What are the latest news in industrial real estate? How to predict what kind of industrial will be in demand in the future? What are some characteristics of an industrial building that would allow you to have different types of tenants? Chad Griffiths, Partner and Commercial Real Estate Agent at NAI Commercial Real Estate shares his knowledge.
Tell us a little bit about yourself.
It has been a year since you and I last chatted and it's crazy how much has changed both in the market and interest rates. In the United States, there's a 50 basis point cut; in Canada, there's a 75 basis point cut already, so the interest rate relief is going to be helpful. One thing people always need to keep in the back of their minds is that interest rates are going down and that should make things more affordable, which is good. However, it is coming down because there are warning signs in the economy. I think Jerome Powell and other central banks around the world probably have their eye on some data that isn't necessarily being circulated widely.
One thing that I've learned in 20 years of being in industrial real estate is that you have no idea what's around the corner. We like to think that we have an idea of what's going to happen, but there are so many things coming at us at every single instance that we just try to do our best to keep our finger on the pulse and be ready to adapt and shift if we need but it's it's never a dull day in industrial real estate.
What are some of the latest things happening in the industrial asset class?
What I find so fascinating about industrial real estate is that it's such a wide variety of activities and subcategories of industrial. Ten years ago, most people just grouped industrial as one big asset class, and they'd talk about it at a very high level, and that was it. But now, we should be breaking industrial into more subcategories, because if you look at the warehousing or the logistics side of it, that's gone through a pretty big roller coaster on its own that's independent of other subcategories. And just to give you an example, there are so many warehouses, distribution centers, and logistics facilities that went up over the last couple of years that in some large markets, they were adding 10- 20 million square feet of warehouse space every year. And now, in some of those markets where they were overbuilt, there's too much inventory. Their vacancy rate has gone from very low to being problematic in some areas, and it's going to take some time to work through that.
If you look at other subcategories of industrial, manufacturing has still done quite well and it is coming back to North America. Manufacturing and warehousing have been on different paths. There's a new one that has only come up within the last few years, which I think deserves its own subcategory, and that is the high-tech industrial which could be EV factories or gigafactories, which is a broad term they use to describe battery factories. Tesla has their gigafactories, and that extended to other companies as well. You also have semiconductor manufacturing plants, like high-tech labs. Essentially, these aren't manufacturing facilities, if you were to picture Boeing making airplanes, that is traditional manufacturing, but these high-tech ones are completely different and there are billions of dollars being invested. TSMC is doing a multi-billion dollar facility in Phoenix, and there's another one going up in Ohio and Columbus, they're popping up everywhere and these are massive facilities. And then the other one that you have is data centers which are growing at a crazy pace.
These are all going somewhat in different directions, even though they are still grouped under the headline of industrial real estate. They also have differences between markets. What's happening in Dallas is different from what's happening in Los Angeles, and Toronto. All these different elements at play become very challenging to understand what's happening in the market, you need to be very focused on the market and on whatever you're doing, otherwise, there are information gaps that can creep in that can be detrimental, whether it's an investor or a company looking to lease space. The emphasis on specializing and being very direct with what someone's chasing and what they're pursuing has never been more important, in my opinion.
How do you keep up with that as an industrial investor? How do you look ahead and try to understand what you should be investing in the future?
There are two primary things that I do myself. First, you need to be in a city that has population growth for the foreseeable future. It can't be that there's population growth because there's one major project going on, and then once that project is done, perhaps jobs leave with it. You need to be in a big city where there's optimism that the population growth will continue. Population grows, everybody needs more things, they're shopping more, they're doing more online shopping, warehouses and industrial investment follows population growth.
The second thing is to invest in properties that have multiple uses. If that one tenant that's in there, or multiple tenants that are in there, whether it's at the end of their lease, or they go into bankruptcy, or they get bought out and they just no longer need it, they eventually leave. I want to make sure that when that tenant leaves, that building is suitable and compatible for the next tenant without me having to spend a ton of money retrofitting it.
There's a horror story that I could tell, the buildings looked great on paper, the pro forma looked great, there was a good tenant in there and there was a term left on the lease, but at the end of that lease, the building just couldn't lease, or required a considerable amount of CapEx, and that destroyed the whole investment thesis.
In one of those horror stories, what were their major tenant or tenants that left? Why do you think they couldn't get it re-rented?
It's about an 80,000-square-foot building, a nice, functional industrial building for the company that was in there which was a fiberglass manufacturer. They had a lot of underground systems on how the raw material would come in and get held in silos, and then the silos would get directed on different systems and racks and conveyor belts. The byproduct, as they were making this fiberglass, ended up going into these underground pits that were on rollers, like a coal mine, and these big carts would then have to get wheeled out. That worked perfectly for them, and it was great for their use. The owner that had that property thought that the company would stay there forever because to recreate a building like that would just cost so much money, and it was 40 years old at the time, so he just assumed that the company would stay in there forever. But like everything happens, they were losing market share to other countries, China most notably, and they ended up closing the facility down altogether. One part of the building had 50-foot ceiling heights, but it was awkward, you could only access it by a wonky ladder system, so that required a considerable amount of work to retrofit. The other side was wide open with normal ceiling heights, but there were no washrooms in there and there was no office in there. You had this building that was great for that one tenant, but half of it was suitable for some kind of tenant, and then the other half was suitable for a different, very limited type of tenant that needs ceiling heights that high. With ceiling heights in theory, the higher the better but you also have to heat and cool and maintain that cubic footage, as opposed to a normal building. If you're paying to heat and maintain all that space that you're not even using, it becomes very inefficient.
I could do a full case study on this building, because it was fascinating to watch it happen. However, it ended up staying vacant for several years because they were trying to find another tenant for it that could take the whole building not having to make several modifications. And what eventually happened is that they split the building in half at first and then the normal side of it, they broke it up into a few smaller bays, but they had to go in and install washrooms in each bay, they had to put offices. They had to fill all the holes in the concrete and then backfill it. These were subgrade basements, so it was a considerable amount of work just to get the floor to be in a level concrete floor. And then, they ended up doing an exterior renovation, because it was a fiberglass facility. Full exterior renovation, full interior renovation, three years of being vacant and having to do the carrying costs on it, with property taxes and insurance, just maintaining it, and the lost revenue for those three years, these cost them something like $2 million just to renovate it. If you're an investor, looking at a building like that, and you see a tenant that's been there for a long time, and the building is specialized for them, so you think that they'll never leave, and maybe they have 10 years left on their lease and you think, "This is perfect, I'm sure they're going to renew because there's no other building that will work for them." But after year 10, if they leave, you're faced with a similar type of situation where you have three years of not making any money and paying all the expenses, and then you have to go and put another $2 million into retrofitting it, that destroys a lot of investors. I couldn't financially recover from something like that, that would cripple me as an investor.
What are some of the characteristics of an industrial building that would allow you to have a diverse number of tenants?
You still want to delineate between whether it's a warehouse or if it's a manufacturing facility. If it's a warehouse, you need to have an adequate loading area so they can get semi trucks in there without impeding their access, that's very critical for a lot of distribution companies. You probably need to have 24-foot ceiling heights as a minimum, knowing that some modern facilities are now approaching 40 feet or higher, the lower you are, the less racking you're able to accommodate, that becomes a problem. You want to be looking at the loading area, the location, and the ceiling height which are all going to be important. The column grid inside, some of the older buildings have more narrow column grids, so it makes it more challenging to put racking in there and get forklifts around. If you're looking at a new property, it was probably designed by an architect that knows what they're doing, or it was probably built by a developer that has built many before and you're much less likely to have an issue.
If you start looking at a 20-30-year-old building, by comparison, you are going to have lower ceiling heights and a tighter column grid. You might not have the same marshaling area, no excess yard, no sprinklers in the building, you might have old lighting and inadequate electricity. Those are the things that really start adding up, but a lot of those can be fixed relatively easily, outside of the roof. That's a challenge that comes with a lot of money to try and raise a roof. A lot of those can be fixed with money, but you need to understand how much money, how long it's going to take, and what the downside is. Understanding the market and what the tenants want are important. Do tenants want 40-foot ceiling heights? Is that a requirement, or are there tenants in the market that are fine with 24 feet, and if they're not, that's a problem. Also, understand what your competition is, what the tenant demands, what the tenant requires, and then make adjustments.
The biggest risk is the manufacturing side, and that's quite often where buildings are much more tailor-made or custom-built for their requirements, the fiberglass one is a good example, but there are many like that which are specific manufacturing buildings. There's a process that occurs inside that is unique or just different from another one, whereas warehousing is pretty simple. Things come in, they're stored. They stay there for some amount of time, then they get picked, then they get sent out. There's not a whole lot of variety in that simple model. In manufacturing, there are so many different variables and individual components of it, that's where I'd want to get a sense if anything is a big impediment, holes in the floor, for example, what's it going to cost to fill that in? Is there enough office space? Are there enough washrooms? Can I split this up? If it's a large building, is there even one tenant out there that would want a 100,000-square-foot manufacturing facility, or do I have to split this into four spaces? And is that even feasible? It comes down to your need to analyze what property is worth vacant, that's your downside risk analysis. Ignore the fact that there's a tenant in there, even if there's a tenant in there for 20 years. What is that property worth vacant, that's a different study than just underwriting it on the financials of the tenant, on what they're paying. That's an underwriting that involves figuring out what this property looks like on the lease market. Then you can start going through the exercise of saying, "The future tenants might not want this specific thing, or this is going to be a big problem for the next group of tenants in this area over here." If you go through that exercise and you understand what that downside risk is, then comes the fun part of trying to build a proforma and seeing how it might look over 10 years, but that's secondary. Protecting that downside risk in industrial is crucial because one mistake can upset the whole apple cart.
Chad Griffiths
www.industrialize.com
www.youtube.com/@industrialize