses. According to JLL 2, 2015 and 2016 rental rates for industrial warehouse space grew by 5.4% and 8.7%, respectively. 70% of primary markets achieved 5% or higher rental rate growth, and 95% of all markets saw a rise in rental rates in The shift allows investors to focus on increased cash flow through rental income and higher credit grade tenants, increasing cap rate stability. Industrials will potentially continue to benefit from the rise in ecommerce activities, especially in noncore markets Deloitte 54 New demand drives rental growth. New development projects are coming on board in most major markets to fill this demand. Demand increases have lowered vacancy to 17 year lows, averaging 5.6% in Q4 2016, with some infill gateway markets below 1% vacancy for Class A industrial. Leases to new to market tenants, such as new e-commerce groups or last-mile shipping companies, grew by 6.7% (JLL) in Q4 of 2016, supporting higher demand rather than shifting leases. Currently, there is million square feet of industrial space in the pipeline, which historically has not kept up with demand, but is now at a balance. 65 GROWTH IN THE US ECONOMY Job Growth and Consumer Demand is Creating Need for More Industrial Real Estate Low unemployment rates and increased consumer confidence will continue to drive GDP. The latter half of 2016 saw triple the expansion rate in the US, despite international volatility in both Asia and Europe. The United 3 Wall Street Journal June CBRE Q US & Logistics Marketview 5 Deloitte Commercial Real Estate Outlook JLL United States Industrial Outlook Q P a g e

3 CHASE FOR CASH ON CASH RETURNS AND INDUSTRIAL ASSET QUALITY VS. RETURNS Geographical Location and Asset Quality Set Alongside Tenancy Profile are Key Drivers for Cap Rates Similar to other asset classes, the typical factors such as location, quality and tenancy covenant strength, drive cap rate. The defining characteristic in industrial real estate, especially in recent years, has been the spread in cap rates between Class A newly built tilt-up industrial real estate and Class B/C sheds. The cap rate spread can be as high as 300 bps, with top level assets going for 4% cap rates and lower quality 7% or even higher. There is an opportunity in B/C grade space for higher cash on cash returns but extensive due-diligence and focus needs to be made on the exit viability of the asset at the end of the lease does the asset still have value? Key characteristics of a quality industrial investment: Long WAULT (weighted average unutilized lease term) with 5-20 years remaining to a strong tenant Mission critical facilities that the company relies on and will likely stay in long-term Infill locations areas where replacing the asset is difficult Proper amenities such as dock high doors, high clear heights, quality construction, ample parking, etc. The concern is for investors chasing yield and/or cash on cash returns. All industrial real estate is not created equal. Many investors, especially from the GCC, are looking at location and tenancy profile in isolation of asset quality, tempted by the current cash on cash. There are instances of large single tenanted buildings or portfolios with long-term lease contracts and high cash flows but with no long-term value once the lease is over. Upon lease expiration, considerable tenant improvement or expensive rehabilitation of the asset will likely be required. In this case, the cash on cash may be over 8% but the exit value of the asset could be low if future asset usability is limited. JLL has predicted that although US 10 year treasuries have increased nearly 100 bps, further compression of industrial cap rates (lower cap rates mean a higher multiplier of income resulting in a higher asset price) could likely occur over the next 18 months. This is due to healthy spreads existing between the cost of debt and the stable income stream from a NNN leased industrial asset. ource: Worldbank and JL 3 P a g e

4 Class A cap rates continue to support stabilized ranges despite recent escalation of debt: Low vacancies and high rental growth continue to fuel stable, compressed cap rates. Despite volatility and rising interest rates in 2016, average cap rates held steady at 4.9%. 2 As shown above, cap rates for prime industrial space vary by location across the country with infill areas commanding the highest values (lowest cap rates). Below, a chart shows growing rental rates for nationwide industrial real estate since the financial crisis. 2 Fundamentals fuel rental growth: 4 P a g e

5 INVESTMENT CAPITAL OFF RECORD HIGHS Investment Volume for Industrial is Still High, but Down from Last Year s Record Total Investors that want high returns are going to have to assume risk Assets with credit tenants in prime locations exist, but at unprecedented low cap rates of 4-5% There are risk adjusted opportunities, such as B/C industrial, with strong fundamentals but short term leases. These assets trade at higher cap rates and have the upside potential to extend the lease or find a new long-term tenant Additionally, there is the potential for blended portfolios with shorter lease terms and core assets An overlooked industrial class is private companies with strong credit in a solid asset that has high risk adjusted yields These opportunities exist but are difficult to find as they are between the seller advantage (core properties) and the buyer advantage (non-credit tenanted) market and are less publicly visible CONCLUSION Industrial Real Estate is at New Highs but Fundamentals are Relatively Sound Demands for industrial space are at unprecedented highs due to a strong US economy, new demand from e- commerce, and e-commerce related logistics uses. Supply is near all-time highs with significant space coming to market. Vacancies in industrial real estate are at 17 year lows with a nationwide occupancy over 95% Rental growth for industrial has been at nationwide highs of 8.7% per year Cap rates compressed to 4.9% but total industrial investment in 2016 was substantially ($14.4 Billion / 31%) lower than There is tremendous focus on the Amazon Factor and core e-commerce tenants. But there is another important factor that is often overlooked. Assets with strong, non-credit tenants in desirable locations with short-term leases. With proper due-diligence into the quality of the asset and the area, there is opportunity for both high yield and upside. Renewing the existing tenant for long-term or leasing the property to one of these coveted e- commerce tenants provides strong exit potential following a period of stable cashflow. Opportunities exist for investors in the US industrial space if considerations are made not only to the location and quality of the asset and tenant, but also to the exit considerations and long-term value of the asset itself. Contact Us Source: JLL Research, Real Capital Analytics chart of transactions larger than $5 million Capitas (DIFC) Limited Regulated by the DFSA Office 10, Level 3, Gate Village 10 Dubai, United Arab Emirates info@capitas.me T: Web: Disclaimer: This report has been prepared solely for information purposes and does not necessarily purport to be a complete analysis of the topics discussed. It has been based on sources we believe to be reliable, but we have not independently verified those sources and we do not guarantee that the information in the report is accurate or complete. Any views expressed in the report reflect our judgment at this date and are subject to change without notice. Statements that are forward looking involve known and unknown risks and uncertainties that may cause future realities to be materially different from those implied by such forward-looking statements. Advice we give to clients in particular situations may differ from the views expressed in this report. No investment or other business decisions should be made based solely on the views expressed in this report. 5 P a g e