BREAKING DOWN THE IOS CAPITAL MARKETS WITH DAVID HARRIS AND LEE SAGER AT CAMPS BAY CAPITAL ADVISORS

How did you first become aware of the IOS opportunity?

We began our work in IOS in early 2021. Having observed some of the strong fundamentals and nascent capital markets trends at that time, we asked ourselves, “Who is the capital markets advisor of choice?” We didn’t think there was a clear answer. So, we went to work identifying as many IOS operators and IOS investors as we could and began our outreach, securing our first client assignment shortly thereafter raising equity for a PropTech driven IOS operator.

Describe how investor appetites towards IOS have changed since you started covering the space.

Investors have understood IOS to be a critical asset class that is institutionally investable and has been sitting right under their noses for many years as an overlooked asset class. Information spread rapidly and investors that got educated early had a first mover advantage. A lot of operator/investor JVs were formed and some operators leveraged their track record to raise discretionary capital. With fewer data points on institutional exits, some investors are still waiting on the sidelines to see how early institutional capital formation and investment will pan out. All told, there are still many more investors interested in the space than there are capable operators that can assemble great IOS portfolios. As a result, we believe there will be future equity recapitalizations that will create great investment opportunities. Like many other asset classes, debt funding will need to be able to support this kind of transaction activity.

Which IOS markets and locations attract institutional and family office capital?

Generally speaking, the same markets that have strong industrial demand also have strong IOS demand. Port markets, major transportation hubs and well-located infill locations within strong submarkets are attracting tenant demand and investment capital, which is especially pronounced in SoCal, NJ/NY and the Southeast. Like other real estate asset classes, there is a wide variation in asset pricing depending on asset quality and subsequent asset demand. We like to ask clients whether they want to pay up for premium sites in premium infill locations or whether they see value in trying to find opportunities where asset prices and tenant rents are much cheaper on an absolute dollar basis. We’d estimate that over 80% of investors prefer paying up for high asset quality, given a choice between the two.

How can new operators best position themselves to win deals and attract capital?

A quality pipeline, strong tenant demand (vacant or leased), debt financing and potential for platform scalability are all critical, especially if a new operator does not have an IOS track record. We’re experts in strategically analyzing situations and pulling the right marketing story together around these components and can help advise on all parts of the capital structure. Our clients’ successes have been accentuated with thoughtful investor marketing processes to find the best investor fit and economics that make sense for both the operator and investor.

How has underwriting changed now that interest rates are up?

Underwriting has become more conservative. Almost every leased IOS deal has a large mark-to-market for rental rates. Growth in underwritten tenant renewal rates is more tempered than was seen in the 1-3 years before interest rates started rising. We’ve definitely seen underwritten exit cap rates expand 100-150 bps from pre-rate hike levels and there are higher exit caps (vs. distribution warehouses) for several reasons: (1) IOS is an emerging asset class and (2) lower tenant credit, where applicable. IOS quality and tenant use can also play a factor across the entire underwriting as well, with more aggressive underwriting for premium infill locations and trucking uses, for example.

What leverage levels are comfortable for IOS equity investors lately?

Debt is primarily sourced from local/regional banks, debt funds and, to a lesser extent, money center banks for larger portfolios. CMBS and insurance lending are very nascent. Max non-recourse leverage from banks is typically around 55-60% LTC and floating rate. Debt funds may provide a bit more leverage, but the capital is more expensive.

Are investors cold on any particular sub-segments within IOS (truck terminals, bulk materials storage, cross-dock facilities, etc)?

IOS tenant uses are generally all in demand. In general, trucking related tenant uses may receive a premium from an asset quality standpoint. Smart IOS operators pay close attention to entitlement and zoning which may dictate specific tenant uses. For example, some sites that allow container storage will allow container stacking and other site won’t allow that use. We see more investor caution when the tenant is engaged in uses that may have major environmental risks.

Where will the most alpha be generated in the next 18 months?

We think about each of the major components to IOS investing like most other real estate investing: entry price, leverage, cash flow, exit price. We believe leverage is constrained and large increases in tenant rent like we’ve seen in the past few years will likely not be replicated in most situations over the next 18 months. Therefore, we encourage investors to focus on operating partnerships where both parties have financial discipline in their underwriting and have an edge on sourcing attractively priced deals, especially out of the fragmented “mom and pop” ownership base. Getting out in front of a wave of cheaper equity capital and putting together a well-constructed portfolio that will receive an exit premium will be the key to generating alpha. Additionally, we expect alpha will be delivered to investors that have a risk tolerance for zoning and entitlement changes or enhancements and can find the right operator that has deep local expertise in these areas, though this strategy may have a slightly longer time horizon than 18 months.

How do you foresee the secondary and tertiary IOS markets evolving in the coming years?

Most institutional investors and operating partners are not focused on this right now. Some of the groups that we have spoken to that invest in secondary and tertiary IOS markets would love to keep it that way. These groups generally seem to be clipping coupons on their investments and are investing their own capital or syndicated retail capital. But like all other real estate asset classes that have strong fundamentals, we think there will be more attention given to secondary and tertiary markets in the future. That said, we see plenty of opportunities in the primary markets.

How are most of your equity deals structured with operator groups?

This is hard to generalize in a short answer, but we have been successful in structuring programmatic JVs and JVs on a deal-by-deal basis. In most cases, operators are putting in 5-20% of the equity as a GP and the LP investor is putting in the rest. Key points of negotiation in these deals are waterfall economics, fees, and exclusivity. What we are most proud of in the work we’ve done to date is pairing great operators with great investors that have a strong cultural fit and look to do business together for the long-term. Everyone wins in those situations.

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