From warehouses and distribution centers to manufacturing facilities and logistics hubs, industrial real estate plays a pivotal role in supporting global commerce and supply chain operations.
This guide delves into the key aspects of industrial real estate, including property types, investment strategies, market trends, and the critical role these spaces play in the era of e-commerce and modern logistics.
Whether you are a seasoned investor, a business owner seeking industrial space, or simply intrigued by the complexities of this sector, this guide will unlock the insights and knowledge essential to navigating the diverse landscape of industrial real estate.
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What is Industrial Real Estate?
Industrial real estate is a broad term that refers to properties that are used for industrial purposes such as manufacturing, distribution, warehousing, and research and development with some associated office space. These properties are designed to support the production and storage of goods, as well as the logistical processes involved in the supply chain.
What is Industrial Real Estate Used For?
Industrial real estate plays a crucial role in the economy by providing the physical infrastructure necessary for businesses to produce, store, and distribute products. It can be used by both smaller businesses, such as auto mechanics, plumbers, electricians and windshield repair shops, to large corporations like Amazon and third party logistics firms that need last-mile delivery hubs.
Examples of Heritage Capital’s industrial tenants, in addition to Amazon, include military contractors, like those that renovate torpedo tubes for the Navy, a large company that prints gift and credit cards for all of the major banks and retailers across the U.S., and another company that makes mochi, a Japanese ice cream dessert.
In each of these examples, the type of industrial property the business needs varies. The company that renovates torpedo tubes needs specialized manufacturing space whereas the mochi company, for example, needs a refrigerated space that can also accommodate a manufacturing line.
What Are the Different Types of Industrial Real Estate?
Flex Warehouse
A flex warehouse space, sometimes referred to as flex industrial, refers to an industrial property that is versatile enough to accommodate various uses from office space to light manufacturing or storage. Often, a flex building will combine these uses: there may be a storefront with windows at the front of the building, some small office component (usually no more than 20% of the space), and then there is warehouse and storage space in the back near the loading dock doors.
Heavy Manufacturing
Heavy manufacturing involves the production of large and often complex goods, such as machinery, equipment, or heavy industrial products. The manufacturing processes in heavy manufacturing are typically capital-intensive. The buildings often require specialized infrastructure such as overhead cranes, loading docks capable of handling heavy loads, and robust utility connections to support power-intensive machinery or significant water use.
Light Assembly
Light assembly is a type of industrial activity that involves the assembly of smaller and less complex products, often using manual or semi-automated processes. The production processes are generally less intensive than heavy manufacturing and may involve assembling components into finished products. Products are typically smaller, lighter, and may not require specialized handling equipment. The layout of these spaces is also more conducive to modular production systems that can be easily reconfigured if the tenant’s space needs change.
Data Centers
Data centers are specialized facilities designed to house computer systems, servers, networking equipment, and other components for the purpose of storing, processing, managing, and disseminating large volumes of digital data. These facilities are critical for supporting the operations of businesses, organizations, and services that rely on digital information and computing.
Data centers are their own category within industrial real estate due to their unique infrastructure and operational requirements. These requirements usually include robust infrastructure that can support a high density of service and electronic equipment, including but not limited to, advanced cooling systems, redundant power systems, and sophisticated fire suppression systems to ensure the continuous and secure operation of the facility.
Industrial Land
Industrial land simply refers to parcels of real estate that are zoned and designated for industrial use. Zoning regulations help ensure that the land is used in a manner that is compatible with the surrounding area and in accordance with the local community’s land use plan. Most industrial land is located strategically near major transportation infrastructure to allow trucks and heavy machinery to easily enter and exit the property without creating a nuisance for residential neighbors.
To be sure, every city and town has its own zoning code that may or may not use the word “industrial”. Some zoning codes may refer to this as “commercial” or “commercial industrial” property. The zoning code will then define the range of uses allowed within that zoning district. For example, some industrial zones may allow warehouses but will not allow auto repair facilities.
Cold Storage Facilities
Cold storage facilities are big warehouses that function like a giant walk-in refrigerator. These can be incredibly large, up to 100,000 square feet in size or more. Depending on a tenant’s needs, the space may need to be refrigerated only or it may need to provide subzero freezer space. Cold storage spaces are typically used to store perishable goods, such as food and pharmaceuticals. The temperature-controlled environments preserve the quality and safety of the stored products.
Built-to-Suit Industrial Space
Built-to-suit industrial buildings are those that have been pre-designed and constructed with a specific tenant in mind. Typically, the tenant will sign a lease for the space prior to construction commencing.
In a built-to-suit arrangement, the developer or landlord customizes the design, features, and layout of the building based on the tenant’s specifications. The developer will then price that design and will propose a financial deal to the tenant since built-to-suit properties are usually expensive to build. This type of development is common in the industrial real estate sector where businesses often have unique operational requirements that may not be met by existing, more generic properties. These are essentially custom-order buildings.
Built-to-suit industrial properties are different from “spec” properties which are built on a speculative basis without having been fully pre-leased to a tenant(s).
Research and Development (R&D)
R&D buildings are specialized industrial facilities that are designed to support scientific and technological research activities. These properties are tailored to the unique needs of companies and organizations involved in R&D processes ranging from product development to experimentation and testing.
Most R&D buildings will have some combination of “lab” space vs. “office” space – usually a 60/40 or 50/50 split. R&D buildings are often characterized by ceiling heights larger than traditional office buildings and have specific HVAC requirements to accommodate activities such as chemical analysis, materials testing, or biological research. Other specialized infrastructure can include chemical storage and clean rooms, for example.
Industrial Outdoor Storage
Industrial outdoor storage space refers to the designated areas on industrial property that are specifically designed for the open-air storage of goods, materials, equipment, or vehicles. Industrial outdoor storage usually features large, unobstructed spaces that are easily accessible to allow for the efficient movement of goods in and out of the storage area.
Industrial outdoor storage can be used for various purposes, including the temporary storage of raw materials, finished products awaiting shipment, surplus inventory, construction equipment, or other large machinery.
What are the Class Types of Industrial Real Estate?
Class A Industrial Property
Class A industrial real estate consists of well-located (i.e. excellent access to transportation infrastructure and/or population hubs), newer industrial properties that generate interest from high-quality, credit-worthy tenants. These properties have high ceilings to allow for efficient storage and operations, as well as other modern requirements like larger parking areas and cross-dock facilities.
Class A industrial assets are often owned by institutional investors who are looking for relatively “safe” and stable assets.
Class B Industrial Property
Class B industrial assets are somewhat older facilities (20+ years old) that are in good, but not prime, industrial areas. These buildings offer ample space but tend to have smaller footprints and lower ceiling heights compared to Class A properties. They generally have a lot of parking but may not have the cross-dock capabilities, making these properties otherwise very functional for most businesses. Class B industrial buildings attract a mix of tenants, including those that value functionality over the latest amenities.
Class C Industrial Property
Class C industrial properties are often located in older industrial areas or regions with less convenient transportation access compared to Class A and B properties. These are also the oldest; they may have visible signs of wear and will likely need significant renovations to meet modern standards. For example, Class C properties may have fewer loading docks and may lack advanced loading/unloading systems found in higher class properties. Class C properties also have smaller footprints and lower ceiling heights, which can make them less efficient for certain types of industrial activities.
Understanding Industrial Tenant Quality
Tenant quality is one of the single most important factors in the success of any industrial real estate asset. To be sure, “tenant quality” can mean different things to different investors. Some investors will only consider the tenant’s balance sheet when evaluating the tenant’s credit risk; others will look at the type of business that tenant is in. For example, someone may lease to the “best” tenant selling typewriters, but if no one is purchasing typewriters anymore, that is not going to be a quality tenant.
In general, industrial landlords will evaluate the following:
- Stability and Financial Health: High-quality tenants are more likely to be financially stable and have a strong track record of fulfilling lease obligations. This stability reduces the risk of rent defaults and ensures a steady income stream for the property owner.
- Lease Length: Long-term leases provide stability and reduce the risk of periods with unoccupied space, contributing to a more predictable cash flow.
- Property Maintenance and Care: Reputable tenants are often more inclined to take good care of the property. They are likely to adhere to maintenance requirements, which can help preserve the condition of the building and extend its useful life. This, in turn, can contribute to the property's long-term value.
- Vacancy Risk: High-quality tenants are less likely to vacate the property unexpectedly. Their financial stability and commitment to their lease agreement reduce the risk of sudden vacancies, minimizing the potential negative impact on the property owner's income.
- Ease of Financing: Lenders often consider tenant quality when evaluating loan applications for industrial properties. A property with financially sound and reputable tenants may be viewed more favorably by lenders, potentially leading to more favorable financing terms.
- Attractiveness to Institutional Investors: High-quality tenants make industrial properties more attractive to institutional investors, such as real estate investment trusts (REITs) or pension funds. These investors often prioritize stable and reliable income streams, which are more likely with reputable tenants.
- Market Reputation: A building tenant’s market reputation also matters. If the property is known for housing successful and reputable businesses, it can be more attractive to future tenants and investors.
Landlords will also want to carefully consider a tenant’s space needs and how that space could be easily retrofit for another tenant if that one was to leave. For example, an owner may only be willing to develop a built-to-suit industrial property for a specific tenant if the building is simultaneously designed to be used for an Amazon-like warehouse in the future should that tenant leave. The original tenant may be forced to compromise on the building design in order for the owner to ensure the flexibility of the space in the future – especially if the tenant is not planning to sign a long-term lease or if they are not otherwise considered a credit worthy tenant. After all, though long term relative to other asset classes like office and, of course, multifamily, most industrial tenants leave at some point and do not stay in the same space forever.
Types of Industrial Leases
Industrial leases come in various forms, each tailored to meet the specific needs of the landlord and tenant. The choice of lease type depends on factors such as the nature of the industrial property, the length of the lease term, and the preferences of the parties involved. Here are some typical types of industrial leases.
Gross Lease (Full-Service Lease):
In a gross lease, the tenant pays a fixed rent amount, and the landlord is responsible for covering operating expenses such as property taxes, insurance, maintenance, and utilities. This type of lease provides simplicity and predictability for tenants, as they have a clear understanding of their total occupancy costs.
Net Lease:
Net leases are typically the most common form of lease used in industrial property. Net leases shift some or all of the operating expenses from the landlord to the tenant. There are variations of net leases, including:
- Single Net Lease (N Lease): The tenant pays rent and the property taxes.
- Double Net Lease (NN Lease): The tenant pays rent, property taxes, and insurance.
- Triple Net Lease (NNN Lease): The tenant pays rent, property taxes, insurance, and all maintenance costs. NNN leases are arguably the most desirable net lease used in industrial real estate.
Modified Gross Lease:
A modified gross lease is a hybrid arrangement where some operating expenses are included in the rent, while others are the responsibility of the tenant. For example, the landlord might cover property taxes and insurance, while the tenant pays utilities and maintenance costs.
- Percentage Lease: Percentage leases are more common in retail, but they can be applied to industrial leases as well. In a percentage lease, the tenant pays a base rent plus a percentage of their gross sales. This type of lease is often used for showrooms or retail spaces within industrial properties.
In reality, the difference between a gross lease and a net lease (the two most common industrial lease types) are not that drastically different in terms of economics. A landlord using a gross lease might charge $14/sq. ft. whereas a landlord using a net lease might charge $10/sq. ft. in base rent plus $4/sq. ft. for maintenance, insurance, taxes, snow plowing, landscaping, etc. In that case the net rent is $10/sq. ft. but the all-in cost turns out to be the same as the gross rent. The difference usually lies in how rent escalations are calculated – e.g., whether it is a 3% annual increase on a $10 base rent or $14 base rent. Owners must consider these nuances carefully.
Ultimately, landlords will often alter the lease structure depending on the standard in the submarket and/or their own risk tolerance.
Average Lease Terms in Industrial Property
The average lease term for an industrial property can vary widely based on factors such as the type of industrial property, the nature of the tenant's business, regional market conditions, and the preferences of both landlords and tenants. Industrial leases commonly have terms ranging from short (1-3 years), medium (4-7 years) to long durations (8-10+ years).
The primary exception is for built-to-suit leases where the landlord constructs a property to meet the specific needs of the tenant. In situations like these, the tenant will often sign leases of 10+ years, reflecting the significant investment the landlord has made in constructing the property.
Most industrial leases will include a tenant’soption for renewal or extension. These options provide tenants with the opportunity to extend their lease for additional terms, providing continuity and stability in their occupancy.
When negotiating a new lease term, industrial landlords must pay close attention to their business plan, including but not limited to their financing and their exit strategy. For example, signing a tenant to a three-year lease becomes problematic if the landlord has a debt payment coming due the following year. Similarly, properties typically sell at a higher value – or refinance at better rates – if the property is well leased (assuming the tenants are paying market value), so owners want to consider lease terms that align with their intended exit strategy.
How Has the Industrial Market Evolved Over Time?
The industrial real estate market has undergone significant changes over the past three or four decades, reflecting shifts in global economic trends, technological advancements, and transformations in consumer behavior.
For example, in the 1990s, industrial real estate was characterized by traditional warehousing and distribution centers that supported brick-and-mortar retail. Manufacturing facilities played a central role, with many companies maintaining large-scale production facilities. At the time, e-commerce had a minimal impact on industrial real estate, as online shopping was still in its infancy. In the 1990s, cap rates were around 10 or 11 percent, and leasing these facilities could be difficult.
Industrial was considered “boring” real estate that rarely attracted interest among institutional investors.
That all changed in the mid-2000s when e-commerce started to create new demand for distribution and fulfillment centers. Companies like Amazon played a pivotal role in this shift. Globalization and increased international trade led to the expansion of logistics and distribution networks, impacting the design and location of industrial facilities. The 2000s was also when technological advancements in supply chain management, inventory tracking, and automation began influencing the design and operation of warehouses.
From the 2010s through today, the industrial story has been all about e-commerce which has fueled demand for large, modern distribution centers strategically located for last-mile delivery. Companies started to become focused on building resilient supply chains, leading to increased demand for industrial space to support efficient inventory management and distribution.
The 20-teens also saw the rise of “3PLs” or third-party logistics companies. These companies serve as distributors for large, national brands. For example, a 3PL might distribute all the washers and dryers for GE. This has allowed many retailers to outsource their warehousing and delivery to companies that have more sophisticated and streamlined operations.
As hot as e-commerce was up until 2020, the COVID pandemic essentially poured rocket fuel on the industry. A surge in online shopping has led to increased, and prolonged, demand for industrial space. Companies want more – and bigger – warehouses. Today, it is not uncommon to see industrial warehouses replacing retail stores as retailers close physical locations and shift more of their operations online. Some retailers will even use their stores as mini warehouses that become a node for distribution in that region.
What is Driving the Demand for Industrial Real Estate?
Without question, the continued expansion of e-commerce is the largest and most significant driver of industrial real estate demand. The rise in online shopping has increased the need for distribution and fulfillment centers to support efficient storage and delivery of goods.
- Pandemic-Induced Shift to E-Commerce: According to the International Trade Administration, e-commerce’s share of total global retail sales increased from 13.6% in 2019 and then skyrocketed to 18% in 2020. That number has continued to gradually climb to 21.1% in 2023 and is expected to continue rising into 2024 and beyond.
- Supply Chain Resilience: Businesses and supply chain managers emphasized the need for resilience and flexibility in supply chains, leading to increased demand for industrial space to accommodate inventory and distribution hubs.
- Last Mile Logistics: The focus on last-mile logistics to ensure quick and timely delivery to end consumers led to increased demand for smaller distribution centers located closer to urban centers.
- Warehouse Modernization: As companies seek to modernize their warehousing facilities to incorporate automation, robotics, and advanced technologies, both building upgrades and new industrial real estate construction have proven to be necessary.
- Increased Manufacturing Activity: A resurgence in manufacturing activities, including the reshoring of production to certain regions, contributed to a need for industrial facilities to accommodate production, assembly, and warehousing.
- Data Center Demand: The growth of digital services, cloud computing, and the need for data storage continue to drive demand for data center facilities.
- Cold Storage Demand: The growth of online grocery shopping and the need to store and distribute perishable goods is driving demand for cold storage facilities within the industrial real estate sector.
- Investor Interest: Institutional and private investors recognized the strong performance and stability of industrial real estate, leading to increased investment in the sector.
Why Are Industrial Properties a Good Investment?
There are several reasons why industrial properties are a wise investment choice among those looking to diversify their portfolios by investing in commercial real estate. Here are 10 reasons why industrial properties are a good investment:
- Continued Growth of E-Commerce:
The ongoing growth of e-commerce has significantly increased demand for industrial properties, especially distribution centers and fulfillment centers. As consumers increasingly turn to online shopping, the need for well-located warehouses to facilitate efficient supply chain and last-mile delivery has surged.
- Stable Income Streams:
Industrial leases often provide stable and predictable income streams. Many leases are long-term, and tenants, especially in logistics and manufacturing, tend to prioritize stability and continuity in their locations.
- Supply Chain Resilience:
The emphasis on supply chain resilience, underscored by events such as the COVID-19 pandemic, has led businesses to invest in robust logistics networks. This trend has increased demand for strategically located industrial properties.
- Global Trade and Logistics:
Globalization and international trade have expanded the importance of logistics and distribution networks. Proximity to transportation hubs, ports, and major highways is crucial, making certain industrial properties prime investments.
- Desirable Locations and Infrastructure:
Industrial properties often benefit from strategic locations with excellent infrastructure and connectivity. Proximity to major transportation hubs, highways, ports, and railroads enhances the efficiency of logistics and transportation, making these properties more attractive to tenants and supporting the overall value of the investment. This connectivity is crucial for businesses involved in distribution, manufacturing, and global trade, further contributing to the desirability of industrial real estate investments.
- Technological Advancements:
Technological advancements, including automation and data-driven logistics, have driven the need for modern and technologically advanced industrial facilities. Investors can benefit from properties equipped to accommodate these innovations.
- Diverse Tenant Base:
Industrial properties often attract a diverse tenant base, including e-commerce companies, manufacturers, logistics providers, and technology firms. This diversity can help mitigate risks associated with economic fluctuations in specific industries.
- Low Vacancy Rates:
Strong demand for industrial properties has contributed to low vacancy rates in many markets. This can result in a more favorable leasing environment for property owners, with the potential for higher rental income.
- Adaptive Reuse Opportunities:
Industrial properties, particularly older warehouses or manufacturing facilities, offer opportunities for adaptive reuse. Renovating or repurposing these properties for modern uses can provide attractive investment opportunities – particularly where the building offers access to in-demand infrastructure like heavy power or water usage.
- Investor Demand:
Institutional and private investors have shown increased favorability towards industrial real estate, leading to a greater availability of capital for investment in this sector. This can contribute to property appreciation and liquidity. The increasing interest from institutional investors, including real estate investment trusts (REITs) and pension funds, underscores the perceived stability and growth potential of the industrial real estate market.
How to Invest in Industrial Real Estate
There are many ways to invest in industrial real estate, ranging from active (direct ownership) to passive (i.e. investing alongside someone else such as Heritage who manages the asset on your behalf). Here is a look at some of the most popular ways to invest in industrial real estate.
Direct Ownership:
Investors can directly acquire industrial properties by buying warehouses, distribution centers, or manufacturing facilities. This approach involves property ownership, management, and responsibility for leasing. It provides direct control over the asset but requires hands-on involvement in property management.
Real Estate Investment Trusts (REIT):
REITs are publicly traded companies that own and operate income-producing real estate. Industrial REITs focus on owning and managing industrial properties, including warehouses and distribution centers. Investing in industrial REITs allows for portfolio diversification and liquidity, as shares are traded on stock exchanges.
Real Estate Partnerships (Syndications):
Investors can form partnerships or joint ventures with other individuals or entities to collectively invest in industrial properties. This approach allows for shared responsibilities and risks. Partnerships can be structured in various ways, such as limited partnerships or limited liability companies (LLCs). These are often referred to as real estate syndications and are how we here at Heritage structure our investment opportunities.
Real Estate Funds:
Real estate investment funds, including private equity funds and real estate investment funds managed by institutional investors, pool capital from multiple investors to invest in a portfolio of industrial properties. Investors can gain exposure to industrial real estate through fund investments without directly managing individual properties.
Real Estate Crowdfunding:
Real estate crowdfunding platforms enable investors to pool their capital to invest in specific industrial real estate projects. These platforms facilitate access to a diverse range of investment opportunities with lower capital requirements. Investors can choose projects based on their preferences and risk tolerance. Crowdfunding platforms can allow individuals to invest in industrial real estate debt and/or equity and in individual deals (syndications) or real estate funds.
It is important to note that each investment approach has its own set of advantages, risks, and considerations. Investors should conduct thorough due diligence – on both the real estate sponsor and the specific investment opportunity, assess their investment objectives, and consider factors such as market conditions, location, and property type when choosing an investment strategy.
Industrial Real Estate Trends
The industrial real estate market continues to evolve rapidly, shaped by technological innovation, changes in consumer behavior, and global economic trends. Here are some of the industry’s most relevant trends today.
- Warehouse Modernization: Warehouses and distribution centers saw increased adoption of automation, robotics, and other technologies to enhance efficiency and meet growing demand.
- Last Mile Delivery: Last mile delivery facilities are becoming more popular due to the growing prevalence of e-commerce and the increasing consumer demand for quick and convenient deliveries. To meet these expectations, retailers and logistics companies are strategically locating last mile facilities near urban centers, enabling faster and more efficient delivery of goods to end consumers. The trend reflects the importance of optimizing the final stage of the supply chain to enhance customer satisfaction and stay competitive in the evolving retail landscape.
- Multi-story Industrial Warehouses: Multi-story industrial warehouses are gaining popularity as urban land becomes scarcer and more expensive, especially in densely populated areas. These facilities allow businesses to maximize storage capacity and operational efficiency by utilizing vertical space, addressing the challenge of limited horizontal space in urban environments. The trend is driven by the need for proximity to consumers for faster last mile delivery, supporting the growing demand from e-commerce and urban logistics.
- Sustainability and Green Initiatives: Sustainability has become a key consideration in industrial real estate development, with a focus on energy-efficient buildings, green technologies, and sustainable practices. This is especially important to industrial properties as they tend to utilize significant power and water relative to other commercial real estate product types.
- Cap Rate Compression: In the early 90s, cap rates were 10-11 percent and leasing could be difficult. Industrial became more attractive in the 2000s, but it skyrocketed in the 2020s with the onset of the pandemic. In many markets, industrial warehouse space has started trading at 4 percent cap rates as rents have climbed to new heights. Some of this cap rate compression is also being driven by more sophisticated investors who are increasingly willing to and comfortable investing in industrial real estate – a product type that was once considered a sub-asset class.
- Adaptive Reuse: Adaptive reuse of older industrial properties, redevelopment of brownfield sites, and the conversion of outdated and underutilized retail space (especially “big box” retail) is gaining popularity, addressing the scarcity of available land in certain markets.
- Demand for Cold Storage: The growth of online grocery shopping and increased demand for perishable goods has caused a surge in demand for cold storage facilities – a trend that is expected to continue into the future as more people enjoy the convenience of online grocery shopping.
- Co-Working Spaces for Warehouses: There are now companies that lease a flex warehouse and subdivide it into smaller warehouse spaces. This allows companies to have warehouse space in larger, more modern and more amenitized industrial warehouse facilities. This model generally has common docks, loading, and some smaller office spaces that allow people to run their businesses more efficiently. These spaces are ideal for companies that do not need a full warehouse space – such as a local plumbing supply company who previously would have needed to lease their own warehouse. Even Amazon is leasing space in these buildings, which allows them to have a more connected network of distribution facilities where they can store product in more places.
- Onshoring of Manufacturing Space: More companies are bringing manufacturing back to the United States, so there is increasing demand for both light and heavy industrial space. There is less concern about investing in manufacturing facilities compared to 25 years ago, when landlords were always afraid that their tenants would move their operations to China or elsewhere overseas. Clean tech and “tough tech” companies – like wind turbine and battery storage companies, respectively – need larger facilities that can support significant power and water use, so they are moving to older manufacturing facilities in second and third-tier cities where the buildings can be retrofit and modernized.
Conclusion
As shown here, the world of industrial real estate stands as a compelling and dynamic investment choice, driven by the forces of e-commerce, globalization, and the ever-expanding need for efficient supply chain solutions. Industrial properties, including warehouses and distribution centers, are at the forefront of supporting the seamless flow of goods across the globe. The sector's resilience, stability, and adaptability, coupled with the continuous evolution of technology and consumer behavior, position industrial real estate as an enticing option for investors seeking long-term value and growth opportunities in the ever-evolving landscape of the global economy.
Interested in learning more? Contact us today to learn about ways to invest in industrial property alongside Heritage Capital Group.
