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Industrial Investors Drive Cap Rates Lower in Secondary and Tertiary Markets

Going into smaller markets in search of yield, industrial investors are starting to cause cap rate compression in those areas.

Investors don't like the high pricing and low cap rates on industrial assets, especially since cap rates continue to compress in some markets. But they still want to invest in this asset class, because continued rent growth and low interest rates should boosts net operating incomes (NOI), overcoming low yields during the first year or two of a 10-year investment horizon, says Jack Fraker, vice chairman and managing director of global industrial and logistics with CBRE.

Strong market fundamentals, including low vacancy and robust demand, have continued to attract investors to the asset class, increasing values and leading to sustained cap rate compression, according to CBRE's first half 2019 cap rate survey.

Demand for industrial space is still outstripping supply, despite a record-high construction pipeline that delivered 126.8 million sq. ft. of new space in the first half of the year. Another 327.5 million sq. ft. underway, according to Cushman & Wakefield's second quarter 2019 MarketBeat industrial report.  Net absorption for the first half of the year totaled 88.6 million sq. ft., and new leasing activity in the first two quarters involved 256.6 million sq. ft.

With demand for logistics facilities still going strong, vacancy has remained at or below 5.0 percent, according to Jason Tolliver, managing director of investment services at Cushman & Wakefield.  

But sales volume is expected to soften in 2019 compared to record-setting activity last year, in part due to “retailers trying to get ahead of tariffs (on Chinese goods),” Tolliver notes.

“We are seeing investor confidence waning and lower business spending as a result of uncertainty in financial markets and the weaker market for U.S. exports,” adds David Bitner, who heads Americas capital markets research at Cushman & Wakefield. The Atlanta Fed is forecasting a slowdown in economic growth to 1.9 percent in the third quarter, and the New York Fed, which uses different data, is forecasting 1.6 percent growth for the third quarter and 1.1 percent growth for the fourth quarter.

The recent drop in the Federal Reserve's benchmark interest rate, which it reduced by another 25 basis points last week to a range of 1.75 to 2.0 percent, is helping sellers command higher prices for assets, according to Fraker. The lower interest should allow investors to still achieve 10-year internal rates of return (IRR) targets, despite paying higher prices.

“Real estate investors make decisions based on longer timeframes,” notes Tolliver, adding that the cost of debt does influence buyer activity to an etent. “The rate cut was a good thing.”

CBRE's cap rate survey reported an overall drop in average industrial cap rates by 5 basis points to 6.27 percent at mid-year. However, the average cap rate on class-A assets dropped to 5.0 percent nationally, the lowest level since CBRE began producing the survey in 2009. Of the 54 markets surveyed, however, more than one-third had cap rates ranging between 3.75 and 4.75 percent, including the Bay Area, Chicago, Houston, Dallas, Atlanta, Northern New Jersey, the Pennsylvania I-87/I-81 corridor and Miami. 

While the average decrease in cap rates was modest, investor's preference for markets with higher yields was evident in cap rate compression of 12 and 14 basis points in Tier II and Tier III markets, respectively.  These included Louisville, Ky., Orlando, Fla., Charlotte, N.C., Nashville, Tenn. and Pittsburgh. There was also compression in cap rates on class A assets only in Honolulu, El Paseo, Calif., Cincinnati and Tampa, Fla., as well as on class-B assets in Las Vegas, Philadelphia, Cleveland and Detroit.

Explaining rising values and declining cap rates in Tier II and III markets, Fraker says, “There is a lot of capital looking for higher returns, so a flood of capital is going into those markets. He notes that the drop in cap rates in Tier II and III markets reflects escalating values due to increasing demand and rent growth and little new supply, which has generated strong competition for the few assets available for sale.

“There is still appetite for industrial product, even in coastal markets with very compressed cap rates, like Los Angeles and Oakland,” say Bitner. The challenge for investors is finding higher yields, which has elevated capital going into secondary and tertiary markets and class-B product, which is now compressing cap rates in these markets, he notes.

Investors have also developed a more sophisticated understanding of the logistics industry’s relationship to smaller markets, which often serve as distribution hubs for larger markets less than a day’s drive away, says Bitner. For example, smaller markets like Indianapolis and Columbus, Ohio serve as distribution centers for Chicago and East Coast markets, respectively, while Phoenix serves as an e-commerce hub for products moving into California.

As a result, cap rate compression on industrial assets in Tier II and III markets will likely continue, Fraker says.

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