November 19, 2020

How to Invest in Industrial Real Estate (Part 2)

16 minutes

What is unit level profitability? What kind of tenant is best to pick for your industrial space? How do you add value to an industrial investment? Neil Wahlgren answers a lot of our questions regarding this popular asset class.

You can read the entire interview here: https://montecarlorei.com/how-to-invest-in-industrial-real-estate-part-2/

What is unit level profitability?

It refers to whether or not you have insight, as a landlord or as a real estate owner into the profitability of the particular location of the building that you're buying. If your tenant has several locations, you are interested on how profitable is this store in this piece of real estate that I'm buying.

When you say that you are getting properties at 8.5 cap rate, how do you add value to that property? Because you're dealing with the seller, and they're going to lease back the property. And it's going to be a 15, 20 year lease. So how do you guys bring value besides that 8.5 cap?

1. The first is cash flow, and with that cash flow with that net lease structure, you have an expense free set of cash coming in to the ownership pool. With those we typically structure our deals to target 8% going to investors minimum on year one, and that's going to increase year to year as rent bumps kick in. One of the nice things about these leases is typically they will have built in rent bumps. So without doing anything, you have typically one and a half to 2% increases in rent kicking in every year. And because there are no expenses, that rent is usually equal to the NOI of that property. Now imagine you have a static cap rate, I know for a fact my NOI is going to increase 2% a year. So that's the first way that I'm creating value such that if I hold it for five years, I've seen roughly 10% increases in NOI. And now at the same cap rate I can sell and see a significant increase in value.

2. The second piece is paying down principal on the debt. You are able to acquire between 70 and 75% leverage on debt on the real estate. Most of our real estate debt comes from local lenders, or credit unions, they know both the tenant company and the area very well. And that's even more important when you're buying tertiary real estate, where the local lenders really believe in the companies, oftentimes those companies have been in place for 40, 50, 60 years, and you're able to get more aggressive and better terms on the lending. We acquire fixed rate debt, fixed interest rate, usually in the low fours or high threes in today's environment. With that, every month, you're paying down principal on the debt.

3. And then the third is a little bit more subjective. We look to buy real estate in growing metros where we feel like there's a chance for a cap rate compression. For example, today Omaha is trading around 7, 8 cap for a lot of industrial properties. If we think that there's a good chance that this might compress down to a six or seven cap environment in five years, based on the growth that we're seeing in this area as a way to create value. And the other half of that third piece is what they call credit enhancement. Imagine if you buy a piece of real estate with a tenant that has $30 million a year in revenue, and in five years, that company is doing 100 million dollars a year in revenue. Now that's a much stronger tenant, which provides a lot more security on your lease. So now you're able to sell that same piece of real estate at a lower cap rate because you've reduced the amount of risk.

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