What is unit level profitability? What kind of tenant is best to pick for your industrial space? How do you add value to an industrial investment? What is happening with the industrial asset class during Covid? Neil Wahlgren answers a lot of our questions regarding this popular asset class.
What is unit level profitability?
If you had an opportunity to either buy a regional hardware supply store, where you were buying one location out of, say, 10, that came with full unit level financials, or to buy a building with a tenant like Home Depot, all other things being equal, what would you choose?
And most people would say, it’s a stronger tenant, they’re a billion dollar company, etc. But, with experience, you actually learn that Home Depot does not provide level financials for the building. So you may be buying one of their least profitable buildings, and you will never know as an investor. And what that means is, if Home Depot as a company ever runs into issues with chapter 11, or more likely, if they do some restructuring, or are looking at how do we grow? And how do we focus on profitability? The building that you purchased, still attended by them, may be one of the first that they shed, or are looking to vacate early. Now you can find yourself in an adversarial relationship with your tenant, in a tough spot where you’re finding yourself having to release that property at an early date. Whereas in the alternative scenario, where you have the, say, regional hardware supply store, if you know that the building you’re buying and is, for instance, their flagship building, the most profitable or one of the top 25% most profitable buildings. Even if that company does have to restructure or runs into issues, your building is likely going to be the last that gets affected, and ultimately gives you a greater security as an investor in terms of the strength of that lease, and reduces the likelihood of your tenant defaulting on that lease.
So the terminology unit level profitability is who the actual tenant is?
Unit level profitability refers to whether or not you have insight, as a landlord or as a real estate owner into the profitability of the particular location of the building that you’re buying. If your tenant has several locations, you are interested on how profitable is this store in this piece of real estate that I’m buying.
Let’s talk about the type of tenant that you have in industrial versus the real estate, the building itself, versus the location of the property? Can you elaborate how they differ, how do they work together in industrial, because it’s definitely very different than in retail and office.
There are several main considerations to look at. The way we approach seeking industrial investment, commercial real estate is we typically will start with a set of cap rate criteria. And as you and your listeners know, cap rate is a function of a lot of things, but it ultimately seeks to incorporate the amount of risk in the project. We’re almost exclusively buying in the Midwest corridor. And that allows us to usually try to find commercial real estate that’s priced between a seven and an 8.5 cap rate. With that cap rate, it’s going to incorporate a lot of things that you’re going to look at, such as what sort of risk premium am I paying for this part of the country. The California coast, and New York are going to have much lower cap rates, you’re going to have them in the twos, threes and fours sometimes, same with Los Angeles. In the Midwest, Texas, Iowa and Nebraska, you tend to have still strong cities, but they’re going to be secondary, tertiary cities that are going to trade at a higher cap rate and cashflow more. So if that’s your focus, which is why a lot of people buy operational real estate in the industrial sector, you have to seek those higher cap rates. Now, with that, you can find a mix of deals.
On one side, you might have a sub credit tenant. A sub credit tenant is going to have revenues between $10, 20, 30 million on the lower side, they will probably have a decent EBITDA margins, typically mid teens to high teens for the better margins. However, the overall sales revenue of that company is going to be smaller compared to larger national tenants, which tend to be at $90, 100 million or more. With that, you might accept a lower credit tenant, if it’s paired with an industrial building that’s in a very central market. For example, I would probably accept a lower credit tenant if it was in downtown Dallas or in the Dallas Fort Worth area, because I know that even if this tenant does default on the lease, I own good real estate in a great metro. I’m not going to have too much issue getting it re-tenanted, as long as the building is somewhat standard in its configuration.
On the opposite end of the spectrum, we have a much stronger tenant, perhaps investment grade, which means it’s typically over $100 million in revenue, strong EBITDA, sometimes a multi-location. However, those locations, in order to have the same cap rate, the same overall risk profile, I might trade lower, or less desired real estate for a stronger tenant. So I might be buying commercial real estate in a much more tertiary area, possibly 100 miles outside of Dallas, or one of these smaller towns. And that’s the trade off that you’re going to look for to get roughly the same amount of yields as an investor. So do I want a really strong tenant with marginal real estate? Or do I want great real estate with a marginal tenant? Those are the outward ends of the alternatives. Ideally, you’re able to get a decent tenant with decent real estate at the same time.
When you say that you are getting properties at let’s say, 8.5 cap rate in the Midwest, how do you add value to that property? Because you’re dealing with the seller, and they’re going to lease back the property. And it’s going to be a 15, 20 year lease. So how do you guys bring value besides that 8.5 cap?
Great question. There are two components of creating value with these investments.
1. The first is cash flow, and with that cash flow with that net lease structure, you have an expense free set of cash coming in to the ownership pool. With those we typically structure our deals to target 8% going to investors minimum on year one, and that’s going to increase year to year as rent bumps kick in. One of the nice things about these leases is typically they will have built in rent bumps. So without doing anything, you have typically one and a half to 2% increases in rent kicking in every year. And because there are no expenses, that rent is usually equal to the NOI of that property. Now imagine you have a static cap rate, I know for a fact my NOI is going to increase 2% a year. So that’s the first way that I’m creating value such that if I hold it for five years, I’ve seen roughly 10% increases in NOI. And now at the same cap rate I can sell and see a significant increase in value.
2. The second piece is paying down principal on the debt. You are able to acquire between 70 and 75% leverage on debt on the real estate. Most of our real estate debt comes from local lenders, or credit unions, they know both the tenant company and the area very well. And that’s even more important when you’re buying tertiary real estate, where the local lenders really believe in the companies, oftentimes those companies have been in place for 40, 50, 60 years, and you’re able to get more aggressive and better terms on the lending. We acquire fixed rate debt, fixed interest rate, usually in the low fours or high threes in today’s environment. With that, every month, you’re paying down principal on the debt.
3. And then the third is a little bit more subjective. We look to buy real estate in growing metros where we feel like there’s a chance for a cap rate compression. For example, today Omaha is trading around 7, 8 cap for a lot of industrial properties. If we think that there’s a good chance that this might compress down to a six or seven cap environment in five years, based on the growth that we’re seeing in this area as a way to create value. And the other half of that third piece is what they call credit enhancement. Imagine if you buy a piece of real estate with a tenant that has $30 million a year in revenue, and in five years, that company is doing 100 million dollars a year in revenue. Now that’s a much stronger tenant, which provides a lot more security on your lease. So now you’re able to sell that same piece of real estate, all other factors being equal, at a lower cap rate because you’ve reduced the amount of risk involved in that real estate transaction.
Industrial is the hottest asset class right now during COVID, prices are going up. Tell us a little bit about what is going on right now in terms of being recession resistant, and the whole COVID story there.
I’ll tell you a little bit about what we’ve seen both in our portfolio and in the asset class as a whole. With COVID, as you know, in the commercial real estate world, it has done a lot of wild things in the multifamily space, with eviction moratoriums. There’s a lot of uncertainty in that space, it has up ended a lot of retail investments, and office, as workers are working remotely, and companies are looking at their overall company culture, whether it’s going to be in office or not. Those asset classes have seen a lot of turmoil.
Industrial, on the other hand, tends to be much more B2B production. The type of industrial that we’ve been focusing on is manufacturing, selling to other core industries, things like mixers, dryers, government, aerospace manufacturers, baby food producers, goods that cannot be replaced. And that has given consistency and a boring level of very predictable cash flow, rents are being paid, there is no evictions required in this case. There’s one or two exceptions, but as a whole, the space has been hit a lot less than some of these other commercial real estate asset classes.
What we’ve seen is consistent rents coming in. The net lease structure means a lot of the variability with operations gets absorbed by the tenant. As an investor, we’ve seen this very consistent, steady type of investment. And a lot of people have seen the writing on the wall, they’ve exited some other asset classes, and really tried to pile more money to the industrial asset class. And when an asset class gets hot, I’ve seen a lot of cap compression. That’s just a function of supply and demand. We’ve seen a lot of REIT’s, pension funds, life insurance groups, that typically didn’t have a heavy mix of industrial in the past, suddenly double or triple their allocation of industrial amongst their portfolio, throwing a lot of money into that space. That has been driving up prices and compressing cap rates across the board.
Is there anything else that you think is important for our audience to know?
I think this goes across any type of commercial real estate investment or evaluation, and that is start small and partner when you can. We always tell folks, it’s a very different world than multifamily, than retail, but if you’re able to partner with someone who has done industrial investments before, or an investment group that specializes in that, even if it’s a passive position, it’s a great way to get your feet wet, and understand the space a little bit better. It’s probably not a great way to fill up your entire portfolio, but we do think industrial is an important way to diversify, especially that single tenant manufacturing side, it’s a great way to diversify an overall commercial real estate portfolio.
You can read Part 1 of this interview here.