Speculative Industrial Development in Northwest Ohio
At Flex Real Estate, we often get asked, "If there is such great demand for small suite industrial, then why are you not building projects locally in Northwest Ohio to lease out?" Well, two main factors are keeping a flex project from being viable in Northwest Ohio for us at this time: the cost of completing the project and the current market rents. Below, I summarize the assumptions and math that we are constantly looking at to come to this conclusion. Included below are some short notes on each cost, and additionally, we have added a financial model to look at the math behind these decisions.
Cost
Construction Cost: In Northwest Ohio, using very round numbers, it will cost roughly $100 PSF to build a new industrial building. This includes the land acquisition through complete construction, including every cost in between: building cost, legal fees, taxes, inspections, etc. This means the cost of a new 50,000-square-foot building will be around $5,000,000.
Construction Loan: Assuming a 65% loan-to-cost, the total loan value would be $3,120,209. With a 6.50% interest rate, $112,322 would be capitalized at initiation to cover a year of interest-only payments, and payments following this would be $21,331.21 per month.
Leasing Fees: To get a tenant into the space as efficiently as possible, we would engage a broker to lease the new space. A 6% commission would equal $180,000 for a ten-year lease at $6.00 PSF.
Market Rents
To determine market rents for a vacant or renewing space, we always compare the asking rent to other leases executed in the area. Below, we conducted a survey of industrial leases in the area; this survey shows that for a 40,000-60,000 square foot space, the rental rate is around $4.82 per square foot. The question of what the rent should be for a new space is difficult to answer because there is such a limited amount of new development in Northwest Ohio, and attempting to set it through a speculative development would be an ambitious and expensive experiment. For a new premium space delivered to a user for 50,000 square feet, we would list it at $6.00 per square foot, and this is also what we have included in our model to find out what our return on this investment would be.
Analysis Model
Below, we answer two questions with our analysis model: What is an acceptable return for the level of risk involved, and what is the return based on the market rent for this space?
What is an Acceptable Return for the Level of Risk Involved?
Including the cost, the lease-up risk, the cost overrun risk, and the potential that we may have to offer a guarantee on the loan, at Flex Real Estate, we would require a minimum 1.8x equity multiple (1.8x the money we have invested into the project) over three years to pursue a speculative opportunity. To achieve this return in our analysis, we would have to reach a rent of $8.00 per square foot triple net (Triple Net: the tenant reimburses the landlord for all operating costs, such as maintenance, taxes, and insurance).
What is the Return Based on the Market Rent for This Space?
Above, we looked at our market rent competitive survey. The survey showed that existing listings are showing market rents of $4.82 per square foot, and we believe that tenants would be willing to pay a 20% premium for a new space at $6.00 per square foot triple net. Our analysis shows that if we lease up this project on month 13 at $6.00 per square foot and sell it at the end of year three, our equity multiple on the investment would be .86x; we would return 86% of our original equity investment. After all of the risk and time, we would not get our full investment back.
Why This Matters?
Comparing our analyses of market rent and required rent, we can see an undeniable problem with developing a small tenant suite-size industrial building: the rent we would need to achieve an acceptable return for development and the rent the market would pay, is a 33% delta. This may not seem like an extreme deviation, but when a cap rate is applied to determine the sales price, it makes a significant difference in the sales price and in the profits. The difference between our comparative rents is $1,600,000 in profit and is the difference between an acceptable return and a bad investment.
At Flex Real Estate, we are interested in speculative development in Northwest Ohio, and we will continue to evaluate new development projects moving forward. That being said, our main focus is on acquiring existing, leasable industrial buildings because there is currently no financial case for new speculative development, and these existing spaces will maintain and gain value.
Reply to this email and let me know if there are any specific topics you would like to hear about next. Thank you for reading, and stay tuned for the July Focus!
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