Industrial construction feeds demand's hunger The industrial market is rarely anything but healthy, and the thriving economy of the last few years has resulted in tremendous growth in new construction, absorption, product demand and rental rates.

"Ultimately, it always gets back to the economy," says David Team, president of the Western Region for Irvine, Calif.-based Lennar Partners, a subsidiary of Miami-based LNR Property Corp. "Economic growth means companies need additional product to meet the increased demand, and centralizing their distribution networks is part of the solution."

"The industrial market has been fantastic," says Rick Shultze, vice president with Atlanta-based Arco Design/Build, an affiliate of St. Louis-based Arco Construction Co. Inc. "Growth in business has been feeding industrial construction."

The construction increase has been precipitous. The Society of Industrial and Office Realtors (SIOR), which monitors activity in 126 markets nationwide, reports that the amount of industrial space under construction rose from 108 million sq. ft. in September 1995 to 128 million sq. ft. a year later to more than 156 million sq. ft. in September 1997.

Even with these great amounts of new construction, supply and demand fundamentals have remained strong, and industrial property values have been going through their 30-foot clear-height roofs.

But regardless of how strong a market is, the cyclical nature of real estate assures that another downturn is always on the way, sooner or later. This realization could be behind the lone dark cloud on the industrial horizon, namely the decreasing amount of capital available to developers.

"The supply and demand fundamentals are still good," says Keith Ross, senior vice president of the Western Region for Koll Development. "Capital sources are just being more cautious trying to decide if the market has reached its peak."

This sudden decrease in liquidity is due to the recent fluctuations in the stock market, which have made investors more cautious concerning the direction of the economy. "The stock market is definitely a factor in the slowdown," says Schultze.

"With the stock market and overseas economies being so unsure, there has been a tightening of capital," explains Ross. "The capital sources are pulling in their horns, and underwriting has become very stringent."

But this is not to imply that capital is in short supply; in fact, it is still abundant in most areas. "Prudent capital is still readily available for good companies," says John McDonald, president of Atlanta-based McDonald Development.

But it has become more difficult to acquire in recent months.

"The demand for equity in projects is rising, and this is slowing down the development process," says Sandy Zuckerbrot, president of Sholom & Zuckerbrot, New York.

Equity commitments that have been ranging from none to 15% are rising to as much as 35% in some cases, Zuckerbrot points out.

"Capital has slowed for the big companies," says McDonald. "We have seen turmoil in the permanent lending arena, and getting quotes out of insurance companies is getting more difficult."

Construction pace slows The impact on new construction has already been noticed in some markets. For instance, last year Atlanta added 13 million sq. ft. of industrial space; however, through the first half of 1998, only 4.5 million sq. ft. of space came on line. "So new development has slowed a little," admits Scott Helms, vice president of marketing with Atlanta-based IDI.

"We have clearly seen a slowdown in new construction in the third quarter of this year," adds Paul Marshall, vice president, real estate development for Phoenix-based Opus West Corp. "The universe of developers and buyers - REITs, pension funds and private developers - have been forced to slow down."

This has been particularly true of REITs, which for several reasons have slowed their acquisition and development activity. First, REIT stock prices have dropped considerably this year, and this has reduced their ability to raise capital - both due to the lesser stock price and because the interest of investors has declined as well.

Secondly, rising property values have made the potential returns on many acquisitions less attractive, especially for the REITs, which historically have sought higher yields.

Some attribute the slowdown in construction to the rising cost of raw land. "In the past 18 months, land prices have increased dramatically," says Marshall, adding that prices are even higher in in-fill locations where the supply of land is limited. He says these sites are particularly sought after because the areas where they are located have already proven successful as industrial locations.

Ross says property values have jumped 30% to 40% in the past 12 months in Southern California, while Zuckerbrot says they have increased approximately 20% in New York. Strong supply/demand fundamentals have resulted in higher prices in all markets.

"I have not seen a REIT deal recently; they have slowed down considerably," says Zuckerbrot. In fact, most REITs are remaining on the sidelines in the current market.

"The stock market upheavals have hurt the REITs a little," says Kim Snyder, director of development for Insignia/ESG's West division, which handles the development activities of a number of West Coast REITs. "REITs have raised the bar in terms of their need for yield. Currently, they are much more in-line with pension funds as far as their underwriting criteria. And that is not a bad thing."

Many feel the reduction in new product is warranted. "REITs have been fueling more growth than the market needs," says Schultze.

After 18 months of tremendous growth, most see it as logical, and even advantageous, that REIT activity has slowed. "That is probably good because it helps maintain a responsible marketplace," adds Marshall.

"It seems as though the interest level in industrial space may be wavering," reports Robert Guthrie, partner with Burke Real Estate Group, Santa Ana, Calif. "That does cause some concern with the increasing supply of new space that is under construction."

This lessening interest in leasing industrial space may be reflected in how long it is on the market. "In Atlanta, things are slowing down; the space built over the past three or four years leased very quickly," says Helms. "But many recent projects have not. As national developers came in and increased the competition, too many buildings have gone up. Absorption has been OK, but the added space is taking longer to lease."

McDonald says Atlanta will absorb approximately 11 million sq. ft. this year - a good total but below the 12 million sq. ft. to 14 million sq. ft. figures it has tallied in recent years. "We have seen perhaps a 10% reduction in leasing activity, and I anticipate it will stay that way for a while," he says.

Even so, Helms doesn't foresee any problems of the magnitude of the early 1990s and, in fact, sees this as part of the process. "The last four years were very good and now the market is slowing as would be expected," he says. But he does project a 5% decrease in rents by the second quarter of 1999.

Demand expected to rise The reason for such optimism is that demand appears to be strong, both now and in the near future. And despite some negative indicators due to foreign economic downturns, nothing pleases developers as much as leasing space.

In Chicago, roughly 5 million sq. ft. of state-of-the-art industrial product came on line in the middle of the year. "It was leased up in a period of three months," says Thomas M. Boyle, vice president of The Alter Group, Lincolnwood, Ill. "This has signified to all developers that there is still plenty of demand."

As a result, Boyle adds that he expects another 5 million sq. ft. to 6 million sq. ft. of industrial to get under way in the market before the ground freezes.

On the West Coast, The Plantation, a 12-building, 1.4 million sq. ft. development in City of Industry, Calif. - and the largest speculative industrial project in the region - began construction in August, and every building was committed to a tenant by October, points out Barry Chase, executive vice president for the Western Region with Koll Development. He adds that rents are rising, and sales prices are unprecedented in the market.

So new development isn't just springing up because of inexpensive capital. "The development activity has been driven by the demand; low cost of capital has just made things easier," says Snyder.

The trend toward consolidation is the main driver in industrial expansion. And although the term usually implies a reduction in size, that is not the case with industrial consolidation. Firms that, in the past, have had several smaller distribution centers in an area are now moving to one large facility. "Consolidation is the trend, but it is not about getting smaller, but rather about growing," says Snyder.

"Consolidation is resulting in more space being taken," adds McDonald. "The second generation buildings that are being vacated lease up last, but they are finding tenants."

CTX, a computer monitor manufacturer recently consolidated from four buildings in Southern California to one larger facility in City of Industry, which was built by Koll Development. "All four buildings CTX vacated were quickly sold to other users," reports Ross.

Distribution facilities are also finding their way back downtown. In cities like New York, where accessibility can be a problem, the advantages of an inner-city location are becoming apparent to many firms, especially food and beverage companies. "The cities have to be serviced, and it is much easier if you are already inside the city," says Zuckerbrot. In addition, he points out that tax incentives, employee training and other programs are other advantages to urban industrial sites.

Another trend across the country is the conversion of older inner-city industrial sites into other uses such as retail and even residential. Zuckerbrot explains that the transformation of these former strictly industrial areas into mixed-use districts is beneficial to the remaining industrial buildings as well.

"The other uses attract more people to the area and upgrade its overall appearance," he says. As a result, lenders and potential buyers are more willing to consider the area for investment because the property has an upside potential apart from its industrial use.

New players on the horizon While the stock market and rising property values have driven REITs out of the industrial development business for the moment, strong supply and demand fundamentals are still singing the siren song to other developers, who to this point have been playing second fiddle to the REITs. And with the absence of REIT competition, private developers and other institutions such as pension funds could be in line to benefit.

"With the slowdown in acquisition and development by REITs, we see this as a good opportunity for privately held companies that are well capitalized," explains Koll Development's Chase.

"Many companies are stockpiling cash in order to take advantage of the opportunities they expect to come available," adds Burke Real Estate's Guthrie.

"During the first and second quarter, the greater activity by the REITs reduced pension fund activity, but that will increase now," predicts Marshall.

The absence of REITs could also result in lower sale prices for industrial properties, which would further enhance existing development opportunities.

"REITs have a history of paying 5% higher or more for properties," says Schultze. "With them less active, the prices may come down, which will be good for pension funds and private buyers."

Zuckerbrot says that prices have already reached their zenith in New York and that the leveling off is currently under way. The result of the lack of REIT competition and the other effects of the unstable stock market may not lead to a decrease in price, but simple slow property appreciation.

"The slowdown in the supply of capital has not devalued properties, but it has slowed the increases in value," observes Marshall about changes in the West Coast markets.

But price corrections are going to take time to trickle down to every market, and so developers will need to be a bit more prudent when putting together deals, stresses Chase.

Best in the West While some industrial trends and market happenings can be generalized on a national basis, regional real estate markets usually travel the real estate cycle at differing rates. And although strong and weak individual markets remain throughout the country, the western United States, particularly Southern California, appears to be the strongest at the moment.

"Southern California is head and shoulders ahead of most of the country with regard to industrial volume," according to Insignia/ESG's Snyder.

Koll Development's Ross says low unemployment and a thriving small business sector are key to the regional market, which has seen industrial property values rise substantially in the past year.

Snyder points out that while industrial property values have risen in most western markets, Southern California is unique in that rents have kept pace, meaning acquisition are more attractive.

"Historically, the West is the last to go into a recession, and one of the last to come out," says Marshall. "So we are still in the recovery portion of the cycle, and markets are on the way up. Add this to the fact that Southern California has deeply diversified markets, and it all points to continued growth."

In 1995, you could still buy existing industrial product for less than reproduction costs, so most of the new speculative construction has taken place since that time, Team points out.

"Absorption levels are higher in the western United States than they are in other parts of the country," he explains. "The West Coast is particularly strong." But he does point out that some eastern markets are seeing high absorption totals as well.

According to a report on the national industrial market - published in August by AMRESCO Research - a third of the 30 national markets still considered in an expansion mode were located in the western region of the country.

Another factor driving confidence in the western markets is an expectation that the eastern markets will provide a warning of a market downturn. "We are hoping the market will slow from east to west," says Guthrie. "If we see problems begin there, we will be able to react to those problem earlier."

The South Bay and San Gabriel areas around Los Angeles have seen the largest increases in industrial property values because "there is not enough land to supply new construction and, as a result, there is a lot of upward pressure on rents and low vacancy rates," says Team.

The Inland Empire is also experiencing strong demand; however, an abundance of land is encouraging new construction and, as a result, rents have remained flat. "Rents are at the same levels as they were in 1986, and they will probably be the same 10 years from now,"

San Diego has experienced some overbuilding, but Team expects it to be only a short-term problem. He stresses strong demand for research and development space in the area.

Elsewhere in the region, Orange County, Riverside-San Bernardino, San Francisco, San Jose, Seattle and Phoenix are all experiencing strong growth.

Around the country, Boston, Charlotte, Cleveland, Denver, Detroit, Houston, Minneapolis, Philadelphia and St. Louis are among a group of strong growth markets, reports AMRESCO Research.

Warehouses in demand The trend toward the consolidation of warehouse/distribution facilities has made these buildings the development of choice in the industrial sector.

Middle-sized boxes to large boxes with the potential for use by a variety of tenant types are what most industrial investors are building, says Schultze, adding that they prefer one or two tenants per building.

"Fewer tenants is best since this means the facilities will be less management-intensive and fewer tenant improvement dollars will be involved," explains Marshall.

Team says the trend in speculative construction is toward larger facilities ranging from 300,000 sq. ft. to as large as 700,000 sq. ft. "Earlier this year I would have said none of the largest projects would be speculative, but rather build-to-suit," he says. "However, in recent months that has changed. The investors want the flexibility that size offers them."

The same is true of ceiling heights, where 30-foot clear height ceilings are becoming the rule, rather than the exception, in order to accommodate state-of-the-art rack storage systems. "There are always some tenants that will need 30-foot clear heights, and if you build 24-foot clear height buildings, it takes you out of the running for a certain percentage of tenants," says Team.

In fact, many developers insist the investor is the driving force in the addition of state-of-the-art features on new buildings because they want to offer as much as possible to attract tenants from a larger pool of companies.

For example, "a minority of users require 28-foot to 32-foot clear heights, but the investor wants it to make the property fit more tenants," says Schultze.

Other considerations in the construction of new warehouse/distribution space includes, advanced sprinkler systems, size of the truck court, floor levelness, on-site trailer storage and building aesthetics.

ESFR sprinkler systems provide more protection from fire. Larger truck courts allow more maneuverability for more and larger trucks. Higher stacking systems require stronger floors that are more level than in the past. And on-site trailer storage is becoming a necessity for distribution systems that can turn over a complete inventory in a matter of days.

These new features offer tenants lower costs in terms of cheaper operations and use efficiency, and they can provide for higher rents. "In lieu of operating in a 1980s building at lower rates, many tenants are willing to pay a few pennies more a foot for long-term savings on operating costs," says Snyder. For example, ESFR sprinklers result in lower insurance costs.

These technological advances have become so important that they, and not age, are often determining the obsolescence of an industrial building. Buildings constructed in 1984 with 24-foot ceiling heights still have another 25 years of useful life, "but the needs of tenants have made them obsolete compared with the new product," explains Snyder.

"The usefulness of a building is no longer determined by its durability, but rather, by what it offers the tenant," adds Schultze.

Most developers say the older space will still find tenants in the current market, but at reduced rents.

Part of the user flexibility question is the user's ability to expand their operation without picking up stakes and moving to an entirely new facility. "We have two warehouse projects currently - one 400,000 sq. ft., the other a 750,000 sq. ft. - where the lease includes provisions allowing them to expand another eight and 12 acres, respectively," says Team. "That can be expensive tying up that much land, but we do it short-term at our expense; however, if they need the flexibility long-term, it is reflected in the rents."

One industrial feature that seems to have declined in importance is rail access. Team says, "In the mid-1980s a developer would not have acquired an industrial tract without rail service, but today it is done all of the time."

He says reliance on rail in industrial site decisions has been declining for a decade and, in the past two years, Lennar Partners has had only one build-to-suit client that required rail access. "Only about 10% of clients want rail, and even then it is usually only used as a bargaining chip with trucking companies."

While the large developers are concentrating on cavernous warehouse facilities, smaller builders are seeking their own niche in which to compete. One of these niches is flex-tech space. "Flex-tech is an overparked industrial building with more glass lines and a lot of flexibility for the tenant/owner to buildout," says Guthrie, whose firm, Burke Real Estate Group, focuses on this product type. "In general, it is more attractive with more people areas and a greater number of the technological needs of today's businesses."

Burke Real Estate's projects range from 5,000 sq. ft. to 20,000 sq. ft. and offer 3.5 parking spaces per 1,000 sq. ft., compared with two per 1,000 sq. ft. for normal industrial product.

Guthrie says the small business sector is doing well in Southern California, but the main reason for his firm's success in this product type is that "it is below the radar screens of bigger real estate developers, so we don't have to compete with them."

Although the question remains about the effects foreign economies may have on the domestic industrial market, most in the industry seem content to rely on the historic perspective of industrial space as a safe form of investment.

"If you look long-term, it has not had the peaks and valleys of the other real estate types," says Helms. "So investors perceive less risk."

Although industrial has fewer barriers to entry than other product types, it can be geared up and shut down more quickly, when needed, as well. So although Wall Street capital has driven much of the new construction in recent years, Wall Street also limited growth by placing REITs on the sidelines and raising the bar for new developers.

But the bottom line is that "the market fundamentals are still good," says Zuckerbrot. " And over the next few years, industrial should prosper."

Hide comments


  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.