The real estate industry, since the covid time, has been suffering a lot. Investors struggle to find the right financing options and even the deals for their investments. This has presented a great challenge for maintaining the portfolio condition and for making a profit from it. It is important to analyse the market conditions during such a tough situation. After all, every part of real estate now sees similar situations that are causing trouble for all.
Industrial real estate is a favourite of investors. But now it has started to experience cracks in those segments, which was previously considered risk-free investment sector. The heightened interest rate and the economic uncertainty in the banking industry have greatly impacted the CRE industry across the board. There is a tightening of the credit, which has made it extremely tough for industries to acquire financing. In fact, despite its performance over the last few years, the sector has not remained unaffected. There are challenges that are making things difficult.
Understanding the market condition during this tough scenario is important to know what steps can be taken for better investment opportunities. The guide will help you understand things better.
If the reports are to be believed, the interest rate and manipulation since the last year’s beginning have taken off. It has negatively impacted the deal financing. Before the condition in 2022, the investors could borrow at the 3.0% rate and then buy it at the 3.5% cap rate. This improved cash flow through the rent growth. The research data from the real estate firm MSCI shows a great change in the investment sales volume as there is an increase in the interest rate. Also, there has been an initial drop-in activity during the start of the covid. The industrial sales volume began to rise in the latter month of 2021. It eventually exceeded the 2019 sales level by almost three times. There was a total sale of about $179 billion. In fact, the sales volume continues to increase in double digits year over year. During the first two quarters of 2022, the sales volume continued to rise. It reached about $42 billion in the second quarter.
However, since the last three quarters, the industrial sales volume has dropped significantly. In the first quarter of 2023, there was a decline of about 52% year over. Here it came to about $19.6 billion, along with a steep drop in both entity-level transactions and portfolio.
The changing landscape
In the current situation, besides the higher interest rate and inflammatory pressure, there are various new factors that negatively impact industrial investment sale activity. A post-pandemic slowdown in online shopping is causing a decline in the demand for warehouse space. There has been a 40.4% quarter-over-quarter drop in the absorption level. It is a lot higher than the historical average of a 5% to 10% decline for that period.
Also, it is noted that a record of $138 million sq. ft of new industrial space was delivered during the first quarter of 2023, and more are coming online later this year. This happens when the demand for industrial facilities normalizes after the pandemic, and the markets are likely to experience increased vacancy levels and better availability.
Further, it is noted that the softening of the sector can be temporary. New construction starts have already dropped by 38% year over year. During the first quarter, about 70% of banks tightened their lending conditions for commercial construction loans. Thus, this has limited the construction start.
Although the demand may not be as what was expected, it is still incredibly strong related to the historical standards pre-set. The industry is returning back to the normal timelines for the assets. The conditions in the market have gone from newly constructed warehouses that were to be leased to warehouses being leased after 12, 16, or 18 months of completion. The vacancies are not surprising but are happening in the market.
Now, one cannot fully understand the changing market landscape. But it is important to pay attention to it so that one does not experience any extensive loss.
A change in strategy
The declining construction start and the positive absorption no doubt continues to inspire investment in the industrial sector, but the current market shows a major decline in demand. It has caused a great shift in the investment strategy. Most of the investors, especially those new to the sector, have shifted their focus from large assets with great investment grades and long-term leases to multi-tenant facilities. The idea behind this shift is that the assets will make it easier to lease and generate better returns as they can raise rents.
The competition for such buildings is quite strong, especially for the facilities in prime locations. The assets are now traded at a fairly Low cap rate while the cap rates continue to increase by 100 basis points on average for other types of industrial assets located in the core market. It has even gone up more in the secondary markets.
As per McCall, the industrial cap rates across the board have moved up by about 75 to 100 basis points from the low level starting in 2022. Herein the higher interest rates are forcing the investors to bring in more equity into the transaction.
MDH partners, during the first quarter, acquired a large warehouse in Fort Worth. Besides, they also have a couple of other similar size deals in the work. But they didn’t acquire any assets in the previous 6-month window. This shows investment approach of the company remains conservative. They are now more focused on investing in deals where they can see long-term cash flow. It is just clear that the investment strategy realized in the short-term the least turnover for growing the rents that could have the opposite effect in a market where the demand for space is decreasing and the vacancy rates are increasing.
He added that the pandemic was surely a once-in-a-lifetime situation that has boosted online shopping and the industrial space demand. This has caused great disturbance for the investments in industrial real estate that increase the prices to a great extent. As a result, he is now avoiding the auctions where they are about 30 groups beating on one asset. After all, the winner always pays too much for the property.
Small goes ahead to mention that along with the potential resources on the horizon, the landing standards have changed greatly. There are tighter rules now. This has resulted in a decline in institutional capital available for new investments. While the higher value of the real estate related to the bonds has made the institutions over-allocated to the sector. He even expects this will make it extremely difficult for industrial investors to raise new capital. The acquisition policy of both GTIS and MDH are being made out for the existing fund vehicles. But McCall noted they were able to raise capital for Charlotte MSA. They got a very strong response from capital resources for raising the money in a few days.
The challenges of the industry are increasing. Besides, a tighter lending environment likely affects debt available to both the investors for acquiring the new assets and those in need of refinancing maturing debt. Thus, the developers are most likely to refund their construction loans at a higher interest rate with more equity as the banking institutions are now reducing the loan-to-value ratio from 60 to 65% to 50 to 55%. This can put the developers in trouble if they don’t have the capital ready to cover up the difference. Thus, it can cause great distress in the development community.
While the decisions are not materialized yet, there are already warning signs of it in some markets showing massive recent new development. For instance, in Savannah, the growing port and increase in international imports have caused zero vacancies. This sets off the development spree at a time when import traffic is low.
Further, Dallas experiences more industrial construction activities than any other market in the US. It saw an increase in industrial vacancy from the current 6%, especially in the case of larger buildings. However, the situation is not like that in Savannah because it has a much larger market.
Given the increase in the rents growth, McCall said the company would remain bullish on the industrial sector. They will try to stay active in the market place just not to the degree it was from 2021 to 2022. Acquiring today has become very location specific, and the company remains to be active on both the existing and development asset side. They are looking for more opportunities to create value in excess of spot cap rates.
The property fundamentals continue to support investment in this sector, especially those in the markets that continue to benefit from the supply chain routes or onshoring changes.
Getting financing during assistance now can be extremely difficult for investors. If you are facing difficulty, then you can consider connecting with Private Capital Investors to get assistance. They have got a good reputation. These experts will provide you with the top options available. Irrespective of the financing requirement, they will ensure you get the right deal. They will support you throughout the process and make things absolutely easy.