By Taylor Williams
Much as the commercial community and society at large would like to avoid a recession, prolonged periods of contraction are part of the natural economic cycle, and the U.S. financial powers that be appear to be on a collision course for exactly that scenario. But for assets classes backed by exceptional demand drivers and fundamentals, like industrial real estate in major Texas markets, is there really a need to sweat a downturn?
Like any conflict, the battle between macro- and micro-level forces essentially comes down to magnitude. Will the severity of interest rate increases — three separate hikes totaling 200-plus basis points in a few months — prevail over robust tenant demand that has fueled record occupancy and rent growth throughout Texas and beyond in recent years?
Only the Federal Reserve can speak to the first variable. The nation’s central bank appears hell-bent on whipping inflation, which registered a year-over-year increase of 8.3 percent in August, and is seemingly resigned to the inevitability of recession as a byproduct of its monetary policy.
As for the competing forces that are industrial fundamentals, third-quarter figures were not available at the time of this writing. But, using Dallas-Fort Worth (DFW) and Austin as proxies for statewide performance, second-quarter data from CBRE shows respective occupancy levels of 5.1 and 4.9 percent — tight by any objective metric.
In DFW, developers delivered 11.7 million square feet of new product in the second quarter, and the market posted 9.7 million square feet of positive net absorption during that time. Nearly 34 million square feet of industrial space was absorbed in DFW in the 12-month period ending June 30, with roughly 7 million square feet or more absorbed in each of the past four quarters.
In the state capital, a considerably smaller market with smaller-footprint buildings, industrial absorption totaled approximately 647,000 square feet in the second quarter, per CBRE. That figure eclipses the roughly 616,000 square feet of new deliveries that came on line during that period. In addition, asking rents for triple-net-leased assets in Austin were up 4.1 percent on a quarter-over-quarter basis and up 16.6 percent year-over-year.
As with any debate, context is key. The mainstream news cycle is replete with stories of single-family home borrowers who bemoan current rates in excess of 6 percent on 30-year, fixed-rate mortgages without considering how that figure historically stacks up. By the same logic, industrial owners who remember a time not so very long ago when the asset class was hardly the belle of the investment ball tend to recognize just how far the product type has come in recent years.
Particularly for infill deals involving e-commerce and third-party logistics users, demand and rent growth should continue to proceed at healthy clips, sources say. As a proportion of their overall cost structure, real estate is relatively low for these companies. So even if rents continue to rise, the success of these users’ business model depends on having a centralized location from which to quickly and efficiently serve major customer bases.
In addition, the unprecedented level of tenant demand that has been unleashed on industrial markets in recent years has, in many cases, allowed landlords to lock in fixed rental rate increases over lengthier lease terms. Some landlords, particularly those with shorter weighted average lease terms on their books, may pull back on rent increases in the event of a recession to maintain occupancy. But sources say this is unlikely to deter investment demand on any sort of meaningful level.
“Even as interest rates have risen, we’ve seen new buyers enter the market based on a need to deploy capital into the sector,” says Trent Agnew, senior managing director at JLL’s Houston office. “In addition, a lot of the proposed new development has dried up in recent months due to simple economics. It’s going to be harder to achieve yields on new development, which puts owners of existing product in a good spot in the coming years.”
“Buyers and sellers are still finding ways to transact within the capital parameters they’ve set, as they know that there won’t be a true market reset until the Fed is completely done raising rates,” adds Lizzy Blake, senior vice president at Colliers’ Dallas office. “While we are constantly re-evaluating and coming up with new pricing parameters by which to underwrite, investors and brokers are also getting very creative and entrepreneurial and figuring out ways to get deals done.”
Subtle Factors
Macroeconomic factors like rate hikes, inflation and fear of recession may cause deal volume to slow, prices to fall and cap rates to rise in the short run. But the prevailing sentiment is that drivers like e-commerce and reliance on third-party distribution service are entrenched as methods of acquiring and delivering goods. For this reason, the sector should emerge relatively unscathed in terms of cash flows and, by extension, valuations.
“We expect a recession to have modest impacts on our industrial market,” says Blake. “Although all parties are impacted on some level by inflation and rising interest rates, we don’t hear much about tenant demand slowing down. Rents are still rising, and we should see about 20 million square feet of positive net absorption this year [in DFW], which is less than the record levels we saw in the last couple years, but still a very strong number.”
In addition, the fact that demand has outpaced supply in Texas markets should make for a soft landing as far as financials are concerned.
“We’re definitely undersupplied in terms of new construction, so even if there’s a slowdown in the e-commerce or distribution segments of the market, that could even out the supply-demand balance by allowing new development to catch up,” says Joe Iannacone, senior vice president at Titan Development. “We also know that industrial demand is still there via onshoring due to so many large companies setting up operations in Texas.”
Especially in Central Texas, where Titan Development has been active of late, the need for industrial space among vendors and suppliers that support these major manufacturing operations is very healthy. Iannacone cites the Tesla Gigafactory in Austin and Samsung’s $17 billion semiconductor plant in Taylor as the two most obvious and visible examples of this trend in action.
He also notes that another key macroeconomic factor — supply chain disruption — has some potentially advantageous implications for industrial owners. This particular form of operational uncertainty is forcing tenants to ramp up their timelines on leasing and expansion decisions, even if that means accepting higher rates.
“In the past, tenants needed the latest technology and equipment, so they waited until the last minute to get the latest model and use it,” Iannacone explains. “Now they’re ordering way in advance just to hit the date that they want to be operational while also trying to lock in financing on that equipment earlier due to rising interest rates. When you add that to concerns over lack of space, you see why preleasing and rent growth are still strong.”
Lastly, there is the bell cow that is Texas herself, a perpetual driving force of growth via exceptional in-migration and corporate relocation. The state’s policies and attractiveness to people and companies in other states will continue to play a somewhat unsung, yet critical role in mitigating the damage that could come from a recession.
“Texas is well-positioned to weather a national recession compared to many other markets,” notes Charlie Meyer, president of Houston-based development and investment firm Lovett Industrial. “Interest rates on construction or acquisition loans are generally the same across all markets, but the net migration and business-friendly climate we have in Texas should ensure that demand is stronger and more persistent here.”
Meyer’s analysis draws attention to the fact that even though high costs of capital and healthy tenant demand are currently clashing to create unusual short-term market dynamics, the long-term impacts of these forces will likely be unrelated.
“Capital availability is due to forces that don’t necessarily have anything to do with owning and operating industrial real estate,” he explains. “You’d think that when fundamentals are strong, there’d be more capital to invest, but that dynamic just isn’t there right now. It’s understandable, but frustrating at the same time to not be able to fully capitalize on that demand due to uncertainty in the capital markets.”
Investment Patterns
To summarize, the volume of investment sales does not currently reflect the level of tenant demand in Texas markets, mainly because volatility and uncertainty are at extreme levels. This characterization holds especially true when considering just how low interest rates have been for so long by historical standards.
Yet sources say that deals are still getting done. That means that numerous trends that define the industrial capital markets landscape in Texas are changing on the fly. And the most obvious shift in deal profiles and executions involves the advantage that well-capitalized, institutional investors have over private buyers.
“It’s tough for smaller investment groups to win deals right now, because they do have to underwrite market debt, and with deals we’ve marketed to a broader range of users, we’ve seen differences in how these groups underwrite debt versus how the institutions do,” says Blake. “The smaller groups need more time to secure debt, so going with all-cash buyers provides sellers with the certainty of closing and shields them from added risk.”
Blake says that she expects this trend to continue until the debt markets have undergone a full reset.
“It’s such a strange time in the capital markets that we have to ask pointed questions and be really careful about how we advise sellers,” she says. “That means not taking chances on buyers that are new and need capital. We’ve seen new groups come in and outbid the competition, which is fine when the debt markets are cooperating. But today, paying up isn’t necessarily going to get these groups the deal because they’re unlikely to get the loan-to-value ratios. So those groups really have to focus on small deals.”
Champion Partners and Cresset Partners recently broke ground on Tradepoint 45 West, a 1.3 million-square-foot project near Dallas. The project is being developed on spec, suggesting that developers have faith in rent growth potential despite uncertainty in the capital markets.
Cash is indeed king in a rising interest rate environment, even if the present value of that cash isn’t what it was a year ago. A period of price rediscovery is occurring after years of sustained cap rate compression, and the investment community has now largely accepted this new reality. As such, sellers are more willing to take lower prices in exchange for all-cash buyers’ certainty of closing in a timely and hassle-free manner.
“What’s been surprising this go-round versus previous cycles when pricing slipped is that generally, in eight or nine out of 10 deals, we’ve had sellers meet the market and transact, even if the price wasn’t what they originally had in mind,” says Agnew. “We’ve seen sellers pick buyers that weren’t at the top of the list in terms of pricing. If the offer is all-cash with a 10- to 30-day closing period, sellers will sacrifice as much as 5 percent on pricing to go with that buyer as opposed to one with a risk of not closing.”
Agnew adds that merchant builders — developers whose business models are built on selling shortly after stabilizing their assets — are particularly willing to go this route. Many of those developers did not underwrite at the historically high rental rates that major markets were seeing earlier in the cycle in their original pro formas. Thus, their exit cap rates and price points did not need to be as low/high to make the deal work, he explains.
Sellers are also coming down on bid-ask spreads, and brokers are seeing less movement between multiple rounds of offers from buyers, Agnew notes. As a result, a decent number of deals are trading at negative leverage, a condition in which the all-in cost of debt exceeds the cap rate at which a property is purchased.
“While the majority of Class A core deals are still getting done with unlevered buyers, we are seeing more Class B deals trade at negative leverage, with the buyer underwriting the deal such that positive leverage will be achieved within 12 to 24 months,” he says.
As a result of buyers being willing to temporarily accept negative leverage, sellers coming down to transact at lower price points and institutional players focusing on major core deals, it’s this smaller, less glamorous segment of the market that currently has the most liquidity.
One final pattern that is emerging amid the tumultuous capital markets landscape is one that, ironically, speaks to rock-solid faith that investors have in industrial tenant demand. This trend involves buyers increasingly targeting deals in which the weighted average remaining lease term is lower — two to three years — than higher.
Several years ago, before the world knew what a wrecking ball industrial real estate could become, investors generally preferred deals whose cash flows were locked in for the longer term, assuming some level of rental rate increases was baked in. Now, however, buyers are looking at properties in which leases were negotiated before markets peaked, meaning that in a couple of years, they’ll potentially be able to renew at higher rates.
This strategy speaks to the belief that industrial tenant demand is unlikely to slow considerably in the next few years. In addition, investors remain confident that they can secure these renewals because vacancy is so low and high costs of capital are beginning to act as a governor on new supply.
“While there will be a slowdown in transaction volume this year and cap rates will likely continue to move upward, rents will still help keep values elevated,” says Meyer. “It remains to be seen how much longer negative leverage will be prevalent and constitute winning bids, and that dynamic has kept some buyers that have higher return thresholds on the sideline.”
“But there are other groups that are still buying and feel like they’re getting a discount today, mainly because they believe rents will continue to grow at a pace that makes negative leverage positive very quickly,” he continues. “In that case, buyers receive a strong total return, not just a strong levered return.”
So there you have it: The macro-level turbulence of the capital markets in one corner and the Texas-specific fundamentals in the other, competing for an audience of industrial buyers, sellers and brokers. Time to place your bet.
— This article originally appeared in the October 2022 issue of Texas Real Estate Business magazine.