This article is sponsored by BKM Capital Partners
Founded in 2013 by CEO Brian Malliet, a 30-year light industrial veteran, BKM Capital Partners is a vertically integrated industrial operator that specializes in acquiring and improving multi-tenanted small-bay industrial business parks across the western US and has amassed a $1.85 billion portfolio to date.
Malliet and Harry Hedison, senior managing director, capital markets and investor relations, argue that the niche asset class not only proved itself to be more resilient than big-box warehousing during the last downturn, but also promises to perform even better in the face of current headwinds because of limited supply and growing demand from a new breed of tenant.
How do the investment characteristics of small-bay industrial assets differ from those of big box warehousing right now?
Brian Malliet: One thing that sets the asset class apart is the opportunity for immediate value creation due to shorter weighted average lease terms (WALT). The small-bay space averages 1.5-1.7 year WALT at purchase versus 5-10 year WALT in big box warehousing. This allows an investor to capitalize on rent growth across the majority of an asset within three years.
That is one reason why Blackstone paid $7.6 billion for light industrial platform PS Business Parks in July last year. They were looking for short WALT to take advantage of the expected rental growth over the next two to four years to offset inflation.
That deal has really raised awareness of the space. Investors are also looking for yield, which has not been available in the big box space, where cap rates compressed to 2.75 to 3 percent. Because of the more intense management required, light industrial has traded at about 150 to 200 basis points higher than big box properties, even though the risk profiles are not that different.
Harry Hedison: As well as being a good inflation hedge, the sector offers strong tenant diversification, both by number and industry. Typically, each of our assets has four to 10 buildings in one location, with 20 to 200 tenants.
Having a large number of tenants in a range of industries helps mitigate the impact to cashflow of any one of them potentially defaulting in a difficult economy. There is much greater concentration risk in the large-bay warehouse segment because you usually have only one or two tenants. In addition, our portfolio of light industrial properties has historically experienced very high levels of tenant retention and low credit loss.
Another advantage of the light industrial sector is that these assets are in infill locations. That provides real downside protection, because those sites have very strong value even if the current use changes. For example, we have seen multifamily developers looking to acquire light industrial properties as sites for urban residential development.
Case study: West Valley Business Park, Washington state
In October 2019, BKM acquired West Valley Business Park, a 206,000-square-foot light industrial scheme located in the city of Kent, to the south of Seattle, in an off-market deal.
The purchase price of just over $30 million represented a 7 percent cap rate. BKM invested $1.5 million on cosmetic improvements, including enhanced signage, a modern paint scheme and drought-tolerant landscaping. A further $2.2 million was invested to convert dysfunctional office units to industrial suites, reducing overbuilt office space and reconfiguring 22 obsolete units.
Rents, which at $1.12 per square foot per month were 12 percent below market levels at the time of purchase, have risen to $2, a 79 percent increase. An average WALT of 1.9 years means that BKM will be able to mark-to-market rents on 81 percent of the space over a four-year investment period.
Occupancy has grown from 88 to 96 percent and NOI has increased from just over $2 million to almost $3.5 million over the same period. At the time of the projected exit in September 2023, the sale price is expected to more than double to $63 million.
What are the supply and demand dynamics of the sector in the US?
BM: Until about 15 years ago, much of the tenant demand for light industrial space was related to the housing boom. Since then, there has been a big change in the tenant base, with three new industry sectors emerging, each of which has added around 15 percent to demand.
The first of those is e-commerce. Increasing e-commerce demand has forced the traditional supply chain to readjust and has driven demand for industrial product to nearly unseen levels. The ability to move product quickly with the shortest delivery times to the end consumer is critical to the modern supply chain, increasing the value of light industrial product in infill locations.
The second new source of demand is innovation driven by advancements in chip technology, such as electronic vehicles, drones, robotics and sensors. Those businesses often locate their office, manufacturing, assembly and warehouse functions within a single small-bay unit, and the only zoning that allows them to do that is light industrial.
The third is advanced manufacturing. The advent of 3D printing has shrunk the size of the building required to house a manufacturing business. A process that might formerly have needed 500,000 square feet can now take place in a 10,000-square-foot light industrial unit.
Meanwhile, we are seeing large manufacturers reshoring and onshoring to the US, and the light industrial tenant base is often composed of the vendors that support them. Add those together and they account for an almost 50 percent boost in overall light industrial demand.
With respect to supply, there continues to be a lack of supply of light industrial space, and that is not going to change because it is still cheaper to buy it than it is to build it. In infill locations, it is hard to find land and expensive to develop it. Of the 500 million square feet of industrial space that will be built this year, less than 3 percent will be small or mid-bay product. The vast majority will be big-box space.
How resilient is the segment to an economic downturn?
BM: During the global financial crisis, light industrial average occupancy was higher and average rents didn’t fall as far in the space as they did for big box industrial. Sometimes there is a fallacy among people who have not invested in the light industrial space that it was just the opposite.
PS Business Parks, which was formerly the largest REIT focused on the light industrial sector, represents an excellent public data set for evaluating the resilience of the sector over time. During the GFC recession, the average industrial vacancy rate was 48 percent higher than PS Business Parks’ portfolio vacancy rate (13.7 percent versus 9.2 percent). While the average industrial market rental rates saw a 15 percent decline, the average decrease for the PS portfolio was only 9.7 percent.
HH: And within light industrial, the new-paradigm tenants are less susceptible to weaknesses in the economy because they typically have stronger finances, higher operating margins and are better-aligned to the factors driving secular demand growth than the older breed of occupier.
It is also important to recognize that there is a discrepancy between what is happening in the capital markets and what is happening in the property markets, where the light industrial sector has very strong fundamentals. We are seeing strong secular demand and limited new supply. Oversupply has historically been the catalyst for weakness in the real estate sector, we don’t expect oversupply to be an issue in light industrial because of the barriers to entry we discussed.
It is the debt markets that are causing the current uncertainty and the slowdown in real estate transaction activity today. We can’t control that, but we can control revenue and net operating income growth. BKM’s current compound annual growth rate is 13 to 14 percent a year, and usually if we hold an asset in a five-year fund, we increase NOI by at least 75 percent over that period. In the current climate, the key for investors is to invest in a sector that offers rent growth, with a platform that allows them to capture that growth within their portfolio.
What is the best approach for investors wanting to access light industrial assets?
BM: Investors have to access the space by teaming up with an operator, one that has been active in the sector for years, so they understand it, and are capable of managing the large volume of lease transactions and speculative industrial unit deliveries. For example, we have just under 9 million square feet of space, occupied by more than 2,500 tenants. We turn over 550 units a year on average, so that means every day we will sign two leases.
Investors need the team, technology and processes to handle that kind of volume. They also need local decision-making authority and oversight to react in a timely manner to capture rent growth and secure growth tenants.
HH: Our flagship funds execute a classic value-add strategy. We look for under-managed and undercapitalized properties. The common thread across everything we acquire is that the existing rents are significantly below market levels because of a lack of attention from the current owner.
We see that at both ends of the spectrum, with big investors who cannot focus on smaller assets, because they don’t move the needle for them, and small investors who lack the capability. When we buy an asset, it is not unusual to see the rents at 20 to 25 or sometimes even 30 percent below market rates. Because of the short-term WALT, we are able to quickly grow the NOI of those properties.
What are the future prospects for investing in the sector?
BM: To buy today, you have to be a lot more selective and much tighter in your underwriting. We are looking for higher returns than we typically underwrote in the past. But there is less competition because a lot of the big national funds that were pushing into this space are not buying right now. That creates opportunity in terms of the deal pipeline.
Debt is still available for a specialized player like us, because many lenders underwrite not only on the economics of the asset, but also on the borrower’s proven ability to execute a business plan. And while it is tough to secure large loans right now, there is still a lot of liquidity in the $15 million to $50 million range, which is the right size for the light industrial asset class.
We are underwriting returns 25 to 30 percent higher than six months ago. Cap rates have moved out less for light industrial than they have for large buildings because of light industrial’s ability to capture rental growth more quickly.
The future holds a number of unique opportunities for investors in light industrial, including attractive pricing spreads, new-paradigm tenants that are more recession resilient, and – given the shorter WALT– the ability to take advantage of the exceptional market rent growth that occurred in 2021 and 2022, which isn’t yet reflected in the current rent roll of many properties.