An Insider’s Guide to Industrial Real Estate – Part I

What is industrial real estate?

The key features of industrial real estate are buildings with an open box, high ceilings and multiple loading docks. These buildings lend themselves to users who need to manufacture goods or store large quantities of products inside.

Loading docks are an especially key feature of industrial real estate. They are essential for loading products in (e.g., raw materials) and out (end goods) of a building. Most loading docks are equipped with a load leveler, a steel plate that moves straight up and down. There is a lip on the leveler to ensure the driver of the forklift does not fall in the space between the truck and the floor of the building. Most docks are exactly four feet high to match the height of over-the-road trucks. If the products cannot be easily moved in and out of an industrial building via loading docks, the building is essentially useless to end users.

Generous ceiling heights, ranging from 20’ to 44’ high, are also very important. High ceilings are essential for companies who need to stack products, like inventory, on top of one another or in racks.

The Difference Between Class A, B and C Industrial Real Estate

Class A Industrial Real Estate

Class A industrial real estate is the highest-quality and generally most expensive type of industrial property. It is characterized by multiple loading docks, an ideal location (usually right off the highway), ceiling heights ranging from 32’ to 40’ clear, and abundant parking. Class A industrial property is generally newer built in the last seven to ten years and as such, will have more modern design and architecture. These buildings also have higher-tech amenities such as ESFR (early suppression, fast response) sprinkler systems. Class A industrial property is typically favored by larger, corporate tenants such as Amazon and Target.

Class B Industrial Real Estate

Class B industrial property will be a bit older, with slightly lower ceilings and fewer truck docks. They may be constructed with older bricks, older windows, and perhaps slightly outdated features like less efficient loading docks. Class B industrial real estate generally attracts smaller, more locally-based tenants as opposed to corporate giants.

Class C Industrial Real Estate

Class C industrial buildings are usually 20+ years old, in need of renovation, have less parking available on-site, and are located farther from major arteries in less desirable areas. Class C industrial buildings usually have lower ceiling heights and as such, are limited to certain types of tenants (such as light manufacturing vs. distribution). Building amenities are limited and infrastructure and technology is usually outdated.

All classes of industrial real estate can be lucrative. Which you choose to invest in should depend on your overarching investment strategy. For example, we have a hard time making Class A industrial deals work because we’re in the business of long-term holds. Larger Class A buildings tend to be built by merchant developers that are leased up and then sold, usually to a pension fund or similar type of investor.

These investors are happy making a 4-5% return on a $30- to $40-million-dollar investment. Our investors are putting out smaller dollars ($50,000 to $1 million, for example), so they’re looking for slightly larger returns, closer to 8-9%, which we can only achieve by investing in Class B properties. We are able to achieve higher risk-adjusted returns this way, but take on the risk associated with having older buildings and potentially less credit-worthy tenants.

Why Parking is Essential for Industrial Real Estate

An often-overlooked component of industrial real estate is parking. Parking is essential for industrial users of all kinds. In the 1970s, it was standard to have one parking space for every 1,000 square feet of industrial space. Then tenants started to realize that as their companies grew, they would need more parking to accommodate additional workers. If they didn’t have enough parking, they’d have to move elsewhere. Today, 1.5 parking spaces per 1,000 is more standard.

Trailer parking is also important to today’s industrial base. Parking for tractor trailers is especially necessary for large distribution companies, even if a truck only needs to park overnight.

One of the reasons parking is so important is that most municipalities do not allow on-street parking and if they do, there’s no guarantee that overnight parking will be allowed forever. Municipalities, with no notice, can put up signs prohibiting on-street parking leaving vehicles nowhere to go. An industrial building with an abundance of parking is very attractive to many users.

How Building Design Influences Industrial Decision-Making

The architecture and exterior design of industrial buildings used to be an afterthought. Today, a building’s aesthetic is more important than ever. One of the largest challenges faced by growing industrial companies is their ability to find and retain a talented workforce. Having an attractive building makes a big difference when trying to recruit workers.

Someone wants to pull up to the building and walk inside feeling good about the feeling of the physical environment and wants to feel like they’d be comfortable working there.

All other factors considered equal, workers will choose to work for a company in a nicely designed building.

That sentiment transfers to tenants. Given their option of three buildings, all else equal, tenants will choose the better looking building.

Moreover, tenants who owner-occupy an industrial building tend to care about how it looks because it influences resale value. They’ll have more interest from buyers, and will get a better return, if a building has more curb appeal than the others around it.

The Importance of Thick, Smooth Floor Slabs

Forklifts and other heavy machinery is often used inside an industrial building, and as such, extremely smooth floors are essential for their safe operation. Moreover, these machines are being used to move and stack pallets of goods. The higher the products are stacked, the more likely they are to fall over if the floor is not perfectly level. It would be like trying to build a tower with wooden blocks on an uneven floor eventually, the tower falls down.

The exception to this is when an industrial building is designed for a food and chemical manufacturers. Food manufacturers often need at least a portion of their floor to be sloped so that anything that drips can flow down into a drain. These are specially purposed facilities and are often difficult to re-lease to anyone other than a food or chemical manufacturing company.

Locations of Industrial Real Estate

Most people don’t notice industrial real estate because it tends to be tucked away behind a shopping center or residential area. In almost every major city or town, there’s an “Industrial Way” or “Commerce Drive” where industrial properties are concentrated out of public view. Large industrial complexes might also have smaller adjacent streets that are often named after the children of the developer, such as “Bonnie Lane” or “Randy Road,” the names of two of Milt Podolsky’s kids.

The exception to this is when you see a major industrial facility located alongside a highway, which is located there given its access to the thoroughfare. You will often see dozens of industrial buildings along the interstate system, as this is where farms used to be, but those farms have been absorbed by industrial developers over time.

Types of Industrial Real Estate

There are many types of industrial real estate. Manufacturing and warehouse are the most common forms of industrial property, but there are others that investors should be familiar with when evaluating different opportunities.

Manufacturing

There are two types of manufacturing properties: heavy manufacturing and light industrial. Heavy manufacturing is what you might expect to find in a city like Gary, Indiana and includes refinement of raw materials like steel manufacturing. Heavy manufacturing requires large, purpose-built facilities with specific energy requirements. Meanwhile, light manufacturing, which is more common and easier to repurpose, is used for the creation and assembly of parts and goods. Light manufacturing facilities tend to have lower ceilings than warehouses because manufacturing tenants don’t need the same degree of clearance, in which case, the additional height is sometimes viewed as “wasted” space.

Warehouse/Distribution

Warehouses and distribution centers are essentially large, square or rectangular boxes with loading docks. Some have a small area reserved for office space, but the bulk of the facility is used for storing goods. Warehouses are used by distribution companies that store the goods produced in a manufacturing facility before those products are shipped to the end user.

Cold Storage

Cold storage is a very specialized form of industrial real estate. Cold storage is used primarily by food manufacturing and distribution companies, as well as pharmaceutical companies who need to keep their goods at particularly cold temperatures. Cold storage has grown in popularity as more grocery stores have expanded their digital footprint and increased online sales. These special-purpose facilities have incredibly high utility demands and therefore, can be costly to own and operate unless leased to a top-tier tenant.

Data Centers

Data centers are another form of specialized industrial real estate. These facilities have specific power and telecom needs and often have unique design features, such as concrete walls with few (if any) windows.

Flex Space/R&D

Flex space/R&D is a catch-all term used to describe industrial property that has some combination of warehouse and office/retail space. This type of facility is often used by high-tech machinery manufacturers, where their showroom is located at the front of the building and the offices or service center is located behind. Flex space/R&S space is often used by certain manufacturers, biopharma, brewers, artists, cabinet makers, etc.

What Drives Demand for Industrial Real Estate

The industrial real estate market was once considered a niche asset class, but it has grown in popularity – especially in 2020 – as more people turn to and become comfortable shopping online. Retailers are competing for customers using 2-day or even same-day delivery, which requires distribution centers in most major metro areas.

At a more local level, demand for industrial real estate generally comes from companies that are growing, either organically or through an acquisition, and need more space. Many companies will begin in a small facility and then, as they grow and hire new employees, find the need for a significantly larger space. They might start by taking a second or third building, but eventually, want to consolidate into a larger building for efficiency’s sake.

These companies usually want to stay in the same area where they’re already located, providing ease for their employees and customer base, so it creates new demand for larger industrial buildings.

The industrial market has proved highly resilient amid market cycles. At the 2008-2010 trough, vacancy rates only rose to about 10 percent. There was still sufficient demand from industrial users. Today, vacancy is around 6 percent depending on geography, which is about the rate you’d expect given natural turnover within buildings.

The Benefits of Investing in Industrial Real Estate

One of the draws of investing in industrial real estate is its simplicity. Unlike a 60-unit multifamily property where the owner is responsible (either personally or through a property manager) for collecting rents from 60 individual tenants each month and then renews leases on an annual basis, industrial properties tend to have only one or a small handful of tenants. This makes rent collection and releasing significantly easier.

What’s more, most industrial tenants have multi-year leases, ranging from 3 to 10+ years. Rent escalations are built into these leases, so after the initial move-in, industrial owners have a relatively hands-off investment. It’s a great way to earn passive income.

Another benefit of investing in industrial real estate is that these properties don’t need much in terms of the interior build out.

In fact, when one tenant leaves, another can often move in without changing the interior at all. Industrial properties tend to be relatively easy to manage as a result.

Industrial real estate is also attractive given the built-in exit strategy: many industrial tenants are ultimately willing to purchase the building from their landlord or nearby neighboring industrial company. If business is good they often plan to stay in place for many years. These are what we refer to as “sticky” tenants—people who stick around, and as such, are natural buyers.

The Biggest Risk of Investing in Industrial Real Estate

The biggest risk associated with investing in industrial real estate is vacancy. Many industrial buildings are occupied by single tenants. If that tenant moves, it can take 60 to 180 days or longer to re-lease the space. In the meantime, the owner has significant carrying costs the mortgage, taxes, insurance, utilities, etc. The best way to mitigate this risk is for an owner to be highly attuned to the local market.

How to Passively Invest in Industrial Real Estate

The primary ways to invest in industrial real estate are through real estate investment trusts (REITs), as part of a joint venture, or through a syndication.

When you’re investing in a REIT, you’re essentially buying stock in a company that owns and operates industrial property. REIT shares tend to ebb and flow at the same rate as the rest of the stock market. If there’s a bubble in the stock market, the value of those stocks goes down.

You might also invest in a joint venture, in which you own the real estate in partnership with someone else. The other party might be someone like a developer who hires a property manager to oversee day-to-day activities whereas you take more of a backseat role. These deals are usually brought to market through a broker.

Lastly, you can invest in industrial real estate through a syndication. Investing in real estate through a syndication is considered somewhat passe. Few groups take this approach, because when industrial investment firms start to achieve scale, they usually end up partnering with an institutional investor and no longer need smaller-scale passive investors. A syndication is one of the few ways people can still invest smaller dollars directly into an industrial property or portfolio.