Hi All - Happy Tuesday. It’s the last day of the month, which means it’s time for the Last Cast Letter.

Since it’s Halloween, I have a little treat for you today: our first guest post. The thoughts below have been shared by one of my best friends who is the Director of Acquisitions at an industrial private equity firm based in the Northeast. I’m intentionally being vague because this person requested to remain anonymous, and I don’t want to give away too much information about them or where they work.

What I can say is that this person is extremely sharp when it comes to thinking about the industrial and logistics space. You know how firms like Blackstone are buying up a bunch of data centers as a way to play the AI boom? Well, this person works at a shop that did the same thing in the warehouse and logistics space with the rise of e-commerce. Except they did this before everyone else and have since built an incredible portfolio.

I always make fun of my buddy. Aren’t you just buying boxes? Four walls and a roof? Anyone can do that, I joke. Of course, this is much harder than it looks, especially because this space has become much more popular recently. One of the largest commercial real estate transactions of 2023 was Prologis buying an industrial portfolio from Blackstone for $3.1 billion … all cash.

Now with that said, I was with this person at a wedding earlier this month and we were talking with the groom (who also happens to work in the real estate investment space) about the industrial sector. US Industrial absorption declined by roughly 50% year-over-year, according to preliminary figures from Savills released this month. Major players are seeing the market cool, especially for larger properties. So I asked: has this space peaked, or at the very least, was/is there a bubble for these boxes? That was the “prompt” for this guest post.

I hope you enjoy it and I want to say thank you to our contributor. I’d love to do more of these so if you work in the space and have thoughts you’d like to share, just reply directly to this email. With that, let’s dive in.

PS: I have an interesting Twitter-related office scoop at the bottom of the email.

Not All Real Estate Is Created Equal: Why Industrial Is Still An Attractive Opportunity

It’s been hard to ignore the myriad of negative press the commercial real estate sector has garnered since the start of 2023.

Rising rates, regional bank failures, intensifying loan defaults, and exogenous geopolitical events have put the CRE sector in the crosshairs. Rightfully so when compared to the 2010s.

The last 8-10 years, driven by an abundance of cheap, readily available debt in a low-interest rate environment, saw real estate values across almost every asset class reach historic levels. 

The office market, pre-Covid, was arguably as strong as it had ever been; multi-family cap rates pushed to unprecedented lows; and industrial, long considered the ugly duckling of the commercial real estate world, was starting to emerge as a solidified institutional asset class as the shift from traditional brick-and-mortar to ecommerce accelerated. 

But then along came Covid, followed by Russia’s invasion of Ukraine, Silicon Valley Bank collapsing and now the Israel-Hammas conflict. This is all set against a backdrop of inflation reaching its highest levels since the 1980s and the Fed’s dogged pursuit to “right the ship”. This confluence of factors means that any time you open your laptop you see these headlines:

These three articles were not difficult to find. They were all published in the past two weeks. What’s frustrating, however, and quite frankly misleading is that these articles are lumping all of commercial real estate under the same umbrella which is a complete disservice to what is actually happening on the ground.

There is no denying that the office sector is in disarray and the catalyst to this black cloud still hangs over the sector. The work-from-home phenomena has eroded vacancy levels at the same time as borrowing costs have doubled and in some cases tripled leading to an almost completely illiquid asset class. Selling or refinancing an office property is nearly impossible today. For context, Boston has seen one office trade since January 2022.

But is it fair to lump in multi-family (maybe but that’s for another day), industrial, data centers, hospitality, retail & gaming, etc. into the same catastrophic, doomsday bucket as office?

I am not as well versed on the other asset classes and while I am biased, I would argue that industrial and office are on opposite ends of the spectrum. Let’s take a look.

Fundamentals

The US industrial market is experiencing an unprecedented wave of deliveries (supply) that were negotiated, entitled, and built in a completely different capital markets environment between 2020 and 2022. This supply is hitting the market at the same time that demand appears to be “cooling” or resetting to pre-pandemic, normalized levels.

According to CBRE, at the end of 2Q23, “the U.S. industrial market added 83 million sq. ft. of vacant supply in Q2, the second largest quarterly total on record. As a result, the overall vacancy rate increased for the third consecutive quarter, up by 30 basis points (bps) to 3.7% but still below the 10-year average of 4.7%.”

It’s no surprise that we are seeing an uptick in vacancy as the supply/demand imbalance is shifting negatively against investors and developers. As such, I would expect we are in for a choppy 12-18 months as tenants reevaluate their space needs and these large blocks of availabilities remain vacant.

With that said, real estate is the old “get rich slowly” game and if you view industrial with a 3-5 year outlook, there is a lot to be optimistic about.  

The high interest rates (the 10-year UST sits at 4.95% as I write this) that have plagued the US market since the start of 2023 have brought new construction to a screeching halt. According to CoStar, industrial construction starts are down 70% with the third quarter being the lowest quarter on record since CoStar began tracking in 2013.

These downstream impacts likely won’t be felt for 12-24 months at which time many markets, particularly coastal markets with high barriers to entry, will see a diminished pipeline of new construction just as demand normalizes or slightly accelerates. This bodes well for high single-digit to low double-digit rent growth (market-specific) over the next few years.

But how do you know demand will stay consistent? Obviously, there are no guarantees but some real tailwinds and demand drivers are helping prove this case. 

First, and arguably the most important, is ecommerce. While there will always be a need and demand for traditional brick-and-mortar retail, Amazon and the likes have made online ordering too convenient and frankly, too easy to see the US consumer reverting to any other way of shopping. 

At the end of 2Q23, ecommerce in the US accounted for 15.4% of total sales. While it’s impossible to pinpoint exactly where this figure will grow to, much of the research points to 25%-30% by 2030. For comparison, China saw 27.2% of sales attributed to ecommerce at the end of 2022.

The punchline is ecommerce remains in the early to middle innings and still has some room to run domestically. Unequivocally, the best statistic that encapsulates the role of ecommerce within the industrial and logistics sector is from a CBRE study a few years back:

To put that into perspective, using the chart below, it is estimated that ecommerce will increase +/- $600B between now and 2027 which would equate to +/- 750 million square feet of new industrial supply needed to satisfy just e-commerce-driven demand.  

Other drivers, while not as impactful as ecommerce, will continue to bolster industrial demand into the future as supply remains constrained:

• (i) The shift from just-in-time to just-in-case inventory management driven by the supply chain backlogs highlighted during the pandemic

• (ii) onshoring of manufacturing

• (iii) advanced manufacturing & “tough-tech”

• (iv) GMP / biomanufacturing

Other Considerations

As I look at industrial relative to other asset classes, outside of what has already been highlighted, there are a few defining characteristics that stand out and ultimately provide the foundation for my conviction in the asset class today.

The first is the fact that industrial is pretty low (if not the lowest) on the list of “highest and best uses”. The existing product is being taken offline and repositioned into something “shiner”: multifamily, lab, mixed-use, etc. where rents are higher and perceived returns are greater.

Additionally, municipalities are reluctant to approve new industrial projects given the stigma attached to the asset class: trucks, traffic, and noise. Pair these two hurdles with the fact that most coastal metros are effectively built out and you’re left with structural supply constraints which will only magnify as time goes on and the small amounts of industrial feasible land are absorbed. Take this incredible stat about Miami from Green Street for example:

The second, which has become more pervasive during this high inflationary environment, is industrial lease structures. The typical industrial lease is NNN which means the tenant is responsible for their share of common area maintenance, utilities, insurance, and real estate taxes; effectively revenue is equal to net operating income.

Therefore, as insurance costs have skyrocketed in places like California and Florida and inflation has taken its toll on day-to-day operation costs, industrial landlords’ bottom lines have remained unchanged and in most cases has grown due to rent growth. Compare that to the multifamily sector: even with 5%+ year-over-year rent growth, many landlords are facing capital expenditure-driven net operating income erosion – i.e. your CapEx growth is outpacing your rental growth.

Ultimately, nothing is ever for certain, and by no means am I advocating for buying industrial “at any number” but there remain a lot of tailwinds at the back of industrial. Those who buy correctly today should be rewarded in the future as the markets normalize. Despite what you read, not all real estate is created equal.

- Anonymous

So, there you have it. Wise words about warehouses from an industry insider. I want to say another thank you again to my friend for taking the time to write this — genuinely awesome to read and think about and I’m excited that we get the chance to share these thoughts with a wider audience.

Office Scoop

Before we go, I’m including another anonymous bit of information from a friend in New York City. This pertains to the office space which, by the looks of it, is still facing an uphill battle. Here’s the email he received with the pictures that were attached:

That’s all for today. I hope everyone has a wonderful Halloween. As always, if you’re interested in investing alongside us, fill out the form below.

— Brooks