Buyers like industrial’s link to e-commerce and multifamily’s demographics.

By Kristin Hiller

Is now the time to buy, sell or hold commercial real estate? The short answer: it depends. The major property types are at different stages of the four-phase real estate cycle that begins with recovery, followed by expansion, hypersupply and recession.
Clearly, the multifamily sector is in the hypersupply phase in many major metros, while the office sector, which was much slower to emerge from the Great Recession, is now in an expansionary period.

Many investors active in the Midwest region are in the acquisitions mode as 2017 gets underway. In a survey conducted by Heartland Real Estate Business late last year, 45 percent of the developer/owner/manager respondents indicated they expect to be net buyers in 2017 compared with only 12 percent who expect to be net sellers.
Another 21 percent of respondents indicated they plan to buy and sell roughly the same amount. The remaining respondents were either uncertain if they would be a net buyer or seller in 2017 (12 percent), or had no plans to buy or sell (10 percent).

Developers and investors are particularly drawn to the industrial sec tor, and for good reason. According to Calvin Schnure, senior vice president of research and economic analysis at the National Association of Real Estate Investment Trusts based in Washington, D.C., industrial properties experienced 6.7 percent rent growth in 2016, the biggest increase among all property sectors. Industrial demand greatly outweighs supply, as e-commerce continues to create a need for shipping and logistics facilities.

“With consumers demanding products to be delivered faster than ever before, industrial REITs have been propelled to redraw logistical maps and shift their portfolios toward more densely populated areas to meet the new demand,” says Camilla Yanushevsky, senior analyst of real estate product operations at S&P Global Market Intelligence.

The strength of the industrial sector is reflected in the FTSE NAREIT U.S. Real Estate Index. The total return among the 11 industrial REITs in the index was nearly 31 percent for all of 2016.
“The most favored sector for the past two years, industrial again takes top billing in 2017,” according to Emerging Trends in Real Estate 2017, a forecast publication produced jointly by PricewaterhouseCoopers and Urban Land Institute. “Most investors who have industrial in their portfolios continue to be net buyers. The advantages of industrial include continued strong demand drivers, restrained construction and lower perceived risk. Strong locations in growing metro areas are typically supply-constrained.”

According to Real Capital Analytics (RCA), the office sector accounted for $12.9 billion in property and portfolio sales across the Midwest during 2016, the largest volume of any property type based on deals $2.5 million and above. Approximately $7.1 billion of those office investment sales were located in suburban markets versus $5.7 billion in central business districts. The volume of multifamily property and portfolio sales came in second at $12.6 billion, and industrial weighed in at $9 billion.

“As office cap rates in major metros continue to compress, investors are looking elsewhere in search of yield, and these large secondary markets [in the Midwest] seem to be the logical areas of interest,” says Alexis Maltin, analytics manager at RCA.

Office cap rates averaged 7.4 percent in the Midwest in 2016, the highest rate of any region in the U.S. Nationally, office cap rates averaged 6.6 percent for the year, according to RCA.
Heartland Real Estate Business recently spoke with several commercial real estate developers, owners and managers to get their take on investment strategies for the year ahead.

Winning value-add strategy

Oak Brook, Ill.-based Midwest Industrial Funds focuses solely on industrial properties and land sites for development. The company recently moved from the northwest suburbs of Chicago to the western suburbs in part to be closer to its properties. With a combination of over 4 million square feet of industrial buildings and more than 200 acres of land, the company’s portfolio exceeds $180 million.

Justin Fierz, Principal of Midwest Industrial Funds, says he expects the company to be a net buyer in 2017. “We tend to always be more of a net buyer than a net seller, which obviously means we do hold a fair amount of our properties as we look to grow our portfolio. That’s one of our goals,” he says.

Prior to selling a property, first and foremost the company determines if it has added all the value it can to that asset through building improvements and enhanced management and leasing. Second on the checklist is the building’s submarket and the direction the submarket is headed in terms of vacancies, demographics and supply and demand. Fierz also factors in migration trends and the flight to infill locations versus urban sprawl.

Midwest Industrial Funds looks for functional B-quality properties to acquire, according to Fierz.

“Some of the things we look for are large land sites, potential divisibility of the property, good ceiling heights and loading capabilities. In general, we tend to look for buildings that might be a little bit older, but are still very functional and work for the majority of tenants in the marketplace today,” he says.

Recent acquisitions for Midwest Industrial Funds include 825-845 W. Hawthorne Lane in West Chicago, 1600 Shore Road in Naperville, Ill., and 6.4 acres at 901 Douglas Road in Batavia, Ill.
The Hawthorne property consists of a 158,000-square-foot, multi-tenant building that was 50 percent leased by three tenants at the time of closing. Midwest Industrial Funds is undertaking a major renovation of the property, including installation of a new architectural metal panel façade with LED lighting, new windows, landscaping enhancements and updating the interior offices and available warehouse spaces.

The property at Shore Road consists of a 45,000-square-foot, multi- tenant building that Midwest Industrial Funds bought partially leased. Renovations are almost complete and the building is nearly fully leased.

Midwest Industrial Funds is in the design and permitting stage for a 100,000-square-foot speculative building on the property at 901 Douglas Road. The building will feature 30-foot clear heights, 110 parking spaces, up to 20 exterior docks and office space.

In 2015, Midwest Industrial Funds purchased nine individual properties, all existing buildings. In 2016, the company also bought nine properties, three of which were land development opportunities. Fierz attributes the strategy to the increasingly limited amount of available space. The ability to find investment opportunities in existing buildings dried up in 2016.
Fierz says the borrowing climate is tightening. Lenders are growing more cautious, plus the possibility of higher interest rates makes it more challenging for investors to achieve the level of return they seek for either new development or acquisitions. That being said, Fierz remains optimistic about the investment climate in 2017.

“One of the best opportunities is that there’s still a lot of capital out there at all levels for real estate, especially industrial real estate. There is equity capital, debt capital and there is exit buyer capital,” he says. “When somebody like us buys, adds value, stabilizes tenancies and aggregates multiple different assets together, there is typically an appetite for a larger institution to buy those assets. I don’t see that changing much in 2017.”

Right location, right price

Dallas-based Trammell Crow Co. maintains a Midwest business unit in Oak Brook, Ill. The company also has its own residential subsidiary, High Street Residential, which specializes in multifamily and mixed-use developments. According to Johnny Carlson, principal on the Midwest team, the office is concentrating on developing properties in suburban infill locations in Chicago and Minneapolis that have low supply.

“There’s very little supply and a lot of demand. If you can get the right location at the right price, we feel like it’s a development mentality,” says Carlson when asked about the company’s strategy on buy, sell or hold for the year.

High Street Residential recently broke ground on Maple & Main, a six- story mixed-use building in Downers Grove, a western suburb of Chicago. The property will consist of 115 apartment units and approximately 4,000 square feet of ground-floor retail space. Completion is slated for May 2018.

Despite the multifamily focus, the Midwest unit is also currently concentrating its efforts on industrial properties, office development and adaptive reuse.

“We’ve found that multifamily opportunities have been the best for us to invest in, but it isn’t all that we’re focused on. We do hope that some of these other areas of industrial and office, as well as office adaptive re-use, emerge as good candidates for us as investment opportunities in 2017,” says Grady Hamilton, managing director in the Midwest business unit.

Hamilton says tenant demand is increasingly shifting from Class A, B, or C office properties into more creative office locations, a trend property owners can capitalize on. Chicago’s West Loop and Fulton market as well as the North Loop in Minneapolis create unique investment opportunities.

Industrial, medical combo

Indianapolis-based Duke Realty owns, manages and develops industrial and healthcare properties. The giant REIT (NYSE: DRE) currently owns, maintains or has under development 138 million rentable square feet in 21 major U.S. metropolitan areas.

“We will continue to cull the portfolio of non-strategic assets and redeploy capital into development and acquisition of bulk industrial properties and medical office assets,” says Nick Anthony, chief investment officer, referring to the company’s strategy for 2017.

Duke owns interests in over 450 bulk distribution properties, which are primarily warehouse facilities with clear ceiling heights of 28 feet or higher. The company owns interests in 85 medical office buildings as of the third quarter of 2016.

In 2015 and 2016, the company primarily sold suburban office assets with the similar mindset of redeploying the proceeds into industrial and medical office developments.
Duke recently developed a 402,860-square-foot industrial distribution warehouse in Aurora, Ill. The speculative building was leased to an e-commerce company. Near Minneapolis, Duke developed a 485,804-square-foot warehouse build- to-suit in Otsego for Room & Board, a furniture store.

Anthony believes two property types, in particular, offer the best investment opportunities today: the industrial sector due to the rapid growth of e-commerce; and medical office properties because of the aging population.

All in on industrial

Boston-based STAG Industrial is bullish on the Midwest. The REIT (NYSE: STAG) is focused on the acquisition and operation of single- tenant, industrial properties. The company’s portfolio includes 300 properties in 37 states, with over 20 properties each in Illinois, Indiana and Ohio. COO Steve Mecke says the company plans to be a net acquirer in 2017.

“The opportunity to identify and acquire industrial assets continues to persist, and these accretive acquisitions provide attractive returns to our shareholders,” he says. “The industrial sector is benefitting from a favorable supply and demand environment, and the emergence of e-commerce as an incremental demand driver for space continues to drive elevated operating fundamentals.”
In 2015, STAG acquired 49 industrial buildings for $427 million. Through the first three quarters of 2016, STAG’s purchases of industrial properties totaled $350 million. The company expects the acquisition volume for all of 2016 to exceed 2015 once the final numbers are tallied later this month.

Continued strong demand for industrial properties and the ability of industrial owners to take advantage of lease rollovers by finding replacement tenants at higher rents are reasons Mecke has a positive outlook for 2017.

Challenges, however, will include the impact of an increasing interest rate environment as well as navigating the Trump administration’s agenda and its potential impact on industrial tenant demand and the marketplace.

Net seller of office assets

Equus Capital Partners Ltd. maintains an office in Chicago and is a private equity fund real estate manager. The firm currently oversees a portfolio of approximately $3.9 billion in assets under management. Contrary to other companies interviewed for this article, Equus tends to be more of a net seller.

“Many times we sell sooner than anticipated if we feel the market is right for a sale or when we have completed our value-add strategy,” explains Joseph Neverauskas, senior vice president.
In 2015, the firm sold $881 million worth of assets and purchased $334 million. Equus sold a combination of multifamily and office properties, either because the properties had been held by investors long enough to exit, or the value-add strategy had been met.

In 2016, Equus sold $601 million worth of properties compared with $267 million in acquisitions. The slower deal velocity in acquisitions stemmed from a more challenging and competitive market to find properties that fit the company’s strategy, according to Neverauskas.

In 2017, Equus plans for the lion’s share of its acquisitions to be in the office sector. Neverauskas is on the hunt for high-quality Class B buildings given the fact that there has been little in the way of new supply. A quality office building, in Neverauskas’s eyes, provides tenants with amenities such as food services, workout rooms and conference centers.

Beyond quality, location is key. Office buildings in close proximity to retail, restaurants and public transportation are more desirable property locations, giving employees the opportunity to embrace a green lifestyle.

As Neverauskas puts it, “People just do not want to get in their cars and drive.”

Appeared in the February 2017-Volume 15, Issue 6 of Heartland Real Estate Business;