UL Interview: How One Fund Sees Opportunity in Smaller and Mid-Sized Industrial Properties

While much of the focus on U.S. industrial is on large, single-tenant facilities, with big names like Amazon taking whole facilities. But multi-tenant industrial may offer diversification and risk reduction while helping small manufacturing firms grow over time.

Robert Sistek, senior managing director at BKM Capital Partners, spoke with Urban Land about his firm’s unique approach to light industrial and multi-tenant business parks in the western United States. Since BKM was formed in 2013, the firm has acquired over $2.5 billion of light industrial properties and currently has approximately $1.7 billion in assets under management.

How big were Funds I and II?

Fund I was about $105 million of equity commitments into the fund and another $25 million of coinvest. So total invested capital of $130 million.

It was the company’s first fund and Brian Malliet, the founder of BKM Capital Partners, had been a developer and exclusively focused on this property type for 30 years and then said, “I’ve got this great concept [for establishing a platform that can bring institutional capabilities to managing multi-tenant light industrial business parks].” Brian established BKM Capital Partners and about one year later raised the fund, which is not easy to do. BKM Industrial Value Fund II was launched in 2018, and raised just shy of $290 million, plus about $60 million of coinvest. So, roughly $350 million total equity committed in Fund II.

Where are you with Fund II now?

Fund II has been fully deployed into 24 investments, totaling 5.8 million square feet across the Western United States and currently includes approximately 1,000 tenants.

With such a shortage of industrial product right now, are you seeking value add or is that what everyone seems to be doing?

There are a lot of new entrants into industrial broadly. Bulk distribution—what you think of as the large Amazon distribution center—has been so bid up and with good reason, as the fundamentals are extremely strong. However, the increased competition makes it difficult to generate decent value-add returns for investors.

If you think about big box or bulk distribution properties being 500,000 square foot (46,451.5 sq m) buildings or warehouses and above, and then mid-bay, which is 200,000 to 500,000 square feet (18,580.6-46,451.5 sq m) buildings, with usually one to four tenants. We focus on multi-tenant light industrial with an emphasis on small-bay buildings, which are generally inside of 200,000 feet (18,580.6 sq m) with a lot of small tenants—it is much more asset management intensive.

Historically, institutional investors have shied away from that side of the spectrum. But there is a tremendous amount of demand, and virtually no new supply in small-bay space. There is a significant supply-and-demand imbalance. We are seeing tremendous rent growth [that is] even more outsized for the small bay space.

[Small bay] is very expensive to build—If you think about a large warehouse, … It’s concrete tilt-up, a roof, very little office, dock high loading, and a nice big truck court. With small bay, you have got demising walls, separate restrooms, metered electricity, and other characteristics necessary for multiple, distinct units. With construction costs where they are today, it is very expensive to build … there is about 600 million square feet (55.74 million sq m) under construction in the U.S. today; it is estimated that less than three percent of that is considered small bay to serve those smaller tenants.

Would you say your fund is in a niche in a very competitive market focused on the West Coast?

[BKM focuses on primary markets in the] Western U.S. … Denver and west although, we are also targeting Texas in a future fund. We have not historically invested in Texas, but we have been underwriting properties in three Texas markets for some time and will consider those in the future.

But because of the shortage of product in the West, you are expanding?

We are intending to prudently expand our footprint with the addition of 3 – 4 markets. There is a significant market opportunity in small bay. Ownership has just been fragmented and not largely institutionally held. Around 40 percent–50 percent of the overall industrial inventory is multi-tenant light industrial, including small- to mid-bay type industrial product.

It is a sizeable addressable market and brokers do not track it as closely. These small deals are not easy to track. A lot of the renewals are done in-house or through property management. You might have a broker on it, but [the deals] are just too small and volume is too high to track consistently.

The largest number of industrial leases are less than 10,000 square feet (929 sq m. While there is a lot of leasing velocity for small deals, you are not going to read about it—you’re going to read about the large Amazon or Home Depot leases.

What kind of returns or have you been getting on your funds and what are you anticipating what are your target returns?

Fund I did really well; we just sold the last few assets last year and liquidated that fund in early 2022. [The fund] performance was top quartile, according to Preqin [Private Capital Performance]; we generated a 25.7 percent gross levered IRR and 2.6x gross equity multiple, which is strong for real estate. It is also worth noting that a good portion of our return comes in the form of cash flow.

With so many tenants—you might have a 400,000-square-foot park that has 100 tenants— serving those tenants is really asset management intensive. However, if a couple of tenants move out, your occupancy goes from 98 to 96 percent. Whereas if you are in a mid-bay or bulk, if you have a couple tenants move out, you are 30 or even 50 percent dark. Not that there is much downtime in [industrial] today, but we are able to generate good cash flow from maintaining high occupancy and managing tenant rollovers.

From a risk-adjusted standpoint, the fact that we are generating 30 percent to 40 percent of that return from current distributions to Limited Partners. It is a different return profile, but Fund II is projected to do even better right now. We just completed our fourth quarter valuations, and the whole industry marked some pretty big appreciation. With values where they are today, we are projecting Fund II to outperform Fund I on a gross leveraged IRR basis.

Who are your investors?

Fund II has in total about 34 investors, including 17 that I would consider more traditional institutional investors. It is a mix of pension funds, endowments, foundations, insurance companies, and fund of funds. Fund I was a little different mix with two significant institutional investors that made up the majority of that fund. And then the investors said, “It is your first fund. Let’s just stop at $100 [million], go deploy it and prove out the investment thesis.”

How are you sourcing deals now?

We have a fully vertically integrated team, so property managers, leasing managers, and a full staff out in the field, which is needed in order to manage these projects and all the tenants. Having that local presence also helps with sourcing. Between Brian Malliet, as the founder, Brett Turner [BKM senior manager of acquisitions and dispositions] and other seasoned members of the management team, BKM has extensive broker relationships. In particular, Brian has been investing in these markets for many years. With the capital deployment across both Fund I and Fund II, our acquisitions team generally sees every multi-tenant industrial deal that comes to market on the West Coast. About a third of our deals are off market, where it is just presence in the market and relationships with owners.

How much leverage do you put on assets?

We do not rely on leverage to financially engineer returns; we target 65 percent leverage on a fully funded basis. Fund II, with the value appreciation, is currently 42 percent LTV; very low leverage for a value-add fund.

What is your value-added strategy beyond tenant return?

The value-add strategy starts with identifying the opportunity at the sourcing stage. Although there are a lot of large players that do own a fair amount of small-bay mixed in with portfolios, we tend to focus on assets that have been undercapitalized due to non-institutional ownership.

For example, a family may own a business park with anywhere from 10 to 20 buildings, a mix of unit sizes throughout the park and dozens of tenants. It is not an easy task to manage and maintain the park. We look for those opportunities where the parks been starved for capital and rents are below market.

We can come in and put a fresh new exterior and interior business plan in place. We start with the painting the exterior, giving the park a distinctive look where we create an identity.

We add or update the monument signage, directional signage, and tenant signage. As a tenant, you want your customers or your vendors that are dropping off deliveries to be able to find you.

What about the role of sustainability?

One of the key things we do is update and improve the landscaping. We are very focused on drought tolerant plantings and water conservation; we were actually doing that before the recent focus on ESG. We do it both for water conservation and to reduce operating expenses for our tenants and for us. We take out the water-intensive vegetation, and put in xeriscape, drought tolerant designs with a nice, clean look.

What are some of the reasons ESG is so important to BKM?

BKM’s ESG efforts includes energy conservation and sustainability efforts that have resulted in a 30% decrease in energy usage from new HVAC installations, 36 percent of its portfolio has completed installation or repairs to incorporate cool or reflective roofing, tenant and spec improvements are completed with 100 percent LED lighting and motion sensors, 100 percent of new landscaping projects incorporate drought-tolerant plantings. Examples include a water conservation project at Hughes Airport Center in Las Vegas where BKM achieved a 76 percent reduction in water usage that translated to a 50 percent drop in water costs; as well as three other solar projects that have resulted in annual reduction of 400 tons of carbon emissions.

What do you do differently for the interiors?

Another key to our business model is to have market ready units for smaller tenants. Small businesses don’t have the longer decision cycle or planning resources that larger international corporations would utilize when evaluating a site and signing a lease. A small business owner may tour a unit and say, “My business is growing, and I need space. I’m packed to the gills; can I move in on Monday?”

We go in and speculatively improve any vacant units right away. We do not wait for a lease. To start, we demolish any extra office space. If a unit has been built out with a significant amount of office improvements over time, it’s generally just not functional for the typical user in the current market. If a unit is 80 percent office, 20 percent warehouse, which is more like the flex/research and development mix—we will demolish a portion of the office to have the right warehouse to office ratio for industrial users. Just by nature of the size, small units are going to have a little higher percentage of office build out. For a 2,000 square foot unit, you still need three offices, a reception area, restrooms, and a break room. We create that right mix for the market and the key is to understand what the market wants in those local areas.

Then, we polish the concrete floors, white box the warehouse, add new carpet and paint the interior to have it market ready. That way when you have a tenant tour on a Friday—we could say you can move in on Monday, just sign the lease. That does not happen all the time, but we are ready for it when it does.