Capital Driving Marginal Cap Rates in Core Markets is Spreading to Secondary Markets

JERSEY CITY, NJ — Industrial property is going through boom times. There’s a lot to work through to unwrap it all, and much of that has to do with institutional capital. So CapRE’s Northeast Industrial Commercial Real Estate Summit dedicated an entire panel to the topic of Strategy of Industrial REITs and Deployment of Capital of 2018: An Institutional Perspective.

Moderated by Eric Frankel, Senior Analyst at Green Street Advisors, the conversation honed in on a critical topic – returns. “Let’s stick to the Return expectations. Obviously cap rates are certainly low and IR expectations are in the low to mid 6% range,” he shared. “So Jim and Nick maybe you could talk about your underwriting assumptions – what are your return expectations for what you’re underwriting today?”

“Unless you’re a developer putting up spec product and selling to the big institutions, it’s more of a long-term proposition if you’re an investor,” replied Jim Clewlow, Chief Investment Officer, CenterPoint. “That’s what we look at. We look at very long-term holds and strategic assets. In terms of the IRRs, they’re not much different than what he’s talking about. But we’re not looking to sell in two years or three years or four years or five years. Our intent is to put together a quality portfolio that is sustainable for the next twenty years. And that’s more dividend-oriented. More income-oriented.”

Jim Clewlow, Chief Investment Officer, CenterPoint

“I kind of liken it to a bond investor that looks at as I’m going to buy this with my income and I’m going to hold onto it through its maturity,” Clewlow continued. “So another point is a dividend vehicle for CalPERS. CalPERS is looking for more income. I’m not saying that the price of square foot goes out the window. We’re always looking at that. We’re looking at replacement costs and we’re always looking at the fundamentals. I come from a real estate background so we are always looking at the real estate. But I think that it’s more of a holistic perspective.”

Nicholas Pell, Chief Investment Officer at Gramercy Property Trust then chimed in, saying that the type of capital that’s really driving these marginal cap rates to compress to the levels that they have in core markets are now trickling down even into secondary markets. “I think we just had Charleston break a six cap on stabilized Class A buildings,” he revealed. “So this really permeates out from the core markets across secondary markets as capital is looking for yield, and the core markets get expanded and expanded. And then the sub-markets get expanded and expanded.”

“We’ve seen that in Pennsylvania as the I-81 corridor has extended south, and frankly what’s happened in New Jersey and seeing Southern Jersey trading where it’s traded, trading today relative to a years ago,” he continued. “So as we evaluate the cost of capital, I think that the exit concern is real. We’ve been too conservative through the last five years on every deal being underwritten. And I think it’s a function of the time that we’ve been investing in. I think that that’s our approach to underwriting generally.”

With respect to exits, Pell’s bet is that equity returns are going to be lower. “You thought that you were going to get a low six, but whatever rent assumptions you’ve got in there and your exit is dependent upon your time horizon, and that solves your six,” he mused. “Well you might just be getting a five on it. And you may be okay with that too. If you’re the right kind of capital, which has a long-term, income-oriented approach, then maybe a five on the global landscape is still really attractive.”

“I think that that’s where we start talking about rates and investment spreads, and at what point of inflection do rates start impacting that?” he concluded. “But if you’re plugging the hole with rent growth in these core primary markets, then people will have a lot more flexibility to keep increasing the market rent growth assumption in the Meadowlands or Queens or in any of these infill markets than they will in the secondary markets.”

For more from this panel, check out earlier CapRE Insider Reports: