Industrial Stability Faces Challenges
[March/April 2003]
by Philip Kibel
The industrial REIT sector is a prime example of making the most out of a bad situation. Although rent growth is soft or even negative, and vacancies have been climbing, industrial REITs entered this recession well prepared financially, with modest levels of secured debt, many unencumbered assets, laddered debt maturities and healthy fixed charge coverages. The leading industrial REITs have also reduced their development risk.
These characteristics are reflected in the investment-grade ratings and stable outlooks of the major industrial REITs that Moody’s Investors Service rates. In fact, industrial REITs are one of Moody’s highest-rated REIT sectors. Moody’s expects industrial property REITs’ performance to stabilize toward the end of 2003, based on a modest development pipeline and further economic recovery. The major threat to these stable ratings is soft market conditions becoming softer still, and stretching into 2004.
In addition to overall market conditions, there are several other characteristics of the industrial REIT sector that investors should understand. The companies within this sector possess many strengths and face distinct challenges that distinguish them as an investment vehicle.
Strengths
- High fixed and interest charge coverages
- Modest levels of secured debt for most REITs
- Industrial sector is not particularly vulnerable to overbuilding. This reflects short construction lead times and a focus on build-to-suit development
- Tenant improvement costs tend to be modest
- Tenants are often inclined to renew leases because they commonly have equipment at the sites that is expensive and troublesome to move
- The stability of cash flows is an inherent credit strength of the industrial REIT sector. Most leases on new facilities have seven- or 10-year terms, and average lease terms place industrial property at the long end of the spectrum, with the office and regional mall sectors
- Because of their size and integrated management, industrial REITs are also well positioned to focus on high-quality tenants and on tenants with more complex needs
Challenges
- Although new construction has come to a virtual halt, resulting in slightly positive absorption, it will be difficult to sustain absorption even if a small amount of new supply comes on line
- Some industrial REIT tenants have been consolidating their businesses, contributing to the soft demand for space
- Real estate will likely lag the broader economy in its recovery
- With rising vacancies, rental rates remain soft
- Industrial REITs’ earnings quality has diminished because of a greater proportion of earnings being clouded by complex joint venture and real estate fund structures
- Some industrial REITs continue to actively expand into markets outside the U.S., which can further heighten their credit risk profiles; such expansions introduce currency risk and special social, political, employee and tenant issues
| A key issue for this property type is that the increasing efficiency in the supply chain is generally dampening growth in demand for warehouse space. |
Importance of Occupancy and Rental Rates
Management teams of industrial REITs are keenly focused on occupancy and operating efficiency through aggressive overhead cost reduction and marketing programs. The average vacancy level for all industrial properties in the U.S. is 10.8 percent, according to Moody’s “Quarterly Assessment of U.S. Property Markets.” However, that number has been rising and should continue to rise through late 2003.
Overall, Moody’s anticipates a slow improvement in industrial property market fundamentals. While the larger industrial REITs tend to have higher average occupancies than the industrial property market as a whole, REITs’ occupancy rates will only likely recover at a pace that mimics the market’s pace.
As far as absorption and rental rates, there has been a negative absorption trend for the last six consecutive quarters, according to Torto Wheaton Research’s “Fall 2002 Industrial Outlook.” Although the gap is closing and there has been less new supply coming into the market, positive absorption in the industrial sector will likely be delayed until mid-2003. In response, management teams of the leading REITs have been focusing more on tenant retention than rental rates. High rates of tenant retention allow the REITs to mitigate absorption issues and re-leasing costs.
Source: SNL Data, Company Financials
Source: SNL Data, Company Financials
Property Sub-Type Classifications
While overall industry trends are important, it also is necessary for investors to look deeper at a company and focus on the specific sub-sector it operates in. Within the industrial sector there are three main sub-classifications: manufacturing, “flex” or research and development (R&D), and bulk warehouse/distribution. A general rule of thumb with these sub-sectors is the greater the level of office finish, the greater the risk. Properties that include “flex” space and R&D facilities can have a high percentage of office finish, and take on some of the risk characteristics of office space.
Here is a quick snapshot of each sub-sector:
Manufacturing facilities are designed for the production and assembly of goods. This sub-category can be broken down into two even smaller sub-sectors: light industrial and heavy industrial. Light industrial facilities typically serve light assembly and manufacturing tenants. Light industrial facilities have fairly stable cash flows. However, in Moody’s opinion, they also have greater exposure to non-credit tenants, which may increase cash-flow volatility. The tenant base may also be more vulnerable to changes in economic conditions than users of generic bulk warehouse facilities. Tenants should continue to be attracted to light industrial space built to current technological standards and located in healthy manufacturing and distributing centers.
Heavy industrial facilities have large frames, reinforced walls and floors, and are laid out for specialized manufacturing processes. Tenants of heavy industrial facilities are inclined to renew leases because it is difficult and cost prohibitive to move some of the equipment at the sites. Most such users own their facilities. Manufacturing output, which will increase with improvements in the economy, should alleviate some downward pressure on rental rates and increase demand for space.
Business service and R&D facilities are commonly referred to collectively as “flex” space, combining warehouse and office or showroom space. These facilities appeal to service-oriented or product sales tenants. Facades generally have at least a portion with high finish and showroom windows. Cash flows for “flex” properties are less predictable because they have a higher level of exposure to short-term leases, non-credit tenants, and higher capital costs (tenant improvements, leasing commissions and replacement reserves) attributable to the high percentage of finished office space. Due to its correlation to office space, the recovery of this type of property will more closely mimic that of office space, and will likely be a 2004 event, with probably some weakening or just a flat performance in 2003.
Research and development (R&D) properties are commonly concentrated in established high-tech and bio-medical corridors. Furthermore, the R&D sector is highly dependent on the performance of a few key industries, thus increasing cash flow volatility. This combination of factors makes these properties particularly vulnerable to regional or industry-specific downturns. In-place rents may be higher to reflect amortization of technology (e.g., clean rooms and other specialized spaces) and tend to be above market for bulk warehouse, but as technology changes at an accelerated rate, the specialized finish may drop in value rapidly. Even if the space does not become obsolete, special improvements of one tenant may not be suitable for another. The concentration of this property type on industries that are weak and in some cases getting weaker will make its recovery a prolonged one and probably a 2004 event, with at best a flat 2003.
Traditional bulk warehouse/distribution facilities are the most generic industrial product type and are generally used for storage and distribution, appealing to a broad tenant market. Bulk warehouse/distribution properties exhibit relatively stable cash flow characteristics. They customarily include an annual rent escalation clause based upon changes in operating costs, and a clause stipulating the pass through of most operating expenses to tenants.
Moreover, the capital expenditures associated with re-leasing space in warehouse/distribution facilities is low, thus reducing the risk and cost of lease rollovers. A key issue for this property type is that the increasing efficiency in the supply chain is generally dampening growth in demand for warehouse space. The demand is going to remain dampened through 2003 as the economy recovers, with demand being stronger in markets that are part of the global supply chain and dismal in small warehouse markets.
 Philip Kibel, CPA, is vice president/senior analyst in the Real Estate Finance team at Moody’s Investors Service.
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