This type of industrial investment is a great starting point for the early-stage investor. These properties are called incubator parks, business parks, business centers, industrial parks, or multi-tenant industrial parks, you get the idea. The concept is that these properties provide multiple small spaces for startups and local service businesses, usually ranging from 1,000-5,000 SF each. Projects can vary from one building totaling 10,000 SF up to 300,000 SF consisting of multiple buildings making up a larger project. Think of these as the apartment complex of the industrial real estate asset class.
Multi-tenant projects provide for income stream diversification. Compare this with the earlier example of a single tenant building where you either have cash flow or you don’t. With multi-tenant industrial, you have 5-50 tenants, whereby no single tenant makes up more than 5-10% of the project. The tradeoff for this steady stream of income is an increase in management duties. Managing twenty leases means that there is more of a need for a property manager, common area maintenance, HVAC maintenance, and enhanced tenant relations.
The nature of smaller tenants is that you are dealing with less sophisticated and usually less capitalized tenants. Small businesses may be less able to weather a down market, challenging business environment, and credit crunches. Smaller tenants also sign shorter leases as they have less visibility into their future than larger, more mature businesses. You will have the majority of your contracts be 2-3 years in length, with few exceptions. That means that you might have 25-50% of your tenants’ leases expiring each year. Marketing smaller spaces, cleaning and prepping each space when vacant, and screening new tenants takes time and money.
There is an upside to this, though. With a five-year lease on a larger building, the market might be going up at 8% each year, but your contract only has 3% escalators. With shorter-term leases, you are better able to price market increases into your leasing strategy.
The financing market for these types of investments is different than it is for owner user buildings. Owner user buildings have more security for the bank because the building owner is signing a lease with his own business in the space. This alignment of interests is seen as skin in the game for the banks as the business executive is usually the largest shareholder and has a vested interest in the success of the real estate venture. As a result, the business owner will likely sign a five-year lease with his building ownership LLC entity.
Banks that do not have a long track record of lending on multi-tenant industrial properties will have some difficulty in getting comfortable with the shorter lease terms. The irony in this is that banks love lending on multi-family properties which consist of 1-year leases and month to month tenants. Renters for apartments are easier to find though then small businesses in down markets the logic goes. I find the majority of the time, any heartburn that the banks might have about multi-tenant industrial property comes from a lack of experience, not a fundamental discomfort for the risk of the asset and the owner’s ability to lease the units. The more bankers know about the multi-tenant industrial property type, the more they favor it because the capital investment needed to re-tenant each unit is modest, which leads to lower risk.
When you buy your single-tenant industrial building for your business, you are borrowing money with 10-25% down, amortize in 25 years, and pay it off in 25 years. When you buy multi-tenant industrial property, you usually have to put 20-40% down. You might even have an interest rate fixed for only five years, and then the rate adjusts to the market for the second five years. You must be aware of the debt coverage ratio, which is the amount of net income that the property produces divided by your estimated debt payment. This ratio can fluctuate but usually hovers around 1.25. So, the property has to generate 25% more revenue than the amount due each month. The purpose of this debt coverage ratio is to make sure that the property economics are robust enough to be able to pay the loan back even if there are unexpected expenses, loss of revenues, a deterioration of market demand, or an increase in the supply of competitive properties.
Amortization rates for these properties are usually 20 years and can sometimes be 25 years. A 20-year amortization differs from the traditional 30 years fixed-rate residential mortgage in that you can see your principal loan balance decrease.
With a shorter maturity date, you have to refinance more often, or be willing to sell and exchange property more frequently. A loan maturity of 5-10 years may mean that you have to refinance during unfavorable market conditions, whereas a 25-year owner user loan provides you with enough time to ride out a down market. The idea here is that you want to set up a mortgage for successful refinance further down the road. Banks want to keep your loan on the books as they are in the business of lending, so they usually will be aggressive in trying to refinance your loan when the time comes.
Your motivation to scale will determine what you do at these financing junctures. You have the option to sell the property every time your loan is due. You also have two refinancing options. On the one hand, you can refinance the loan and continue to pad your property account. You will then pay down your principal towards the coveted day when you have paid off 100% of your mortgage. On the other hand, more aggressive investors will refinance back up to the maximum loan to value and take out proceeds to reinvest in another property. The winning strategy here is that the money you pull out of the property is tax free.