For investors in industrial real estate, age is just a number. While most investment managers would hesitate to buy a decrepit office block or shopping mall with anything other than demolition and redevelopment firmly in mind, their thirst for older industrial stock is currently unquenchable.
The explanation for the phenomenon is manifest: weight of capital. “We have a saturation of players looking to partake in the industrial arena. There are so many new entrants and so much competition. Not all of them want to do ground-up development, but everyone can get their arms around a strategy to reposition an existing asset,” says Leslie Lanne, executive managing director and lead of JLL’s urban infill practice in the US.
Laurie Lagarde, head of European logistics at CBRE Investment Management, says that would-be buyers, frustrated by ending up as underbidders time and again, are turning to older assets because they cannot acquire newer ones. “They have no choice if they want to buy something in the logistics segment. There is too much capital in the market, and there are fewer off-market deals available because sellers can get better pricing from high competition on the market.”
Inevitably, pricing for older assets has increased. Lagarde pegs the spread between cap rates for new buildings and older ones at 50bps or less, with virtually no difference at all in some supply-constrained locations like Paris, London, Barcelona and Lyon.
Repositioning is considered a core-plus strategy, while buying to demolish and redevelop fits into the value-add bucket, she notes, with abundant capital available and willing to cover the risk spectrum.
Are older buildings worth the prices that investors are paying? The crucial factor in determining value is location, argues Logan Smith, head of European logistics at investor-developer Hines. In that respect, dated assets often have an advantage over newer ones. “Because cities have expanded, they tend to be closer into the urban area of conurbations. And because the location is good, the land component of total value can be relatively higher.”
Smaller warehouse, bigger punch
Assets close to urban populations play into the logistics sector’s defining present-day trend: e-commerce. “The nature of what is being asked of industrial real estate today – the ability to move product quickly – has increased the value of lower clear-height dated product that is close to people,” observes Jason Tolliver, Americas logistics and industrial investor lead at Cushman & Wakefield.
“It offers a tremendous opportunity to deploy capital and realize rent growth. In the US on a one-, five- and 10-year unlevered basis for investment returns, smaller multi-tenanted industrial product has outperformed both overall industrial returns and bulk warehouses, as well as offices, retail and multifamily. The smaller the warehouse, the bigger the punch, if it is the right small warehouse in the right location.”
Rental growth, and its expectation, is the justification for the high prices currently being paid, says Smith. “That is something we have clearly seen in dense, infill markets. If vacancies are low, there is no more stock to take up, and the cost of replacing these assets is increasing because of higher land and construction prices; all things being equal, you would expect the rents to increase.”
Adam Berns, chief investment officer at US logistics platform GLP Capital Partners, argues that the attractiveness of a building in any given market or submarket is primarily related to the context of other buildings in that market. “A building built 10 to 15 years ago in a market with abundant new supply will get to the point much quicker where it becomes less desirable from a tenant perspective, and an owner has less ability to attract tenants and push rent growth. Compare that to infill and coastal markets where it is very challenging to add new supply, and a building that was built 30 years ago may be very attractive.”
The importance of context is nowhere more evident than in the extremely land-constrained markets of East Asia, where multi-story distribution centers are already commonplace. “Those warehouses are in such high demand that they just cannot be obsolete,” says Chris O’Brien, executive director, capital markets, industrial and logistics for APAC at CBRE. “They still serve a purpose in good locations, and from a structural perspective they are still sound. When vacancy levels are so low, they are always going to be relevant.”
Alongside location, the two further factors that buyers of older industrial stock must account for are functional and physical obsolescence, advises Jack Cox, head of EMEA industrial capital markets at CBRE. Functional obsolescence relates to building specification, including eaves height, yard area and floor loading capacity, factors on which last-mile logistics operators are typically willing to compromise if they are close enough to affluent consumers to reduce delivery times.
Physical obsolescence is largely related to the condition of the building, especially the floor and roof, which are the most expensive elements of an industrial unit to replace. “There will be a price adjustment, or not, for those items. But investors can get very comfortable with buying older assets if they feel they have the right advice on those three factors,” says Cox.
The essential simplicity of most industrial buildings means that they tend to retain their value better than other real estate assets, opines Ben Bannatyne, president of Prologis Europe. “Obsolescence is not such an issue as people make out. Most 20-year-old space still works very well. It looks like a modern facility. We might upgrade it with LED, put cladding on to make it more energy efficient, and put more docks on it to make it more suitable for e-commerce. Our portfolio in the US has buildings that are 50 to 70 years old and a lot are still fit for purpose. You can reclad them pretty cheaply and reroof them, and tenants can do a lot inside that rectangle.”
Meanwhile, if the location is good enough, then the condition of the building becomes almost irrelevant for managers with a long-term eye on redevelopment potential. “We are buying a lot of older product as a land bank for the future,” says Bannatyne.
“When the leases expire, we will flatten whatever is on it and rebuild. It is a covered land play with income until we are ready to redevelop. For example, we have a lot of older space on [West London industrial district] Park Royal. We may redevelop that for multi-story because land prices are so high, but, in the meantime, rental growth has been phenomenal.”
Meeting ESG goals
While dated industrial buildings are highly attractive to tenants right now, some managers are beginning to plan for a longer time horizon where their underperformance in meeting energy efficiency and other ESG goals will start to undermine their ability to attract tenants and their liquidity in capital markets.
“If we are buying to continue to use a building, we really do look at sustainability,” says Bannatyne. “Upgrading a 20- or 30-year-old building can quickly become pretty uneconomical, and sustainability will become an even bigger issue, with certain buildings effectively becoming obsolete unless you can upgrade them sufficiently.”
It is worth investing capital for improvements even in cases where strong tenant demand and meagre supply means that a building would otherwise let without the manager needing to do much work, counsels Lagarde. “Some of the older buildings would attract tenants at a lower rent without being repositioned. But this is not sustainable in the future. I would rather spend capex to make the asset more operational and get a higher rent.”
Older buildings offer both a challenge and an opportunity for meeting ESG objectives, says Smith. “There are some advantages to reusing and repositioning buildings. When you think about embedded carbon in concrete and steel, there is real value to buying older buildings and investing the capex necessary to improve them, strictly from an environmental standpoint.”
When conducting a broader evaluation of their carbon footprint, occupiers of older buildings closer to city centers may find that shorter drive times reduce emissions compared with a more modern building further out of town, he adds.
Other potential risks await incautious buyers of older assets, including navigating local regulations and planning conditions. “Some older buildings have a strict operating permit or license that will just accommodate a single type of goods. An e-commerce company will not go there because they need to deliver any kind of product,” says Lagarde.
Not all redevelopments are likely to secure planning permission, even if there is an existing industrial use on the site, warns Bannatyne. “In locations that are now surrounded by residential property, the local authority or city may not want any more logistics.”
Market appetite for older stock in high-demand locations is such that competition has become every bit as fierce as for new assets. Meanwhile, the relatively low value of individual properties makes it challenging to put capital to work at scale, says Tolliver. “If you are a large fund that has to deploy a tremendous amount of capital, or you are trying to rebalance your portfolio away from office and increase your exposure to industrial, it is hard to do that with smaller buildings unless you can find a portfolio or buy an operator.”
Investors desperate to find opportunities are acquiring property in secondary markets around smaller settlements, observes Lagarde, a strategy that she believes could entail long-term risk.
“They are taking a bet on the change in supply chain dynamics. I can see that demand is spreading out to get closer to consumers, but I am not entirely convinced by that trend. In a downturn there would be a reduction in consumption, and users would consolidate back to the larger cities where the demand is strongest.”
Prologis’s Bannatyne also stresses the primacy of location in informing asset selection. “That is for sure the key. When these markets turn, which they will at some point, those investors who have rushed into logistics and decided to buy anywhere because everything is going up in value will not look so clever.”