How To Conduct Due Diligence on an Industrial Property, Part 1

Over the past decade, a confluence of circumstances — including the rise in online shopping and the COVID-19 pandemic — have contributed to nearly unprecedented investor and user interest in industrial properties. Previously, industrial was often viewed as lacking the pride in ownership that office, retail and multifamily properties confer, but it has since become the darling of the industry.

Even now, when most analysts predict a relatively challenging year ahead for the sector, industrial assets experienced rent growth of 9.3% over the 12-month period that ended March 31, which represents more than 10 times the growth experienced by the office sector during the same period, according to statistics provided by CoStar Group, the publisher of LoopNet.

For nascent industrial investors, though, the sector can initially seem intimidating. Unlike multifamily, retail and office properties — which most investors have encountered as a user or as a client at some point in their lives — many investors may have never set foot in an industrial facility, which makes the prospect of evaluating them from an investment perspective more daunting.

This is why LoopNet enlisted Justin Smith, a partner with brokerage firm Lee & Associates (and a frequent LoopNet contributor) to walk us through the process of conducting due diligence on an industrial asset.

Smith, who is based out of Irvine, California, and has more than 19 years of experience in industrial real estate, broke the process down into seven primary steps. According to Smith, the key phases of the industrial due diligence process are:

1. Collecting property information.
2. Financial analysis.
3. Market analysis.
4. Legal and regulatory investigation.
5. Property inspection.
6. Lease analysis.
7. Risk assessment and mitigation.

In this article, we’ll cover the initial two phases of the process — collecting property information and conducting financial analysis — while the remaining five steps will be detailed in part two of the series.
While aspects of the industrial due diligence process differ from the multifamily or office due diligence processes, for instance, Smith noted that there is a fair amount of commonality.

Ultimately, as Smith observed, the process is about endeavoring to “get your arms around” a project and understanding “What is it that I'm about to underwrite?”

According to Smith, the first and most basic piece of property information you’ll want to understand is the size of the property as well as the land it resides upon. That means computing the total square footage of the industrial portion of the property. It also means looking at any mezzanine or office space that is part of the building and the square footage of the land parcel itself.

From there, it’s important for an investor to uncover any upgrades that have been made to the building and grasp the key industrial specifications that users will be most interested in. Smith said that the most critical industrial specifications are the minimum ceiling height or clearance; the power capabilities of the property, and not just the phases but also voltages and amps; and the sprinkler system information. Smith said that ceiling heights and the sprinkler system are particularly important because industrial users “can only rack as high as the ceiling goes, and they can only rack as high as the fire suppression system goes.”

So, a high ceiling that’s not complemented by a similarly scaled fire suppression system won’t be particularly useful. Smith said that many novice investors will just confirm that the property has a fire suppression system, but that’s not sufficient. Smith said that the question an investor should ask is not “does the building have a fire suppression system?” But “does it have one, and how many gallons per minute over what square footage does it cover? And is that appropriate for how tall the ceiling is?”

These are key elements to understand because, according to Smith, the ceiling height and fire suppression system, more than any other aspects of the property, will dictate “who you can lease your building to, or who is going to pay your rent and represent your return on your invested capital.”

While not specific to an industrial property, Smith also said that investors will want to investigate when the roof was last replaced, repaired or had a new coating installed. In addition, some key documentation that an investor will want to collect includes any Phase I or Phase II environmental reports (and we’ll cover those reports in more detail in the legal and regulatory investigation section of this guide) and a preliminary title report.

The financial analysis phase of the due diligence process “is where you'll build your model, you'll make your assumptions and then you'll calculate your returns,” Smith said. It’s important to note that while we’ve placed the financial analysis phase second in this process, it’s really ongoing throughout an investor’s due diligence. That’s because information garnered during other phases of the process, such as the lease analysis or legal and regulatory investigation, are constantly informing and refining the assumptions that impact your financial analysis.

And, as Smith noted, “There's countless assumptions; I mean, there's probably like 52 of them.”

Determining which program to use for your analysis. Another important aspect of this phase to consider is what software program an investor should utilize to conduct their financial analysis. Smith said the answer to that question is largely dependent on the number of tenants at the property. That’s because the number of tenants will dictate the volume of assumptions you need to integrate into your model. The more tenants you have, the more costs and assumptions — such as brokerage commissions, capital improvements or market rents during different time frames — you’ll need to include.

Accordingly, if you’re purchasing a multi-property industrial park with more than a dozen tenants and numerous capital improvement requirements, you’ll probably want to invest in a dedicated financial modeling program, such as Argus, to complete this task.

On the other hand, if you’re acquiring a single-tenant class A property that was recently constructed and has a long-term lease in place, “You need to know what the tenant’s rent is,” Smith said. “You're not going to do any big improvements. You need to know what the market rent is when the lease expires, and that's kind of it.”

For that scenario, running your analysis in Excel is probably sufficient. And given that the majority of industrial properties — Smith estimated 80% — are single-tenant properties operating under a triple-net lease, that’s the situation that most industrial investors will be confronting.

Revenue and expense assumptions. Once you’re building your model, your first assumption is how much income is being generated currently from the property — this represents the revenue side of your ledger.

If you’re pursuing a value-add opportunity, you’ll then want to make assumptions about how much you can increase that income by making enhancements at the property and pushing rents up to reflect the value of those improvements. In this scenario, you’ll need to make a variety of corresponding market leasing assumptions, including how long it will take to lease the property, what rents you’ll be able to achieve and how much brokerage commissions and tenant improvements or concessions will cost you.

With the exception of the new rents, most of those assumptions will end up on the expense side of your analysis, where they’ll be supplemented by the property’s various operating costs, including property taxes, insurance and maintenance. It’s important to note than in a triple-net lease scenario, all of those expenses are reimbursable, so they will feature on both sides of your analysis.

Financing assumptions. With regard to financing assumptions, Smith acknowledged that the dramatic rise in financing costs over the past year has skewed loan-to-value (LTV) ratios. Whereas financing assumptions a year ago ranged from 65% to 75% LTV, the range is now 50% to 60%. To compensate for this, many investors are securing loans that are interest-only for the first 12-24 months “to try and lower their payment and increase their return in a high interest rate environment,” Smith said.

Exit assumptions. In terms of your exit projections — e.g., when you plan to sell the property and how much you expect it to appreciate during the hold period — Smith indicated that most investors model a five-year hold period. While some investors may hold the property longer — for a 10-year period or even indefinitely —the five-year hold projection makes sense because “oftentimes your financing interest rate is only fixed for that period of time,” according to Smith.

With regard to an exit cap rate, Smith noted that determining a fair exit cap rate in today’s somewhat turbulent economy has been a topic of much debate in commercial real estate circles. Many investors currently believe that modeling a lower exit cap rate is too aggressive in the present economy, and Smith said that the most common assumption he’s seen recently is modeling a .5% cap rate increase over the going-in cap rate for the exit cap rate, assuming you don’t plan to complete substantial improvements during your hold period.

Understanding your investment objectives. With all of this information (and more) plugged into your model, you’ll now be able to analyze your prospective investment from a variety of perspectives, including “how much of the return is in the form of cash flow, and how much of that return is in the form of appreciation,” Smith said.

But even though this analysis will provide you with numerical estimations regarding the benefits of your potential investment, whether the opportunity is a beauty or not will often be in the eye of the beholder.

“It gets back to that question of ‘what are your objectives for the investment?’” Smith said. Investors looking to fund their retirement, for instance, might be focused almost entirely on cash flow, he said. While for others “this is just a wealth building activity, and they might not care that much about their quarterly distributions.” They will be more concerned with the property’s appreciation at the end of the hold period.

Common investor mistakes. Smith noted that a common mistake new investors make is to follow the proforma provided by the seller. That analysis could have any number of issues, such as overly aggressive assumptions about achievable rental rates or the length of a vacancy period. Smith added that one of the most common errors he sees is investors using the existing tax burden in their analysis.

“And that's a beginner error to just use yesterday's property taxes,” Smith said. “If you do that, once the property taxes go up … then all of a sudden you have a bigger expense that you weren't ready for.”

For that reason, it’s important that investors understand the methodology by which commercial property taxes are reassessed in their state. In Florida and Texas, for instance, property taxes are assessed on an annual basis; whereas in California, they’re assessed every time a property is sold.

In part two of this guide, we’ll tackle the remaining phases of the industrial due diligence process, including risk assessment and mitigation and lease analysis.