The big story of 2023? It’s undoubtedly been higher interest rates and the slowdown in commercial sales that they caused.
We spoke with Peter Mork, managing partner of Edina-based Capital Partners, about the impact that interest rates have had on the industrial sector, the asset type in which the company specializes.
Here is some of what he had to say.
A challenging 12 months: I will say that 2023 was a fascinating year. Our company owns and manages industrial real estate. From a tenant side, this was a good year. Tenants were expanding. Rents remained strong. We could charge more to fill our vacancies than we did the year before.
Industrial real estate has been strong this year. Vacancies remain low and will continue to remain low in 2024. New construction has dropped off and with vacancy rates already low before that happened, tenants won’t have as many choices to consider when they are looking for new space in 2024. It’s a landlord’s market right now.
But sales activity … But 2023 was also fascinating because it was such a bifurcated market. You had the capital markets side of the business that had some huge years pre-COVID. We would be looking at big portfolio deals every week. But then interest rates took off and debt got scarce. The capital markets just shut off. When you have 11 interest rate hikes in just more than a year, that’s going to happen. Sellers said that if they didn’t have to sell a property, they weren’t going to.
From a leasing perspective, the industrial world remained strong in 2023. Industrial tenants aren’t like office tenants. When COVID hit, office workers could run home and hide in their houses. Industrial tenants can’t do that. They have to stay in the shop and make their widgets and keep production going. There has been strong demand for industrial space throughout 2023.
Peter Mork, Managing Partner, Capital Partners
Differing impacts: This year has been fascinating for a lot of different reasons. Usually, when you see a downturn in the market, everyone suffers. In this downturn, industrial real estate did just fine. COVID actually helped industrial real estate. The office market suffered. The capital markets suffered. The apartment market held in there but is now getting hurt by debt.
When it comes to sales, debt has become the biggest factor in restraining sales velocity in the industrial market. It is so hard to find debt. New construction has turned off, too. Banks are putting down their pencils into 2024.
New loan requirements: In the old days, if you were buying a building, you could borrow up to 70% with five years of interest-only. Today, that doesn’t work. You need 40% equity down. Interest-only money is off the table. Lenders are going to float the interest rate. If you do get a fixed rate, it is close to 9%. This all means that so many deals don’t pencil out.
We had two portfolios under contract. The sellers took the deals to their publicly traded boards. The boards said, ‘No. Let’s not sell.’ The boards know that everyone is saying that interest rates are coming down or moderating in 2024 and 2025. If their loans aren’t maturing, why should these owners sell?
When will sales activity pick up? I talk to investment salespeople in the Twin Cities. They all say that in the second quarter of next year or at the end of the first quarter they will get a lot of new listings. The owners that held off in 2023 will launch their portfolios in 2024. Some institutional groups told Wall Street that they were going to trim their commercial real estate assets. They still need to do that and will probably do this in 2024.
I think 2024 will see more sales activity. Interest rates will come down. It is politically aligned. We are going to see interest rates cut before the presidential election. Once that occurs, we should see CAP rates decrease and we should see more demand for sales.
What’s interesting is that all this money will now be chasing just a couple of asset classes. Before, industrial competed with office and everything else. Now, all that money will focus on industrial and multifamily. We are going to see pent-up demand that will push CAP rates down. Sellers will have a reason to put their buildings on the market.
Tough times coming for industrial tenants? With new construction down, it is going to be very challenging for tenants to find industrial space in 2024. It’s not great news if you are an industrial tenant and your lease is coming up in the next 12 to 24 months. Do you want to do a short-term or long-term lease? Does a landlord want to do a long-term lease for 4% annual bumps? If a landlord does that, will that landlord be behind the market in 10 years? These are all big questions. And with the lack of new industrial space that has been built, tenants looking for space will have limited options.
Another 2024 problem for industrial tenants is that property insurance rates are going through the roof. Building owners will have to pass these costs to tenants in the form of higher rents. That being said, the cost of real estate compared to the overall costs of running a company is still a relatively low percentage. Rent typically accounts for something like 15% of the costs of running a company.
Finding debt still a big story in 2024: The big story will continue to be the difficulty of finding debt. And once you find it, you’ll have to put up more equity. Interest-only money will be off the table. Banks are still not participating in commercial real estate loans right now. You have to go with institutional debt. We are starting to see owner-financing come into play.
I do think new construction in the industrial sector will pick up in the second half of 2024. It’s going to be difficult for developers to sit on the sidelines when they see vacancy rates so low in the industrial sector. You just have to make the numbers work.