By Taylor Williams
“Numbers never lie; they simply tell different stories depending on the math of the tellers.”
Mexican-American poet Luis Alberto Urrea may not have been talking about commercial real estate development and investment when he wrote that line, but the implications of that statement are undeniably applicable to those fields.
The use of numerical projections in commercial development and investment is different from employing sabermetrics in sports or using predictive analytics to diagnose illnesses in medicine. Hard costs are what they are, and the formulas that developers and investors rely on to make critical decisions tend to be well-established in their rigidity, even if their inputs can and do change.
Respecting the time-tested veracity of these formulas can make the difference between coasting through a down cycle or being crushed by it. Yet this is a world in which complex equations, algorithms and computations increasingly influence key business decisions.
And so the ability to accurately forecast, control and manipulate numerical inputs is beyond valuable. Underwriting represents the piece of the real estate development or acquisition process in which these numerical details are shoved under the microscope and relentlessly finagled in hopes of keeping a development or deal alive.
Three years’ worth of globally disruptive events — not all of which were detrimental to the sector — has fundamentally altered the numbers that industrial developers and investors scrutinize when deciding whether to pull the trigger on a new project or acquisition.
Most notably, a string of interest rate hikes over the last year has drastically complicated the process of financially engineering deals at the underwriting level. The magnitude by which these numbers have moved is simply too great to ignore. As a result, owners are facing a new reality in terms of what constitutes economic feasibility.
“It’s no secret that debt has basically doubled over the past 12 months and really put a wrench in our numbers as developers in New Jersey and Pennsylvania,” says Anthony Amadeo, vice president at Woodmont Industrial Partners. “A lot of institutional capital sources are on the sidelines due to economic uncertainty, and the return metrics have gone up for those that are still in the market.”
“Interest rate increases really act as a double-whammy with regard to project costs via an increase in carrying costs. On top of that, they increase cap rates, so your overall project has less value when you’re trying to sell it,” concurs Ronel Borner, senior vice president of development at Chicago-based CenterPoint Properties. “And nobody knows when and where it’s going to stop. So whether you’re a merchant builder or a long-term holder, it’s very difficult to accurately underwrite exit cap rates right now.”
Indeed, of all the underwriting challenges that exist in today’s environment, accurately assigning values to exit cap rates might be the most dicey proposition of all.
“A year ago in New Jersey, a well-located industrial site that was shovel-ready would be underwritten by institutions at a 4.5 to 5 percent return on cost, on average,” Amadeo says. “That’s now up about 200 basis points to 6 to 6.5 percent, which affects underwriting and the cost of the project. So the institutional capital partners are waiting for the market to stabilize before jumping back in.”
All factors being held equal, developers want to develop, and investors want to invest. But as the macroeconomy shifts, fiduciary responsibility to shareholders and financial backers takes priority over conducting business as usual.
“Most investors are looking for data to support their assumptions and explain why an investment will work. But the problem right now is that we have inputs like interest rates, but we don’t have a lot of comprehensive data,” says Borner. “Nobody wants to act until there’s enough data to where they feel comfortable going to investment committees with real confidence in the numbers and can justify putting money into an investment.”
It all adds up to some degree of stagnation in the development and investment cycle. Because despite healthy tenant demand and rent growth throughout the core markets of the Northeast, the ramifications of nine rate hikes totaling 475 basis points in 12 months simply can’t be written off.
“While we still see very strong tenant demand in Northeast markets, it’s a volatile time for underwriting, although cap rates have begun to adjust to movement in interest rates,” says Ohad Porat, chief investment officer and partner at Faropoint, a New Jersey-based industrial investment firm. “When a recession is looming, responsible underwriting principles should not be rosy, even with the high occupancy we have in New
Jersey.”
Healthy Fundamentals
Cushman & Wakefield recently released its first-quarter 2023 “Northeast Industrial Labor Report,” which tracks basic property metrics and workforce statistics across all major markets in the Northeast. The report stated that in Northern New Jersey, direct vacancy was slightly above 2 percent at the end of 2022, down nearly 400 basis points from its 2017 level.
According to the same report, the vacancy rate was only slightly higher — just a shade over 3 percent — in Central/Southern New Jersey at the end of last year, a period that saw the highest level of new deliveries in the past five years. Pennsylvania’s I-81/I-78 corridor, which encompasses the high-demand Lehigh Valley region, had a similar vacancy rate as of late 2022. That submarket added more than 25 million square feet of new industrial space last year, and the volume of net absorption almost matched that of supply growth perfectly.
“Even with healthy demand and the expectation that meaningful rent growth will continue, it’s hard to underwrite 10 percent rent growth when there are so many indicators of recession out there,” Porat says. “So we’re underwriting rent growth that is more in line with historical averages. We have to assume that there will be a slowdown, whether it’s mild, moderate or severe, otherwise the inflationary environment will not go away.”
Porat concedes that for the New Jersey industrial market, going into a potential recession at 97 to 98 percent occupancy should soften the blow and keep rents from dropping off too sharply.
“We’ve seen ridiculous rent growth — 15 to 20 percent a year for five or six consecutive years — and it’s unrealistic to expect that to continue for another five to 10 years,” adds David Greek, managing partner at New Jersey-based Greek Development. “Last year, we saw some of our competitors make some aggressive assumptions on rent growth and future residual values. The silver lining of what’s happening right now is the realization that you can’t afford to stretch those assumptions too far — deals get riskier a lot more quickly with expensive money.”
Supply Constraints
The mathematical formulas that guide underwriting principles can be stubborn, even if their inputs are currently subject to major change. Further complicating the underwriting challenges is the fact that industrial sellers and landowners have been reluctant to play ball under the new economic conditions.
“Whether it’s a land deal or a fully stabilized asset, it’s just taking longer for sellers to recognize the new realities, and nobody wants to admit that they made a mistake by not selling six to nine months ago,” explains Borner. “There’s been so much demand in recent years that developers were willing to bear risk by closing on sites before they had entitlements in hand. Now that sellers are bearing more risk, they’re reluctant to budge on pricing.”
“With the increase of both debt and construction cost rising due to inflation, we are seeing land values falling, even in land-constrained markets like New Jersey with high barriers to entry,” says Amadeo. “However, there is still a large disconnect between the bid and asking price on new deals.”
“Most buyers are hesitant to take on entitlement risk in the current environment and thus are looking for longer due diligence and approval time periods,” Amadeo continues. “That’s great for developers because we no longer have to put money down two years before getting approvals; we can wait for that and then bring our institutional capital into safer places.”
All sources interviewed for this story acknowledged that the amount of time and work required to secure approvals for new projects in New Jersey effectively serves as another barrier to entry.
One of CenterPoint’s newest projects in New Jersey is CenterPoint at Linden, a 321,765-square-foot development located just south of Manhattan that is a redevelopment of a former Walmart-anchored retail center. In discussing that project, Borner praised local officials for allowing the rezoning of the property to meet rampant demand for industrial space. That type of municipal support isn’t always putting wind behind the backs of developers in the Garden State.
Sources also agree that diminished competition for sites has contributed to falling land prices.
CODA Logistics & Distribution recently signed a full-building lease at CenterPoint Linden (pictured). There are two different I-95 interchanges within a five-mile radius of the property, and the site is also located about 10 miles from Port Newark-Elizabeth. Newark International Airport is about eight miles away from the facility.
“Land and development sites have been particularly repriced lower than stabilized assets have,” says Greek. “There’s not great data and statistics on this, but we estimate that land values have fallen anywhere from 25 to 50 percent, depending on the market, compared to early 2022.”
“Generally speaking, if there were 20 potential buyers for a stabilized asset a year or two ago, it’s probably more like five or six today,” he continues. “But to put that into context, having 20 bidders on an industrial building is not normal — that’s a frothy time in the market. What’s happening now feels like a return to normalcy with regard to the types of buyers, the competition for space and especially in terms of
pricing.”
Greek Development is currently underway on construction of Phase III of Logan North Industrial Park in Southern New Jersey, and the company recently received $50 million in permanent financing for the 3.2 million-square-foot development. Greek noted at the time that the loan, which was provided by an undisclosed life insurance company, spoke to lenders’ recognition of just how robust demand is for industrial space in these markets.
Despite historically low vacancy rates across many major markets of the Northeast, the skyrocketing costs of capital and high risk of securing approvals aren’t exactly incentivizing industrial developers to be aggressive right now.
Construction pricing remains equally volatile for certain materials. While prices and lead times for core materials like steel and lumber have stabilized relative to recent years, the cost and availability of specialized products like dock levelers and electrical switchbox gear have shown violent fluctuations of late. While the absence of those items doesn’t necessarily delay shell construction and interior build-outs, it can preclude owners from securing certificates of occupancy, thus preventing them from getting tenants into the facility and collecting rent.
There is also the question of which subcategories of industrial product will see the biggest dips in supply growth. For example, Faropoint targets smaller assets — typically nothing bigger than 200,000 square feet — which Porat says represents a very small percentage of the total new product under construction. Among the company’s most recent acquisitions within this segment of the market are a 24,000-square-foot building in the Long Island community of Brentwood and a portfolio of four buildings in Maryland that range in size from 30,333 to 81,650 square feet.
The volume of larger product under construction in New Jersey, Porat says, is closer to 6 or 7 percent of the total existing inventory.
“We do see less development during economic downturns, so going out of a recession, if you have existing buildings or are about to complete a building, you’re in a better position because there’s less construction,” he explains. “Many developers have been building large buildings and leasing them up successfully in recent years. But if you’re entering a recession and still have 6.5 to 7 percent of inventory being built right now, that might cause some challenges in terms of leasing in a down cycle.”
Land constraints limit the number of large-scale developments — call them 500,000 square feet and bigger — that the New Jersey market can bear. But as land prices fall, these sites do become more appealing. This is because these sites allow developers to amortize their costs of capital and construction, which increase with the size of the project, at lower bases.
Ultimately, the combination of incurring heavier costs of capital, navigating challenges to securing approvals and overcoming land constraints is almost certain to put a dent in new supply growth. The real questions are when this dip in new development will manifest itself and how much it will upset the supply-demand balance.
“A year ago, we were a little concerned about the amount of product being developed, especially in Eastern Pennsylvania and Southern New Jersey, where there’s more available land,” says Greek. “But now that some of those projects have been put on hold, it feels like there’s a healthier supply-demand dynamic.”
“We do expect the interest rate environment to be significantly better in two to three years and for the buyer pool to be significantly larger,” he continues. “However, we shouldn’t necessarily expect pricing to get to the sub-3-percent cap rates we saw in 2021 and 2022, but closer to that mark than they are today.”
A New Concern
Prior to mid-March, the general sense was that the Federal Reserve would continue raising short-term interest rates as part of a prolonged war on inflation, which has yet to return to pre-pandemic levels.
However, following the collapse of two large U.S. banks and a government-forced takeover of an even larger European institution, the nation’s central bank may have little choice but to pause or reverse course on rate hikes to give ailing lending institutions some relief.
At its most recent meeting on March 22, the Fed did raise short-term rates by 25 basis points while also signaling that it will slow or desist from rate hikes in the near future.
But even if the Fed elects to abandon more rate hikes in the short term, industrial owners will in many cases still be hamstrung by costs of capital that remain high and make pursuing new projects and deals unjustifiable. And while rate cuts would likely have the opposite effect, restarting the development pipeline is not an overnight task.
Regardless of the extent to which concerns about the stability of the banking system plays out, this latest development adds another element of uncertainty to the mix.
And uncertainty almost always leads to pause.
— This article originally appeared in the March/April issue of Northeast Real Estate Business magazine.