#313 - Sean Dalfen - CEO @ Dalfen Industrial - Investing in Industrial RE Across North America

Chris Powers: Sean, welcome to the show.

Sean Dalfen: Thank you for having me. 

Chris Powers: It's exciting to have you here today. And if you're listening to this, this is round two; we'll plug the first episode in the show notes, where we talked a lot about how you have built the company. Today, we're not going to go over that. We're going to talk more about our environment, and an exciting place to start would be what we were talking about before we walked in here, which was you just commented, Hey, I started selling stocks.

May of 2022 may indicate a larger picture of how you felt about the market or where the world was going. So, let's start there. What was happening in May of 2022 that got your attention? 

Sean Dalfen: I could be a better stock investor.

Chris Powers: I don't think any real estate people are.

Sean Dalfen: Well, maybe me in particular, but one of the reasons I'm not the most significant stock investor is cause I need to learn more about the individual stocks I'm buying and the real estate we know. And the non-liquid nature of real estate is also a benefit because it can prevent you from doing dumb things.

So, at that period, inflation would undoubtedly continue to spike. I didn't have faith that the Fed could curb inflation. The Fed has historically not been very good at that, not in real-time. I thought the fundamentals were off.

Not in the industrial space per se, but in a lot of free money has been printed and given out, and, you know, prices continue to increase. Then you put up the infrastructure bill in place, which will keep particular pricing of labor and materials up, and all that combined just led me to believe that we were on the road to recession, and I like to sleep at night.

So, I sold the stocks and invested in real estate. 

Chris Powers: Quickly, why does the infrastructure bill put in place keep labor and wages up in material cost? 

Sean Dalfen: It's a good question, and the short answer is nobody pays more than the government does for things, especially when that government is getting perceived free money.

And so, although the uses of concrete may be different. And the type of steel may be other than they're using in general infrastructure. They're still using steel, concrete, the same labor, and that's a lot of money on stake out there. So, traditionally speaking, your materials and your labor would decline as construction declines.

But as you well know, construction costs have not gone down now. And 20 percent of the new starts were, even 12 months ago.

Chris Powers: I need to build more than you are. And so this was later on the conversation, but let's bring it up here. What is going on in construction?

Because on one, and I can feel that they're not going down, but we do minor CapEx, we do maintenance, you're building from the ground up. Has anything given, or is there anything in the next, you know, quarter year that gives you any hope that prices are coming down? 

Sean Dalfen: It's difficult to say. Certain elements will come down, and we'll normalize. 

Chris Powers: Like what? 

Sean Dalfen: Maybe roofing materials. Something like that. But again, everything is tied somehow because various construction types have consumed different products or elements. But just from a broad base level, if I look at it, or we, when we look at it, we say, We've seen lead times come in on certain products. Still, it's beautiful if you can finish your installation on time, especially regarding electrical, whether switch gears or different elements you need to power your building. You can get your roof on, but if you don't have electricity, it's a little problem to lease it.

We don't see that slowing or improving substantially, and we have not seen substantial c

construction price decreases; there has been a decrease in lumber and certain other elements. Generally speaking, there has not been a decrease. And so it has become the new normal, at least for now. And we need to build more than we did. We're not, by trade, a merchant builder. And so that's a significant benefit for us when we're building, we're making to hold the asset in one of our vehicles.

And we're building because we can't find property. That's new, vintage, modern, and best in class at below replacement costs. And so in very tight markets, where we're paying above replacement costs for older assets, if we can find a great piece of land and build super infill, then we will do that.

Because then we must build a product to perfection in the most modern and new standards. And we have paid replacement costs. But in today's world, if we can produce under replacement costs for new buildings, we will do that. 

Chris Powers: What is on time these days, and could you give a sense of framework, like what is built by you on time, pre-COVID, and what is making on time today?

The question is, how long does it take to build a building now? 

Sean Dalfen: A heck of a lot longer than it ever did. 

Chris Powers: And why is that? Is it material? Is it a lack of labor or all of the above?

Sean Dalfen: It's all of the above. Before, in many markets, especially in the Southeast Southwest, you could within a year, a little bit over a year, you're done today.

It's years, and in certain Counties or cities, say in Texas, say not Dallas or Houston or San Antonio, it's on par or worse than some of the most bureaucratic regions on the West Coast. There's, you know, specific projects that we had it four years to break ground. And that's as a result of COVID did come into play where you had a lot of, you know, approvals that needed to happen.

People were absent from the office, et cetera. And there was a backlog, but today, it's just the city of Austin where you had. I know they did a McKinsey study recently, and there were 1400 steps before a project was approved. 1400. And it's a bureaucracy, so all along the way, those steps fail, and suddenly you have to go back to the drawing board, preventing one from breaking ground.

And therefore, that prevents, you know, buildings from being built on time. And on average, every delay for a housing project adds to every month of delay. You know, up to a 10 percent monthly cost increase on that home. 

Chris Powers: It's the front page of the Fort Worth Business Press today. It's a multi-project, but the developer has something along the lines of it; it's costing 46,000 a month every time this project gets delayed, making housing more expensive.

So not; I'm surprised to hear that you guys own 50 million square feet. You've built a company to scale. And so, the question is, how do all these negative impacts on building links create an advantage for you all moving forward? 

Sean Dalfen: It creates a significant advantage. If you're the more extended term holders like us, traditionally, we're holding a minimum of five years, what's happening today, which, just like yourself, we will benefit from.

You ride out the storm. So today, it is challenging to get exact numbers, but we would venture to guess that roughly 15 to 20 percent of the construction that happened 12, 18 months ago is happening today. So the homework is completed and shown to you. But that product started a few years back, back to your earlier question, at least, and new starts where people acquire land and then break ground.

I mean, it's not happening anymore. It's few and far between. And so what ends up happening, and we saw it in COVID, which was everyone stopped building. People got worried about leasing vacancies, so they gave him away for free. And there were groups like ourselves who recognized. In that case, we were locked at home, so we all had to get our goods somehow.

And that's going to bolster our space. People are going to need more warehouses, and we're not going to give away our room, and we're going to continue to buy existing. And what happened was rents almost overnight doubled by 50 percent because all your space was absorbed, and there was no new product to fill that void.

And so from our perspective, the fact that building has taken more extended costs and that we're in a much softer market today allows us to buy some of the best products out there and even for the stuff we completed, which is best in class product, not have to worry about having to lease it right away.

Although we'd like to for reasonable rates, we recognize that if we wait for this cycle out, industrial, without question, will not only bounce back much higher, but there needs to be more industrial in this country today to contend with the demand for industrial products. If every square foot of industrial space is coming online now, this is going to be a banner year for products being, you know, delivered online. Every vacancy that is currently vacant remains vacant.

You put those together and are still under 5 percent vacancy overall nationwide. That's very healthy. That's the best of times in the past. Five percent vacancy was regular. And today, we're still going to be subbed that, and then you factor in, guess what? Nobody's building any new product after this year.

Suddenly, as the man picks up again, which it certainly will, there will be no product for people to go to. And they'll pay much more for rent, which benefits us, Chris. 

Chris Powers: That does; you're talking dirty to me a little. Okay. Explain a little bit, and go on a little bit further on a timeline.

So everything will be delivered by you in 2023. That's the most oversized delivery, but all those projects started in 2020-21. That's why that's happening. Now you just said virtually nothing is getting off the ground. How do you see the next two to three years playing out, and how does that spike come back into play?

When do we start feeling that vacancy heading towards zero? We're going to have to start building more products. How does that then change your outlook or not change it? But what do you think about the next three years? 

Sean Dalfen: Well, I have a magic eight ball at my office that answers many questions, but I didn't bring it.

How we see it is this falls. There's undoubtedly a softening in the market. With that said, if you look at leasing stats from 2019, you know, we're still on par with that, and those were good years. They're not 2020 leasing, and it's not 2020 lawn leasing, but it's still delicious. So, with everything I'm saying, the market is steady and holding up the leasing.

We're not talking about an office slowdown. We're talking about still very, very healthy numbers. That said, they're not pandemic-like numbers. So what happens going forward? There will be tremendous pain across the commercial real estate sector; there's a nationwide margin call and many assets; I need to remember the number off-hand. Still, a couple trillion over the next 18 months or so needed to get refinanced.

You know, extended and so, especially with the new banking regulations put in place on banks, you know, above 100,000,000. They must put additional reserves associated with troubled loans, even if they are not agitated. So, for example, you're an industrial builder and, uh, your developer, you built a great asset.

You assumed you would sell it tomorrow at a four-and-a-half cap. Well, that assumption is gone. Your construction costs were higher. Your TI costs were far more elevated, and your interest was four times what you had budgeted. Okay. Leasing has slowed down somewhat, and you can only sell the product after some time.

And your bank loan is coming due. So what happens then? Well, your banker says, okay, we like you. And so we'll let you extend, but you'll have to have a 10 percent paydown. Some groups aren't able to do that. And my gut. It may be incorrect on this one, but it is my gut that eventually, what's going to happen is the industrial assets are probably some of the only assets that are on bank books that even if somebody has trouble refinancing or extending that loan, simply because of the market today, it doesn't have anything to do with the quality of the asset.

Banks know, with a lot of certainty, that all of their equity is still there. So they can liquidate that asset and collect all those proceeds. So unless you're very close or have a long relationship with that bank, it doesn't eventually benefit the bank. Let you extend without that paydown because they will have to mark that asset on their book as troubled in some way, and they will have to put a reserve against it, which means that.

That quarter, at least, they're taking a hit on the value of that loan. If they turn around and sell that loan that quarter, they're booking again the next quarter because they already booked that loss. So if they sell that, that loan at a hundred cents on the dollar, and they marked it to 70.

They're getting a gain. And so there's stuff like that, and that will happen. So there's going to be pain across the real estate sector. And because all commercial real estate falls into the same bucket in the lending world. So if you have an office, which we know you cannot finance today, you have retail, which is very difficult, and hotels, which are also very difficult to finance.

And then you have industrial, which is the bell of the ball, but still, you know if there are fewer lenders and their other real estate burdens them. It's tough to finance also, well, you know, you throw multifamily in there, and that's a whole different kettle of fish of problems associated with overleverage.

And you have banks just stopping to lend, and then you have life codes with only so much capacity, and you have a lot of debt funds for other reasons that have, you know, pulled back. And so your lending community has reduced substantially. It is a long answer to your question, but you factor everything in.

You factor in that a lot of product is coming online now, and that's because, as you said, construction times took longer. Then, you bring in the fact that the capital markets are frozen. That means people who wanna sell their assets, and it's tough for them to sell right now because you need the buyer pool.

Because commercial real estate runs off leverage, at least most of it does. And then you have a softening leasing market, or at least a soft leasing market, compared to the past two years. That means rates are growing less, and borrowers are nervous about making debt service or refinancing that loan.

And so what they're doing is they're going to give away their space to get some cash flow. So what will happen is you're going to cause a reduction. In some markets, the rental rates are due to the demand there and the distress on the ownership side; things improve, and what happens?

People with space who were nervous about it gave away their freedom, locked it in for a long time, and effectively annihilated any gains they could get later. Companies cannot enter new space if cap rates remain at this range. And they'll get leased up at very high speeds, whatever vacancies come available.

And then we're off to the races, and people will start building again. And that's our projection. It's a very long answer to say that everything is tied together. And thankfully, in industrial, we're still seeing rental rate increases. And we're still catching our ability to sell and finance. But the ability to sell and finance is a tenth of what it was.

You know, 18 months ago.

Chris Powers: Yep. Q2 is some of the best leasing we've seen. So I know we're landlords, but if you flipped it right now as a tenant, it could be a good window for a tenant, maybe in 2024, to try and pick up some space if it's available and not push off till 2025-26 when that vacancy dries up.

And now prices are on their way back up. And I'm just I'm giving them. Years, like we know, I'm just playing the game.

Sean Dalfen: I'm going to go back to what I said. I want all listeners to recognize we are not seeing a substantial slowdown in leasing.

Chris Powers: Correct, and it's fair to sit here and say 2021 and 2022 are anomalies.

Sean Dalfen: They were anomalies. 

Chris Powers: So 30 percent off of highs means we're still higher than usual. 

Sean Dalfen: Like 2019 was a banner year, it was record-breaking for that period. So now we're back there. That's still really good. With that said, some tenants have taken that approach, and we see that because they want to lock in longer terms, and it went from before you're having to, you know, twist some tenant's arms into longer-term leases.

Today, they all want to sign longer-term leases. And that's another anomaly of what's going on right now. Anomaly-based on logic and, typically, you want to lock in a credit tenant for a longer rate, and you're going to be able to turn around and sell that asset at great profit. Today, that's not the case.

If you lock in that tenant at today's rates, even with good bumps, you lock in a ten-year deal. It will take a lot of work for you to monetize that deal. If cap rates at least remain static or close to what they are today with current financing rates. So in a few years from now, you're not able to sell that asset at, you know, theoretically an excellent yield because any buyer that comes in needs that positive leverage.

And so, for example, if we buy an asset today like we purchased one recently in Orange County in California, and over the next three years, you know, I mean, based on today's rates, we bought that asset at a mark to a market cap rate of a seven three or something. That's unbelievable. It's class and an asset. It's unbelievable.

Chris Powers: How did you get that deal? 

Sean Dalfen: We got it from a sizeable open-end fund with a broken sales process. And we got it for 30 percent above the land value for the buildings. But the point is, on this deal, the cap rate initially might've been anemic on a mark-to-market basis for those rents because they were a little over two and a half years of term in place.

We were getting a seven, seven, three or so cap. That's unbelievable for that market. This market had traditionally traded, you know, definitely mid-fours, but sub-four, at the peak. And you know, nobody can get to that if you lock in a long-term lease. Call it the pot of gold at the end of the rainbow.

So if your debt is at 6 percent at best today, it's higher, but say it's at 6% at best. You know, that means that you need a cap rate above that. If your lease goes out long, your leverage will be neutral. So if you buy something for a six, six cap, and your debt is a six cap, you're effectively neutral, maybe a little better as time goes on with, you know, commanding growth, but still, you're not getting any pop there, and so reduces your buyer pool. 

And when you have T bills, call it four or three on a ten-year basis. You're going to have a significantly diminished buyer pool there. And that was never the case. We did something brilliant a few years ago, a couple of years back, maybe it was, maybe 18, no, perhaps it was a couple of years back.

When we saw this happening, we decided to push back on long-term leases because we realized we were a value-added operator. So we value add funds that, on our value add side, it didn't make sense to lock in these long-term deals. If our anticipated hold period was five years and we had three years left, it needed to be clarified because, suddenly, we would be selling a product.

With a much longer lease term, the next buyer will need more meat on the bone. And shockingly, today, if you have an asset with a three-year weighted average lease term, or WALT, or a little under 3, versus a property that has a ten-year WALT, It could be Amazon, it could be Home Depot on that property, and it could be non-credit tenants in the other.

If the two assets are equal in quality, the one with the shorter waltz will get more looks and better pricing without question. 

Chris Powers: Oh, God, I have so many things I want to ask you, but I'm going to riff off that one thing you just said. You said that the buyer pool gets narrowed and narrowed.

T bills at a 4% cap rate. You mentioned buying something at a six cap with a 6 percent loan. Who are those buyers? Like who else? Who, who is this around sovereign wealth? Who are the last buyers that stay around when this is all happening?

Sean Dalfen: I mean, there's always buyers for things.

It's a relative value thing. You can buy real estate today versus the past three years at perfect numbers. And if you're purely a real estate buyer and it's part of your alts, your alternative, investment side, let's say you're a sovereign wealth fund and say, I don't know, uh, 7 percent of your portfolio goes to alternatives and, you know, you hope to have a good percentage of that in real estate.

Well, this is a great relative value play. You're buying real estate at substantially off-peak pricing. You're not that worried about the debt. You have money to place, and you can go all cash. And so those are buyers. They're buyers like ourselves who are out there who are seeing this as we're able to buy assets at far below replacement costs in markets that we have never been able to penetrate, like the Inland Empire entirely or, you know, Jersey, et cetera, because the buyer pool has so substantially thinned. The assets we're looking at are very high quality and are vend.

We can get in on these properties at opportunistic returns. Irrespective of the leverage we use in many cases, it's almost you. You're better stable than levered in certain situations. But from our standpoint, as long as a deal doesn't have a long-term lease in place and we can get to that value relatively quickly, we're excited about that opportunity.

And so there's buyers out there, but the fact that we're able to participate in these core traditionally core markets. Adding value to opportunistic returns on trophy assets is saying something about the depth of the buyer pool, which is very limited conversely. We have sold a whole bunch of help to users at fantastic pricing.

So, the users have filled in a lot of that void as rental rates have continued to rise. The users have been able to come out and say, we want to own our facilities, and the investor market has previously priced them out while now they're getting the opportunity to buy those assets. So recently, there were two assets that we sold before even taking possession of the assets.

They were forward sales. And we just sold off the contract, or we closed the two deals simultaneously where we, you know, bought it, and they bought it from us, but we're seeing that not on a one-off basis, we did five last month of user sales. 

Chris Powers: Wow. And are they coming to you, or are you going to them?

Sean Dalfen: Both, you know, something that we focused on, Chris, over the years is we wanted to make sure that the assets we're buying are selected one at a time. And they're, optimally, last mile. They are best in class or have some of the best features within that area. Given the asset ages and the assets, irrespective of what will happen in a market, there'll be demand for those properties because they are some of the best.

So that meant we weren't buying portfolios and getting stuck with a whole bunch of assets that just got thrown in there. By purchasing an asset one at a time and looking at the value of that asset itself and doing the hard work and rolling up your sleeves, just like you do buying properties, 10 million, 20 million, and doing the hard work.

As the markets have shifted, like today, where debt is more complex, we can take advantage of selling to users. And our leasing activity is still extreme. And that's because we have the right assets in the suitable locations and bought them for the correct prices. And so if you select your assets individually, you're not accountable in the same way to the market, and you can take advantage of whatever the market is providing you.

So today, it's the users, or it may be to get those tenants out there at the best rates who are out there or to be able to sell an investor a minor deal with a shorter Walt because you have what they want. If people do like you and I do. Then they're much better off when the market changes, and I don't need a crystal ball to tell you it constantly changes.

Chris Powers: Okay. Let's go in our backyard for a second. You answered this question differently, but many discuss DFW as an incredible industrial market. And we could talk about the drivers behind it, but they'll say, yeah, you all have 55 million square feet of new product coming online.

It may not crash the market, but that's always the rebuttal. And again, you've already touched on how to answer this, but if I said, What do you say to the person who says, yeah, but you all have 55 million square feet in your backyard? That's going to be more of a negative than a positive.

How do you answer that? 

Sean Dalfen: Well, I mean, it's evident that the more product you have out there, you know if leasing isn't as robust as it was at the height, then it's a negative to a degree, but unlike other markets, I mean, I don't know the exact stat right now, but I remember it was at last year where we had 30 million feet of absorption.

It was more than that. You might know the exact stat now. I get market merge because we're nationwide, but Dallas has some of the most absorption anywhere. And so it's a big difference. Yes. We are putting a lot of products online, but companies want to move here for a reason, and people are moving here for a reason.

There's not a day that goes by, and this is just personal, you know, on a personal note, where I don't encounter people who live in Dallas. Whether they work in our office or whether I know them personally who aren't from Dallas initially, myself included. There are a lot of people who moved to Dallas for good reason.

And it continues to be the case. And we don't see that slowing. As a recession hits, the most brutal hit is traditionally your blue-collar and middle class. And people forget that any tax increases or additional bureaucracies supplementary to states impact these wage earners the most, you know if you're increasing your income tax or minimum wage.

Well, guess what? The guy making five million dollars a year will pay the additional cost of his groceries. It's not going to change his life. He's going to eat the same thing. But for that individual making 50 a year, and their grocery bill ends up being 300 bucks more a month, it starts to eat into what they can do.

And then you throw in your housing costs, et cetera. Well, guess what? Those are all great reasons for people to move to Dallas. And so they come here, and it's not just Me saying it; it's in the stats that people and businesses are moving. And it's also, where is the product being built? In South Dallas, I think there will be a bloodbath.

Chris Powers: Why? 

Sean Dalfen: Because something we talked about on the last podcast, but just the fundamentals as, as we know them in the supply chain, where, you know, the movement of goods or your transport is 45 to 75 percent of your cost, and your labor is 15 to 25. And then you have your inventory and down to your real estate at three to six percent, which is why, you know, rents continue to go up because if you're closer to those consumers or workforce, then guess what, you're able to, it makes sense for a tenant to pay a higher rent because they reduce those more impactful costs. At the same time, they built so much in South Dallas, and your workforce was already so small.

And although it increased substantially over the past five or ten years, right? It's still tiny. So if you have to pull workers from, say, East Dallas to South Dallas, and somebody has got to drive 20 minutes there on average, let's say for an e-commerce sorting facility, that's going to cost, at a very minimum, a buck more an hour to that employee.

And you multiply that across a warehouse workforce, which equates to double your real estate costs if you're a company, meaning if you have to get your workers driving 20 minutes to your facility and pay them a dollar more an hour. It's the equivalent of doubling your rental expense because it's much more significant on the supply chain side, and in South Dallas, you need that workforce.

East Dallas, we see a lot of building, and we've built a ton there and seen tremendous absorption because of the workforce itself. I'll tell you a little story that illustrates this best. We owned an asset that we bought from the state of Alaska several years ago. We bought it in partnership with a terrific group, and this property needed to be added compared to the brand-new 36.

You had 28 clear ceiling heights. You had a truck court that was too shallow and didn't have all the best-in-class features of a new building. What it did have was a piece of land in front that was 12 acres, and you could expand that truck court and make a considerable parking facility, and it had the proximity to the workforce.

Anyway, we bought the building for a song, really for nothing at the time, and there was a tenant in there, and the tenant had done a built-to-suit in South Dallas. And it was a certainty they were leaving. They just leased a new building in South Dallas. This building also had direct rail access, the one we had.

And so there are a lot of benefits to it, but here they were getting best in class, new product. And we had a bet internally. And it was, I am trying to remember what it was for, it was five bucks or something at, myself, my counterpart at AW bet on it. And we had the bet or the dolphin side that this tenant would try to sublease their building in South Dallas.

And renew at our facility at a higher rate than they were paying in South Dallas. So they would continue at a higher rate in a building built in 1989 versus that built-in, I don't know, 2017 or so. And it was a bet that we won because the tenant tried to do it.

They were willing to renew at a higher rate because they recognized. They couldn't get the workforce, and it was costing them more. And so that was just an illustration of understanding that a place like South Dallas, although eventually it will be a terrific market, and there has been absorption there, absorbed as a function of such demand in the Dallas market. Still, tenants want to go to better locations as the market pulls back. If they have those options, it'll be a tale of, you know, two cities, meaning that there will be locations in every central Metro Dallas included that will suffer from overbuilding simply because there was more land.

Other areas will see an increase in demand because tenants in down markets will gravitate to your better buildings because suddenly they can get them at more affordable rates than they otherwise could have in the past. 

Chris Powers: Okay. Let me tie a couple of things together. So, the workforce costs more the further they have to get to the building. That's just like increasing your labor cost, directly impacting what they can pay on real estate. Then you've mentioned the term best in class, new product, and how people build buildings. The third leg of this question is like robotics. You can answer this however you want.

You've built many buildings nationwide for all different types of tenants. How many of these tenants use sophisticated robotics to offset that labor force they can't get? Is it just the Amazons of the world and the biggest, or are you seeing a difference in what tenants are asking for and how they're using the building, and you can answer this however you want.

Sean Dalfen: It's more than before. Even in Dallas, we have a furniture distributor facility, which is automated. We have on our advisory committee an individual who runs a vast international shipping company and freight forwarding company, and in their warehouses globally, they're starting to use specific sorting systems that are minimizing, you know, the aisle spacing or taking it out entirely because if they don't need the people there, what they can do is pack and pick from the top rack anywhere at the same speed or quicker than having people there and how much do we see that though?

Not that much. You're seeing robotics, but it's taking time because there's a difference. There's the, I need my product now. Which most of us do, and then there's what I want to build for the future. And so you're seeing the proliferation of this technology. One presentation I recently saw was from an AI-based company hooked into the camera system of a given warehouse operator. They will monitor the people's movements throughout, say, a month.

After that, they will give someone schematics for designs on building their engineers by trading actual machinery to replace the people. And so you're seeing that happen, but it's costly and takes time. And so, just like a few years ago, there were only a few Teslas on the road. And then suddenly everyone, you know, has one.

It will be like that, and you know, as wages continue to rise, which is terrific for the people getting the wages, you start legislating that stuff. What happens is what you'll see in any airport, especially in certain states where you go, and there are no longer people.

It's a kiosk. And so that company can say, yes, we're paying our workers 22 bucks an hour, but instead of having 15 workers, that facility, they have one. And so you're going to see that more and more. We should only see it in some places because many costs go into it.

And, you know, it's like Moore's law as technology, you know, it doubles every year in speed, and the cost also diminishes. And so, as the price decreases, you'll see more, but it will undoubtedly come. 

Chris Powers: Is that an argument for bullish rents because more robotics lowers the labor pool?

And when leases turn, there's more margin to capture back. 

Sean Dalfen: It's a point that I hadn't thought of, but there are many variables in there. So, cause I can't give you an answer if that is a bullish point for rent, arguably speaking, you could say that facilities will need fewer warehouses.

Because if they're reducing the, you know, your aisles, any turning lanes for forklifts, et cetera, they're just going to need less space from a packing standpoint. But that means the area you or I own will get even more valuable. Unless you have that teleporting machine, they had in Star Trek, you still have to get the goods to the consumers or the businesses somehow.

And that means the closer you are to those consumers or those businesses, the less it will cost to get the goods there. 

Chris Powers: On that notion of smaller spaces, possibly in the future, one of the questions I had going back to leasing activity, so we've said, look, leasing has softened, but it's still.

On par, if not better than 2019, and we're just off our highs, but if you had to break leasing down by a million square foot leasing, you know, five hundred to fifties, like, where is how do you categorize leasing activity based on size right now of tenant. 

Sean Dalfen: Again, It's a tale of 2 cities. You see significant demand for large base spaces in specific markets over a million. 

Chris Powers: What would characterize a market with high demand for million square feet?  

Sean Dalfen: Say the IE. In the empire, you have over a million, you're going to have, you know, people vying for that space—many companies. But if you're a hundred thousand, it's crickets.

Chris Powers: Really? 

Sean Dalfen: Yeah, and that's an anomaly. Well, it's not an anomaly because it's happening. And it's just the nature of the market today. So we're seeing a good amount of activity in smaller spaces in some markets and larger spaces in others. So we have assets in West Palm Beach, for example, and there's lots of demand.

For smaller spaces, spaces under 40 000, but in rooms above, say 60 000 50 000, it's a much smaller pool. It's not something we anticipated, but it's happening. The market trend is the smaller, the better right now. I'm not talking about incubator smaller, but I'm talking about at least what we do because we're not familiar with incubators, but it's more of, you know, you're 25 000 square foot to, you know, 100 150, you're typically good right now in some markets up to 250, but the 300 plus.

It's slow nationwide or during the summer, but I'm saying that with a grain of salt because we've seen a real uptick in leasing activity since, maybe, the heat broke in Dallas. 

Chris Powers: Thank God. I have been thinking about this thing you said earlier in the conversation. I can't get away from it.

So we'll go back real quick to lending for a second. And I want to make sure I understood this right. If a bank has a loan on a new development industrial building that, again, took longer, cost more, all those things. And then they also say it's a 50 million loan. I'm just picking a number.

Then they have a 50 million loan on a class B suburban office that's just structurally toast. Did you say they're more likely to want to foreclose on that industrial loan and get it off the books because they know they can get all their money back at par than trying and Working on this janky loan? Are they more likely to go after this more solid asset and then hold this 50 million office loan or sell it at a discount?

Is that what you said? 

Sean Dalfen: It is what I said, but that explanation has a nuance. And so that will take a bit of time across the board. But if you think about it, these janky loans are the office. And so, in most cases right now, what's going to end up happening is they want to extend that loan as much as possible within reason, pretend, and extend.

Because the moment they recognize that loss, they must take back that asset. They're better off. I'm not a banker, but they could liquidate that loan at 40 cents on the dollar. And they're better off than holding it on the book from a default office standpoint.

So if they could sell that loan at 40 cents, they're better off. But if you have that asset, you can push out the problem. You may put some reserves against that asset. You say it's worth a bit less, but the operator continues operating it, and you're not returning the keys. 

You need to realize the significant loss because you haven't had to mark that asset so substantially in terms of industrial; they know or believe that they can get the value out of those assets because they're certainly worth more than the debt in most cases. And so it's logical to think eventually, given that the repayment rates are 2 percent, if that nationwide, on commercial real estate right now.

Annually, and you're having mounting pressure on the side of commercial lenders to, you know, bring down their losses and how they can book losses and book gains. As I mentioned, if they say okay, I must extend this loan. Then, they extend this particular loan to industrial buildings. They take a loss of 20%. They booked that as a troubled loan. 

Then, they're able to sell that asset. It could be six months later at a hundred cents on the dollar or even more because it's worth more than the debt. They've now booked a game. And so there is an incentive to do that because it's one of the few assets They can move. They can drive for all like a hundred cents on the dollar. Earlier in the conversation, you asked me how we got such a good deal from an institutional open-ended fund. In such a core market, the one I mentioned in Orange County is because they had to sell something to meet redemptions. And what did they sell? Well, they sold the most liquid of what they could sell. And that was industrial. And so, it's logical to think banks would do the same thing.

It will only be so long that your banker buddies will say, it's okay. I'll give you that extension. Eventually, they're going to get pressure internally. They're going to have to. Get some money back on their books. 

Chris Powers: Okay, I want to pivot a little bit—industrial outdoor storage. I think when we talked 2 or 3 years ago, it was maybe becoming a thing.

We have yet to code it for iOS. Maybe we had, but I was late to the party. We sit here 2, 3 years later. Wow, this thing's come quickly, and I know you all are getting into it. Why are you all getting into it, and how do you view that world? And do you consider it differently than traditional industrial?

Sean Dalfen: Yeah. So, when we talked a few years ago, we were not active in the space, although he had owned iOS sites. We didn't even term their iOS, and we were buying them because of the real estate that sat there, you know, the, the building, the site was just the, you know, parking lot or whatever store, you know, pipe lay, lay down, was, was a benefit.

It was a stencil benefit of the facility, but we have a venture with a center bridge. We're buying quite a substantial amount of this product, primarily in the coastal markets throughout the country. And our perspective on it is, in many cases, irreplaceable real estate. What is iOS? And so, iOS has some different definitions.

One of the definitions we can all understand is, you know, you drive by a port, and you see the shipping containers piled up on land, you know, on a lot. You know, and they're piled six high in some instances. Well, that's like an iOS site. You have a FedEx facility where you have trucks parked outside.

That's another iOS. And then you have, you know, your, your truck terminals. That's another version of iOS. Although that's a niche, you can even store boats; you have contractors with their machinery or materials that the site holds, iOS. You have somebody who's your carpet cleaning company or, call it, a pest control guy who has got a lot of trucks.

They need a ton of parking and only 2,000 square feet of space. That's also iOS. And so I'm mentioning all these things because it is a critical component of one last mile, but also, there is a necessity for this space in every single Metro market. And it is challenging to find. And the market could be more cohesive.

Over 95 percent of iOS is owned by mom-and-pop. If you want to go online and you're a tenant. Let's say you want to go on a CoStar or something, and you want to see your availability of iOS in a given area; you can't find anything because CoStar only tracks some of the data. After all, the mom and pops who own it are not submitting any of those details to CoStar.

In every market we operated on, we hired people to do extensive surveying of that entire market using aerials, calling every facility and getting as much data as possible to canvas the market as a whole. Every sub-market in that market knows every iOS facility and uses a zoning map as their basis for that template, understanding, at least on a high level, what's acceptable within these markets.

And what did we find? What we found was. In many markets, iOS sites needed to be correctly zoned. And so it comes down to why iOS is so enjoyable for us. One, it's a fragmented market. And when there's dysfunction in a fragmented market, and there's high demand, which there is, we will be able to take advantage of that.

We're going to be able to buy assets, you know, excellent prices, off-market, from smaller sellers. We can move markets by buying enough bulk in that market. Here's an example. We purchased a Jersey-based facility where a tenant played for $ 3,000 a month per acre. The only comparable facility we could find was the lowest close comp; sorry, it was 25,000 an acre.

Okay. You can also get that information out there and make the market more aware. So it's a benefit for us if the lady across the street is now charging 25,000 an acre as well. And what we also found is that cities hate it. And they hate it for a reason: because it's ugly.

It isn't lovely. Specific sites with environmental issues. And so what does that mean? That means cities are going to be likely never to want to zone areas iOS. I mean, they don't want to zone them lovely industrial buildings. They're certainly not going to want to zone their iOS. And so it's a finite resource.

Home Depot, you know, Amazon, FedEx, and many companies rely on these facilities. To make their transport costs cheaper, so they don't have to store those facilities, you know, 60 miles outside of town and then drive, you know, to their worksite every day or wherever they're going. And so these are critical components of our supply chain, and they're a finite component because many people who bought them were just land banking.

We know cities don't want to continue to zone anything iOS. And we know that there's high demand and a dysfunctional market. You add all those together, and we see a real opportunity to make outsized returns. 

Chris Powers: Do you think, and we'll tie this into, your view of the supply chain and how it continues to evolve? Part of the reason there's such high demand is that the supply chain continues to change.

You have more of these, you know, trucks on our roads that are delivering product. You have more tenants that need to be closer to their customers. The question we'll tie it into is. How do you see the supply chain continue evolving today and just as we go forward? When I say that to you, what comes to mind that excites you about where supply chains are heading?

Sean Dalfen: The exciting part about our industry is that nothing is changing the dynamic of the supply chain cost matrix, meaning that transport is still your number one cost. And e-commerce is continuing to grow. We are in a society where we want everything now instantly. And the more that, Instacart just came out with their IPO today.

And we are an Instacart world. And we want everything now. And if you want it now, well, you want to make a profit, then you have to be close to your consumers who are consuming those goods. Therefore, our real estate continues to be more valuable, whether it be iOS, traditional industrial, or smaller bay industrial that you go after.

It's going to continue to increase in value. And I can tell you one thing, that's another certainty: cities hate industry, even Texas. Even in Dallas, we deny some projects in conservative-leaning areas. People just wanted their, called their Amazon package very quickly.

They didn't want to see the trucks. And we get that. I get that, logically speaking, but it will take a lot of work to get the zoning or the entitlements, or it will be much more costly. Uh, in the future, because the gig is up on industrial before we could fly under the radar today.

We can't, so that means our product gets more valuable.

Chris Powers: What do you think about Amazon? We don't do anything with them. There was this, and they were growing like crazy. And then there was news a couple of years ago that now they're choking back. Then they were going to own their buildings, maybe. To be honest with you, there was just. Even for someone in the industry, it was more confusing than anything for someone who's worked with and built for them and remains close to just that part of the world. What's going on with Amazon? How do you think about them?

Sean Dalfen: They're very active right now. They are swamping their last-mile fulfillment centers.

Chris Powers: Big facilities, are they niching down into smaller spaces?

Sean Dalfen: It's probably across the board, but more of their smaller facilities, the infill product. Traditionally, natural infill is smaller just because the land somebody can get is smaller.

There were higher and better uses in the past than industrial office, shockingly, and another product that, you know, enclosed malls, but they, you know, if they could go after a million-foot fulfillment center, they would, I'm sure. Still, we're negotiating deals with them right now, and they're very active because they figured it out before any other companies.

And that's what they recognize. The more drop-offs that they can do in a single van leaving that facility, the more households they can hit to drop off those goods and come back within, say, an hour or two, the more profitable and the network built out, recognized now they're able to achieve profitability.

As we've seen in their financials on the delivery side, it's going to increase, and they're going as they've done, forced companies to either pay a fee or use their logistic services. So that's going to bolster it even further. And so, they were highly active when they made that announcement. A few were a couple of years ago; we should have charged them at least a quarter more on every lease that we, you know, did with them after that because of all the problems that they caused for our investor base and the phone call that I got, you know, they announced they were subleasing 10 million feet.

At 400 million feet, it's a rounding error. And they weren't giving up the space. They were subleasing it, meaning they still wanted the option to get into that space. We had a 40,000-square-foot space. That one was one of the spaces that they subleased. They were leasing it at roughly 750 a foot.

We released that space at about 11 bucks. Okay. Within one month, they were still paying rent. We said, you know, we're going to go direct to the, or sublease tenant. And we leased it at like 11 bucks or something. It was a significant benefit for us, but it wasn't a fundamental change to their philosophy, although the announcement made a lot of news.

So, from what we've seen, Amazon is very busy right now. And there are another number of companies who also are. Corporate decisions are taking a lot longer to ink those deals. 

Chris Powers: Are we 95 percent occupied because demand is just growing in a way that it hasn't historically, if we go back decades, or are we 95 percent occupied?

Cause we can't build it like we used to. I know that's a chicken and egg, but the question is, are the fundamentals of the world changing so much that it's almost? In any one 10-year span, it is impossible for supply to keep up. Or have we just gotten so damn slow at building that demand's pretty good, but we're now not good at putting the product on the ground.

Sean Dalfen: Demand is just higher today. That's all there is to it. Demand is higher. You have, your e-commerce continues to grow, and you have a change in how we do business, you know, companies recognize they want to behave maybe. If they go to nearshore or onshore, they will have more manufacturing requirements.

You're going to be building semiconductor plants. You still have your traditional industrial companies, or at least those in commerce, which still need the space. And as a percentage of everything in this office or that we're wearing. It's all been an industrial building, and those demand drivers continue to be there, and they've only increased.

And so there's a sector of the commercial real estate space with many more legs. And the last part about it is just the supply chain costs. Real estate is still the most minor component of that. And so you have a lot of room to raise those rents as long as you're able to positively or call it to reduce the impacts of the more critical variables like transport or labor by being closer to the workforce or the customer, you're able to keep charging more, and there's a lot of runways for us to continue to increase that.

As long as the demand is there, and that's not the same for any other product type. I mean, especially multifamily. There's only so much you can raise people's rents, you know before they can't pay bills. I mean, red or blue state. No politician will allow for a mass eviction because multifamily landlords budgeted too high a rental rate, so they must keep increasing it. They won't allow it, but I don't see politicians stepping in if industrial rents double.

Chris Powers: That will not be the hill they die on. Alright, we're in an exciting place in the world. If you were going to get it, we talked about buying it, but if this is like.

If anybody's listening to this with a deal they want to bring to Sean, we will end it on this. We can break it up into acquisition versus development. What needs to be in place right now for you guys to pull the trigger on buying a deal and answer it in two parts: acquiring existing values and new development deals.

Sean Dalfen: We have a built-in core account as well. So, we'll start with the built-to-core. It must be in the coastal markets, or there are a few select markets like Tampa and Orlando that we continue to love every infill Dallas. We do as well. But on a yield-to-cost basis, we're looking, let's say, it's in a coastal in the high sixes or the sevens for any secondary markets.

I mentioned that's a particular vehicle, though. In general, we're focused on class a product. Or what is perceived as Class A, because let's say you have very infill Jersey where, you know, it's not the same as Class A here, but the locations are, you know, irreplaceable for it must be Class A, preferably least, but doesn't have to be?

And we have to feel that we're buying it at below replacement costs, or if we're not, then you can only replace it if there's dirt there. We're being extremely cautious in what we buy, and we expect a lot more pain out there, and we want to have the dry powder to take advantage of that.

But with that said, we are actively buying deals and closing them regularly, although it's a small percentage of what we did in the past. That's because there's going to be continuing opportunities. So, bring us class-A deals, sell us in coastal markets or top significant metros, and infill in those markets.

And we'll look at everything. We'd instead look at it and, and, and say, it doesn't work for us than, than not having seen it at all. 

Chris Powers: Sean, this was fantastic. Thanks for joining me today.

Sean Dalfen: Thank you very much. I appreciate your time and having me on. Of course.