If I were to collect 100 private investors in a room and ask for a one sentence explanation of their preferred investment opportunity, I’d be willing to bet that more than half would say value-add opportunities. For those unfamiliar with the term, value-add opportunities (as it pertains to real estate) are deals in which a buyer will increase the cash-flow and thus increase its value. This increase in cash flow can be generated by improvements to the property, its management, or by simply increasing rental rates as is outlined below. While it sounds simple in concept, being a value-add investor requires considerable analysis of the details surrounding a property, accurate determination of costs and areas for improvement, and effective execution of plans in a timely manner. If done properly, a value-add investor can attain much higher returns than an investment of similar value into a stabilized property. If executed poorly, a value-add investment can easily become an enormous loss.
As to the subject of this post, are all small tenant flex parks now value-add opportunities? Many in the brokerage community would say yes, and private investors are rapidly catching on. So how do we get to this conclusion? The answer can be boiled down in its most basic form to a simple supply and demand argument.
The existing supply can be considered fixed for several reasons, the largest of which is the replacement cost to create similar space in the current market. To evidence this, lets consider a hypothetical 60,000 sf flex property with 12 tenants, each occupying 5,000 sf with a standard 750 sf office. The majority of this sort of product in King County was delivered in the 1980’s, so we will use 1985 as a benchmark. In the table below rough approximations of the expected costs in 1985 and 2016 to develop our hypothetical project are outlined…
|1985 costs**||2016 costs**|
|Raw land :||$ 5 /sf||$ 11 /sf|
|Pre-development site work:||$ 2.50 /sf||$ 5.50 /sf|
|Building Shell:||$ 25 /sf||$ 70 /sf|
|Office Improvements:||$ 60 /sf||$ 100 /sf|
|Utility connections:||$ 5,000/unit||$ 20,000 / unit|
|Permitting costs and fees:||1.25% of project cost||2 % of project cost|
|Legal costs (median apx)||$ 7,500||$ 50,000|
|Misc. acquisition costs:||6% of land cost||9% of land cost|
**numbers above compiled using recent and historical comps, CoStar, CBA, county records, and market experience**
Applying these costs to our hypothetical development (below), one can quickly see why it is unlikely anyone will be building another small tenant flex park anytime soon. Note that the site coverage has also changed, this is to accommodate the storm water, parking, fire lane, and site coverage requirements that new development faces. These requirements were either far more relaxed, or entirely non-existent in 1985.
|Land acquisition||3.44 acres (40% site coverage)
|4.59 acres (30% site coverage)
|Pre-development work:||$ 375,000||$ 1,100,000|
|Building Shell||$ 1,500,000||$ 4,200,000|
|Office Improvements||$ 540,000||$ 900,000|
|Utility Connections:||$ 60,000||$ 240,000|
|Permitting costs and fees:||$ 40,000||$ 172,800|
|Legal costs||$ 7,500||$ 50,000|
|Acquisition costs:||$ 45,000||$ 198,000|
|Subtotal:||$ 3,317,500||$ 9,060,800|
|Taxes:||$ 225,590||$ 860,776|
|Grand Total:||$ 3,543,090 ($ 59.05/sf)||$ 9,921,576 ($ 165.36/sf)|
As you can see, the costs a developer for this type of product would face today simply make it unrealistic to build anything similar in the current market conditions. Especially when comparable product trades at substantially lower numbers, as can be seen in several small tenant park sales that have occurred recently:
- Alvis Industrial Park in Auburn: 42,260 sf multi-tenant flex/industrial park built in 1990 went under contract in less than a week for $3,950,000 ($93.47/sf) when it was listed for sale on March 18, 2016. Inside sources have confirmed that the seller received multiple full-price offers within days of listing.
- Park 341 in Federal Way: 11,324 sf multi-tenant flex building built in 1999 sold for $1,250,000 ($110.39/sf) on June 26, 2015
- Wulff Industrial Park in Auburn: 104,600 sf multi-tenant industrial park built in 2000 sold for $12,500,000 ($119.50/sf) on May 28, 2015
- South 200th St. Bldg in Seatac: 79,080 sf multi-tenant industrial park built in 1988 sold for $8,000,000 ($101.16/sf) on May 8, 2015
Of course, costs alone do not dictate what will or wont pencil for development. The income a property can generate is a major factor as well. Based on recent lease comparables and marketing material for this type of space, the current “market” rate is approximately $0.65/sf blended, NNN. Taking that number into consideration on our hypothetical new development in 2016, we are looking at a maximum annual income of $468,000, less expenses, vacancy allowance, structural reserves, etc. Lets say in a good year an owner can make $425,000, which means that you will see a maximum cap rate of 4.28%. Most investors can find rather low risk investments that will easily achieve 5%, smart money will not be building this property type any time soon until they can see much higher returns.
On a comparable sale basis things get a little better, the average pricing of the recent transactions listed above comes out to $106.13/sf. If the 1985 version of our hypothetical development sold today at that pricing a new owner could expect to pay $6,367,800 and achieve a 6.67% return. This may be enough to entice some investors, but it has no impact on the supply available. This is where the value-add factor comes into play in a big way.
The vacancy rate for small tenant industrial space in the Kent Valley is currently at a record low of 3.1% and falling each month, the demand is high and the predictions are that it will only increase over the coming years. As Seattle and Tacoma continue to grow and expand, so too does the number of businesses who need commercial space to operate in. I can’t count how many times in the last two years I have worked with startups and first-time commercial tenants. The increasing aerospace activity in the region with companies like LMI, AIM, Crane, Esterline, Blue Origin, and Boeing has led to an enormous boom for related contractors and manufacturers. Amazon’s dominance in the e-commerce world brings manufacturing companies of every kind into the area who exclusively sell through the internet giant and benefit from a location near their headquarters. As the population of the region increases so too does the number of small businesses that flourish in the booming economy. It is no secret that tech companies are starting to see the benefit of moving to the Northwest from Silicon Valley, they are used to paying well over $1.00/sf for basic warehouse and often will seek out warehouse space for their operations rather than higher image office or tech space. Nearly every factor that can be interpreted in the area indicates a level of demand that is already high and actively increasing with no slow-down in sight.
Supply vs. Demand:
With the fixed supply already established, this increasing demand has a direct upward pressure on the rates landlords can expect. Just 3 years ago small tenants could expect to pay a mere $0.50/sf for industrial space, now they are at $0.65/sf, next year they could easily be reaching over $0.70/sf for comparable space. By purchasing a multi-tenant building now an investor can expect to benefit from this growth even doing nothing but following the market. Paying $106.13/sf this year a buyer can expect to achieve an 6.5-7% cap rate immediately. Some of the properties I represent have seen $0.03/sf rent growth in the last 6 months, already achieving $0.68/sf for new deals. By doing nothing but charging market rents a 6.5-7% cap rate deal this year could easily become a perceived 8.5% cap rate by 2018. A deal such as this is a value-add opportunity with almost no effort required. With a focused effort to keep rates at or above market, combined with increases in management efficiency and reduction in operating costs, a buyer in the current market could reasonably expect to increase their perceived cap-rate by as much as 3% in the next 2 years.
To put a 3% increase in perceived cap rate into perspective: if a buyer pays $1,000,000 today for a 7% cap rate deal and increases the perceived cap rate to 10% in 2 years, they could sell the same property again at a 7% cap rate in 2018 for $1,428,571. That works out to a little more than 19.5% increase in value annually.
So how long can this trend continue? Lets use 8% as a solid benchmark for cap-rates, in my experience this is typically what private investors like to see. In order to achieve an 8% cap rate on our hypothetical new construction, rates will have to nearly double, reaching $1.10/sf, NNN. Assuming the current rent growth trend continues with annual increases of approximately $0.03/sf, that gives current investors a solid 15 years before new construction can become realistic, and that is assuming construction costs remain constant. It is not unreasonable to think that a 6-8% cap rate deal today will continue to be “value add” for another 15-20 years if the existing market conditions continue.
What about a recession?
One of the beautiful things about small tenant industrial space is that it is considered to be far more recession resistant than most commercial space out there. When things start slowing down many small businesses shut down, while larger businesses often will downsize. By owning small-tenant space you can take advantage of this downsizing to accommodate the larger business, filling in the vacancy that the failing small businesses leave. While rates may fall to some extent, small tenant landlords are far less likely to see the catastrophic vacancy rates that office properties and larger industrial parks may feel in recession periods.
Based on the replacement costs associated with small multi-tenant industrial parks, the supply can be considered fixed until rates and sales prices nearly double. Until that occurs, demand can be considered rather high and fairly constant given the strength and momentum of the economy in the Puget Sound region. This combination puts strong upward pressure on rates. In the current pricing environment, small tenant industrial parks are trading substantially under replacement costs with considerable rent growth possible and little work required to achieve that growth. Buyers of this type of product today can reasonably expect any deal to be a value add opportunity, the only variable is just how much value can be added.
If you would like to learn more on this subject, or if you would like to be informed of any new opportunities that arise in the market, please don’t hesitate to contact us. I will be happy to add you to my distribution list for new investment opportunities with a promise that you will only receive things relevant to you and your goals.