As intermediaries in the sale of investment real estate between institutions, private equity fund managers, REITs, family offices and a multitude of other participants, we are faced with the daily challenge of identifying the correct investment opportunities for the correct investors and their capital sources. Our team constantly asks: “What are today’s investors’ return requirements, and how can opportunities in Indianapolis fulfill those needs?”
As we have traveled around the country in the last 12 months to meet with investors, we have increasingly fielded interest from new and diverse sources of capital with surging appetites for high-quality real estate opportunities. Certainly, this interest is not unique to Indianapolis. Secondary markets across the country are reporting similar conversations, and “searching for yield” has become the chorus of the investment community.
According to Preqin, nearly $150 billion of private equity has been earmarked for North American real estate investing in 2018 and more is scheduled for 2019. The pressure on primary market pricing has led to an increase in capital focused on finding opportunities in secondary markets. Indianapolis, with its projected population and economic growth, is uniquely positioned to deliver on the promise of outsized returns relative to both its secondary peer set and larger gateway markets.
Indianapolis delivers on its return potential through three key fundamentals: job growth, population growth and leasing trends. Job growth during the latest bull market has been extremely healthy, leading to low unemployment and the addition of office services jobs bettered only by Nashville and Raleigh last year. Secondly, the Indianapolis MSA gained net inflow population growth of 11,911 residents in 2017, bettering its peer set and providing needed skilled labor to an increasingly tight job market. Overall population growth in Indianapolis for 2017 was 1.1 percent, which was exceeded in the Midwest only by Columbus, OH at 1.6 percent.
Potentially the most important metric for investors considering Indianapolis comes through its supply/demand and leasing fundamentals of its industrial and office sectors. Although there has been a slight increase in vacancy due to recent build-to-suit projects, CBD and suburban office vacancies across suburban class-A assets reached 10-year lows. Rental rate growth is climbing, and significant speculative office deliveries scheduled through 2019 are nonexistent. Indianapolis has experienced 16.4 percent rental rate growth since 2011. Similarly, industrial user demand continues to be a driver of increased returns through both the modern bulk and light industrial segments. Overall 2018 direct net absorption for industrial product is projected to reach 10 MSF.
The Industrial Market – Investment Activity
The Indianapolis industrial market is comprised of 252 MSF in total. Nearly 40 percent of this supply, or 95 MSF, is modern bulk distribution product. Overall investment activity in Indianapolis industrial product averaged $526 million per year from 2015-2017. This year, total investment sales product volume is on pace to match that average, totaling nearly $400 million by the end of Q3 2018. Of this total volume, less than half is represented by single-asset trades. The current ownership makeup of modern bulk industrial product within Indianapolis is 73 percent institution/REIT, 8 percent private market, 4 percent private equity/funds and 15 percent owner/user. These percentages represent an increasingly institutional shift in Indianapolis’s ownership base.
Sales activity is in line with a trend Real Capital Analytics is reporting throughout the country. Year-over-year overall industrial sales volume is up 34 percent and portfolio-excluded sales are up 5 percent as early cycle investors look to monetize their bets.
Pricing for industrial assets has increased healthily for both modern bulk distribution product and traditional industrial product. Modern bulk sales have averaged $52.81 psf, representing a 7.7 percent increase from 2017 and a 10.9 percent increase since 2015. Cap rates continue to compress, highlighted by a market record sale of a 600,000-square-foot distribution center leased by Geodis Logistics for a 5.23 percent year-one unleveraged yield on cost. Additionally, all other industrial pricing has improved. As of September, all industrial investment sales have averaged $60.42 psf, again representing a huge increase of 43.4 percent from a lull in 2017 and a 21.5 percent increase since 2015. Capitalization rates for industrial product have compressed nearly 200 basis points in the last 24 months, dropping the 2018 average for stabilized cap rates to 5.5 percent.
The Office Market – Investment Activity
The Indianapolis office market is comprised of 38.53 MSF inclusive of 11.66 MSF in the CBD and 26.87 MSF in the suburban markets. The Class-A suburban office market includes 12.6 MSF and the CBD Class A market includes 6.1 MSF. All categories of office product in Indianapolis have experienced increases in achieved rental rates over the past 36 months.
Rates have increased to $22.45 psf in the class-A suburban market and $23.38 psf in the class-A CBD market, representing a 12.6 percent and a 10.4 percent year-over-year increase respectively. The Indianapolis office market is fundamentally strong with tenant demand across a diverse set of industries including, biotech, legal, marketing, design and technology.
Naturally as the fundamentals continue to improve, investment sale activity and pricing has improved. Year-to-date, more than $300 million of office product has sold. Nearly all product that was affected in the recession has traded, experienced significant capital improvements and is going through its second round of sales or refinancing as value added/core plus capital has entered into the market. Pricing in both the CBD and suburbs has increased. Average CBD per square foot sales prices have increased 40 percent over the past three years while suburban sales prices have increased 33 percent.
Trends to Watch in 2019
Overall, Indianapolis’s investment sales activity has been measured through the current cycle. Although industrial is the most active subset of property sales in the Indianapolis market, it is not overpriced relative to both like-kind and gateway markets. We believe there will be an increase in overall sales volume throughout the entire industrial market in 2019. Several high-profile modern bulk portfolio transactions are already on the market targeting an early 2019 close.
Although about 5 MSF of new speculative supply will become available for occupancy by Q2 2019, more than 78 percent is owned by institutions with long-term investment horizons for the product. Due to the ownership types developing in Indianapolis, we anticipate a reduction of single-asset sales in the modern bulk space in 2019. Additionally, as high-quality infill product continues to be an attractive bet for investors and fund managers, we expect increased activity across the remaining industrial subsets. The leasing fundamentals in this product set support the investment rationale, and rental rates have yet to hit a point to justify new construction, further limiting the supply in the space.
These two undercurrents will lead to increased attention from private and institutional investors alike. Finally, we believe cap rates will remain flat for 2019 as cost inflation and interest rate growth begin to bear out. However, with increasing rents, we estimate market assets will benefit from NOI growth that will result in overall increased pricing for assets during the upcoming year.
Based on feedback from current owners and potential investors, we anticipate an increase in sales activity in 2019 for office product. Both early-cycle buyers looking to monetize their bets and long-term holders of property in Indianapolis have executed their business plans and will be looking to sell in 2019. A diversified set of investors including institutions, REITs and family offices have turned their attention to Indianapolis as a potential market for investment. These groups have increasingly long-term investment periods and find the supply constraints, job growth and overall tenant demand metrics in Indianapolis intriguing.
Differing from industrial product, we believe investor return requirements for office product in Indianapolis will tighten slightly as increased competition in class-A projects prepare to trade by Q2 2019. An increasing number of investors will continue seeking high quality risk adjusted yield opportunities in the market.
Alex Cantu is executive vice president of the Indianapolis Capital Markets and Investment team for Colliers International. Alex Davenport is an associate on the same team. Both are based in Colliers’ Indianapolis office.