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.