Bigger Is Not Always Better
Small real estate investors throughout Southern California are proving that you don’t have to be pretty to be profitable. Forget high-rise office buildings, fancy retail stores and luxury apartments. Humble warehouse and manufacturing space are what these buyers want.
Investors have been bidding up the prices for small industrial buildings--structures no larger than about 20,000 square feet--thanks to the improving local economy and its ever-more-entrepreneurial makeup. Small buildings that might have sold for a song just a few years ago are now selling for more than it would cost to build new space, and experts say this niche of the market is likely to hold its value because relatively few new buildings are being constructed.
“This is one of the tightest markets I’ve seen in a long time,” said Chuck Lyons of Fu-Lyons Associates, a Paramount-based developer that has built more than 1.6 million square feet of small industrial buildings during the last 20 years and plans to break ground on another 167,000 square feet in Downey before the end of the month. The company started in the 1970s buying small “incubator” buildings of 1,000 to 3,000 square feet.
“The market for small space is extremely tight, and there is not a lot of new construction planned,” said Jim Center, a senior vice president with Grubb & Ellis Co. who specializes in industrial properties. “Most of the development is in big-box projects.”
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According to those who specialize in this niche, demand for and investor interest in such space is a public secret.
“Nobody talks about it much or notices it much except those of us in the business, but there is space like this throughout the L.A. Basin,” said Mike Ibarra, a senior vice president with CB Commercial Real Estate Group. “The tenants are a real mixed bag, everything from people expanding out of their garages to big-name companies needing a small location for light distribution.”
Ibarra said such space for the most part is the domain of individual investors, partnerships and family trusts because the properties “fall underneath the radar screen of the [real estate investment trusts].”
Many of these investors have amassed fairly large portfolios of small buildings. Among these is Industrial Realty, a Torrance-based family business that owns more than $10-million worth of such property, according to Mike Quagletti Jr., whose father started the company in 1958 with one building.
Quagletti said he and his father--like lots of investors in small industrial buildings--are loyal to this class of real estate. They prefer it to apartments, retail shops or offices, and they stick with it despite the tug of other investments.
“Real estate is something that’s material. You can drive by and look at it and touch it, and it’s something that we’ve always felt is a little bit safer,” he said. “I’m not knocking the stock market and mutual funds and other investments, but we’re not that kind of passive investor. We like to have a little more control when we invest.”
According to broker Center, whether small industrial buildings are a good investment depends on individual investors’ age and financial goals, how much risk they are comfortable with, and whether the investors want a passive investment such as a bond or something hands-on such as real estate.
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Small industrial buildings can provide annual pre-tax returns of 8% to 9% and good potential for appreciation, provided the buyer can find a property in a good location and doesn’t overpay, Center and Quagletti said. Whether the investment is a wise one depends on the investor.
“Buyers have to look at their individual tax situations, what kind of return they’ll get after taxes, and whether they believe the property will maintain its value over time,” Center said. “That last part is always where the risk always is in real estate.”
Getting into the investment is the easy part.
“You have to be prepared to hold the asset for a long period of time unless you’re a developer building them on a speculative basis to sell them right away,” Center said. “But that’s a highly sophisticated specialty, and I don’t recommend it for beginners.”
Small industrial loyalists also believe such properties are easier to manage than other types of real estate.
“It requires less maintenance, and tenants pay more regularly, assuming you make sure you lease to good tenants,” Quagletti said. Small industrial buildings don’t require an on-site property manager as apartments do, and the leases typically require the tenant to take care of many of the minor maintenance items that apartment residents would want the landlord to handle.
“You don’t have to worry about people calling you up to fix their garbage disposals,” he said.
The management question is partly a matter of personal preference, according to Center. Many first-time investors would probably be more comfortable with apartments because industrial space is unfamiliar to them, he said. However, he called industrial property “probably among the least management-intensive investments in real estate.”
“Everything’s relative in terms of what is a management headache,” Center said. “If you do your homework to make sure you have tenants who are financially viable, you’re probably going to do OK and you probably won’t have a lot of problems. The biggest downsides occur if you overpay for the property, if you’re over-leveraged and can’t ride out the down cycles, or if you get a tenant who damages the premises or declares bankruptcy.”
Demand for small buildings is driven by two primary groups of buyers: individual investors or partnerships who buy them solely as investments, and owner-users who buy them to house their businesses.
Owner-users can be an obstacle to other investors, experts say, because they are willing to pay higher prices and accept lower returns on their investments just for the security of owning their own buildings.
“Owner-users will pay more because a lot of them have the kind of business that are expensive to move and they don’t want to be vulnerable to a landlord,” said Lyons, who explained that industrial tenants often have costly equipment that is expensive to move. “Some of the people who have bought our buildings said they didn’t want to risk having to change buildings again soon because it costs them several hundred-thousand dollars every time they move.”
Owner-users also represent an obstacle to pure investors because they can often get cheaper financing, allowing them to pay more for buildings.
“SBA money is cheap right now, and they [owner-users] can buy for 10% down,” Lyons said. By contrast, conventional financing requires higher down payments at higher interest rates than Small Business Administration loans.
According to Ibarra of CB Commercial, new industrial investors also may have a tough time buying buildings in the best markets because much of the property has already been bought and owners generating steadily rising cash flows might not want to sell.
“What that leaves then are peripheral or secondary marketplaces, and there’s a lot of product that is at best only an OK or even a tough investment. It can be hard to find and keep good tenants in those markets,” he said. “Even in today’s market, some buildings struggle to get tenants.”
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A final caveat for would-be industrial investors comes from Allen J. Anderson, chairman of San Francisco-based Meridian Industrial Trust, a real estate investment trust that owns and manages 6 million square feet of space in Southern California and owns 25 million square feet of space nationwide.
“The risk somebody runs in the current stage of the real estate cycle is that prices have run up considerably over the past 24 months,” Anderson said. “The future profit for those who buy today in hopes of selling at a profit in the future may not be as large, or may not even be existent, when the investor needs to sell.”
Meridian is building industrial property throughout the United States, in part because the company can build it a lot cheaper than it can buy it today, Anderson said. That means buildings now are selling for more than the cost of new construction, or “replacement value,” one of the gauges that industry experts follow to decide whether prices may be close to topping out.
