Service Industrial

While fundamentals across the overall industrial sector have deteriorated as a pause in demand, coupled with supply pressures, has halted rent growth nationally and sent vacancy to levels not seen in years, not all industrial is created equal.

Service industrial consists of small-bay assets less than 120 feet deep with 12- to 24-foot clear heights, predominantly grade-level loading, and average suite sizes below 10,000 square feet with less than 30% office finishes. These spaces are tailored toward service-oriented businesses focused on local populations, making the ideal service industrial location in infill, densely populated, or rapidly growing areas. Here, as these assets are converted into higher and better uses, negative supply is resulting in low vacancy–at just 2.1% to close out the year in 2024¹–far below that of the overall industrial sector at 6%, per data from CBRE.

Additionally, this niche subsector has not yet been institutionalized in earnest, resulting in going-in cap rates that are still at reasonable levels in today’s interest rate environment. Plus, the lack of institutional operations generally creates a large mark-to-market opportunity. Short lease terms, strong fundamentals, and frictional market vacancy allow investors not only to capture the existing mark-to-market but also provide a runway for additional market rent growth, generating attractive yields on cost within 24-36 months of ownership (Figure 1).

Sources: CenterSquare, as of December 31, 2024. Based on typical transaction: going-in cap rates range from 5.5%-6.5%, existing leases 30-60% under market rents, weighted average lease term under two years, 4% annual escalators, and 3% rent growth.

Purpose-Built Rental Communities

Despite the supply in rental housing in the last few quarters, home ownership affordability remains a critical issue. Mortgage rates are near 7%, home prices remain elevated, and maintenance and insurance costs have risen dramatically across most markets. Altogether, since 2020, mortgage payments have increased 88% while incomes have only increased 17%², exacerbating affordability concerns. Meanwhile, the demand for suburban lifestyles and single-family living continues to rise (Figure 2), driven by the confluence of several factors. The millennial generation is aging into family formation years and needs more space and strong public schools for growing families. Further, increased hybrid and remote work arrangements allow individuals to live further from the city center as commutes become limited to a few days a week. The real estate industry’s solution to this has been the rise of institutional single-family rentals. While many large institutional platforms have embraced the scattered site model of purchasing disparate homes, we are focused on a niche within the space – Purpose-Built Rental Communities (PBRC).

Sources: The Brookings Institution, as of June 6, 2024.

We define PBRC as, single-family detached home and/or attached townhome communities consisting of primarily three- and four-bedroom homes, built solely for rentals, adding new single-family supply in traditionally under-supplied suburban submarkets. These communities are ideally suited across generations: for millennials aging into the single-family lifestyle and baby boomers seeking to move out of home-ownership responsibilities. Like traditional multifamily, PBRC has been impacted by elevated levels of supply versus historical levels. As a result, we believe the most attractive ways to access this niche in the coming year will arise from 1) providing rescue capital in the form of preferred equity for developers with aggressive underwriting assumptions in need of refinancing expiring debt, or 2) acquiring assets directly from homebuilders, at certificate of occupancy, below replacement cost in strong submarkets experiencing easing supply pressures and strong demand drivers that reduce the lease-up risk associated with the business plan.

Essential Service Retail

While the industrial and residential subsectors have had their fair share of time in the sun, retail was largely forgotten by most institutional investors in the last decade. However, sentiment has shifted meaningfully for the sector and fundamentals are emerging as the strongest across core subsectors. Retail remains insulated from new supply as rents across the sector still do not justify new development (Figure 3); supply for the sector is not expected to surpass 0.5% of existing inventory for the foreseeable future.

Sources: Green Street - U.S. Strip Center Outlook, as of January 24, 2025.

Interest from institutional investors in the sector has been particularly concentrated in grocery-anchored shopping centers. Blackstone’s acquisition of Retail Opportunity Investments Corp. (Nasdaq: ROIC) at a 6% nominal cap rate (or 5% economic cap rate after capex) in November last year, arguably made the largest splash in the market and indicated institutional investor appetite returning to the sector en masse. We remain focused on Essential Service Retail (ESR), a niche subsector in which competition from capital has not forced cap rates to such low levels.

ESR consists of unanchored shopping centers leased to e-commerce resistant tenants whose customers must visit the store to consume the service (i.e., hair salons, coffee shops, dentists). These are typically 20,000 to 40,000 square foot shopping centers with average suite sizes less than 2,000 square feet, catering to a wide array of tenants. Strong fundamentals have resulted in high occupancy (97%) and high re-leasing spreads (14%) in 2024 for this subsector, and we anticipate this strength to continue in the coming year. Additionally, the lack of institutional ownership across the subsector lends itself to strong income growth at the property level from simply institutionalizing operations, offering attractive returns with limited business plan execution risk.

Sources: Hodes Weill & Associates - 2024 Institutional Real Estate Allocations Monitor, as of December 31, 2024.

Sources: PREA 2025 Investment Intentions Survey, as of November 2024. The above data includes forward looking information, actual results may be materially different.

We anticipate this investor appetite to deploy capital will be coupled with two developments in the real estate debt markets to drive transaction volumes:  1) existing lenders no longer willing to extend and modify terms on an expected nearly $1 trillion in loans maturing this year, and 2) increased debt availability from alternative providers of debt capital (more to come on this in our upcoming private real estate debt outlook).

Increased transaction activity should also lead to rationality on true valuations. We have seen the private market (mainly ODCE funds) lagging meaningfully on appraisals as valuers continue pointing to a lack of comparable transactions. Consequently, appraisal cap rates across core properties⁴ are essentially on top of the 10-year treasury yield today (Figure 6). Historically, when the spread between the 10-year treasury yield and appraisal cap rates collapsed, a meaningful cap rate expansion followed. As outlined in our macro outlook, we anticipate treasury yields to remain above 4% for the foreseeable future, which would warrant appraisal cap rates closer to 5.5% if they were to return to historical spreads versus the 10-year treasury yield, creating additional pressure on appreciation returns across most core funds.

Sources: NCREIF, Bloomberg, as of January 30, 2025. The above data includes forward looking information, actual results may be materially different.

As valuations reset, investors should recognize that the time to invest is now. Those who invested in real estate through the recovery following the Global Financial Crisis can attest to the benefits of investing early in the market cycle. The difference in cumulative returns between those who invested at the trough versus those who waited just two years is greater than 70% (Figure 7).

Sources: Colliers, as of December 31, 2024.