By Brian Martucci - Finance & Commerce
October 22, 2018
An ambitious Fridley redevelopment project expected to take eight years is on the verge of wrapping up in five, amid growing lender enthusiasm for industrial real estate in the Twin Cities metro area.
Even as appetites cool for other types of commercial real estate, lenders are bullish on industrial, said Paul Hyde, owner of Minneapolis-based Hyde Development, the industrial project’s developer. “That caution you’re beginning to see in multifamily and hotels – we’re benefiting from it,” he said.
Lenders and investors like the lower average cost of industrial projects, but they’re also betting on continued e-commerce growth driving a fundamental shift from large-scale manufacturing to warehousing and fulfillment, he said, adding the trend is likely to support long-term demand for industrial real estate.
Hyde Development and Mortenson closed this August on the purchase of the final parcel in the eight-building Northern Stacks industrial park at 5101 Industrial Blvd. NE in Fridley. The 122-acre Northern Stacks property is a former Superfund site that had been occupied by BAE Systems, a defense contractor.
Lender interest in Twin Cities industrial real estate is driven by a favorable confluence of financial factors. On the demand side, explosive e-commerce growth is driving demand for “last mile” warehouse and fulfillment center space closer to end-user customers, said Murray Kornberg, executive vice president at Minneapolis-based Dougherty Funding.
Case in point: Amazon, which built a giant fulfillment center in Shakopee and recently announced the conversion of a Brooklyn Park warehouse into a sorting center. Brooklyn Park is also weighing a proposal from Scannell Properties to build a 2.56 million-square-foot fulfillment center, which for now is being called Project Hotdish. Amazon hasn’t confirmed it’s the retailer involved, but has said it frequently scouts for sites.
Each $1 billion increase in e-commerce sales requires 1.25 million square feet of additional distribution space, according to CBRE research.
With e-commerce accounting for 9 percent of total retail sales in 2017, “there appears to be a lot of runway left for online retail growth,” said Hyde.
Hyde accelerated the planned eight-year redevelopment timetable as the industrial market improved and “leasing velocity increased,” he said. The final building will be ready next year, about five years after Hyde began the redevelopment.
The industrial vacancy rate in the overall Twin Cities market is 4.4 percent, according to CBRE. Rent growth is measured, but “what is being built or becoming available is successfully being filled,” said David Larsen, senior vice president and market manager for the Commercial Real Estate Minnesota division at TCF Bank.
Smaller average deals appeal to lenders
Demand factors aside, lenders appreciate the industrial sector’s smaller average deal size, said Kornberg. A “big industrial deal in the Twin Cities” means a 400,000-square-foot building, whereas “a big office deal is a 1 million-square-foot CBD [central business district] office tower,” he added. With less than 20 percent of their floor area used for finished offices, true warehouse or manufacturing industrial properties are easier to turn over for new tenant leases than office properties.
A landlord might spend $50 or $60 per square foot to prepare Class A office space for a new tenant, far more than a typical warehouse space with minimal office finish, said Kornberg. “You have less value erosion due to transaction costs in industrial,” he said.
Industrial construction costs are lower as well, perhaps $100 per square foot compared to $400 per square foot for a downtown office building, he said.
Increased competition in “primary markets” and smaller spreads between banks’ capital costs and the rates they charge on real estate loans have national lenders chasing yield in places like the Twin Cities, said Colin Ryan, senior vice president at Colliers International’s Minnetonka office. In the country’s hottest industrial markets, such as Pennsylvania’s Lehigh Valley and California’s Inland Empire east of Los Angeles, industrial capitalization rates are lower, he said.
“A ‘6-cap’ in the Twin Cities is a low ‘4-cap’ in the Lehigh Valley,” said Ryan. In general, higher capitalization rates are more attractive to property owners and lenders.
Those lenders – and their local counterparts – are diverse. Blue-chip life insurance companies seek bigger industrial deals – “those 400,000-square-foot properties,” which sell for $40 million, said Kornberg. Smaller insurers conserve cash and spread risk by limiting deals to $20 million or less.
“Industrial loans work well” for smaller insurance companies, said Kornberg. “A $30 million apartment loan might be hard for them, but they can do $15 million industrial loans all day.”
Life insurance companies favor loan-to-value ratios under 70 percent, said Kornberg. For borrowers, the upshot is “better rates and better terms” – up to 20 years, amortizing over 30 years, he said.
Many industrial borrowers seeking higher leverage and lenient early-year repayment terms turn to commercial mortgage-backed securities lenders, said Kornberg. “If you absolutely need 75 percent loan-to-value and a bunch of interest-only, you have to go with CMBS,” he said. But many Twin Cities borrowers are wary of CMBS lenders due to their complexity, he added.
Meanwhile, local and national banks dominate the “merchant build” market, said Kornberg, who specializes in commercial real estate financing for industrial and other property types. Low construction costs and lively demand draw developers to speculative projects, he said, because the risk is manageable and the prospect of a successful exit is good. “Once that product is built and standing, someone buys it,” he said.
“It’s still a seller’s market for ‘merchant build’ industrial loans,” said Larsen at TCF. “Financing terms remain attractive despite the recent rate increases and capital is readily available on both the debt and equity sides.
“Depending on the tenants the borrowers have in hand, pricing has experienced compression” on construction loans, he added, meaning interest rate spreads have tightened.
Merchant builds are comparatively rare in the office sector, where extensive pre-leasing is critical. Banks tolerate higher leverage better than life insurance companies – 70 percent to 75 percent loan-to-value ratios are common, said Kornberg.
Borrowers seek mix of financing sources
It’s also common for borrowers to seek financing from multiple sources, particularly on new construction and buy-and-hold transactions.
Hyde Development secured construction financing for Northern Stacks from Nebraska-based First National Bank of Omaha, which Paul Hyde credits with “the foresight to see that [the project] would work before we put a shovel in the ground.” Bank construction loans generally have two-year terms with the option for a three-year “mini-perm” extension, repayments for which include principal, he said.
Bankers prefer these shorter-duration construction and mini-perm loans. “Term debt often is commodity lending and, while we offer it, we are better suited for construction and mini-perm/transitional debt structures,” said TCF’s Larsen, who wasn’t involved with Northern Stacks.
Hyde then turned to Golden Valley-based Allianz Life Insurance Co. of North America for a nonrecourse permanent loan on a package that included the second, third and fourth Northern Stacks buildings. Hyde declined to reveal the exact size of the loan, but indicated that Allianz offered favorable terms in part because the company was interested in originating a similar permanent loan on a second three-building package at Northern Stacks.
“They like it when they can move more money in a transaction,” he said.
Hyde’s experience with Allianz reinforced his bullishness on industrial real estate. Allianz stretched all the way to 75 percent loan-to-value, an uncharacteristic concession to compete with bank and CMBS lenders, he said.
“I think that’s the last indicator that the appetite for industrial is back” following the late 2000s crash, Hyde said. “They’re starting to push LTVs because that’s the only way they can get these industrial infill projects in their portfolios,” he added. Higher loan-to-value deals are riskier for lenders, who stand to lose more if borrowers default.
Still ‘bullish on industrial’ real estate
Hyde’s sentiment appears to be widely shared by local and national buyers, developers and lenders. The James Campbell Co., a Hawaii-based real estate investor, recently paid $10.1 million for its third building in Burnsville's 35/13 Crossings Distribution Center, adding to a Minnesota portfolio that includes at least six other properties, according to the company's website.
“We are very bullish on industrial, as are many others,” said Kathleen Burgi-Sandell, vice president at James Campbell Co. The company, which owns property in more than a dozen U.S. metro markets, is divesting some of its suburban office portfolio to accommodate further industrial acquisitions, she added.
The Twin Cities industrial real estate market might benefit from looming weakness in other commercial real estate sectors, as well.
“Some lenders would believe we’re getting close to the top of the cycle in multifamily,” said Dougherty Funding’s Kornberg. While he doesn’t share that view, he warns against dismissing it outright. Lenders with “cycle concerns” around multifamily are more likely to favor what they view as the next best commercial real estate sector: industrial.
A more consequential decoupling might be in the making. As e-commerce grows and drives demand for warehouse space, the industrial sector appears less reliant on manufacturers’ fortunes. Accordingly, the correlation between rising gross domestic product and demand for industrial real estate has weakened, said Hyde.
“Manufacturing isn’t driving industrial anymore,” he said.