What is the difference between Warehouse, Distribution, Manufacturing, Flex Industrial and Specialized Industrial? How do you assess a single tenant risk profile within industrial? What is a sale leaseback as an alternative form of financing? Neil Wahlgren answers a lot of our questions regarding this popular asset class.
Tell us a little bit about you.
We focus on industrial properties and I’ll be happy to share some of my experiences with the asset class, deep dive into some of the nuances on how to look at it from an investor standpoint. And then also from a brokerage and operational level, how we look at it as well. A little about my background.
I’m a California native, I grew up just outside of San Francisco, went to school at the Air Force Academy, it’s non standard for most real estate guys, but I ended up going off and flying jets for the Air Force for about 10 years. I did lot of travel in that period and then finally got my MBA while I was in there, working business development and finance. And then I was lucky enough to be introduced to a family friend who actually had a commercial real estate investment firm up here in the Bay Area. I worked with him for about four years. And we had a business where we would partner with operators, typically commercial real estate brokers, who had a knack for putting together solid commercial real estate investments, but lacked access to equity and capital.
We had a network of investors, and would pool together that capital and be able to place the equity in order to make the investments happen. Through that process, we actually had an opportunity to work with a number of different asset types and operators, and really got to see firsthand through a partnership role, the nuances, strengths and weaknesses of a lot of different commercial real estate investment classes. Everything from multifamily to retail, multi tenant industrial, single tenant industrial, and with that I had the opportunity to partner and work with Dax Mitchell and Andrew Gi with Mag Capital Partners and really cut my teeth with them over the last three to four years in terms of focusing on largely single tenant industrial. We actually acquire most of them through sale leaseback, so we can really talk about any of those pieces that you think would be most interesting.
There are all kinds of industrial properties. Can you elaborate on what each one of them is and what the differences are between them?
The four main categories, or sub asset classes of industrial are:
1. Warehouse distribution: this tends to be the most common. For example, that would be an Amazon distribution center. Those can range from a large, empty space, four walls, a roof, all the way to these extremely state of the art, modern, brand new Amazon distribution centers that have lasers, artificial intelligence, robot handlers with all the parcels coming and going. Ultimately, you are creating valuation and creating value through what’s inside those four walls and a roof. That defines the warehouse distribution side.
2. Manufacturing: that tends to be a range. Everything from, again, four walls, typically metal sided, oftentimes built from scratch for a particular operating company. These operating companies are typically core producers, they can make everything from widgets to industrial dryers, mixers, aerospace parts, and even commercial food, really anything that’s made, oftentimes B2B, where you’re creating large things with specialized equipment inside of them. Those are categorized as manufacturing space, some will be more agnostic, where you have just a core building, and sometimes five or 10 ton cranes on top. And on the other end of the spectrum, you can have some very specialized built to suit ones, oftentimes irregular shaped buildings. For example, the Boeing manufacturing plant outside of Seattle, that one is a very specialized facility designed to be able to create entire airframes. So you have a massive building that’s unlike commercial or industrial real estate in the area.
3. Flex industrial: imagine an entire tenant area, each typically with truck bays, loading and unloading facilities, and those tend to be very flexible in that you have an outer shell of a building. And then the interior walls and the actual square footage of each tenant space is adjustable by the owner of the building to meet the needs of the tenants. Oftentimes, tenants will grow and they want to knock down a wall, take some of the adjacent space, and oftentimes that industrial will be more of an even mix of office and warehouse space.
4. Specialized R&D industrial: that’s kind of the catch all for everything else. It can be everything from laboratory space to really high tech, pharma type of real estate, or everything in between.
The thing that I always worry about within industrial is most of them are single tenants, can you elaborate on how you or any investor should approach that when looking at a property?
Absolutely. And you are right about that, the vast majority of industrial spaces tend to be single tenant occupied with the exception of those flex industrial. One really important thing to look at is, with a single tenant, you do have more or less a binary set of risks there. Either your tenant is in place, financially solvent, paying rent, or they’re not. And that gives a lot of investors pause. And for good reason. If you come in, if you backed the wrong horse, and that tenant declares bankruptcy or defaults on their lease, you can find yourself in a position where you still owe debt service. If you have debt on the property, and you’re not bringing in any money at all, the risk assessment when you start looking at the single tenant space shifts.
For example, in multifamily, you’re looking at the aggregate of market demographics, what can the rent support, what occupancy level Am I expecting, whereas on single tenant, it’s almost solely and squarely focused on the financial strength and credit of that tenant. As an investor, you either want to be looking at that yourself, or partnering with a firm that has a really strong background in credit advisory and credit analysis, to be able to look at that financial picture, and make an educated guess to say, Hey, during the period of time that I plan on holding this building, do I firmly believe that this tenant is going to stay financially solvent?
I was reading the other day a horror story that a tenant went bankrupt and the landlord could not kick the tenant out for two years. That sounds really scary. I don’t remember which state it was. I believe it was on the East Coast somewhere.
Wow. Now that that would probably be the worst scenario you could possibly put together. But the interesting dynamic of how this asset class is structured really comes down to the strength of the tenant, and also the strength of the lease. That lease is your contract with that tenant. And not all leases are created equal. Some important things that you should look for as an investor, if you are looking at a single tenant, industrial or even a single tenant in any asset class is, is your lease a net lease? That net lease aspect, as you and your listeners may know, you can have a NN, which is signifying the two ends, NNN or absolute NNN.
We typically seek to find NNN or absolute NNN deals. That means that the tenant is responsible for just about all the expenses. When that happens, the tenant has to pay for the taxes, insurance, all operational expenses, including utilities. And when it’s absolute net, they also have to pay for exterior things such as roof, pavements, landscaping, improvements, all those known repairs, and future repairs that come up are all the responsibility of the tenant. So it results in a situation where you have a much more predictable set of cash flows as an owner or an investor than you would in other asset classes. And then the second piece that you look for in a lease is, does the lease give you access to tenant financials? A savvy operator for a strong lease will typically allow the owner to request, or to have the owner have rights to quarterly and annually annual audited financials from your tenant, in order to be able to see their financial picture, the profit and loss statements, the balance sheets, what kind of debt they’re taking on. That allows you as an investor to see trouble or blood in the water long before that tenant actually defaults on the lease, or declares bankruptcy.
So when you guys look for properties, do you only look at leases that have that, and that you can see the tenant’s income and expenses prior to buying the property?
We absolutely do. And there are two main ways to acquire industrial properties. One is to acquire an existing lease. When that happens, usually the lease was set up a certain amount of years ago, you would come in as an investor or an investor group, and say, I’m buying the remaining years left on this lease, and then the main risk at that point comes to determine whether or not I think that tenant is going to renew, if they do, what kind of concessions they may ask for, are there options left on the lease? Or what if they choose not to renew? How much time do I have in terms of getting that building re-leased, and what sort of TI’s might I have to expect and budget for us to get a new tenant? This is if you’re buying an existing lease.
The alternative is what’s called a sale leaseback and that’s what we focus on almost exclusively. And that’s where we will come in, approach a seller who is actually the operating company. That operating company also owns the real estate, and for a variety of reasons they will come and it will be advantageous to both parties where they will sell us the real estate, and then they will turn around and we will actually create, and have a brand new lease for them to sign at the same time, simultaneous with them selling us the building. That is called a sale leaseback. They’re selling us the building and then leasing it back typically for 15 or 20 years.
And I assume that they would want to do that in order to get some cash and expand our business, is that typically the case?
There are a lot of reasons, the best way to look at that purchasing tool is it is to view it as an alternative form of financing. Imagine that operating company can either take a line of credit, they can take corporate debt, or they can have access to capital that’s tied up in the real estate by performing a sale leaseback. Most of our deal flow actually comes from private equity purchased companies. Usually, a private equity company will come in, buy a brand new portfolio company, oftentimes that portfolio company will come with a real estate that any company is not able to get the type of returns they seek because they’re operational focused. They’re not able to get the returns that they are seeking for their investors by owning real estate. That’s the reason they would rather sell us the real estate, lease it back and reinvest all that capital into the operational piece of that business, which is why they bought it in the first place. Typically they’re paying down corporate debt. They’re reinvesting in staffing and manpower, maybe adding a new manufacturing line or some combination of those.
You can read Part 2 of this interview here.