Investment Analysis: Cap Rates & Risk (Part 2)

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Click HERE to Read Part 1

Competition

Competition describes and covers a variety of factors impacting the risk associated with a property. The governing principle is the law of supply and demand, which states that the greater the demand for a product/asset relative to its supply, the more valuable it is. Alternately, the greater the inventory/supply of a particular product/asset relative to its demand, the less valuable it is. In real estate investment, the space market and capital market combine to determine the market value of particular property types and asset classes.

The space market represents the relationship between the demand and supply for commercial space with the intersection of the supply and demand curves establishing the market rental rate. Because of the time required to construct and deliver commercial properties, supply remains relatively constant. Therefore, demand for space is the main driver of increases or decreases in the market rent for a particular property type and asset class. Cap rates are similarly influenced by supply and demand; however, it is the point of equilibrium in the capital market which determines the market cap rate. The capital market represents the supply and demand for resources (money) to invest in real estate or other assets, i.e. stocks and bonds. The higher an asset’s return relative to its risk the more desirable that asset becomes in relation to other investment alternatives and the more capital allocated to that particular asset class. As demand increases, investors are willing to pay more for the same net income; leading to an increase in the asset’s value.

Amazon’s disruption of the retail industry and the rise of e-commerce coupled with the exponential growth of data and the need to store it, has led to an unprecedented increase in demand for industrial space. In terms of the space market, this has led to rent growth, year-over-year, that has outpaced all other asset classes. In the DC metro area, industrial rents have increased by an average 3.6% over the past 5 years and by 22% total since the subject property began leasing up in 2013. Most, if not all, industrial leases are triple net; meaning the net operating income is calculated by the rental rate multiplied by the square footage. This means, that on average and relative to market cap rates, industrial properties in the DMV have increased in value by an average 3.6% per year since 2015. The increase in market rents in the Route 28 South industrial submarket is only slightly less than the DC metro average; totaling 19.3% since the first/existing leases were signed at the subject property. With e-commerce expected to grow by 10% in 2020, demand for last-mile delivery space should remain strong and contribute to sustained rent growth.

All forecasts decrease in reliability as they increase in length of time. The subject property’s below-market leases are scheduled to expire in 2021 and 2022. The relatively short timeframe reduces the risk of any adverse changes in economic conditions that might impact demand and market rents for industrial space. This allows prospective purchasers to predict with greater certainty the potential increase in net operating income as a result of simply bringing contract rents up to market. Market analysts predict industrial rents to grow by 3.1% in 2020; insulating purchasers against overstating potential NOI growth in their acquisition assumptions and likely leading to an underestimation of the actual increase in future value.

The capital market is not totally independent and is heavily influenced by activity in the space market. Increased demand for industrial space, driven in no small part by Amazon, led to an increase in market rents, both generally and in relation to other commercial asset classes. As discussed previously, the more demand for something relative to its supply the more individuals are willing to pay more for it. What’s striking about the DC metro industrial market is the strong and sustained rent growth over the past 5 years despite millions of square feet delivering during that time. Due to the relationship between rental rates, net operating income, and value, industrial real estate has become more and more desirable from an investment standpoint. This has led investors to accept increasingly lower returns for each dollar of net operating income; represented by a decrease in the market cap rate and rise in property values.

Industry experts are calling for a 10% increase in e-commerce and further cap rate compression in 2020. Each would contribute to an increase in market value, independent of one another; however, when combined they act as a one-two punch byboth increasing the net operating income that is being capitalized and lowering the capitalization rate (required return). With its proximity to Dulles Airport and major transportation nodes, the subject property is ideally positioned as a last-mile delivery facility and should benefit from increased demand in both the space and capital markets.

Competitive Advantage (Space Market)

As mentioned previously, the subject property is comprised of 12 approximately 2,600 SF units. While seemingly innocuous, this data point reflects a competitive advantage that can actually be calculated. Currently, the smallest block of industrial space available in the Route 28 South industrial market is 3,162 SF. This is relatively low in terms of minimum blocks of space for industrial properties, but is still 562 SF larger than the subject property’s individual units. At the subject market’s estimated market rent of $9.50/NNN the annual rent is $30,039.00. Using this example, a tenant would be paying an additional $5,339/year or $444.92/month for space they may not need. Another way to look at it is that the subject property could, theoretically, charge an additional $2.00/NNN and still have a lower occupancy cost than the next alternative.

Spaces can always be doubled up to accommodate larger tenants but it is difficult, if not impossible based on the building’s layout, to demise bays into smaller spaces. The subject property is thus uniquely positioned in the market to be able to appeal to a broader tenant base on both square footage and price. The landlord has the option to price the space slightly above market due to the net difference in occupancy cost attributed to its competitors larger blocks of space or price the space(s) at market and reduce any potential vacancy losses by being the best deal in town.

Competitive Advantage (Capital Market)

Until recently, small retail strip centers have been one of the most desirable commercial real estate investment types. While still desirable, the Amazon effect has shifted capital to the industrial sector of the real estate market. This trend, alone, increases to the subject property’s present and future value; however, one of the reasons that small retail strip centers continue to be desirable also applies to the subject property.

As mentioned previously, value is measure of demand for an asset relative to its supply. All things being equal, the more desirable an asset the greater its value. The enduring demand for small retail strip centers comes from their size and thus their affordability. Market rents are subject to change; a property’s rentable building area not so much. A property’s value is determined by dividing the net operating income by the market cap rate, and because net operating income is limited by the current market/contract rents and cap rates are influenced by interest rates, in addition to other factors, there is an upper limit to its value simply based on square footage. Smaller buildings will always be affordable to a larger group of potential buyers. When you increase the number of buyers relative to the supply of available properties, the value goes up simply due to competition. This is true at the macro level as more capital is being allocated to industrial real estate; however, the effect is multiplied for the subject property, which at 32,000 SF and $4.16M is affordable to most commercial real estate investors. Size (rentable building area), therefore, acts as a type of value protection; maintaining and maximizing value through competition by being affordable to the largest group of prospective purchasers.

13893 Willard Rd, Chantilly, VA 4x

For more information on the subject property or to discuss listing your own property, please contact me at Ryan@RealMarkets.com or 703-943-7079.

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