Borrower profile: CapRock sees rates making slow-moving impact on industrial pricing, valuations

CapRock, a Newport Beach-based industrial manager, anticipates that steadily rising interest rates will have a slow-moving impact on the pricing and valuation of properties in the sector.

The observations come as the firm earlier this month completed the sale of CapRock Tropical Logistics Phase 1, a pair of newly built Class A warehouses in North Las Vegas totaling 1.1 million square feet. The properties were fully leased to a trio of investment-grade credit tenants, factors that helped to spur interest in the assets, said Taylor Arnett, first vice-president of acquisitions.

The company took the property to market earlier this year via Cushman & Wakefield with the aim of getting the assets in front of a global institutional audience. More than 100 investors expressed interest in the properties, with Cushman fielding multiple offers due to the property’s location, design and tenant roster, Arnett said.

The story around industrial properties is likely to become more nuanced, however, as interest rates continue to rise, Arnett said. CapRock believes there will still be extensive demand for the Class A assets on which the company develops or executes value-added strategies because of long-term secular changes stemming from the covid-19 pandemic. The industrial market was red-hot prior to the pandemic and saw demand accelerate even further, both from tenants and investors, he explained.

“What drove this interest was the further shift from traditional retail to e-commerce,” Arnett said, noting demand is particularly high in the firm’s target markets of Orange County, Northern California, Phoenix, Texas, Salt Lake City and Las Vegas. “Industrial jumped about 10 years forward due to covid, with more warehouses needed. With the supply chain issues we saw, companies wanted to house more products so that they were not the prisoners of the old just-in-time inventory model.”

Prior to interest rates rising, CapRock was observing what Arnett called a dramatic decrease in cap rates that propelled increased valuations. At the same time, many markets were seeing rent growth of 30 percent to 50 percent in 2021.  The combination of decreasing cap rates and unprecedented rent growth had drastic effects on valuations.

“I am not exaggerating that we have seen certain assets in certain markets have doubled or tripled in value in the past few years,” Arnett said. “It has been a historic run in industrial, but things are starting to change a bit. We are starting to see some choppiness in some parts of the market because almost all real estate investors use debt and obviously rates have gone up significantly in the past few months. Still, the fundamentals are strong for industrial real estate.”

One impact from higher rates is a ripple effect affecting the pricing of assets, specifically properties leased to tenants on a long-term basis.

“If you have a property with a 10- or 15-year fixed lease and you are a buyer who wants to buy a coupon and use debt to get to a specific yield and you see debt prices go up by 150 basis points, then you obviously cannot get the same type of yield you are trying to seek,” Arnett said. “Because the fundamentals of the leasing market in industrial are so strong, we have not seen so much of an impact on value-added or development deals where there is low vacancy, and you can mark tenants to market sooner and that is largely due to the fact that rent growth is strong and supply is way behind demand.

“As long as you are not locked into five plus years of an income stream, the market feels good about the potential for rent growth increases. But if you are running your pro forma based on interest rate changes, you may be seeing a bit of a cooling off of land values at the front end of the development process.”

While Arnett has not seen this yet, the phenomenon will likely take a few months to trickle through the market. “Tenant demand is extremely strong and, because of the two- or three-year process of getting new product to the market, it is a slow-moving ship. I think development and construction are going to be strong, but there will be a cool off of land values and how aggressively developers might be on new land given the simple math of increasing interest rates and cap rates over the next 12 to 24 months,” he said.