Industrial Cap Rates Are Among the Lowest of All Asset Types
If you’re an industrial real estate investor, looking at the current market cap rates of potential investments is often an essential part of the underwriting and investment selection process. In today’s market, industrial cap rates are among the lowest of all asset types.
According to data from research firm Real Capital Analytics, as of the end of 2020, cap rates for newly constructed industrial properties averaged 5.2%, while average cap rates for existing properties sat at 6.2%, falling from 6.5% at the end of 2018.
What is Cap Rate?
Before getting into the details of industrial cap rates, it’s important to review exactly what cap rate is and its importance for commercial real estate investors. Cap rate is determined by dividing the current market value of a property by the property’s net operating income (NOI).
NOI is defined as property’s gross income minus all expenses, including taxes, operating expenses (such as property maintenance, repairs, and replacement reserves), and other costs.
For instance, a $2 million property with an annual NOI of $100,000 would have a cap rate of 5%.
Cap rates are highly correlated with risks, with Class A industrial and multifamily in major metropolitan areas generally having the lowest cap rates, while lower-quality B and C class hotel retail and exotic property types (think marinas or parking lots) generally having the highest cap rates. Cap rate can be considered a measure of the amount of money an investor is willing to pay for a specific cash flow.
However, cap rate is only one way to determine the ROI (return on investment) of a commercial property. Unlike levered IRR (internal rate of return) and levered cash-on-cash return, cap rate does not incorporate debt into the equation.
What Factors Influence Industrial Cap Rates?
There are a variety of factors that impact industrial cap rates, some of the most important which include:
Overall Market Conditions: Overall economic and real estate market conditions impact the cap rates of all properties, and industrial properties are no different. When property values reach high levels and the real estate market cycle is at its peak, cap rates are lower, but when the market is cooler, cap rates increase due to an increase in the perceived risk of investing in industrial real estate.
Property Supply and Demand: The supply and demand for industrial properties is another major factor that influences industrial cap rates. For example, in February 2021, the construction value of newly built warehouses for the previous 12 months reached a record high of $39 billion, a 260% increase from the average pace of new supply from 1993-to 2020. This increase in supply represents a high level of demand for new properties, leading to a drop in cap rates.
When demand is high and cap rates fall, it becomes relatively more profitable for developers to build new industrial properties. However, if supply increases too quickly, it can reduce relative demand, which can lead cap rates to swing in the other direction.
Interest Rates and Cost of Capital: In recent years, interest rates have been set at record lows, and lower interest rates are directly correlated to lower cap rates. Lower interest rates reduce the cost of capital for new investors who take out financing to purchase properties, which increases the demand for industrial acquisitions, hence decreasing cap rates. In contrast, when interest rates spike, it’s relatively more expensive to acquire properties, reducing the demand for industrial property acquisitions.
Consumer Spending and E-commerce: Increases in consumer spending generally decrease cap rates, as industrial properties required to manufacture, ship, and distribute goods are in higher demand. The rapid growth of the c-commerce industry has accelerated this trend, as more industrial facilities, including warehouses, shipping centers, and last-mile distribution centers are needed to facilitate the movement of goods to consumers.
This trend is likely to keep increasing in future years. According to data from the U.S. Department of Commerce, retail e-commerce sales reached $204.62 billion in Q3 2021, a 6.8% from $191.57 billion in Q3 2020. In addition, research firm Insider Intelligence forecasts that U.S. retail e-commerce sales will grow 16.1% in 2022, reaching a record $1.06 trillion.
Manufacturing Trends: As more manufacturing is brought back to the U.S., particularly skilled manufacturing and defense manufacturing, the demand for manufacturing facilities, research facilities, and other manufacturing property types will also likely increase, leading to a further drop in cap rates.
Industrial Cap Rate Considerations for Individual Properties
Above, we talked about factors that influence industrial cap rates on an industry-wide level, but there are also factors that influence the cap rate of an individual industrial property. Some of these include;
Property Location: The old adage of “location, location, location” is just as important in industrial real estate as it is for single-family homes. Industrial properties located near major distribution hubs or manufacturing centers, such as Amazon fulfillment centers, are likely to have higher values and lower cap rates than properties located further from potential industrial tenants.
Property Class: As always, property class impacts property value and hence cap rate. As previously mentioned, class B or C properties with deferred maintenance will nearly always have higher cap rates than Class A assets, with newly constructed industrial properties having the lowest cap rates of all.
Lease Type: Lease type also matters when it comes to industrial properties. Gross lease properties, in which the landlord is responsible for paying many of the costs of the property, will generally have the highest cap rates due to increased investor risk.
In contrast, net lease, double net lease, triple net lease (NNN), and absolute net lease properties will typically have respectively lower cap rates, as properties with these lease types shift the risk to tenants rather than property owners. According to research firm Stan Johnson and Company, as of Q3 2021, cap rates for net lease industrial properties sat at 5.8%, somewhat lower than the average cap rate for non-net lease industrial properties.
For industrial properties with multiple tenants, properties with staggered leases generally have lower cap rates than those with leases that expire around the same time, as this leads to additional risks and lease-up costs that are concentrated around a specific time period.