Why Now?

Tenant demand for industrial space has been fueled by the rise of e-commerce, a trend further accelerated by the pandemic. Ten years ago, e-commerce accounted for ~5% of total retail sales. Today, online sales account for ~20% of all retail sales (U.S. Department of Commerce Data, Nov 2021) and that figure continues to increase each year. In fact, 2021 saw a 45% increase in e-commerce sales while brick and mortar retail sales grew by only 17%. As society continues to adopt online shopping, e-commerce companies will need more and more industrial space.

How much more space is needed? CBRE research estimates that every $1 billion in incremental e-commerce sales generates 1.25 million square feet of new demand for warehouse space. Given the rapid growth of e-commerce, it makes sense that a year-over-year comparison of leasing volumes looks like this:

Industrial Demand > Industrial Supply

Surely, tenant demand for industrial real estate must mean supply has kept up with the demand, right? Actually, no. In fact, there has been positive net absorption for more than 44 straight quarters. That means more space has been leased than delivered for more than 10 straight years! 

Why? One of the primary reasons for limited supply is due to highly regulated zoning and land use provisions. Despite the high demand, strict local regulations have created a natural barrier to entry. Many municipalities across the country have limits on the location, quantity, and pace of new development. Essentially, NIMBY (Not In My Backyard) has protected the industrial real estate sector from overbuilding.

Low Vacancy = High Rent Growth

Since demand continues to surpass supply, just how low are industrial vacancy rates? Simply put, the answer is – low. According to CBRE’s Q2 2021 Industrial & Logistics Figures report, the national vacancy rate is down to 4.0%, and the rates in primary industrial markets is even lower – Inland Empire 1.4%, Los Angeles 1.2%, Boston 2.5%, Central New Jersey 2.1%, and Chicago 2.1%.

These low vacancy rates have put upward pressure on rental rates since tenants are continuously competing for limited space availability. In fact, rents have experienced positive year-over-year growth for 40 straight quarters. In the past year alone (as of Q2 2021), national year-over-year rent growth for industrial real estate increased 9.8%, an acceleration from previous quarters.

How do these metrics translate to profits?

Well, no one is profiting more than developers since the development spread (development yield minus stabilized cap rate) is wider than normal right now.

What is a development yield? This figure measures the annual return a developer expects to earn once a project is leased (“stabilized”), and is calculated by dividing a project’s expected net operating income by the project’s cost. What is a stabilized cap rate? This figure is the yield a buyer could expect to earn if they buy a stabilized project for a given price. The spread between these two rates is the main way a developer earns profit when selling a project. The larger the spread, the more beneficial to the developer (seller). So what does the spread look like today for industrial real estate?

Let’s first look at development yields. The denominator (cost) has increased dramatically. Limited land availability, supply chain issues, and labor shortages have caused the price of land, materials, and labor to all climb. Inflation is real.

As we established earlier, the numerator (net operating income) has been increasing at record rates thanks to record rent growth. So much so, that even with rising costs, development yields are generally in line with the trailing 5-year average of ~6%.

And how about cap rates? These are far lower than the trailing 5-year average. Based on the chart below, in Q1 2016, buyers were willing to receive just over a 5% yield for a stabilized industrial project. Fast forward to Q3 2021 – buyers are now willing to receive just over a 3% yield. In other words, buyers of stabilized industrial real estate are now willing to pay much more for the same income stream, resulting in a seller’s market for industrial developers.

Conclusion

Thanks to the booming e-commerce industry, we are seeing record high rents and low vacancies with every passing quarter. This trend has made industrial real estate one of the most in-demand property types. So, that only leaves one question: what’s the best way to invest in the asset class today?

Investors who want to earn current income should focus on investing in a stabilized project or fund. However, be aware that cap rates are at all-time lows, so stabilized investments don’t provide the same annual yield for the same level of risk that they used to generate just a few years ago.

For investors willing to defer current income for a larger potential future return, an investment in a development project or fund could be the best way to approach industrial real estate. Tenant demand continues to significantly outpace new supply, resulting in a favorable environment for leasing a new development project. And once a development is leased, new buyers are paying record low cap rates for stabilized buildings, resulting in record high pricing for developers selling projects.

How do the top and bottom performers compare?

Smaller funds in the top quartile generated a median net IRR of 15.8%, outperforming the 12.4% and 12.0% median net IRRs produced by mid-sized and large funds, respectively. No one year buoyed the overall median net returns either. Top quartile small funds outperformed top quartile larger funds in 8 of the 10 vintages examined.

Even the worst of the smaller funds outperformed the worst of the larger funds. Smaller funds in the bottom quartile earned a medium net IRR of 6.2%, beating the 2.8% return generated by both mid-sized and larger bottom quartile funds.

Do smaller funds mean more risk?

Generally speaking, yes. Smaller funds are more volatile than larger funds. While these funds typically demonstrate higher net IRRs than larger funds, the returns typically have a higher standard deviation around them.

Is the risk worth the reward?

According to Preqin data, the best risk/return profile is offered by smaller funds. The higher variability around returns is worth it to generate the highest absolute returns.

If larger funds underperform smaller funds, why do they attract the most capital?

Most capital invested in private real estate funds comes from institutional investors (pension plans, endowments, sovereign wealth funds) who often allocate between $100 million and $1 billion per fund. These institutional investors usually have internal governors preventing them from being less than 40% of the capital in any one fund. This means they are not even able to consider most funds that are smaller than $500 million. This is one primary reason why large funds attract more capital than smaller funds – big begets big.

Secondly, it is more convenient to invest in larger funds than smaller funds. It takes more work to conduct due diligence on a smaller fund manager because their track records are usually more limited than larger fund managers. Often, the institutional investment teams do not view the extra work to be worth it. After all, no one gets fired for recommending an investment in a large, trusted fund that other institutions are investing in as well.

The advantage for private investors.

Private investors do not have rules preventing them from investing in certain funds. Because of this, they have a much larger investment universe. After all, there are hundreds of small funds in the United States and only a small handful of large funds.

And private investors do not have to worry about losing their job for making a less “safe” investment decision. Private investors can take calculated risks to grow their own wealth instead of just investing in what is most convenient.

How can Uncommon Capital help?

We realize it is difficult for private investors to access differentiated, smaller funds, let alone determine which ones are better than others. Our team of industry experts has worked at private real estate firms for nearly a decade. We have deep relationships with talented fund managers across the country, resulting in unrivaled access that we share with our community of private investors.

We are also skilled at analyzing real estate offerings, allowing us to curate opportunities with strong risk-return profiles that are structured fairly and transparently for our community.