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Industrial leads the pack to recovery

If you are wondering, the egg that has been on the faces of real estate executives for so long has been replaced by smiles, and the biggest grins may be reserved for those handling industrial properties.

While the entire real estate market seems to be breaking out of its slump, the industrial segment seems to be at the head of the pack. Five years of little or no new industrial construction, combined with changing business philosophies and a bump from a growing economy, has demand and rent rates all increasing.

Confidence in the industrial market is so high that even a slight drop in occupancy during the last quarter has had little impact. "It is too early to tell if it is a significant turn, but I don't think so," says Michael Brennan, COO with Chicago-based First Industrial Realty Trust. "I believe it is just a function of larger obselete buildings being added to the industrial base."

In the lending market, capital, although still conservatively apportioned, is available for industrial investment in amounts previously unheard of and at low interest rates.

This combination of factors has attracted a great deal of investor interest in industrial properties and, as a result, has sent the prices of existing buildings up to the point that substantial amounts of speculative development are now reported in every major market of the country and in numerous secondary markets as well.

"The markets have all been positive," says Peter Krombach, president of St. Louis-based Nooney Krombach and current president of The Society of Industrial and Office Realtors. "It just depends on the location as to what degree."

"Demand is high in all major markets," says Jim Dieter, executive vice resident and principal with Chicago-based Frain Camins & Swartchild * Oncor, adding "the supply of class-A, high-cubed distribution facilities, is at an all-time low. I think the market has been undersupplied for a long time."

Nationally, industrial space availability dropped from a high of 10.5% during the second quarter of 1992 to just 7.8% during the second quarter of 1995, according to the most recent statistics of the nation's top 52 metropolitan areas, compiled by Boston-based Torto Wheaton Research, a division of CB Commercial Real Estate Group. The Torto Wheaton forecast calls for the availability rate to level out at about 7.5%, the lowest level since the early-1980s.

Torto Wheaton projects rents to increase 6.7% this year and 6.4% in 1997. Increases between 4% and 6% are expected for the rest of the decade. The company recorded a rent increase of 4.4% last year.

More specifically, Brennan says, industrial space of 75,000 sq. ft. and under has experienced rent increases of 5% to 6%. This is mainly due to a lack of development in this size property and that business creation of firms of that size is on the increase; two factors that have led to a positive shift in the balance of supply and demand.

Of course, the balance swung the other way just a few years ago, and a number of factors have played a part in the reversal, besides lack of development. Among these were: the changes in corporate distribution patterns, the removal of old/obsolete space from the marketplace and the improving economy.

"Until 1995 there was no significant new industrial development for the past five years," says Gary Beban, president of CB Commercial brokerage, Los Angeles. "So as the excess space was absorbed, we finally got to the point where, currently, there is a pent-up demand for space in many markets."

While the creation of new space was being curtailed at one end of the market, some existing space was being eliminated at the other end. In the midst of the down cycle, Beban says, many old/obsolete industrial buildings were being converted into office or residential use, particularly those in urban areas. That trend continues in many markets.

But just as the industrial marketplace was ridding itself of unneeded space, so were many companies. The downsizing of Corporate America included industry. Companies who invested in numerous distribution facilities in the more prosperous 1980s have changed their philosophy to favor fewer and larger facilities.

Where a company once had a distribution facility for each of two areas, today, they have a centrally located, larger facility that serves both areas at less cost. "This varies from industry to industry but, in general, that is what is happening," says Anthony J. Lydon, national director of industrial services with San Francisco-based Grubb & Ellis.

"Business is moving to larger distribution facilities," says David McClatchy, vice president Chevy Chase, Md.-based Carey Winston, who adds that many of the smaller vacated facilities are being occupied by new growth companies.

Beban says, "These more efficient corporate distribution patterns are just as much a factor of the current healthy supply/demand ratio as economic growth."

Some say they are more important. Many industry executives credit the economy for at least a portion of the increased demand for industrial space; however, others feel it has had a negligible impact.

"The economy is growing but not at the rate where it would drive the real estate industry," says Dieter.

Other factors considered in the turnaround are that the industrial market never reached the economic depths of the office market and that a tremendous amount of capital has become available for industrial investment.

"There are more dollars chasing industrial properties now than ever before," says Lydon.

Indeed, the rising rents and occupancy rates in the industrial sector have caught the eye of investors. "From a liquidity standpoint, industrial is the favored investment alternative with institutional investors," says Beban.

Favored by institutions

"Institutional buyers have come back to the real estate market, and industrial is their first choice," says Krombach, "but bulk distribution centers are the properties most in demand."

Institutions are targeting industrial properties now, because they are relatively easy to manage and have a favorable riskreturn factor for companies just returning to the real estate market.

"Industrial is not a complicated property type," says Beban. "There is generally not a frequent turnover of tenants, no complicated lease provisions to be ironed out and, usually, no tenant improvement money to be paid."

"Industrial is a sound investment," says Richard W. Vaughn, director of leasing in the Atlanta office of Charlotte, N.C.-based Faison. "It is the backbone of business. "It is not glamorous, and the returns are not as large as other property types. But the lower price of properties equates to less risk on the part of the investor."

Another reason for industrial's popularity is that institutional investors, who attempt to cover all the bases by diversifying their portfolios, are lacking in this property type. "Many institutions are underfunded in this class," says Lydon.

Real estate investment trusts were among the early industrial buyers. "In the beginning we were acquiring properties because of the great discount-to-reproduction cost," says Lisa Closson, national marketing director with the National Marketing Group of Security Capital Industrial Trust, a Denver-based REIT.

But, in addition to price, REIT executives saw the opportunities industrial properties had to offer to an owner with large amounts of capital to spend.

"Absentee owners that, because they were so far removed from the property, had no feel for the needs of the tenants or the facility or fragmented owners, who were local but did not have the capital needed to keep the properties updated," says Closson. "As a national company with a hands-on management approach and access to large amounts of capital, we felt we could drive the success of those properties in ways the former owners could not."

But bargain prices were an attraction to insurance companies and pension funds as well, and the best deals went quickly. In addition, the demand sent prices on industrial properties upward, lessening the value of the properties that did remain.

"Today, the industrial market is pretty thin on great buys," says Beban, although he admits investor interest is still high. "The problems for the institutions is acquiring enough square footage to make the move worthwhile."

"Finding enough industrial property for an efficient portfolio is difficult," agrees Vaughn. "Pension funds are coming into the market with $100 million to invest and, at $30 a sq. ft., that is an enormous amount of space."

He adds that since there are few large industrial portfolios available, investors have to complete a large number of transactions to create efficient economies of scale within their portfolios.

The competition to acquire this square footage has become so intense it has even extended to properties that don't yet exist. Institutions are contracting to purchase speculative industrial properties before they are constructed.

Lydon says that this kind of real estate purchase, called forward commitment, is currently, high-cube distribution facilities. But he stresse, that it indicates investors' confidence in the industrial market.

"In order to get the jump on the competition, [institutions] are willing to buy properties before they are built," says Lydon. "It has been 10 years since we have seen this number of forward commitments."

The prices for industrial properties have firmed, and even risen in certain markets to the point of reproduction costs, the point where speculative development is, theoretically, supposed to become practical.

As stated earlier, all major markets are experiencing speculative industrial construction but, as with any economic recovery, it is occurring at varying rates. In some markets, speculative development is past the initial stages, while in others it is just beginning to show itself amid the build-to-suit development market.

"The build-to-suit activity is still the primary driver in most markets," says Beban. But he adds that the strongest part of the build-to-suit business is for midsize buildings between 50,000 and 100,000 sq. ft., because speculative development is supplying most of the large space users.

Krombach agrees, and he adds that there is a definite rise in speculative developments, even in conservative St. Louis. "I don't think it is too much of a risk to build a 200,000 sq. ft. spec building today. It would be leased before it was finished."

Lydon says the build-to-suit market is the reason significant amounts of speculative development has occurred. "Build-to-suit has been the only option for those seeking new space," he says. "And those that did not want to experience the higher cost of a build-to-suit project created the demand for spec space."

Vaughn says speculative developments are favored by some tenants, because they usually provide more flexible lease lengths. "Developers of speculative projects usually offer leases from seven to 15 years, requiring less commitment on the part of the tenant," he says.

Developers of build-to-suit projects usually demand longer-term leases since they built the structure for a specific tenant. But speculative space is still scarce in many markets.

"Users don't have many options," says Dieter. "If you are working with a 150,000 sq. ft. distribution user, ideally they would have five or six locations from which to choose, but often they have no other option. It is a landlord's market."

In Chicago, Dieter says 14 speculative, high-cubed distribution facilities are planned and, although some may not be built, the impact on the market will be significant. "If only half of them are built, it will help level off the supply and demand in the market," he says.

Lydon estimates between 4 million and 6 million sq. ft. of speculative industrial space is planned for the Chicago market, while 2 million sq. ft. more is scheduled for Dallas, with significant amounts also planned in Atlanta and Denver.

Vaughn agrees and adds Kansas City and Los Angeles to the list. "We are seeing a marked rise in speculative development," he says. "All of these cities are regional hubs with good railroad, highway and air transportation, so these markets are going to lead the way in speculative development."

Brennan says the core Midwestern markets should all remain healthy due to several reasons: their central locations, which are attractive from a distribution standpoint; they do not rely on the military and aerospace industries, which have left mass vacancies in other regions; and because theirs is a higher percentage of corporately owned buildings, which have more efficient management.

He cites Detroit and Minneapolis, which features a 98.5% occupancy rate, as two of the nation's most active markets.

As a region, Vaughn cites the South as being particularly strong, due to its absorption of 24 million sq. ft. during the past two years. In addition to Atlanta, he says both Memphis and Orlando strong markets.

Recent trade agreements are having an impact on particular industries and on the border markets.

NAFFA and GATT are having major impacts on the textile industry, particularly in the Southeast. "These trade agreements have made it easier for American textile companies to have work done more inexpensively outside of the United States," says Lydon. "This eliminates jobs and the need for these domestic factories."

On the positive side, new business generated by these agreements have boosted industrial growth in cities such as Detroit and El Paso, Texas.

But in smaller markets that have yet to experience speculative construction, the development community is stirring. "There is a lot of positioning going on," says McClatchy.

This positioning usually involves lining up land sites. The resulting interest has had the expected impact on prices.

"Land prices have certainly gone up between 10% and 30%," Lydon says. "Particularly on in-fill locations. You can still get a `green field' site very cheaply, but we are basically back to where we were 10 years ago with regard to pricing."

Vaughn points out that real appreciation will begin only when speculative development fully re-enters the market.

The number and size of new industrial parks are increasing, another obvious example of the perceived health of the industrial market. "There are about eight business parks in Chicago that are either new or are seeing a great deal of new activity," says Dieter, adding that the age planned for new parks has grown.

"A few years ago, a developer looking opening an industrial park was thinking of about 40 acres, but today that has risen to about 200 acres," he says.

Vaughn says from 1989 to 1993, brokers could not give away land parcels. But today, "if you own the land, you can offer build-to-suit packages and have prime sites for speculative construction."


Developers are being cautious to avoid what befell some of their brethren in the early 1980s. Many large business parks with expensive infrastructure were prepared for the expected continued growth in the industry only to have the recession take the wind out of their sails and leave them with large land parcels that did not pay off.

"I don't think we are at the point where the developers or investors want to build-up a lot of inventory," says Beban. "Their memories are not so short that they cannot remember what overbuilding did before."

"The development cycle is kicking in, and they want to get something out of the ground, but hopefully they will be reasonable," says Vaughn.

But the "act now" mentality may still exist with some developers.

"The remote possibility of overbuilding does exist," says Dieter. "So the thinking often is the sooner you get your building up the better off you will be."

But should developers' memories prove to be shorter than expected, banks are hedging their bets with conservative lending policies.

"Construction lenders are being very prudent, and that will keep building under control," says Vaughn, stressing that only developers with good and extensive track records will be able to finance projects, at least in the short term.

The speculative projects that are financed have a different look from those of five years ago. Development may stop, but technology and the minds of business executives do not. Flexibility and efficiency have been added to the new industrial designs.

"We prefer to build 28- to 30-foot clear height buildings," says Closson, adding the increased size means more storage room for the tenant and more flexibility to the landlord.

These higher stacking heights have led to more precision requirements in floor flatness. "The flatness of the floor being a little off won't make much difference in stacking at 15-feet but, at 30-plus feet, it could present a real problem," says Vaughn.

Larger, "piggy-back" trucks are also a consideration, requiring deeper truck courts for added maneuverability. Computerized inventory and distribution tracking systems also require more sophisticated power and communication hook-ups.

Early Suppression First Response sprinkler systems are an added feature for safety reasons and because they save tenants on their insurance costs. Additional parking is also a feature most new facilities require.

Vaughn says energy codes and the Americans with Disabilities Act have affected recent industrial designs. However, he adds, new energy-conservation codes may shift construction back to more efficient brick structures.

As speculative development continues to overtake the marketplace, supply of quality industrial space will increase and bring about an equilibrium with demand. But industry executives think prudent lenders and developers will prevent the overbuilding that has plagued markets in the 1990s.

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