As investors and lenders vie to connect and place bets on warehouse and infill last-mile distribution space, ongoing low-interest rates, cheap debt, and red-hot demand will continue to keep the industrial sector center-stage in the second half of 2021. Similarly, the story for office is expected to remain a patient exercise for both owners and capital of wait-and-see.
Rick Ellison, SIOR, vice chairman, Cushman & Wakefield based in Irvine, Calif., shared that cap rates on Southern California industrial are compressing. This is the result of more capital being allocated toward industrial as well as more capital overall than opportunities. Simultaneously, rental rates are climbing because of a huge influx of tenants driven by e-commerce. On the flip side, industrial will find it difficult to secure entitlements as a result of communities not wanting trucks without jobs.
While spec development is in play, a lot of Southern California is mature. This leads to new development opportunities being focused on the infill markets of Los Angeles, with Orange County seeing redevelopment or tearing down inventory and building new. The tight market has served to preserve values.
“We're seeing such inflation of industrial values, and of course, office values have declined because of COVID, that there are some strategic opportunities where we're actually converting office buildings [for industrial use],” Ellison says. In early June 2020, Cushman & Wakefield advised on the sale of four office buildings totaling 221,921 square feet on approximately 13 acres in Orange County, Calif. The portfolio was sold in two separate transactions to the joint venture of Western Realco and RREEF, which acquired the sites on a land basis with the intent to redevelop them into new high-end industrial use.
Because there’s so much capital chasing industrial deals in SoCal, deals are closing in all-cash and debt is put on post-close once the property has stabilized. The sheer availability of debt is helping to drive cap rates down. “We're seeing multiple offers on every asset that we bring to market, anywhere between 10 and upwards as high as 25 offers depending on the wide appeal of the opportunity,” he says.
Because the market is moving so fast, most in-place leases are below market so the lender will look at marking that to market and see how that looks from a debt coverage ratio standpoint, Ellis explains. As for the remainder of 2021: “We think it's going to continue to be a red-hot market with all-cash buyers, and a lot of capital available to do it.”
Despite a slight dip in the office sector in 2020, office buildings with long-term good credit tenants like the government of Germany, for example, are seeing competition. This is a result of a massive shortage of good quality product, which is pushing prices higher, according to Tobias Schultheiß, SIOR, managing partner with Blackbird Real Estate GmbH based in Königstein, Germany.
Similar to the United States, the German market is also awash in capital, and Class-A properties are trading hands in cash. For example, Blackbird recently sold a €70 million office project to an institutional investor in an all-cash deal. “This is almost the normal case for high-quality products that these investors just don't need finance because money is so cheap these days. When you have the money in your bank account, then you pay an extra fee in Germany called a ‘punishment fee’ for having money in your bank account in excess of a certain amount,” Schultheiß says.
Developers seeking financing in Germany in either office or industrial will find insurance companies willing to provide mezzanine debt to top off the senior bank tranche leaving the borrower's total investment small. Loan to values (LTVs) begin at 70%. However, Schultheiß was able to secure 100% LTV from a bank for a general office building with high-quality tenants and an “extremely good valuation” when he offered to bring in a mezz partner to fill out the capital stack.
“The inquiries that we get for folks looking to deploy and loan are constant.”
Private German banking institutions like Deutsche Bank Commerzbank AG are looking to do high volume on easy-to-underwrite Class-A properties with stable occupancy in cities with over 100,000 inhabitants. Below that, local savings banks (such as Sparkassen and Volks & Raiffeisenbanken) offer competitive terms to borrowers. Together with their partners, Blackbird was recently able to secure 65% LTV for a development scheme from Volksbank Erlangen at a 2% interest rate for three years. The short-term loan features a low ratio of repayment each year, with the biggest part of the loan requiring payback when the property is sold.
Ken Salzman, SIOR, executive managing director and principal in the Lee & Associates New York office, says, “I think you're going to see that the cost of borrowing is increasing in office, in particular.” That’s because large occupiers of office space are having some difficulty getting their employees to return to work, creating a flight-to-safety and increasing the cost of borrowing for office 20 basis points higher.
Salzman anticipates the second half of the year will see a lot of currently subleased space reoccupied and pulled off the sublease market. Lenders will continue to be conservative, lending on top-quality office product while waiting for higher absorption to lower their rates.
As lenders watch and wait, Salzman has developed a personal barometer that he calls “Ken's Coffee Cart Index” that he calculates by eyeballing how busy the coffee cart vendors are in the morning, the number of people at the lines in Midtown Manhattan at various coffee carts, and how quickly the vendors are selling their wares. “People are beginning to return to the office—the trains are more crowded—the streets are more crowded during the day—tourists are beginning to come back into Manhattan,” he says.
The belief and hope of office owners is that the level of interpersonal collaboration is stronger in an office than at home. A number of Lee’s clients are learning that they can't grow their business the way they want to with their employees dispersed, and while some have discovered that they don't need their office space, most are recognizing the role that office plays in a communal environment.
Although New York City office occupancy stood at about 30% in late June, Salzman predicts once childcare issues are solved, occupancy rates will begin to climb until they have fully recovered in March 2022.
Brian Knowles, SIOR, principal of Lee & Associates of Eastern Pennsylvania, says he doesn’t believe we're going to see any changes in the second half of the year in the industrial sector. “We think it's going to remain pretty stable going into 2022,” he says, barring anything on the political front in terms of the possible repeal or limitation of 1031 exchanges, which would be a gamechanger. Even so, if any sector is “insulated” he believes it will be industrial simply because of sheer demand and, as such, it’s a haven for the lenders.
In the Philadelphia region, a wide triangle from South Jersey to Scranton to Harrisburg—a billion square foot industrial base—Knowles anticipates construction lending will be down. This is not for lack of demand for new industrial development but because COVID created a 6-month backlog in existing construction projects, many of which are now delivering late.
That’s not to say that borrowers that find opportunities to build won’t find lenders and equity waiting for them with open arms. “The inquiries that we get for folks looking to deploy and loan are constant,” he says, offering 70-30 LTVs consistently. His office recently sold an existing million square foot industrial building that was dated but not uninhabitable to an investor for $110 million to knock it down as a covered land play. By tearing down the original structure—which was located in the New Jersey Turnpike, a supply chain market with less than 2% vacancy—the investor intends to build 3 million square feet of Class-A space.
Knowles also points out another hallmark of current market conditions: industrial cap rates and interest rates are so low that tight spreads are taking lenders out of the loop, with buyers opting to go all-cash as a requirement to make deals pencil out.
Ken Morris, SIOR, president of Sun Rise, Florida-based Morris Southeast Group, reports similar conditions for industrial in South Florida, with four caps for industrial product the norm. What’s more, Morris predicts smooth sailing for the next 18 to 36 months, with available capital at attractive rates.
Even the office sector appears likely to perform given pandemic corporate relocations, a business-friendly environment, and geographic features like the Everglades and the Atlantic Ocean that create a natural development boundary for Miami-Dade, Broward, and Palm Beach counties, keeping the market tight.
Blackstone, with a portfolio of roughly 16 million square feet of industrial in South Florida, has also been placing hefty office bets in downtown Miami. The private equity giant recently bought 2 Miami Central and 3 Miami Central, comprising a total of 320,000 square feet, 98% occupied by tenants signed to 8-year leases on average.
Despite the rosy picture, Morris points out that South Florida lenders are underwriting office buildings with shorter lease terms until there’s more clarity. Supply chain issues have driven up construction costs by 40 percent in the last year and cheap debt “is almost like a drunken sailor. When money is cheap, people will pay more because they can afford to pay for real estate.”
Rick Ellison, SIOR
Brian Knowles, SIOR
Ken Morris, SIOR
Ken Salzman, SIOR
Tobias Schultheiß, SIOR