Stabilizing Strategies in Turbulent Times
The ugly paradigm of the current (mid-2023) industrial investment market is that like 2022, almost every current investment deal features a below-market lease and will sell well below replacement cost, but transactional volume is way down from the historical highs of 2022.
Typically in this investment scenario, “value-add” investors would clamor for the opportunity to acquire the asset on the cheap and then execute one of two leasing strategies:
negotiate a renewal agreement with the existing tenant at higher rents but at minimal leasing cost (commissions, free rent or tenant improvements), or
play hard-ball and force the tenant to vacate at end of lease term, only to renovate the premises / building and then lease the vacated space at full market rents with full leasing costs.
There are many nuances to the binary strategies mentioned above, but either one, if conducted properly, should generate superior returns for investors over a short-to-medium hold period than acquiring a stabilized asset and holding for a longer period. This is one of the many reasons why cap rates compressed in 2021 & 2022 to the point that most industrial investment transactions featured negative leverage, especially in the most rapid rent growth markets such as Northern NJ or Los Angeles.
However, although this trade appears fundamentally sound, readily available, short-term debt financing at record low levels stimulated a rapid increase in prices that began to offset the superior return potential. With the federal reserve having raised short-term lending rates by 575 bps in the past 12 months, the all-in cost of bridge financing has increased from ~4.0% to ~10%. Although leasing rates continue to rise, investors are less willing to pile into these value-add opportunities judging that the risk-return calculus is not sufficient. Perhaps they are concerned about ballooning construction on the supply side or subleasing / bankruptcies affecting demand. The chart below shows though how quickly supply can turn off in the industrial space.
So for now, the bid-ask spread thus widens as Owners are unwilling to change their selling price as they are witnessing historically strong rental rate increases. So how does a value-add investor juggle this paradigm of rising lease rates, rising financing costs and static prices. Sitting out the market seems easy, and frankly that is what a lot of investors are doing. Creative buyers will devise financing strategies that include some level of seller financing to replace the expensive bridge debt market. We are definitely in this camp. Other larger private or institutional buyers will tap into lines of credit negotiated in better times to fund transactions during this bridge period. But what if there is another way to avoid the bridge market.
A less-popular strategy that Snowball Developments likes to deploy is the tenant-partnership model to “stabilize” an “unstabilized” asset prior to closing. This could involve working with the existing tenant to modify their lease prior to closing, or acquiring a vacant, or soon-to-be-vacant asset, with a “tenant-in-tow”. The key driver here is that a traditional lender views the speculative leasing transaction as a “fait-accompli” at closing and therefore provides acquisition financing that resembles terms (Loan-to-Value, Interest Rates, Amortization) offered to stabilized transactions.
169 Callender Road, Watertown CT - 81,500 SF industrial flex facility on 20 acres
We recently closed on a transaction at 169 Callender where the incumbent tenant, Utitec Inc and the Seller could not agree on a cost-sharing or reimbursement method for capital expenditures. As the Seller saw it, the Tenant was the principal beneficiary and principal contributor to capital expenditures for maintaining the HVAC equipment and whose trucks were causing damage to the asphalted areas. The Tenant believed this was a Seller obligation as part of its lease but was in the process of seeking a new financial partner and needed to prove operational stability and building performance.
Snowball Developments stepped in as a buyer and with Seller permission negotiated a new 7 lease (with renewal options) with the Tenant (and its future buyer) where capital expenditures are an Owner obligation but can be charged back with interest to the Tenant over their useful life. As such the Tenant knows that it is in the Owner’s interest to perform the work but should it ever decide to vacate is not responsible for paying the amounts up front. By stabilizing the asset prior to closing, Snowball was able to achieve a rate lock at 5.49% fixed for 5 years versus closing with bridge financing and negotiating the renewal under duress. A win-win for both parties, and since acquisition we have completed the majority of the asphalt repairs.
Before and after asphalt repairs at 169 Callender Road
Acquiring an industrial asset with a tenant-in-tow is a trickier maneuver to execute as the prospective tenant needs to feel confident that the physical space will work for their business needs. Additionally, it is only natural that there are a lot less vacant buildings “for sale” versus “for lease”. As such, the Tenant needs to feel that there is an economic incentive in selecting the targeted acquisition asset over other available opportunities. However should the vacant space fit, now the magic happens. First to analyze is whether the entire building vacant or just a portion of it. The best situations are when the value is discounted due to the fact that there is some vacancy and the property is not stabilized. Second component is whether the tenant is showing up with equity (perhaps through the sale of their existing property) to contribute to the funding of the deal. Third, is the tenant willing to pay aggressive but defendable lease rates in exchange for equity.
Based on the parameters above, options abound to maximize leverage and loan terms from a traditional lender and augment returns for the tenant and your investors. Every scenario is curated to the transaction, however fundamentally the tenant will need to sign the longest lease term and have options to renew and will likely want to have rights to acquire the asset at pre-determined formulas. Snowball Developments is currently exploring a series of transactions on these lines where we are working with our existing tenants to assist in their expansion or relocation, as well as coordinating with neighboring user/owners where we are seeking to acquire their property as part of accretive land assemblages.
The industrial leasing market is currently experiencing an unbelievable shift in perceived value. Tenants are recognizing that operational stability is significantly more valuable than flexibility. Owners meanwhile are being challenged by short-term interest rates that have spiked. This now aligns the interest in creating stabilizing solutions, but only through partnership is this possible. Not all owners are up to the task of partnering with tenants, sometimes for ideological or corporate governance reasons, but this less competitive landscape allows more nimble owners to seek out these value-creation opportunities.