Hidden Risks in a Small Bay Industrial

The Boom in Small Bay Industrial

Over the past several years, small bay industrial (SBI) properties have surged in value, driven by a combination of tight supply, increased investor interest, and a growing tenant base of small businesses. With institutional players now entering the space, investors have treated these properties as a hedge against economic uncertainty, believing them to be more resilient due to their diverse tenant mix.

But is small bay industrial a safe bet, or are investors overlooking significant risks?

Institutional Interest and the Reality of Small Bay Tenants

Historically, small bay industrial has been a domain of local private investors and owner-operators. The sector’s tenant base is fragmented, comprising businesses ranging from HVAC contractors to auto repair shops, machine shops, and small logistics operations.

As institutions have entered the space, the narrative has been that SBI provides:

• A broad tenant mix, reducing credit risk.
• High demand, with low new supply due to zoning restrictions.
• Sticky tenants since small businesses often lack the capital to relocate.

However, the reality is more nuanced. Institutional investors may be underestimating tenant concentration risk—even when rent rolls show diversification, many tenants are still tied to the same economic drivers.

Credit Costar

The Myth of True Tenant Diversification

On paper, a 100,000-square-foot small bay industrial property with 20 different tenants might look like a well-diversified asset. But if 80% of those tenants are in related trades, such as general contractors, home service companies, or suppliers tied to a single economic sector. Then a small bay industrial property is highly exposed to industry downturns.

For example:

• A building may have 15 different tenants, but if 10 of them are subcontractors working on new Amazon fulfillment centers or residential developments in the area, they are all reliant on the same economic cycles and market forces.
• Many small bay tenants function within the same social and financial ecosystem. Contractors, for example, extend credit to each other and prioritize paying their vendors over rent in downturns.
• If a major developer halts projects, multiple tenants in the same industrial property could struggle simultaneously, leaving landlords vulnerable to cascading defaults.

The Illusion of Industrial as a “Simple” Asset Class

Industrial real estate is often seen as one of the simplest asset classes to own and operate—just four walls and a roof. However, this oversimplification ignores the nuances of:

• Asset specificity – Small bay industrial buildings designed for logistics use (e.g., last-mile distribution centers) may struggle to transition to manufacturing or flex space in the future.
• Geographic dependency – While there is high demand for small bay space in major metro areas, regional economies vary widely. A property in Chicago’s O’Hare submarket may see stable demand, while one in a secondary market could face prolonged vacancies.
• Lease structure complexity – Many small bay leases are gross or modified gross, meaning landlords carry operational cost risks that can escalate quickly in an inflationary environment.

Are Valuations Getting Ahead of Reality?

At the peak of the industrial real estate boom, cap rates on industrial assets compressed below 5%, with some markets seeing small bay industrial trading in the 4% range or lower. As interest rates have risen, the spread between financing costs and cap rates has narrowed dramatically.

Yet some investors still assume SBI will continue appreciating indefinitely due to high demand and limited new supply. While it’s true that small bay construction is difficult due to land constraints and zoning challenges, that doesn’t mean demand will remain consistent.

• The Amazon Effect: Many industrial investors assumed continued expansion from Amazon and e-commerce players would drive demand indefinitely. However, Amazon has cut back on warehouse expansion, subleasing excess space, and rethinking its logistics footprint.
• Hidden Shadow Supply: Some analysts believe industrial supply is higher than it appears, as major tenants hold excess space in reserve or plan to consolidate locations.
• The Interest Rate Reality: Rising rates mean industrial valuations must adjust downward—yet many owners are reluctant to sell at reduced prices, keeping transactions artificially low and masking real market trends.

Small Bay’s Hidden Weakness: Recession Sensitivity

Unlike large-scale logistics hubs that benefit from major credit tenants, small bay industrial properties are highly susceptible to economic slowdowns due to their reliance on small businesses and low-credit tenants.

What Happens in a Downturn?

1. Contractors and Home Services Struggle First – Many small bay tenants rely on discretionary spending. If new construction slows or homeowners cut back on renovations, these businesses are at risk.
2. Tighter Credit Markets Hit Small Businesses Hard – Unlike national industrial tenants with access to corporate credit lines, small bay tenants often rely on short-term loans or business credit cards, which become more expensive in high-rate environments.
3. Vacancy Risks Increase Quickly – A single major vacancy can have an outsized impact on NOI, particularly for multi-tenant industrial properties where operating expenses remain high even when occupancy drops.

The Exception: When Small Bay Industrial Still Makes Sense

While many small bay assets are vulnerable to downturns, there are key exceptions where the asset class remains strong. Here are a few of the more common diverse exceptions we see in the small bay industrial space.

1. Machine Shops and Specialized Manufacturing

Machine shops require expensive, specialized equipment and often have established long-term relationships with customers in aerospace, automotive, and industrial sectors. These tenants are less likely to relocate and more stable than general contractors or home service businesses.

2. Cold Storage and Food-Related Uses

Refrigerated storage, food distribution, and small-scale food production are high-demand industrial uses that are largely recession-resistant. These tenants are difficult to replace but often provide stable, long-term occupancy due to the high cost of moving.

3. Life Sciences and Biotech Manufacturing

Some industrial properties are home to small-scale biotech, pharmaceutical, or medical device companies, which are less sensitive to economic cycles. These tenants often require controlled environments and infrastructure that make relocation expensive, providing landlords with added stability.

4. Niche Automotive and High-Value Vehicle Storage

While general auto repair shops may be vulnerable to recessions, businesses that cater to high-net-worth individuals—such as luxury car storage, specialty auto restoration, and motorsports companies—tend to remain stable even in downturns.

5. Government and Institutional Users

Some industrial tenants, such as fleet maintenance facilities, utility infrastructure storage, and public works departments, serve municipal or government contracts. These users provide long-term, reliable cash flow with minimal risk of default.

The Takeaway: Proceed with Caution

Small bay industrial is not a monolithic asset class, and investors should take a more granular approach to assessing risks.

Key Questions Investors Should Ask:

✅ Is the tenant base truly diversified, or are tenants all linked to the same economic cycle?
✅ How much of the tenant revenue comes from highly cyclical industries like residential construction?
✅ Are tenants financially stable, or are they small businesses with limited access to credit?
✅ Is the asset’s use flexible enough to adapt if market conditions change?

While some small bay assets will remain strong performers, the sector as a whole is not immune to economic downturns, interest rate shocks, or tenant-specific risks. Buyers should sharpen their pencils and scrutinize the underlying fundamentals before assuming small bay industrial is a surefire bet.

If you’re interested in buying or understanding your industrial space’s market value, our team of industrial real estate agents is happy to help.