Industrial

Industrial Shifts Gears

Following the Economy`s Lead, the Industrial Sector Should Rebound by Year`s End.

By Warren Lutz |

Although double-digit vacancy rates are common in many markets across the country, industrial properties continue to be one of the more stable commercial real estate market segments. Less status conscious than office, not as quickly affected by new trends as retail and multifamily, and not at the mercy of consumer demand as much as hospitality, industrial remains the workhorse of the industry. But as the economy makes its slow rebound, industrial may be last in line to feel the full recovery.

However, interest rates remain conducive to new industrial development and, although banks are lending more cautiously and insurance and security costs are rising, many industrial real estate professionals are optimistic about the future.

“I think this is going to be a higher-than-average year, and 2003 could be even better,” says Steve Pettit, CCIM, a senior associate at CB Richard Ellis in South Bend, Ind. With favorable interest rates and an improving economy, he predicts his region's vacant space -- most of which is in manufacturing -- may be absorbed by the end of the year.

Location is key for most segments of the industrial sector. “It all gets down to logistics,” says Aaron Paris, vice president and chief operating officer of DP Partners, a Reno, Nev.-based industrial developer. “In our business, that is the driver.”

While demand for the industrial sector still is down nationwide, emerging trends in various segments, including research and development/flex space, biotechnology, and warehousing and distribution, are drawing new attention.

Location Key for Flex Development The national vacancy rate for R&D/flex space grew from 7.18 percent in 2000 to 11.54 percent in 2001, according to Grubb & Ellis' Spring 2002 Industrial Market Trends . At the close of first-quarter 2002, vacancy rates further rose to 12.46 percent nationwide, according to Grubb & Ellis. The vacancy jump is compounded by the office sector's high vacancy rates, since flex properties often carry a significant amount of office space.

Higher leasing costs are another factor contributing to flex properties' rising vacancy rates. With additional built-in amenities, such as extensive wiring and power access to accommodate high-tech tenants, flex properties command significantly higher rents than other types of industrial properties, says Chad Jacobson, corporate research director of Daum Commercial Real Estate Services in Los Angeles. In today's economic climate, “many technology companies don't have the resources available to pay inflated rates,” he says.

In general, cities that fed heavily on the technology industry in recent years, such as San Francisco, Boston, and Austin, Texas, currently are experiencing the lowest demand for R&D/flex space. In fact, when high-tech companies began to suffer in the Boston region, large blocks of R&D space flooded the market. Tech companies such as Lucent Technologies, Nortel Networks, 3Com, and Cisco Systems halted expansion plans and sold properties, while per square foot rental prices for flex space were slashed roughly in half between 2000 and 2001, according to Grubb & Ellis's 2002 Real Estate Forecast . The story is the same in many of the nation's well-known high-tech hubs.

However, R&D/flex space has remained relatively steady in markets that weren't part of the dot-com boom. In Chicago and its suburbs, demand for flex properties has dropped only slightly, according to Jeanne Rogers, CCIM, SIOR, executive vice president of Arthur J. Rogers & Co. in Des Plaines, Ill. The area didn't draw Internet companies and, except for recent cutbacks by local electronics giant Motorola, the high-tech troubles have had little effect on the Chicago industrial market. A stabilizing factor has been a relatively strong health-care and pharmaceutical industry, she says. Abbott Laboratories, Baxter International, and other major pharmaceutical companies in the Chicago area have kept demand and occupancy rates fairly steady.

In the East, the story is the same. “Because we weren't known as the capital of the software world like the [San Francisco] Bay Area, we didn't have the big boom that they had,” says Peggy Gallagher, CCIM, owner of Peggy Gallagher Commercial Real Estate in Spring House, Pa., located outside of Philadelphia. “We just had a steady increase here. We did have new construction, and we had a lot of renovations in the past 10 years, but we didn't have the big super boom that [other markets] had.”

Flex development is growing in secondary and tertiary markets such as Montgomery, Ala., because of the lower construction and labor costs. “We're getting more of a call for flex space right now,” says Mickey Griffin, CCIM, director of corporate services for Montgomery's Aronov Realty Co., which currently is developing roughly 300,000 square feet of flex space locally.

Another factor contributing to lower vacancy rates and growth is that developers in smaller markets follow a less-risky build-to-suit strategy. Many large markets are experiencing high flex vacancies due to an overbuilt speculative building market.

R&D/flex demand also is resilient in northern Virginia, according to Kevin J. Goeller, CCIM, an associate broker at KLNB in McLean, Va. With national defense spending on the rise, government and military contractors in that region are seeing significant productivity, Goeller says. A number of contractors have set up shop, particularly in the industrial area south of Washington, D.C.'s Dulles International Airport.

Biotech Boom As the high-tech segment crashed, the R&D niche of biotechnology started to grow. Cambridge, Mass., home of the Massachusetts Institute of Technology and Harvard University and one of the Northeast's hottest R&D and biotechnology centers, provided some buffer to the Boston area's dot-com bust. While the total office vacancy rate in Cambridge soared above 23 percent in first-quarter 2002, the rate for biotechnology space --which usually employs a mix of lab and office space -- stood at only 4.1 percent, according to Meredith & Grew's Market Viewpoint . More than 500,000 sf of new space is under commitment, and a number of newly constructed office properties recently have been converted into biotech space due to the increasing demand in this segment.

Such is the case at University Park, a mixed-use office park where two buildings originally designed for office tenants have been redesigned for biotechnology companies. “There is no question that biotech is the one strong component of the Cambridge market,” says Mike Farley, vice president of asset management for Forest City Enterprises, the developer of the project. “You see a number of developers who are converting what were previously office developments or telecommunication developments into biotech developments.”

The biotech segment remains relatively strong in other areas that have been similarly hard hit by the dot-com fallout. For example, in the San Francisco Bay Area, where pharmaceutical giants Genentech, Chiron Corp., and Johnson & Johnson own large facilities, the demand for new “biopharm” development continues.

“Technology as a market sector here in California is just flat, completely dead,” says Douglas White, principal of Sunnyvale, Calif.-based WHL Architects/Planners. “Big projects based on the dot-bombs have stopped here and have retooled into biopharm development.”

White, whose firm does a significant amount of biotechnology design, says the trend is toward building robust shells that are structured and set up for biotechnology and pharmaceutical firms. These projects generally are multistory buildings with higher floor-to-ceiling heights that tenants can customize as they see fit.

However, not every market that serves as a pharmaceutical hub is bristling with activity. In New Jersey, home to Bradley Pharmaceuticals and DexGen Pharmaceuticals, drug companies do not make up the bulk of the new development, says Stan Danzig, executive director of East Rutherford-based Cushman & Wakefield of New Jersey.

“Most of the new deals are consumer product companies or retailers and some apparel,” Danzig says. “There is a concentration of pharmaceutical headquarters in New Jersey, but most of that is contained on companies' own campuses and own facilities.”

Secondary Markets See Growth In recent months, a trend toward developing expansive warehouse space outside of large markets has emerged. Large national retailers are driving the trend, says Garry S. Weiss, CCIM, SIOR, senior vice president and national director of First Industrial Realty Trust in Chicago.

Several factors feed into this new pattern, according to Griffin. Labor and land generally are less expensive in smaller markets. Less traffic congestion is another motivating factor, especially in warehouse development for companies that rely on truck distribution. Such towns also are more likely to offer aggressive economic incentives such as free utility connections, roads, financing, and tax breaks. For example, to lure Hyundai Motor Co. to build a $1 billion plant in Montgomery, the state and local governments gave the company more than $200 million in incentives.

However, regardless of their size, cities in optimal locations continue to thrive as consolidated distribution centers, Paris says. The best markets are accessible to multiple modes of transportation: air, sea, rail, and major highways, or all four. Such towns do not have to be heavily populated, only accessible to major population areas where most goods are delivered. Cities such as Memphis, Tenn., which has “maximized the air part” by being the headquarters of FedEx, and Harrisburg, Pa., with its network of highways that connects to points throughout the Eastern seaboard, are experiencing increased distribution and warehouse activity.

A spillover effect also is benefiting metropolitan suburban markets. For example, California's Inland Empire --comprising Riverside and San Bernardino counties -- saw 21 million sf of new industrial space last year, much of it in the warehouse and distribution segment. “The big push has been to move all the huge warehouse and distribution centers out to the Inland Empire,” Jacobson says. Rents are a key factor: a 500,000-sf distribution facility in Los Angeles County ranges from 45 cents psf to 50 cents psf, whereas rates below 30 cents psf are available in surrounding counties, he says.

The greater Seattle market is experiencing a similar effect. Tacoma, Wash., was the only submarket with a positive industrial absorption rate during first-quarter 2002, according to CB Richard Ellis' Puget Sound office. The city also accounted for 780,000 sf of industrial construction during the first quarter, more than half of industrial construction in the Puget Sound market, and offered the lowest net lease rates at 31 cents psf.

Across the country in New Jersey, most new projects under construction or recently completed during first-quarter 2002 included warehouse and distribution properties, with some high-tech space, according to Cushman & Wakefield's Northern & Central New Jersey Industrial Overview . Outside of a glut of new warehouse and distribution space in one submarket, however, the industrial market remains relatively strong. The total vacancy rate for the region stood at 6.3 percent for the first quarter.

Less robust are markets heavily dependent on the manufacturing industry. “Nationally, manufacturing has taken a hit, and we are proportionally heavy in manufacturing,” says Andy Wells, chief executive officer of Prism Development in Hickory, N.C., an area that, despite strong telecommunications growth in recent years, traditionally has been rooted in the furniture and textile industries.

But manufacturing may be headed back on track, says DP Partners' Paris. He cites low interest rates as well as consumers continuing to buy major items like homes and cars despite the recent recession. “Inventories have been drawn down,” Paris says. “Now manufacturing is going to have to start replenishing.”

In Indianapolis, the sales and leasing market was “almost non-existent” during the latter part of 2001, says Jeff Castell, CCIM, SIOR, principal and manager of industrial sales and leasing for Colliers Turley Martin Tucker. “People have just postponed making significant occupancy decisions. We had several major projects on the goal line last year and corporate mandates came down,” he says. “Literally, people were told ‘you're not doing any real estate transactions.'”

But the market seems to be making a turn, according to figures from Castell's company. The Indianapolis market saw a positive absorption rate of more than 900,000 sf during the first quarter while the industrial vacancy rate stood at around 8.3 percent -- a somewhat small bump from 2001's rate of 7.9 percent. That's high for Indianapolis, Castell says, but it may be skewed by the increasing size of new buildings. Warehouse properties in the area have grown from an average size of 125,000 sf with 24-foot clearance to current projects that are between 400,000 sf and 800,000 sf with 30-foot to 36-foot clearance.

Food Safety Issues Companies in the food industry have growing concerns about product security, Paris says. Following the Sept. 11 terrorist attacks, terrorism experts and several U.S. politicians have cautioned that terrorists could tamper with the U.S. food supply to unleash a biological attack on Americans. Though the chances of this happening are remote, some food manufacturers and distributors reportedly are not taking chances, according to Paris. “They can't afford somebody contaminating their product in any way, shape, or form because the liability to them is just enormous,” he says.

Some properties are being outfitted with added barbed-wire fencing, security cameras, and 24-hour guards. “Every one of our clients in the food industry has redoubled their efforts. I think it will continue to change as their leases start to roll over and they begin to look for new spaces and look for much more security,” he says.

Future Strength While optimistic, few commercial real estate professionals are willing to predict very far into the future. However, the general consensus is that an industrial recovery is on the way and likely to follow a general economic upswing.

Marked improvements in industrial development will depend on how quickly market supply is absorbed. The industrial market should improve by midyear, when the industrial vacancy rate is expected to peak at 9 percent, according to Bob Bach, Grubb & Ellis' national director of market analysis. “The economy seems to be picking up, and in particular, the manufacturing sector of the economy seems to be doing better,” Bach says. “There's more goods and services flowing around the nation's supply pipeline, and that means more demand for manufacturing space and distribution space.”

Yet nationwide, the R&D/flex property segment may have to wait until next year to see better performance, Bach says. As a result of the upheaval of Internet-related businesses combined with sinking prices for class A office space, “the technology sector is still in the tank and won't show any real signs of recovery until 2003,” he says.

In many markets, industrial vacancies must improve before development can begin. Dan Poulin, CCIM, senior regional director for Sealy & Co. in St. Rose, La., says his company began increasing its marketing budget earlier this year as leasing activity began to pick up in Baton Rouge and New Orleans. “You got to have a positive outlook, and we're doing everything we can to make things come around quicker,” he says.

“I think things are looking up,” Paris says. The industry has learned much since the go-go 80s, he says, when lenders and builders “were off to the races.” Today's real estate developers have more governance and are more careful about overbuilding. As his market begins to turn around, “We and our competitors are going to have to be regimented and more careful so we don't all put product on the market all at the same time,” he says.

“As far as our outlook, I'd say guarded optimism,” Castell says. “As long as economic conditions improve, I think there may be some pent-up demand and it may be a strong second half.

“It remains to be seen.”