Thoughts on an industrial property purchase?

Question

Greetings all. Long time reader, first time poster in this forum. I ran this by the "general" forum, but wanted to put this over here to maybe get a different set of eyes on it...I'm considering a possible industrial property that's for sale. I wanted to get some feedback on this deal. The specs:

-24,000+ sq ft industrial space on about 1 1/2 acres. The property itself is in good condition; new roof 3 yrs ago, 3 phase elec, solid HVAC, 16ft drive thru, 2 roll ups, 2 docks. needs no current upgrades(technically, everything except roof, structure and parking lot is tenants responsibility).

-triple net lease. 6 yrs left on current lease.

-tenant has a solid reputation. multiple locations throughout the midwest. i like the business, i like the long term prospects for the industry.

-depending on sale price, cap rate will be in the 8.8%-9.3% range(rent increases each year). Tenant paying under FMV; my agent thinks this could draw rent to equal 10-11% cap rate in 2024. It will probably sell in the $3.50-3.85/sq ft range.

CONS:

- the location is not a bad neighborhood per se, but it is a solidly industrial neighborhood. There are two buildings for sale in close proximity; one with tenants, one without. I can't say with complete confidence that I could put a tenant in it in 2024 if need be.

-It's sat on the market for almost a year. Either there's been offers and the seller doesn't wanna play ball, or there's something on this property I'm missing, cause good commercial deals don't sit very long right now in my market. I was told by the seller's agent that the seller "doesn't care if he sells it or not", because it's a solid earner and zero maintenance.

Any thoughts, one way or the other? Anything I'm not considering? Thanks.

Taylor Hazard · Answer

@Rj Kro Its a hard question to evaluate without knowing a little more about the deal specifics. When evaluating industrial properties its important to consider their utility / usability for the likely tenant pool overall. For example I would want to know more about the building itself such as clear height, construction type, age of construction, is it sprinkled, how much office space? The 6 year lease is great but what happens if the tenant vacates at the end of the term? What are your prospects for re-leasing the building?

For example I would consider anything with less than 20' clear height functionally obsolete as industrial buildings are growing in height every year to accommodate new high bay distribution strategies. 24'+ is ideal. Similarly anything more than 10% office and the building may be considered "specialized" or "flex" by the tenant pool, which again handicaps you when it comes time to release.

regarding the lease itself, 6 year term is great from the perspective of a secured income stream but you need to consider where we are in the cycle. This differs market-to-market and I would defer to your local broker for accurate information but most people would tell you where in "the 7th inning stretch" at best which means there is a good chance we are in a down market in 6 years. You will have to make a decision with your broker about the true prospects of both releasing AND raising rents at the end of the term; if the market corrects and we see vacancy rates rise you may need to reduce rent just to keep the existing tenant in place. Additionally make sure you account for commissions in 6 years. Chances are, even in a renewal, your going to be paying leasing commissions of 3 - 8%. Personally I would not count the ability to push rents in 6 years, but again I dont know Ohio in detail and would defer to your agent.

Same story for the cap rate, this varies market-to-market and depends wholly on the building characteristics and credit of the tenant. You said they are a regional business with multiple locations? I would take that to mean 5-15 across multiple states; in my opinion 8-9% cap is low. Class A credit in primary locations (coastal cities, Denver, Atlanta, Chicago etc.) is going for 4-5% cap but I have seen Class A credit in secondary / tertiary submarkets around Seattle (one of the hottest industrial investment markets in the world) going for an 8% cap. Again you and your broker will know Ohio better than me but from a macro perspective my knee jerk reaction is you should push for 9-10%.

Lastly you said the building has sat for a year, major red flag in such a hot market. For this fact alone I your default has to be there is unknown hair on the deal. Has it been under contract before? If so the problem could range from unknown deferred maintenance on the property to unfavorable language in the lease; if it has not been UC in the 12 months its been listed its likely because of any of the above issues or a combination thereof. The tenant credit isnt as strong as you think coupled with a subprime location and functional obsolescence of the building.

Bit of a ramble with no definitive answer, feel free to respond or PM me more details if you want to continue the convo.

Hope this helps,

Robert Ellis · Answer

With any asset class, a proper investment analysis spread sheet is the best place to start.  Gather all the information, put the analysis together and then your able to see what the real costs and returns are.  Industrial is one of the better asset classes to invest in at the moment here in Columbus.

Rj Kro · Answer

Thanks Taylor! I appreciate it. As best I can tell, the immediate location within Columbus looks promising. Attached is the absorption numbers; the property would be considered more flex than industrial, as I'm told. A major player here just announced a $34M investment in the region(southeast columbus). It's near Rickenbacker air force, and has some major companies in the region with massive plants; Coke, Schottenstein's, a few others I'm forgetting.

Yes, carrying costs for 2 years is not a problem. My leverage on it will be extremely minimal;  one years' income would currently cover 4 years of carrying costs, and barring something like an atom bomb, I see no reason I wouldn't go into year 7 with at least 2 years income stashed.

Since this isn't my "bread and butter" type of work, I just don't have the years under my belt of following the industrial market here. Any hunches either way would be great. If you don't mind, I'd love to

know what you think of this chart, and how SE region falls on your eyes. Thanks!!!

Taylor Hazard · Answer

Unfortunately I just dont know enough about the deal and your market to comment on lease up probabilities etc. Without knowing what is driving the industrial market in OH, how the building is positioned within its submarket, likely tenant pool etc. it would be inappropriate for me to comment on lease up probabilities.

It sounds like you have all the info you need to make a decision, digest and interpret your agents advice and move forward or back out.

I will say that 12-24 months sounds like a long time to release space regardless of market. Can you cover the carry costs for 2 years? Thats a long time, when is the tenants notification period for renewal (e.g. 120 days)? As the LL you need to be hyper aware of this benchmark, if tenant doesn't renew then start marketing the property for lease IMMEDIATELY.

Good luck.

Rj Kro · Answer

Hey guys, first off, THANK you. Your thoughts are incredibly helpful! Kudos to the knowledge pool here.

Taylor-sorry if I portrayed 2 stories; I didn't mean to say he didn't want to sell PERIOD-he put it on the market-I meant to say that I was told he "is fine if it doesn't sell"; I took this to mean that at less than X below list price, he'll just keep the prop. I have no idea what X is.

My only real question I have on this property is this: if/when the lease expires, what is the probability that I either A) couldn't sell the prop(even at a haircut), or B) couldn't re-lease within 12-24 months. Is this a question you guys encounter on investments, and if so, how do you get as close to a solid answer as possible? Does it just come down to vetting the usage+location thoroughly? My agents are very helpful, but they seem to be reticent to weigh in on their opinions regarding this location. They LIKE the location, but I get the feeling I'm up against that invisible "you gotta make that decision" line with them, if that makes sense. :) Thanks again!

Taylor Hazard · Answer

So what is the actual clear height in the building? I.e. how hi can a tenant stack? if its 16' id run away, if its 24' your probably in good shape but be aware that buildings are getting taller and 24' will be considered outdated in the next 10 years. Block construction is solid (better than metal but not as desirable as concrete tilt), im assuming it was built in the 70's?

The single greatest attribute of the property is your ability to divide into to units. Lease rates and overall square footage in industrial properties are inversely related. I.e. the smaller the space the high price per square foot you can achieve (and thus increase the buildings return). Two tenants also helps you mitigate risk, should one leave you still have 50% of the building occupied which means your carry costs are only 50% of the NNN's and PITI. Two tenants also gives you more negotiating power in a renewal scenario. For example when the current tenant renews in 6 years they know (especially if they are represented) that the path of least resistance for you is to renew them, the threat of vacancy - particularly for a local owner - is daunting and tenants know it.

Again, when it comes to the "long term desirability of industrial buildings in this class" I would trust your broker as the answer is still very much a local one. But in general a 24' clear masonry building in good shape for its age and ability to add value through reverting to multi-tenant would be attractive to me and so long as your comfortable with the tenants credit, your return and ability to release it in 6 years if needed then go for it.

Regarding price im starting to hear two different stories: first he was unmotivated and doesn't want to sell, and now he wants $$$ to move to CA and start new projects? Also 16% increase over the last 2 years of the hottest industrial market this countries every seen is suspect, after commissions and closing costs he wont clear very much at all. Does he have debt on the property? This makes me think its sat for reasons unrelated to price, but if your comfortable with all the above and its location then tie it up and do your due diligence.

I agree with everything outlined by Joel.

Joel Owens · Answer

Being an industrial property I would want  a clean phase one. I would also want to make sure this is an absolute triple net lease and not a double net. Double net you need to watch out for landlord responsibilities in the lease such as utility lines, parking lot, roof,structure,etc. For example with parking lot annual snow removal can get expensive in a cold belt state. Also the roof and parking lots take a beating and tend to wear out faster from the cold,snow,etc.

For lease guarantor you would want the corporation as well as a personal guarantee on the lease. You would also want ongoing personal and business reporting updates to the landlord at least quarterly.

The company might have many locations as an example but set up a single entity LLC or just a few locations backing the lease. Companies like to do this in case a property or location is not performing they can bankrupt the remote entity and walk away. Without a personal guarantee you then have no leverage to negotiate an early termination buyout to hopefully cover your lost rent, leasing commissions, and future tenant improvements to land another tenant.

Net worth of guarantor and how easily it is to attach assets is key. If net worth is high but most of it is in retirement accounts then you can't generally touch it.

6 years is not a lot of time left on a NNN lease and is harder to finance. Often the lender will hit you with a lower amortization schedule and more down to reduce the loan balance outlay. That way when option period comes due and tenant leaves instead of renewing the lender could liquidate and be made whole on the loan. They do not want the dark value with no tenant value to be less than mortgage balance at end of the primary lease term.

You want to look at absorption  and comparable rents for industrial in the area to see how your property stacks up.

If you buy at a high cap rate you want to look at the option periods for the current tenant in the lease. Does it say market or a set amount? You might want to renegotiate the option and get the tenant to commit to another additional 5 or 10 year term today. That way you have 11 years or a 16 year primary term lease that might could be sold at a much lower cap rate years later when the industrial market cycle cap compresses. Additionally if there is not a guarantee in the lease and other items I mentioned it might be a good time to add them to the lease amendment.

What does the tenant get out of it? If the option period had a big rent jump spelled out maybe you reduce that amount of increase to entice the tenant to extend the lease today. I look at this on retail sometimes. If the option only goes up a buck a foot then there is not much negotiating room to sweeten the pot. If I am buying a higher cap rate on a shorter term lease and the option has a large rent jump to the tenant then I could have negotiating power with the tenant getting a lease extension.

If it's way under market I might want them out anyways. It's all situational.

No legal advice given.

Rj Kro · Answer

Thanks guys! Super helpful thoughts here. Glad to know I'm sniffing around in the right place!

A bit more details: Ronald, if "cash on cash" refers to this essentially being a play for ROI on capital, then yes, you are right. It would do some balancing in the context of my portfolio, to some degree; I've got a NNN lease expiring in Feb 2018, so this would provide some laddering of vacancy risk, of sorts. My other commercial prop is auto related; this is a different industry.

Taylor: a bit more about the prop: it is technically 16' clear height, but that is for the drive thru wall-the actual roof hieght is 24'. Block construction, sprinklers throughout, office space is ~7%. My agent said that the upside in regards to competition is that it'd be virtually impossible for someone to build a similar building for the same price now. Oh, I forgot to mention-the building is constructed symmetrically; at one point it was 2 12,000 sq ft units. It'd be pretty simple to convert back to 2 units in the future, if desired. You sound like you know a fair amount about industrial properties; how do the specs on this building sound to you? Do you have thoughts on the long term desirability of industrial buildings in this class?

The buyer purchased in April 2015 for $33.87/sq ft. He's trying to sell for $39.5/sq ft 2 years later. the narrative I'm told is that he wants to move back to California, and wants the liquidity for a project there. Generally, 12 months on the market would be a red flag for me. What if it's sat on the market cause the seller really just wants to have his cake and eat it too? (And what if I'm rationalizing away a red flag! :)

Cap rate: yes, I'd like to be in the 9-10% range, but what I'm seeing around here for ~10% cap rate props is shorter lease terms. This one is by no means a "home run" obviously, cause it'd be gone by now if so, but what i'm wondering is this: what if the right purchase price could make this an 8/10? How long am I willing to wait around for a home run deal? A year?

At some point, you gotta play with the properties that are on the market, obviously. That's my ultimate question I need answered-do I want to wait around for a possibly better prop to come on the market, and run the risk of losing a shot of trying to put a good deal together on this? Or am I ok with that?

Thanks for all the thoughts folks!

Ronald Rohde · Answer

If its a cash on cash return that is better than some other options, then I'd say put in an offer. You'll either discover the prior issues, or you can close in confidence. When a Seller doesn't care if he sells or not, its usually a pretty high price. You have to consider what you can do to increase NOI because otherwise you're probably paying a high(er) cap rate.

Depending on your other holdings and investments, try to ask how it fits into your portfolio, is it a hedge? geographic or industry? there is extra value to you there.

Thoughts on an industrial property purchase?

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