IOS: Higher Rents Than Traditional Industrial But Weaker Tenants

Rents for industrial outdoor storage (IOS) have grown faster than traditional industrial in most markets since the onset of the pandemic, especially in sites catering to logistics users located near seaports. However, it is a volatile market, with demand and rents accelerating faster in upcycles but also performing worse during economic downturns.

This is according to a Green Street report on the sector authored by Vince Tibone and Jessica Zheng. 

IOS is defined as a site zoned for an industrial use where the tenant can store something outside, such as vehicles, construction equipment, building materials or containers. 

IOS is seeing growing demand in line with the broader industrial property boom and Green Street expects this positive trend to continue. Green Street believes that IOS sites in infill submarkets in particular are priced to deliver risk-adjusted expected returns “that are superior to those available on most other commercial real estate property investments, including traditional industrial”. 

But one of the reasons IOS tends to suffer disproportionately during economic downturns is the overall weaker tenant profile. 

“Many third-party logistics providers (3PLs) are local or regional businesses, possibly with a significant share of total revenue tied to several customers or specific industries. Combined with more limited access to credit and customer contracts that can be short-term in nature, 3PLs are susceptible to bankruptcy when consumption, seaport volumes, and overall movement of goods slow,” Tibone and Zheng write. “Traditional industrial also houses 3PLs and weaker credit tenants but the overall creditworthiness of IOS tenants seems worse than traditional industrial.” 

Lack of reliable historical and current data on IOS market rents, due to the fragmented and non-institutionalized nature of the business, is “both a blessing and a curse”, according to Green Street, in that it makes underwriting more difficult but also potentially deters new entrants.

But despite the scarcity of  historical data on IOS, key underwriting inputs can be estimated within a reasonable range to assess the attractiveness of an investment in IOS versus other property types, Green Street says. For the purposes of the analysis, infill was defined as a blend of Los Angeles, Orange County, and New Jersey and lower barrier as a blend of Atlanta, Chicago, and Dallas. 

Based on conversations with market participants, IOS nominal cap rates are similar or marginally higher than traditional industrial in infill submarkets and approximately 25 to 100 basis points higher in lower barrier submarkets. Transaction volumes are a fraction of traditional industrial and sizable IOS portfolios seldomly trade. 

IOS capital expenditure primarily consists of leasing commissions and modest maintenance of the surface lot and building. “Conversations with market participants indicate a cap-ex reserve in the 5% to 8% of annual NOI range seems appropriate, versus a 14% cap-ex reserve for traditional industrial,” Tibone and Zheng write. “For comparison, Green Street estimates the annual cap-ex reserve as a percentage of NOI for other land-heavy sectors such as manufactured housing, self-storage, and ground lease to be 10%, 7%, and 1%, respectively.” 

One of the main potential value drivers of IOS is the option to redevelop to a higher and better use of the land at a later date, according to the report. For its risk-adjusted expected return calculation, Green Street assumes 30% of infill IOS sites and 10% of lower barrier IOS sites will be redeveloped over the next decade at 20% profit margins, which ultimately boosts LT NOI growth by ~30 bps and ~10 bps, respectively. 

Given the more favorable supply backdrop and redevelopment optionality, Green Street expects long term NOI growth for IOS that is 20 to 50 basis points higher than traditional industrial in the same market.