5 key factors driving an outsized opportunity in industrial property

There is a significant opportunity on offer to investors in industrial property over the next six months, with interest rate cuts underpinning potential upside in the real estate market. 

That's according to Trilogy Funds' Laurence Parisi, who believes interest rate cuts could kick-start a new real estate cycle. 

"There are significant tailwinds, namely device usage, growth in online sales, strong population growth, government infrastructure spending in road-rail ports and the connectivity of roads," Parisi says. 

"And then if you look at the demand-supply dynamics across the industrial space at the moment there is this chronic undersupply and that can't be solved quickly." 

This is thanks to the significant amount of rental growth that the space has seen in the last couple of years - with Parisi arguing these strong tailwinds will translate into continued rental growth in the future. 

In this Q&A, Parisi outlines the industrial opportunity, shares what makes a good deal (as well as the dealbreakers that turn the team off an investment), and outlines the importance of long-term relationships in property investments. 

Chris Conway: Hello and welcome to Livewire Markets. My name is Chris Conway. Today I'm sitting down with Laurence Parisi, Manager - Property Funds at Trilogy. Today, we'll be talking about the major trends in the property market and how industrial property can be its own unique opportunity. Lawrence, thanks for sitting down with Livewire.

Laurence Parisi: I think the largest theme that's occurring right now is the economic backdrop, sticky inflation and rising interest rates, and the impact that that's having on commercial and residential real estate nationally, but also globally as well. We're more than two years into a property down cycle, which commenced in mid-2022 with the first rate increase. However, we're starting to see the light at the end of the tunnel. Chris Conway: Laurence, I want to ask you a follow-up question. I want to pull on that thread, something that you said at the top, we're two years into a property downturn. Have you seen this before in your career? This mustn't be a new movie that you're seeing for the first time. And do you get excited in moments like this because you've had to be patient and now you get this opportunity to buy these great properties?

Laurence Parisi: This is the second real estate cycle that I've been part of. The anxiousness and nervousness have abated somewhat, and now the excitement has started to creep into the daily job. We are looking at the opportunities that now present, and we're quite optimistic about the opportunities that will present in the next six months.

Chris Conway: I bet. Laurence, we're here to talk a little bit more about industrial, and you touched on it in that previous answer. What is the appeal of industrial at this particular point in the cycle?

Laurence Parisi: When analysing all the major sub-sectors that we typically invest in at Trilogy, retail, commercial, and industrial, we're most excited about industrial. The reason being is there are significant tailwinds, namely device usage, growth in online sales, strong population growth, government infrastructure spending in road-rail ports and the connectivity of roads. I'm sure the RBA is not enthused about that potentially causing inflation. However, from an industrial perspective, it's quite a strong influencing factor.

Chris Conway: Laurence, just another follow-up there, if I may. You talked about a significant undersupply. What are the conditions that have led to that undersupply that we currently are seeing in the industrial space?

Laurence Parisi: There are two sides to that equation: you have demand and you have supply. The demand, as we know, has been very strong over the last couple of years, particularly post-COVID. However, the supply constraints, given the zoning of land and the availability of land have had an impact on the amount of new supply that has been able to come to the market.

Trilogy's deal process and investment metrics

Chris Conway: Laurence, I want to talk to you about how deals are put together because we investors often hear that everyone has a process for rejecting the bad deals and of course accepting the good deals. But the devil, as always, is in the details, so a couple of questions in this area. The first one is what is the yield for growth? And what is the hurdle rate you use at Trilogy to assess suitable yield for growth?

Laurence Parisi: Yield for growth is a pretty simple philosophy, really. From our perspective, property is all about income. We hold the view that if you focus and concentrate on the income, growth typically takes care of itself. In terms of yield, there are a number of ways that you can look at that. From a portfolio perspective, if you're managing a fund, there's typically what we call a weighted average cost of capital, and that's really the simple average between your debt cost and your equity cost, just given the amount of leverage you have in your capital stack. The weighted average cost of capital is really your minimum hurdle rate when you're looking at a potential new acquisition. So, if your weighted average cost of capital is 6%, then you'd really want to be looking at buying a piece of real estate yielding north of 6% so that it would be accretive to earnings.

Chris Conway: Laurence, how do you define strength and stability and income? Again, what are the actual metrics that Trilogy uses to define those?

Laurence Parisi: There are many. It starts with the physical real estate, the location, what it is, where it is, how old it is, when it was built, has it been maintained, and how lettable is it? Then you're looking at the maintenance CapEx, what's required to maintain the building? Does it reach building codes? From a tenant perspective, you're looking at the sector that the tenant is in. Are they profitable? How long have they been around? Do they have growth aspirations? Have they been paying the rent on time? And importantly, it's coming back to the yield for growth mantra that we have. It's all about the income, and can that income continue to support that piece of real estate, which translates into growth over time?

Opportunities in property today 

Chris Conway: It sounds quite complex, Laurence. It's not just you look at a piece of property and go, "That's a nice price, we're going to buy it." It sounds like there are plenty of metrics that go into figuring out whether it's suitable or not. How hard or easy is it to find those properties right now? Again, where we are in the cycle and perhaps compared to history. Are you guys finding lots of opportunities at the moment?

Laurence Parisi: It's a lot easier today than it has been over the last five to seven years. As interest rates approach zero, a tremendous amount of capital globally infiltrated the Australian market and it became very difficult to transact. Given recent interest rate increases, the weight of capital has abated somewhat and has made it somewhat easier to acquire real estate. The level of transactions is lower than what it has been historically, however, we're starting to see more transactions come to the market.

Chris Conway: So Laurence, just let me clarify there. The lack of deals being done or lack of suitable properties previously was not necessarily about the properties, it was more about the cost of the capital to purchase those properties, is that a fair assessment?

Laurence Parisi: That's exactly right.

Chris Conway: And now that's swung around and so it's a little bit more balanced. So the properties still exist, but you can get debt and capital at an appropriate price so that you can go and do the deal, is that where we're living now?

Laurence Parisi: Correct.

Property deal breakers 

Chris Conway: Laurence, let's talk about some deal breakers, and I'll couch this in terms of all the people watching out there and would walk into a residential property that they might be looking to buy for their family home. They walk in and immediately there's a checklist. Not enough bathrooms, not enough bedrooms. The ceilings aren't high enough, I don't like the colour of the paint on the walls. What are some of the deal breakers in industrial property? When you guys physically walk into a space and you look around, what are the things where you go, "No, that's not going to work"?

Laurence Parisi: It's not too dissimilar, Chris. So firstly, the location. How well is it located? How well has the building been maintained? To what spec has it been built? Is it re-lettable in its current form? Or do we need to spend a significant amount of maintenance CapEx to get it to a point where it is re-lettable? Is the warehousing component suitable for target tenants? Will the office accommodation meet the requirements of the tenant? Are there any value-add opportunities on the real estate? What's the site coverage ratio? We often hold conversations with the tenants as well to talk about their growth aspirations and how we may be able to work with them going forward.

Chris Conway: Laurence, do you guys ever look at a property, and it's got some of those characteristics that you were just talking about, but maybe it's missing a few others and you go, "Well, that would be a suitable property for another potential tenant?" Or is it just binary? You look at a property and it either meets the criteria and it's a yes, or it doesn't and it's a no. Do you ever come back to properties, I guess, is what I'm asking?

Laurence Parisi: It's an interesting question. We're typically on the hunt for a particular type of property, when we start our search, we know which fund and which strategy it's going to find a home in, and therefore that has a predetermined set of criteria. In saying that though, there are situations where we see some potential for some value-add. 

Importance of relationships

Chris Conway: Laurence, how much of Trilogy's ability to do deals is based on relationships? Trilogy's been around for north of 25 years, as I understand it, and obviously built some very strong connections in the property game. How important is that when you're out there and there might be multiple people fighting for the same piece of real estate? How important does that become?

Laurence Parisi: It's critical, Chris. Purchases are relying heavily on our ability to transact on a piece of property. Having a 25-year track record across real estate credit and equity gives us significant leverage when negotiating with a purchaser.

A real-life example

Chris Conway: Laurence, can you give us a real-life example that highlights all of the things that we've been talking about so far today?

Laurence Parisi: Sure. One that comes to mind is a commercial office asset that we bought a number of years ago located on St. Kilda Road in a very similar economic environment today. There was uncertainty, the interest rate concerns, and the asset was housed in a syndicate that came to an end of its life. I would say it was a motivated seller, but not a distressed seller, a single tenant with a very short WALE. 

We got the asset into due diligence and met with the tenant. We worked out that the amount of money that the tenant had spent on its fit-out meant that it wasn't likely to move. Through the due diligence period, we were able to renegotiate the lease, extend the lease, and ultimately purchase the property. We're able to on-sell that property within six months, delivering north of 25% IRR for our investors. That's a good example of when you understand the market and you do the work, you can deliver outsized returns for your investor clients.

Chris Conway: Laurence, one follow-up, if I may. Just because you've referenced it a couple of times and it's the conversations that you have with tenants, existing tenants and understanding their growth aspirations and what they want to do. How important is that? If we had to put a percentage on it, is it 10% of the overall consideration or is it more than that or less than that? How important is knowing that a tenant is able to stick around and wants to stick around?

Laurence Parisi: It's critical for us and the way we manage real estate. The tenant's ability to continue to pay the rent, and if they can't, that piece of real estate's lettability. We're in constant dialogue with our tenants throughout the ownership of the asset to get a good understanding of where they're at in their business cycle. Does the real estate still meet their needs? What are their growth aspirations? What can we do as a landlord to help them grow their business?

Chris Conway: Laurence, thanks so much for sitting down with Livewire today. If you enjoyed that interview as much as I did, make sure to give it a like, and don't forget to follow our YouTube channel because we're adding lots of great content every single week.