SIOR held their Fall Conference in Los Angeles recently. One panel made a lasting impression. They pointed out the spreads and prices between A and B warehouses are the widest it’s ever been. While no one spelled out the specific reason, a combination of low interest rates, Quantitative Easing, flight to quality, and the Port/Gateway story has revived the investment market for A Industrial. Cap rates of 5% are the current norm for A property in the best industrial markets. Lower grade (non-institutional) sell at 200 to 300 basis points higher. Returns climb in secondary markets. Why aren’t more investors buying up the sub-institutional real estate where returns are greater? It will happen soon and this will be a turning point for dormant industrial markets around the country.

Since the Great Recession, the non-institutional industrial market has been sleepy. With low confidence in the U.S. turnaround story, ominous signs for another downturn and scarce entrepreneurial financing, there is no driving force to purchase Class B property. However, the case for action is slowly changing the same way the economy is grudgingly moving forward.

Cyclically, we have seen the economic bottom. Much of the contraction, downsizing and corporate deleveraging are behind us. Fears that the Fed has been artificially creating an asset bubble by its QE program is true, but the priming effect has been felt a lot less in the lower quality property than in higher quality industrial. Financing and credit has not been widely available in the middle and lower end of the market

There is also a large organizational challenge. Companies that have a focus on B property have limitations, not in terms of success, but in scope. These investment groups tend to be locally oriented in one specific region or they are opportunistic in the deals they find. Both lack a comprehensive roll out strategy. For instance, there is no large branded business seeking spread differences in the same way the larger REITS or national developers are searching for A. For one thing, funding on a large scale is difficult in the lower grade world. After all, Friends and Family financing can only carry an idea so far. Personnel factors are also a hindrance when the territory gets too large for the properties to be seen by trusted eyes. But if major investment groups can run a business purchasing and managing thousands of depressed single family homes, money and talented people will soon be available in a larger scale for non-institutional industrial.

By early next year, if the economic indicators continue their slow but upward climb and our long term fiscal issues get addressed, we will start to see more focus on buying up the lower grade industrial in a more concentrated fashion. I’m not sure who will lead but it makes sense that some of the larger players who already have a national brand will have a head start. For instance, Prologis or Trammel Crow can use their name to gain instant recognition. Other investment companies already in the A space will begin looking for higher returns. Finally, local companies, who have already developed core competencies in turning around older buildings, will begin to expand geographically.

The non-institutional property market is very tricky when trying to balance location and quality. The early crop of buyers will do so methodically and first try to capture the best of the sub-class. The most organized will likely be more direct than they have been in previous buying cycles. For instance, they will simply pick out the best properties from independent research and try to acquire them directly without waiting for the buildings to go on sale. These were techniques that were developed before the Great Recession and will be revitalized with better technology, people, and relationships. In other words, the acquisition teams will be aiming directly at off-market strategies and not waiting for shop worn offerings to be emailed.

Real estate investors are sitting on large amounts of capital just like large corporations. Both are looking for signals that we are entering a new growth phase before they make large commitments. So far, there have been some good buys by the early adopters. But it won’t be long until we see new fund raising packages on the street targeting the B property market in much more comprehensive way.

(In the next installment I explain what Buyers will be looking for in the B space and what that means for Building Owners)