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Empire Building in Southern California

Industrial demand has returned to the Inland Empire, but only for the largest of spaces.

The bright California sun washes the thick concrete walls of Watson Land Co.'s newest industrial building in Watson Commerce Center Redlands and streams through the open space where two-story glass windows will span the entryway.

On track for completion this year, the 616,542 sq. ft. structure will be a model of energy efficiency, built to earn a Leadership in Energy and Environmental Design (LEED) certification, and is designed for the latest high-volume distribution operations.

But the most distinguishing aspect of the building is that Watson built it on a speculative basis. In fact, it is the first spec building to break ground in the Inland Empire since 2009. Even so, the developer is confident the space will land a tenant soon after its completion later this year.

“There really is a huge lack of supply for buildings over 500,000 sq. ft. in the Inland Empire,” says Lance Ryan, vice president of marketing and leasing at Watson Land. “We expect that story will remain intact next year. It's highly likely we'll [develop] more buildings as permitting gets done.”

Indeed, Watson Land has applied for building permits to construct a similar building just to the south, even as it tweaks plans for 1.5 million sq. ft. of industrial space that it plans to break ground on next year in Chino, located in the western Inland Empire.

Watson Land owns and operates more than 15 million sq. ft. of industrial space in the region and is one of Southern California's largest industrial developers.

Why would a developer attempt speculative industrial projects when the U.S. economy is still staggering from the aftereffects of the Great Recession, and industrial vacancy nationwide has barely receded into single-digit rates?

Because this is the Inland Empire, a burgeoning powerhouse of distribution activity that soaked up 7.5 million sq. ft. of industrial space in the second quarter, accounting for a full 25% of absorption nationally, according to Grubb & Ellis.

The market is close enough in proximity to the ports of Los Angeles and Long Beach to thrive on the flow of goods passing through the ports. And it is just far enough away from Los Angeles to provide room to build the massive distribution centers required for today's high-volume logistics operations.

But in that distinction between old and new, large and small, lies the greatest risk for this market that is the envy of distribution clusters across the nation. Locals know that the strong demand for space here is limited to the largest assets.

Among smaller properties measuring 150,000 sq. ft. or less, vacancy remains high. There are signs, however, that even these smaller, more traditional warehouses are making headway toward recovery.

Leading the rebound

More than half of the industrial absorption tracked by Grubb & Ellis in 2010 occurred in the Inland Empire, according to David Burback, an executive vice president and managing director in the commercial real estate services firm's Inland Empire office.

In the first two quarters of this year, the region absorbed more than 13 million sq. ft., compared with about 62 million sq. ft. nationally. “The Inland Empire has to be the brightest spot on the commercial industrial landscape in Southern California, if not nationally,” says Burback.

Most of the distribution space in the Inland Empire has been built since the late 1980s, when developers ran out of developable land in Los Angeles and moved inland with projects to handle consumer goods shipped into the ports. Development came to a halt during the recession, but has rebounded in the past year in response to renewed demand for distribution space.

Since the recession, however, user demand is concentrated in the largest industrial properties. Burback attributes that trend in part to an emphasis on consolidation and companies seeking to boost efficiency through economies of scale.

Footwear provider Skechers USA, for example, is closing six warehouses in the Inland Empire's Ontario submarket this summer to consolidate into a 1.82 million sq. ft. distribution center in the Moreno Valley.

Port traffic also contributes to the growth of large distribution centers, says Burback. The number of shipping containers passing through the Los Angeles and Long Beach ports fell after 2006, but has been rising since 2009.

Container traffic is measured in 20-foot equivalent units (TEUs), with one TEU equal to one container that is 20 feet long. After peaking at 8.2 million TEUs in 2006, imports through the ports of Los Angeles and Long Beach fell to 6 million TEUs in 2009.

Volume bounced back up to 7.1 million TEUs in 2010 and is on track to reach 7.6 million TEUs in 2011, according to Economics & Politics Inc., a market researcher based in Redlands, Calif.

Exports reached a record 3.4 million TEUs in 2010. To handle mushrooming volumes of goods passing through the ports, a number of retail and logistics companies have sought to establish larger distribution centers. “The Inland Empire had what everybody was looking for, and that is large blocks of available space,” says Burback.

As a result, overall vacancy fell to 7.3% in the second quarter from more than 13% about 18 months ago, according to Burback. Average monthly rent for distribution space was about 31 cents per sq. ft. at midyear in the Inland Empire, and he expects that average rent to increase over the next 12 months to about 33 cents.

Unequal demand

Many of the Inland Empire's industrial landlords are struggling to attract and retain tenants, however. Of the roughly 500 million sq. ft. of space developed in the market since the mid-1980s, only about 20% falls under the highly sought after size of 500,000 sq. ft. or higher and is fully occupied, according to investor Jason Schirn.

Space in the super-sized industrial sector has typically leased or sold to large public companies with the necessary liquidity to close those deals, says Schirn, who is a principal at Hager Pacific Properties.

The Los Angeles-based commercial real estate company owns and manages nearly 100 properties nationwide with an aggregate value in excess of $1 billion.

Another 90 million sq. ft. of the Inland Empire's buildings measure between 250,000 and 500,000 sq. ft., estimates Schirn. The remaining inventory consists of hundreds of smaller buildings.

This smaller stock makes up more than half of the market, and caters mostly to private companies and small corporations that are likely to delay space decisions until the economy improves.

That is why virtually all of the Inland Empire's industrial vacancy is concentrated in these smaller properties, says Schirn. “Exclude those massive, fully occupied buildings from the market, and the vacancy rate is in the middle teens,” he says. “The only segment that has really recovered is the big-box industrial segment.”

Brokers say the rest of the market is catching up with absorption, however. In the softer segments of the market, a flight to quality is driving tenants to lease space in the Inland Empire, according to Brian Bennett, a principal in the Irvine, Calif. office of commercial real estate firm Newmark Knight Frank.

A tenant that leased distribution space in Los Angeles five years ago was probably paying 57 cents to 60 cents per sq. ft. per month on a triple-net lease, says Bennett.

By moving to new space in the Inland Empire in 2011, that same company can expect to lease higher-quality, newer space for about 35 cents per sq. ft. on a triple-net lease. (A tenant who enters into a triple-net lease pays the costs associated with operating and maintaining the property in addition to base rent.)

In Los Angeles, where the industrial stock is growing obsolete and vacancy is about 3%, a move to the Inland Empire may be the only option for a tenant that seeks to open a large distribution center, says Bennett.

“If you're in the L.A. basin and you're 150,000 sq. ft. or larger, the chance of you finding a good-quality facility is minimal,” he says. “Now if you're 50,000 to 100,000 sq. ft., you have tons of space to look at.”

Investment outlook

The largest and highest-quality industrial properties in the Inland Empire command premium prices, say investors. In March, for example, Bixby Land Co. paid $29.45 million to acquire Empire Business Center, a five-building, 393,000 sq. ft. industrial park in Mira Loma.

“We paid a 6% cap rate for it,” says Mike Severson, vice president of investments at the private REIT based in Irvine, Calif. “We think it's a great piece of property, and it was 100% leased at the time.”

Bixby owns approximately 1.4 million sq. ft. in 10 buildings in the Inland Empire. That accounts for about 20% of its 5 million sq. ft. portfolio of office and industrial space.

While Severson would like to buy more real estate in that market, the company has shifted its attention to value-add properties that offer a better opportunity to boost returns through upgrades and leasing vacant space.

Schirn of Hager Pacific confirms that prices on stabilized assets in the Inland Empire are growing prohibitively high. His company acquired several older properties just after the recession at prices equivalent to the cost of vacant land.

“The Inland Empire buying opportunities are gone,” emphasizes Schirn. “There's so much competition there. To get anything above a 6.5% cap rate is difficult.”

Matt Hudgins is an Austin-based writer.

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