Pros and cons of investing in industrial property

industrial commercial real estate

Are you looking to invest in industrial property and expand your portfolio in 2022? If yes, then you may be taking the right decision since industrial commercial real estate is flourishing post-pandemic with the rise of eCommerce. Moreover, you can also opt for passive investments and still earn great returns without the hassle of day-to-day management and direct ownership. However, just like any other investment option, it is wise to weigh the pros and cons of investing in an industrial property before diving into the arena.

So, this blog by Lilypads summarizes the pros and cons of adding industrial real estate to your portfolio that will simplify your due diligence and market research.

What is an Industrial Property and what are its major types?

Industrial real estate is one of the three major asset classes of commercial real estate. These are primarily used for manufacturing, warehousing, assembly, storage, distribution, etc:

  1. Industrial Lands – 

These are barren lands that are zoned industrially but don’t have any structure or building. Owning a piece of land allows the investor to build the structure as per their requirements.

  1. Bulk Warehouse – 

These are the largest industrial space ranging between 50,000 – 1,00,000 square feet and are usually used as storing and distribution centers. Companies like Amazon have bulk warehouses.

  1. Cold storage/Temperature controlled facilities – 

Cold storage facilities are a subset of general-purpose warehouses that are equipped with freezers and are commonly used to store perishable food goods.

  1. Flex Warehouse – 

As the name implies flex warehouses are meant for a wide range of uses. These are usually located in rural areas and densely populated urban areas. Moreover, these types of industrial spaces are known as ‘infill industrial.’

  1. Heavy Manufacturing – 

These industrial spaces are typically used for heavy industrial manufacturing. They often feature tens of thousands, if not hundreds of thousands, of square feet of usable area, as well as heavy machinery, three-phase electrical supply, and enough room for trucks to load up merchandise. 

  1. Light Assembly – 

These manufacturing buildings are typically much smaller and less complicated than their heavier counterparts. That’s because they’re primarily where commodities are put together from tiny chunks, stored, and then dispatched to be marketed to consumers.

  1. R&D – 

R&D stands for research and development, which is the process by which businesses develop new products and improve previous systems.

  1. Data Centers – 

Data Centres are extremely complex facilities that are normally located in centralized areas and are outfitted with computer systems and networking equipment that is focused on the purpose of saving, analyzing, transferring, or enabling access to massive amounts of data.

  1. Industrial Showrooms – 

Industrial showrooms are a blend of retail and warehousing environments. Showrooms usually include a mix of office, warehousing, and, most significantly, showroom space. More than half of the room is usually dedicated to exhibiting and conducting business.

Industrial buildings are classified as Class A, Class B, and Class C properties. 

Class A represents the latest and best quality structure that exists in the industrial sector. These asset classes are the most expensive buildings, have lower cap rates, and generate more passive income. Also, these are relatively less risky for real estate investors. 

Similarly, Class B properties are older buildings that investors can invest in on a value-add basis.

And lastly, Class C assets require major renovations and redevelopment by the investors. Hence, such properties require huge capital investment and are the riskiest investments. But once repositioned, Class C properties can generate stable rental income.

Read Lilypads’ blog on the various types of industrial real estate here.

Ways of investing in Industrial Real Estate

With retail giants and even entrepreneurs moving online, the future of industrial real estate is booming. The vacancy rate of industrial property in the USA is merely 5.1% and it is even lower for the small and medium industries. Furthermore, vacancy rates continued to decline in Q4 2021.

Many cities experienced a decline in vacancy rates. For example, Los Angeles showed a decrease in the vacancy rate to 1.1% from 2.7%. Similarly, the vacancy rate reached 2.3% from 4.2% in San Diego. Therefore, such a low vacancy rate may reach zero which results in the renewing of the lease terms by the tenants. 

Industrial buildings are generally single-tenant properties with longer leases which means a hassle-free property. Hence, to invest in this hassle-free investment you can opt for various ways. 

Firstly, you can buy your property through which you can gain full control over the property and also maximize your returns. However, you may face difficulty in securing finance. Secondly, you can invest in a real estate investment trust REIT. Owning a share of industrial REIT allows you to achieve a percentage of a large, diversified portfolio. 

In addition to this, CRE investors can choose real estate crowdfunding for acquiring an industrial asset. Real estate crowdfunding platforms offer you the ability to purchase an equity share in a given property even if you are not an accredited investor. 

Why should I invest in Industrial Commercial Real Estate?

Deloitte states that industrial commercial real estate is experiencing its golden phase since the rise in e-commerce in 2013. Since then, the industry has mostly experienced positive year-on-year growth. But there has also been a decline in the availability of properties. However, the demand for industrial real estate is forecast to rise by 14.8 billion sq. ft by 2023. 

Hence, it’s wise to start investing in industrial real estate while the demand is still high. Industrial investments require less maintenance and also are long-term investments. The vacancy rates for these properties are very low, which means it doesn’t take much time to find new industrial tenants in case of turnover.  

The liquidity rate of these asset classes is high, which means you can liquidate your asset whenever you want. Q4 2021 was the strongest quarter with investment sales volume reaching $67.1B. Therefore, it is evident that there is demand and liquidity in the market.

The rise of 3-D printing and the adoption of robotics in manufacturing has reduced labor costs significantly. In the present day, the demand for fully automated systems has driven the demand for industrial real estate assets and accelerated further rent growth.

Pros and Cons of Industrial Commercial Real Estate

What are the advantages of investing in industrial properties?

1. Offers Greater Diversity

If you are a CRE investor, who is keen on expanding your portfolio, consider investing in industrial assets. Industrial real estate offers a wide variety of options that ensures greater diversity. For instance, a single industrial property can be put to several uses- logistics companies, manufacturing facilities, and so on. Hence, CRE investors can always have a diverse clientele at any point in time. 

Thus, industrial investments provide a greater ability to adjust to changing market demand. Moreover, if, for example, the demand for warehouses in a certain location is low but the demand for storage facilities is high, industrial property can offer itself as either. This means that even if one asset class is underperforming due to inflation or other economic factors, another section of your portfolio will continue to perform well. 

2. Provides longer lease terms

Industrial properties have longer lease terms ranging from three to 10 years and even go up to a maximum of 25 years. Also, such leases are often non-negotiable and include the base rent, common area maintenance (CAM) fees, utilities, maintenance, and repair costs. 

Hence, companies like Walgreens, CVS, and Starbucks typically sign triple-net leases so that they can maintain the look and their brand by managing those costs. 

On an average basis, the utilities usually belong to around $2 per square foot annually and CAM fees range between 15% to 35% of the annual lease payment. After the termination of the lease terms, the agreements are generally renewed since tenants want to avoid relocating elsewhere with their heavy machinery and other industrial equipment. Hence, real estate investing in industrial properties generates stable and passive income for years. 

3. Higher rental yields

Another major reason behind investing in industrial real estate is the income potential. While traditional office building offers roughly 5% returns on investment and retail delivers even greater yields of around 6%, industrial real estate outperforms both- generating around 6-7.5%.

4. Due to high demand, it ensures minimum vacancy rates

According to JLL, there’s been an exceptionally high demand for the US industrial market in the year 2021. And vacancy rates fell to a minimal level. In the fourth quarter of last year, industrial tenants signed leases for 122 million square feet. Industrial rents accelerated to $7.11 a square foot during the same quarter. 

Furthermore, research suggests that industrial rents have grown by 11.3% since the fourth quarter of 2020. Moreover, the net absorption at the end of the year exceeded 496.3 million square feet which is more than 81% on a year-over-year basis. Atlanta had the highest net absorption with 12.4 million square feet. California’s Inland Empire and New Jersey spotted a significant drop in vacancy rate from 1.5% to 1.4%.

For the first time in the history of real estate, the vacancy rate dropped below the 4% threshold. This boom in the industrial space will continue in the coming year also. And, if the demand outpaces the supply chain and the industrial space continues to decline, then the net absorption will also accelerate.

5. Low maintenance cost: 

It is a known fact that any property requires the investor or owner to keep maintaining the property. These expenses generally include updates, repairs, and restorations, which are both expensive and time-consuming. But, industrial real estate, on the other hand, requires little or no maintenance at all. This is because most industrial sites are large, open spaces with concrete block floors and high, exposed ceilings. Therefore, they don’t require carpeting, insulation, high-end fittings, or other added expenses.

6. Investment Stability

While all other real estate sectors have risks, industrial real estate tends to be more recession-proof than other asset types. It appreciates in value over time. According to Forbes, the USA e-commerce sales accounted for 15% of the overall retail sales at the end of 2019. And it will be nearly 43% at the end of 2030. Hence, investors are sure enough that this rising demand will increase stability, rent growth, and appreciation.

7. Flexibility and technological advancements: 

The biggest feature of industrial real estate is that it can be used for a variety of purposes. An industrial structure does not have to be primarily used for offices, storage facilities, shopping centers, production, or logistics. You can rent out all three for one firm, or you can get multiple renters.

Today e-commerce firms require multiple warehouses and distribution centers in numerous locations at the same time. However, the best use of industrial properties can be achieved due to automatic operations in the near future. You can enhance your monthly cash flow by pulling in higher-paying tenants if you revamp your industrial real estate assets in the next few years.

8. Potential tax benefits: 

Lastly, the benefits of investing in industrial real estate will remain incomplete without mentioning the potential tax benefits. Industrial properties are depreciable business assets. And depreciation offers significant tax benefits. These include depreciation, 1031 exchanges, interest expense tax deductions, and so on.

What are the disadvantages of investing in industrial properties?

1. Huge capital investment

One of the major demerits of industrial properties is that it involves a large investment compared to other investments.

Also, longer lease terms of industrial properties imply less appreciation potential.

2. Longer leases

Industrial spaces often have single tenants for a longer period. So, it can both be a boon as well as a curse. This is because if the tenant faces any financial losses, they can fail to pay their rent on time. And, since the lease terms are long in such property, the owner cannot evict or get a new tenant. Therefore they can face problems with their mortgage rates and debt obligations. 

3. Less number of Flipping

The real estate investors who rely on the fix and flip and want quick profits may not find industrial investments suitable.

4. Long term vacancy risk

After the completion of one lease term, it sometimes becomes difficult to find another suitable tenant. For example, if a manufacturing space becomes vacant then finding an appropriate tenant for that particular space becomes difficult. This is because the previous tenant may have installed certain equipment or made the property suitable for their needs. 

So, renting the space out to a new tenant often requires major remodeling to make the property compatible for other purposes or to revert it to its original condition. But, these require a huge capital investment. Hence, once a tenant leaves, industrial property can remain vacant for a longer period.

5. Oversupply Risk 

Due to the rising demand for e-commerce, industrial real estate developers are constructing warehouses and fulfillment centers in large numbers. But, if suddenly the market deteriorates then it will impact the occupancy and rental rates while decreasing the property value too. 

The Lilypads Bottomline

Investing in industrial properties can be a boon or a bane to the investor. The investing strategy for industrial spaces should be devised to maximize market potential while minimizing operating costs. Furthermore, market analysis is crucial before investing in the industrial real estate market. 

A competitive analysis, employment study, and economic analysis can influence the demand graph for industrial growth. Moreover, if you balance your benefits against the drawbacks and research the market flow properly, you’ll find that industrial real estate offers minimal risks and maximum returns in the long term.

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