What's the state of industrial investments today? How to analyze an industrial property? Top lessons learned from a bad industrial investment. Chad Griffiths from Industrialize has been an industrial real estate broker since 2005 and an industrial real estate investor since 2014 and will share his knowledge with us.
Tell us a little bit about you.
I started in industrial real estate in 2005. I was originally in residential real estate, and didn’t see a path forward on extrapolating my career. I made the transition into commercial real estate, and the brokerage that I ended up joining happened to be heavily involved in industrial real estate. Almost by accident, I stumbled into industrial real estate, like a lot of people interested in learning about it, I didn’t know a whole lot about it. I’ve been at that brokerage now for 17 years, I live, breathe and sleep industrial real estate.
What is the state of industrial real estate today?
All of real estate in general is under pressure with rising interest rates. That is by design, the feds are intentionally trying to slow down the economy by rising raising interest rates. Anyone that is not concerned about what the short term impact of this will be, is either naive or just very optimistic about the medium to long term. I fall in the latter camp myself, I don’t concern myself with short term aberrations because I don’t buy real estate to sell it in six months, I’m trying to buy real estate for the medium to long term. In the short term, rising interest rates are putting a damper on the economy, and the real estate market as a whole.
Out of all the major asset classes, investment grade real estate such as office retail, industrial and multifamily – industrial and multifamily would be the two strongest to weather a storm. That does not mean that rising interest rates won’t have an effect on the market, but if I were to contrast it to office, or even retail, those have more implications for more downturn than the others do. There will still be some pressure in the short term on prices and we might see an adjustment either in the form of higher cap rates, or a stagnant market where there are not many transactions.
The feds have increased interest rates so fast that the markets are still taking time to adjust. Most sellers can’t just say “I want to sell my property”, put it on the open market, push a button and it’s sold. It’s a long process, it will take time for some of these transactions to trickle through the system, for those sales to actually become comparables that other people look at, it’s going to take time to work its way through the system. But I am still bullish on industrial weathering the storm, even with a longer term outlook, industrial has a long runway ahead of it.
Why do you think industrial is going to weather the storm better than office and retail?
We are still seeing very low vacancy rates in many key markets. Vancouver is an example in Western Canada, they have sub 0.5% vacancy rate, and even in other markets like New York, Inland Empire and other coastal markets, they are still sub 2%. Dallas is around 5% vacancy rate, you start seeing these low vacancy rates suggesting that demand is still outpacing supply. The supply can catch up and perhaps over build, which is always a risk in real estate, developers tend to get optimistic and over build. Until that happens, there is a pretty big buffer and industrial vacancy rates would have to increase a lot, and we will then see a corresponding drop in rental rates. That is one of the main reasons.
Industrial real estate is also an attractive asset class for companies that don't want to lease a conventional office or retail building. Provided the municipality can give them a business license, if they can move from a high profile retail location to an industrial location, or if an office user can move from an office tower to an industrial building, they can save a tremendous amount of rent.
If we go into this economic downturn, then companies will become more rate sensitive. They're not going to close their doors, businesses aren't just going to go bankrupt, but they're going to try and be more nimble. A lot of businesses will look to industrial to see if they can save some money. And it can't work the other way, a warehousing company can't go into an office tower, or into a retail strip center, but they can flow towards industrial buildings. Vacancy rates are still very low, and the outlook for the industry is still high, and it has the ability to attract office and retail users.
What is the difference between warehousing and industrial?
I break industrial into three subcategories - warehousing, manufacturing and flex industrial. Warehousing is distribution centers like an Amazon distribution center. Things come in, they are stored, prepared for another time and then shipped out. The other major one is manufacturing, where things are made, manufactured and produced. Then there is flex and flex industrials, where a lot of retail and office users can go into. They are typically buildings zoned industrial, but not necessarily compatible for either warehouse or manufacturing. Common examples are churches, bottle depot’s or art galleries, I own a building where we have 100% office tenants in it. It’s an industrial zone building, but 100% office. So those flex ones are a catch all miscellaneous category.
So that's the type of investment that you have been investing?
Everything I own is either manufacturing or flex. Warehousing is typically a lot larger buildings. There’s an Amazon facility near a local airport, roughly a million square feet. It’s probably a $20 million building just by itself. That is out of my budget, and those are usually owned by big institutions like pension funds, or REITs.
What is your success criteria for selecting an industrial property for purchase?
I am a big believer in looking at downside risk first. Instead of trying to convince myself why I should do that deal, and to some extend you have to, but I do look at the downside risk first. How I look at it is, once the property is vacant, I do the exercise of finding out what that property is worth vacant. Even if you’re buying an industrial property and it has a five year tenant in it, that tenant might not renew when their term is up, they might go bankrupt, there are any number of reasons why the tenant could move out before their lease expires.
I go through the exercise of determining what that building is worth vacant, and compare that to the pool of available properties for lease, properties for sale, any comparable transaction data that can be offset against it is helpful. This helps us go through the exercise of identifying any things that might be wrong with the building – for example: low ceiling heights, limited power or a poor marshaling area for trucks to get into.
If a property has any of those characteristics, at some point it will be vacant and I want to know what my downside risk is by identifying that first, then I will start building out a pro forma on 5 or 10 years and making a number of assumptions. You can manipulate a pro forma in any way you want to have it spit out numbers that look appealing, but before I go through that exercise, I’m making sure that I don’t have exposure that I can’t afford.
Can we go over a deal that you have recently looked at and you either decided to write an LOI for, or not move forward with it?
I can share one that I bought, and subsequently sold and lost money on it which is what really helped shape my position on this on why I’m so diligent about this. In 2015, the second property that my partner and I bought, it was a condominium building, similar to residential, a lot of people don’t realize that industrial can also be condominiums. This was a 20,000 square foot building, and there were 10 individual condo warehouse bays, and the neighboring company owned their bay, they were a seafood distributor that wanted to expand, but couldn’t afford to buy the one next door, it was a new development that was vacant and unoccupied. We ended up doing a lease with the owner at the time and then buying it back from him.
We thought we were geniuses, this company already owns the bay next door, they just invested $250,000 and a cooler, and when 5 years comes up, we’re either going to be able to renew them at a higher rate, or we can sell it to them at that point. When the time came, we caught word that they had moved to another building and they were preparing to vacate ours. They were either brilliant in their negotiation tactic, or we just panicked, but we ended up selling it to them for about a 15% loss, because they called our bluff on it.
The main reason that they were successful in calling our bluff is that it only had a cooler in it. There was not even a washroom, no office space, so we would have been forced to pay to have that cooler decommissioned and removed. We tried finding other companies for it and we couldn’t at the time, and we just didn’t want to take on that risk, it was right at the beginning of COVID. We were nervous about the economy and what was going to happen, so we panicked and sold it. Had we gone through the exercise when we bought it of asking what is this space worth vacant as opposed to having starry eyes about this company, had we actually gone through the motions of asking what is this worth if the company doesn’t buy it, we wouldn’t have paid the price that we did. That’s the one property that I’ve bought so far that I’ve lost money on, and it was because I didn’t treat that property as being vacant.
Had the company actually moved, or they just told you that they had moved?
It actually came through a third party, someone else told us that they had moved. Someone in our office knew that they were a tenant of ours, and they brought it up that they had just secured a 10,000 square foot lease somewhere. It wasn’t even them that had said it, because if they were telling us that then we would have tried holding our ground more, but because it came from someone outside, we took it at face value. Since they bought the bay that we sold them, and they still owned the one beside them, I wouldn’t of been surprised if they actually expanded. Their business was pretty good, they were always full, so we panicked. It was also a symptom of us being nervous, if we were in a better position, if it was a property that we knew we could find another tenant for, we wouldn’t have panicked, but we didn’t know how long that would take. We didn’t know what the cost would be to build it out to whatever specification the next tenant would have, so there was a lot of uncertainty. Ultimately, we made the decision, and it wasn’t a backbreaking amount of money by any means, but nobody likes losing money on real estate.
How long did you have to make that decision? Was their lease expiring within six months or a year?
They had a unilateral option to renew on their side, and we were approaching them up until that point, and it was a six month deadline. We were approaching them up until that time and they let it lapse, they weren’t giving us any communication. We started marketing it, which was within our rights since the option expired.
We were trying to find a tenant that could work for a cooler space, trying to be creative and see if another tenant wants to come in if we could build it out for them, but it was just a tough time in the economy. There weren’t many people fishing for space in the spring of 2020. It did actually turn around, and the industrial market started picking up steam right after we sold it at a loss. We should have been patient for a few more months and it would have been a completely different story.
What are some other pitfalls to watch out for in industrial besides the fact that you need to analyze how much the property is worth vacant?
Another big one is to make sure that there’s actually a market for the property that you are considering buying, and the most obvious one is to consider smaller markets. I want to be in large metropolitan areas, and know that market really well. Every property that I own is within a 20 minute drive of where I’m sitting right now, so I can visit all these properties very quickly.
A lot of people are tempted to invest in smaller markets, such as small towns which historically pay a higher cap rate, just for the risk that’s in there. But it gets to a point where there’s no cap rate that can actually incentivize a rational investor to pursue it. I go into every property that I look at with the mindset that the tenant is going to leave, it could be 20 years, but sometime the tenant is going to leave. If it’s in a small market, is there actually a market for another company to come in to take that space?
I have a client, wearing my broker hat, who bought a property in a small market, the tenant vacated a couple of years ago, and the company is still paying rent on it, but they're still paying rent on it, trying to sublease it. The property has been vacant for two years, their lease technically comes up in the next couple of months, what happens if they don’t find a tenant? They have lost 100% of their cash flow, and they are paying property taxes and building operating expenses. There’s also a provision in their insurance that somebody has to check the property every two days if it’s vacant, just to make sure that there’s no water damage, or break ins. The main principal who owns that has to drive over 1.5 hours, plus the time it takes him to physically inspect the property, every two days, just to keep his insurance in place.
That is a painful example of things that can go wrong if you don’t really understand the market. I am a big believer in looking holistically at a 30,000 foot view. Make sure you fully understand what market you are investing in, and when you get more granular, make sure you understand all those downside risks specific to that one property.
Is there anything else that you think is important to know that we haven’t covered yet?
Be a student of the game. It’s difficult to be a passive investor unless that’s specifically what people want to do. If you want to be a limited partner, and in a transaction you could find sponsors that are doing deals, and you could be a limited partner.
If you want to be actively involved in real estate, it’s imperative that you become an expert in the market. Whether it’s industrial, office, retail or multifamily, you have to have a really good understanding of what transactions are happening, what the comparables are, who’s in the market? What type of tenants are in the market? What are they looking for? What properties are starting to become functionally obsolescent? What are the trends? Staying on top of all the news.
If you don’t have the bandwidth to do it full time, it needs to at least become more than a hobby, constantly studying trends, market information and data so you have the ability to make the most intelligent decision that you can. With this, you have a much higher chance of success versus someone that just tries to do it on a pure part time hobby basis.