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Surge expected in industrial properties with short-term leases, Newmark says

Logistics real estate investors looking to clean up in an era of tight supply and strong demand should consider going short, according to a leading commercial real estate firm’s latest research report.

The term is known as WALT, which stands for “weighted average lease terms.” For the past few years, buildings with short-term WALT — leases rolling off their original terms — have been a more attractive deal for investors than those holding long-term leases, according to Newmark Group Inc. (NASDAQ: NMRK). 

That’s because the pace of market rent growth has far exceeded the rate of rent increases on leases signed five to 10 years ago, Newmark said. The typical “long” lease is about 7 years old, though many go as long as 10 years or longer.

That means a hypothetical six-year lease signed in, say, 2016, that had a 2.5% annual rate escalation would be, on average, 36% below today’s market rents, according to Newmark. Once those leases “mark to market” — financial lingo for being priced at current levels — investors would be presented with an “opportunity for substantial income gain,” Newmark said in a white paper published in January.

On the other hand, assets with a longer WALT — nine years or more — will not be as attractive because they won’t be able to capture the spike in market rents available to the shorter-term WALT assets once those properties roll into new pricing levels, Newmark said.

A 2022 analysis of industrial sales transactions found that assets with three years left of WALT achieved, on average, a 55% premium on pricing per square foot over assets with a longer WALT, according to the research.

According to Lisa DeNight, Newmark’s managing director of national industrial research, a significant portion of properties sold in the past 12 months have three years or less left in their terms. With year-on-year rent increases already averaging in double digits, the price adjustment on those properties could continue to fuel lease inflation well into mid-decade, DeNight said.

A continued interest in short-term WALT assets is predicated on exceptionally strong demand and lenders’ willingness to underwrite deals in an environment of higher interest rates. For the year, slowing industrial demand will coincide with a continued spike in new construction that was already set to deliver. National vacancy rates will loosen, causing a decline in the pace of rent growth, Newmark said.

As the year progresses, less space will enter the development pipeline. Construction starts slowed markedly at the end of 2022 amid challenging financial conditions.

If the Federal Reserve begins to cut rates in 2024,as some have projected, investors who bought shorter-term WALT assets maturing in ’24 will be able to refinance at lower debt costs. Those investors will also likely benefit from continued attractive supply-demand fundamentals for securing new tenants at higher rents, according to Newmark.