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Industrial Landscape

New Design and Tenant Parameters Promote Healthy Build-to-Suit Development.

By Hessam Nadji |

Like other commercial investment real estate segments, the industrial property sector is benefiting from positive economic conditions, corporate reinvestment, and continued business growth. U.S. companies have invested internally in plants, technology, and equipment, which has paid off in terms of bigger profit margins, greater employment, and additional growth and expansion.

The result? A resurgence in all types of build-to-suit industrial properties and even speculative development in some markets. Previously, a rise in spec development has led to a decline in build-to-suit, but that may not be the case in today’s turn-of-the-century scenario. Investors and developers remain tuned to customer needs, so a strong build-to-suit market may thrive side-by-side with the riskier spec investments that are driven, as always, by access to easy capital.

National Market Overview
The national industrial market has posted steady improvement since the downturn of the early 1990s. Although the industrial market did not fall as far as the office market, the first few years of the decade witnessed rising vacancies, softening rents, and stagnant values. Industrial vacancies have fallen from 12.5 percent in 1992 to the current rate of 9 percent—despite a steady rise in construction activity during the same period.

Industrial construction starts bottomed out at 55 million square feet in 1993 and reached an estimated 115 million square feet in 1997. While this trend reflects a large increase in construction activity, 1997 starts remain dwarfed by the last peak of 165 million square feet in 1985.

The industrial construction recovery largely is due to robust absorption generated by an improving economy. However, two other key factors have contributed to the improved numbers. The first is obsolescence—much of the older industrial inventory no longer is usable and artificially pushes up the vacancy rate. Additionally, the inventory of available space that traditionally has worked for most tenants no longer may be useful for today’s tenants.

The second factor is the dominance of build-to-suit projects during the recovery. The consistent increase in construction activity in the last five years was driven largely by build-to-suit projects. In the past 18 months, speculative developments have returned to notable levels.

Short-term Trends. New construction is expected to fall to more moderate levels in late 1998 and 1999. Absorption also is expected to fall as a result of a natural slowdown in the economy and reduced exports to Asia. In the near future, if new construction levels are aligned quickly with the reduced leasing activity, vacancies will remain stable in the 9 percent to 9.5 percent range. However, a delayed reduction in construction activity in light of tapering demand could lead to rising vacancies. Construction is highest in areas including Chicago; Atlanta; Baltimore; Riverside, California; Orange County, California; and Dallas.

Build-to-Suit Market
During the severe downturn of the early 1990s when speculative construction virtually came to a halt, build-to-suit development for office, research and development (R&D), and industrial users continued in various suburban markets. Despite high vacancies and softening rents in existing buildings, tenants’ specialized functional and geographic needs continued to propel build-to-suit development. In addition to these tenant needs, several financial factors support today’s strong build-to-suit market.

Changing tenant needs, geographic relocation or expansion issues, and the dynamics of finance differentiate this expansion cycle from the past. Unlike previous cycles, as speculative construction begins to take off again, indicators point to longevity for build-to-suit activity.

In the 1980s, the development environment had a much higher risk tolerance and was driven by factors other than supply and demand. Until the 1986 tax reforms, many projects were justified based on tax benefits and were built as a result of ample availability of capital. At the same time, more product could be built on a speculative basis, since the major shifts and changes in the manufacturing and distribution industries had not yet materialized. Tenant requirements were simply less sophisticated and specialized. Although capital flows into real estate have rebounded at record rates, loan-to-value ratios and other underwriting criteria remain substantially more conservative. Nevertheless, speculative construction will continue to gain ground as the market tightens and investors compete for their share of the upside in a strong market.

Functional Requirements
Since 1992, the U.S. economy has created 14.5 million jobs, posting 12.9 percent growth. Although the service sector has dominated job growth, manufacturing has added 400,000 jobs, while trade jobs have grown by 3.3 million. As a result, demand for manufacturing, warehouse, and R&D space has been strong.

Of equal importance to real estate demand is the changing nature of industrial space use. As the influence of traditional heavy manufacturing has waned, the U.S. position in high-tech manufacturing and global trade has increased dramatically. Technology—with an emphasis on productivity and cost control—dominates this paradigm shift.

Manufacturing now accounts for approximately 15 percent of the U.S. job base, compared with 30 percent in 1960. Automation and global competition have translated into fewer jobs and less square footage. At the same time, the emergence of just-in-time inventory control, advances in intermodal shipping methods, and the pressure to reduce delivery times have produced significant changes in real estate configurations affecting manufacturing, assembly, and warehouse properties.

New Property Characteristics. Modern manufacturing facilities require more design flexibility, environmental controls (such as clean rooms), and specialized power needs with redundancies and back-up systems. They also must accommodate computerized production methods. For warehouse users, shorter-term storage with high turnover in high-cube, flexible facilities is in demand. Properties must accommodate maneuverability and inventory control with effective docking, clear-height, reduced-column spacing, and, often, access to multiple modes of transportation. Virtually all build-to-suit projects require large floor plates and ample parking.

New Tenant Profile. Besides accommodating changing property characteristics, real estate owners and developers face a changing tenant profile. Large corporate users no longer dominate the demand for new space. In the past five years, total jobs in manufacturing firms with fewer than 100 employees have grown by 13 percent, while firms with more than 100 employees had a work force reduction of 0.5 percent, according to the Bureau of Labor Statistics. The same trend is true for import/export firms. Firms in trade with fewer than 100 employees expanded their jobs by 5.5 percent, while companies with more than 100 employees grew by 2 percent.

New design parameters and a changing tenant pool have rendered many existing manufacturing and warehouse properties obsolete or simply impractical for growing tenants. While reconfiguration and repositioning have proven successful for many owners and investors, the demand for new and, in many cases, near-custom space, is the primary force in the build-to-suit market.

Strategic Locations
In today’s competitive environment, both manufacturers and distributors must select their geographic deployment with incredible accuracy. Third-party suppliers, specialized manufacturers, and bulk distributors all must be close to clients and consumers. This pressure has had a visibly positive effect on industrial properties and build-to-suit trends in established transportation and manufacturing hubs around the nation.

The Cost Factor. Cost reduction also has played a major role in build-to-suit and relocation decisions. Driven by lower real estate and labor costs, many tenants have found the best relocation or expansion choices in secondary markets and low-cost major markets. Suburban and rural areas near major markets have benefited from this trend. A sampling of affected areas includes: Dallas; Phoenix; Portland (and a number of small Oregon markets); Colorado Springs, Colorado; Las Vegas; Salt Lake City; Charlotte, North Carolina; parts of South Florida; Nashville, Tennessee; and Albuquerque, New Mexico.

Local government and community development groups typically work hard to attract build-to-suit developers and tenants to their markets, offering reduced land costs and taxes, as well as attractive financing and other financial incentives. Often build-to-suits are the only viable option because secondary and tertiary markets usually have a limited supply of existing space. In turn, local communities benefit economically from new jobs and new workers.

Financing
While tenants still seek to protect their balance sheets and avoid tying up capital in real estate, the dramatic influx of capital into real estate and ample capital sources for build-to-suit projects are influencing the market. In the early 1990s, financing for build-to-suit projects was limited to credit tenants with long-term commitments. The current availability of capital and the rebounding real estate market have made it easier for developers to obtain financing for lower-rated tenants. In addition, more creative solutions, such as bond financing, also have grown in popularity.

Industry Outlook
Several forces will affect the industrial build-to-suit market in the next few years. On the positive side of the equation, long-term tenant demand for sophisticated, highly functional, and efficient build-to-suit projects will be strong. In the next 12 to 18 months, the Asian financial crisis will have a dampening effect on high-tech, manufacturing, and export firms. Tenants in these sectors will suffer from weak Asian demand for U.S. goods and services as a result of currency devaluation and some disappointment from Wall Street. A number of established industrial firms—likely build-to-suit candidates—may postpone expansion or relocation plans.

Concurrently, new firms may grow at a somewhat slower pace, further reducing demand for build-to-suit projects. Most experts are discounting the possibility of a severe or prolonged slowdown as a result of the Asian financial crisis. However, a key indicator will be Japan’s reaction to the turmoil, because its economy has a greater impact on the United States.

Success Factors. However, long-term demand for industrial build-to-suits is expected to stay strong as a function of the same factors that drive the market today. Build-to-suit developers will benefit from partnerships with multimarket tenants with specialized needs. Creating successful prototypes and configurations that can be duplicated across multiple markets has proven to be an effective approach.

Flexibility also will become increasingly important as a factor in developing industrial space. The ability to accommodate space modifications during the lease term and future expansion needs of existing tenants is primary to client retention. From an investment perspective, the ability to reconfigure existing projects for future tenants in different industries with varied needs will be critical. The more highly specialized buildings naturally will carry more risk.

Securing well-located land with proper zoning and infrastructure will become more difficult as markets tighten. Secondary markets and remote communities in the vicinity of established markets will continue to attract tenants and build-to-suit projects. Redevelopment of existing sites and conversion of properties into functional build-to-suit choices also will increase in the years ahead. Competition from speculative construction will reduce the need for build-to-suit projects to some extent; however, the industry is expected to stay active for at least the next few years.

Hessam Nadji

Hessam Nadji is senior vice president/national director of research services for Marcus & Millichap Real Estate Investment Brokerage Company. He is based in the company\'s San Francisco office. He can be reached at (415) 391-9220. Luxury Apartments Suit New Lifestyles Apartment development in the Phoenix metropolitan area continues its blistering pace, with construction levels at their highest in 10 years. In the past year, more than 8,500 units were added to inventory, while about 7,000 apartment units are anticipated to be completed in 1997. The majority of the new construction has been centered in A-type product targeted at the high-end, affluent lifestyle renter. These new multifamily projects usually are large in size, offer high-amenity units, and demand higher rents. In the short term, these luxury properties may become vulnerable to oversupply resulting in higher vacancies, lower rents, and concession policies. Concessions already have reappeared in several submarkets as owners and property managers respond to increasing vacancies. However, given current levels of absorption, most properties that are offering concessions only are doing so on a limited basis. A sample of the new luxury product coming on line is the Legend at Kierland, developed by Mark-Taylor Residential of Phoenix. Located in Scottsdale within the confines of a new master-planned residential community, the property opened in February 1996 and has just completed lease-up. Within the immediate area, the median household income is $61,801, and the median age is 37. One of the fastest-growing areas in the metropolitan area, Scottsdale has grown nearly 29 percent since 1990; population around the property has grown 25 percent between 1980 and 1996. Home prices range from $50,000 to $5 million, with $160,000 as the average listing price. The Legend at Kierland is surrounded by a 27-hole golf course and boasts mountain views. The fitness center has a variety of workout equipment, in addition to saunas and locker rooms. The development has an impressive schedule of other amenities available with its choice of 11 floor plans, which average 958 square feet: nine-foot ceilings, attached garages, microwaves, electronic access gates, fireplaces, walk-in closets, alarm systems, clubhouse, a lagoon-style pool, and tennis and volleyball courts. The typical resident is between 20 and 40 years old; 80 percent are couples; 100 percent are employed; and 80 percent are long-term residents. Average rent at Legend at Kierland is $941 compared to a submarket average of $547 and a metro average of $578. —by Matt Schneff, research manager, Marcus & Millichap, Phoenix. Seniors Development Anticipates Demographic Needs The demographics of the New Orleans market suggest that demand for seniors housing is strong and will continue to grow in the future. Currently, the most populous age segments in the New Orleans market are 40 to 49 (16.89 percent of the total population) and 75 years and older (9.05 percent of the total population). To meet what it expects to be a growing need, the Christwood Retirement Community in New Orleans opened in May 1996. The community has 118 apartments, an assisted-living section in a health center, and a skilled nursing facility with private rooms. The facility is privately owned by Christ Episcopal Church. Population projections for 2001 show that the facility is located in an area where residents 65 and older will comprise between 10 and 30 percent of the population. Between 1996 and 2001, the number of residents in the immediate area 65 and older will increase by 7 percent. According to Christwood\'s associate marketing director, although the minimum tenant age requirement is 62, the youngest tenant is 71 years old; the oldest is 94. The community has eight different apartment models, including two styles of one-bedrooms, five styles of two-bedrooms, and two styles of three-bedrooms. Entrance fees vary depending on the plan to which a resident subscribes. "Traditional plan O" residents receive a refund upon termination of the residence and care agreement only if the termination occurs within 90 months of the initial occupancy. Traditional plan O entrance fees range from $69,500 to $149,500. "Capital return plan 80" residents receive a minimum refund upon termination of the residence and care agreement of 80 percent of the entrance fee paid. Capital return plan 80 entrance fees range from $99,500 to $215,500. For both plans, a $10,000 additional entrance fee is charged for a second apartment occupant. In addition to entrance fees, residents also pay monthly service fees ranging from $1,050 to $2,555. If an apartment has a second occupant, the monthly fee is an additional $520. Amenities include multiple-entree meal service, daily continental breakfast, light housekeeping, personal laundry service, scheduled transportation, move-in assistance and coordination, health care on site, licensed nurse on duty 24 hours a day, a wellness program, planned social activities, 24-hour security, inside and outside maintenance, and trash removal. Although most of the residents are from the New Orleans area, some are from as far away as Pennsylvania, Florida, and Oregon, according to the facility\'s associate marketing director. —by Jennifer Trendler, national research coordinator, Senior Housing Group, Marcus & Millichap, San Francisco. Low-Income Housing Revitalizes Downtown For entry-level workers and residents on fixed incomes, finding affordable housing in the central city-no matter what city-is a challenge. Attracted by proximity to jobs, public transportation, services, and cultural amenities, middle- and upper-income workers increasingly are drawn to revitalized urban areas, and developers are responding with a building spree of upscale apartments and condominiums. That is squeezing low-income downtown residents out of the housing market. Yet, city planners and economic development officers desperately want to build an inventory of affordable downtown housing to ensure a healthy, economically balanced urban core. One program that encourages the creation of affordable housing in urban areas is the federal low-income housing tax credit (LIHTC). Most often used for new construction in suburbs and small towns, LIHTCs also can be used to rehabilitate downtown structures, providing a safe, attractive environment for people living near or below the poverty level, while at the same time enhancing the existing community. Portland, Oregon, boasts one such example. After more than 12 years standing vacant, the old Pine Street Building in the heart of downtown reopened this summer as the WestShore Apartments, with 113 units of affordable housing, and the Pine Street Garage, with 306 parking spaces. The development was designed with three goals in mind: to produce decent, humanely sized housing at affordable rates for downtown entry-level workers; to provide nearby older commercial buildings with badly needed parking; and to integrate the architectural style and scale of the new development with the surrounding historic neighborhood. The existing structure initially was designed by architect Pietro Belluschi in 1955 as an addition to the City Police Bureau. Due to budget constraints, only two of its eight floors actually were built. Developer Brian McCarl & Company adapted the existing two above-grade stories for parking and added three floors for new apartments, taking advantage of structural steel and a third-floor deck that lay unused for 40 years. The $7.2 million mixed-use project offers affordable housing to entry-level workers and low-income individuals with annual incomes of less than $16,200. Most units are studios averaging 350 square feet, with rents starting at $404 a month. Rents include electric appliances and heat, carpeting, smoke alarms, mini blinds, and cable TV access. The parking garage will be used by up to 38 WestShore residents and nearby office tenants. Other building amenities include storage, laundry, lounge/vending area, bicycle parking, secured/valet parking, and 24-hour on-site management and security. The building, which originally was a modest concrete structure, has received a new streetscape clad in brick, metal canopies, bay windows, and architectural features that help it blend in with the neighborhood. William Wilson Architects has maintained sensitivity to detail, color, and scale throughout the project, which is evident in such elements as an interior landscaped courtyard, terra-cotta colors, and exterior balconies. The city of Portland supported McCarl\'s proposal because it replaces affordable housing that was eliminated by recent downtown development and it offers a desirable blend of public and private financing. The Arcand Company, a full-service real estate investment firm specializing in federal low-income housing tax credits, led private investment in the WestShore Apartments property and arranged for a pool of investors to supply more than $1.16 million in equity financing in return for federal income tax credits. Armed with that private-sector commitment, McCarl then was able to attract the state of Oregon and city of Portland as primary and secondary lenders, respectively. The LIHTC remains the most effective means of financing the nation\'s affordable rental housing inventory. It is a proven model for creating attractive, safe, low-income housing with minimal government involvement, providing ongoing incentives for corporations and private investors to help finance affordable housing development through a federal tax credit. In the case of the WestShore Apartments, it also revitalizes an inner-city, abandoned building and enhances the urban core. —by Robert Arcand, founder of the Arcand Company based in Portland, Oregon, which sponsors and manages affordable housing investment portfolios. He has served as president of the Oregon State Council for Affordable and Rural Housing, and as a director of the Affordable Housing Tax Credit Coalition. He can be reached at (503) 598-9800.

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