Of all the subsectors in bank lending, industrial commercial real estate (CRE) has been a favorite for the past year. Warehouses, distribution, logistics and manufacturing properties have performed well and banks that sought to curtail retail lending over the past five years have largely increased lending on industrial properties. Since this is such a popular subsector, we wanted to take a look at the data to see what we can glean to increase bank performance.
After hitting a peak vacancy rate in 2010 of 11.4%, the national industrial vacancy rate at the end of first quarter was 7% for an occupancy rate of 93%. The average loan on community bank’s books produced a debt service coverage ratio (DSCR) of 1.79x, had a loan to value (LTV) of 62% at origination which all equates to a 0.59% probability of default and a loss given default of 38.5%.
A loan with a 20-year amortization due in ten years with the above profile is expected to produce an approximate 21.5% risk-adjusted return on capital for the average bank in the U.S. That is one of the best risk-adjusted returns in banking which helps explain the popularity of the sector save for hospitality and self-storage lending.
Loss rates remained higher than multifamily and office but better than retail and specialty properties. While the average loss given default for all community bank commercial real estate loans is around 32%, industrial properties are running almost at 39%. However, despite slightly higher losses, the rate at which these losses occur continues to decrease.
Part of the lower probability of default performance is driven by record net effective rent growth of 4.4%. This rent growth is even more impressive when you consider that the level of construction has been strong and would normally be a harbinger of oversupply. However, in the case, it appears absorption is not only keeping up with supply, but demand continues to increase for future development.
According to REIS data, annual construction completions have averaged approximately 96mm sq. ft. since 2014 which hit 118mm sq. ft. of new product in 2017. This growth is similar to our last two cycles as construction growth was similar in 2000 and again in 2006. Balancing out the threat of oversupply, annual net absorption has been running 135mm sq. ft. As absorption continues to exceed supply, rents are expected to continue to increase in the near future.
According to Real Capital Analytics as of April 2018, industrial property prices are 19% above their peak 2007 levels. While that sounds like a risk factor, this is far below multifamily property levels that are now 50% above their pre-crisis peak levels.
Capitalization rates, because of the above-mentioned fundamentals, continue to grind tighter and are now at 6.4% at the end of 1Q according to Real Capital Analytics. This, we point out, is lower than the nadir from the last cycle which hit a low of 6.8% during the first quarter of 2007.
Looking ahead to the future, banks need to ask themselves can industrial properties continue to perform. Our analysis continues to be “yes” as we predict support will come along three dimensions. One aspect is the recent tax reform legislation still has businesses increasing cash flow in 2018 above 2017. More cash flow and lower taxes will make risk lower and capital investment more attractive resulting in more opportunities.
The other continued support comes from e-commerce. Over the past 17 years, e-commerce and industrial vacancy rates have been inversely correlated. More e-commerce sales have resulted in lower industrial property vacancy rates as more distribution/logistics hubs are needed, and more manufacturing becomes profitable. What has changed over the last several years is the recognition that e-tailers need more last mile distribution facilities particularly near metro markets.
Finally, it merits mentioning that the legal cannabis industry is absorbing huge amounts of space for indoor farming and distribution. While banks may not be lending on these facilities yet, growers and distributors are raising prices and taking out space in places like CA, OR, CO, WA, ME, VT and MA.
Putting This into Action
Changing consumer behavior and a growing economy has reduced the risk for industrial property lending. Given the demand/supply balance, we look for outperformance to not only continue but provide a defensive position for banks as demand for industrial space created by e-commerce and cannabis continues (although at a slower pace), even during a downturn. As such, banks should consider continuing to increase concentrations in order to lower the overall risk of the CRE portfolio and reduce cross-correlation coefficients.
Submitted by Chris Nichols on June 19, 2018