Technology Industrial

Warehouses Think Big

Today's high-tech facilities encompass storage and distribution under one roof.

If you asked a commercial real estate industry outsider to describe a warehouse, most likely he would answer "cramped, dark, and dusty."

In today's industrial market, that reply is far from the truth. New warehouses are mammoth concrete structures through which goods move with lightning-fast speed thanks to the latest technological innovations. Due primarily to customers' desire for quick product delivery, warehouse users are migrating to these functional properties that expedite package dissemination. In many regions, users are consolidating both warehouse and distribution functions into industrial behemoths. Company consolidation, technological improvements, and the increasing prominence of third-party logistics companies have precipitated this evolution.

Bigger Is Better

A decade ago, a 200,000-square-foot warehouse was a large property, says Gerry A. Shear, CCIM, president of Genco Distribution System's real estate group in Park City, Utah. Yet today's buildings approach 800,000 sf or more.

Why the trend toward bigger space? Manufacturers and distribution companies are consolidating into fewer properties to save costs. "There are more economies of scale with all operations under one roof," says David Miles Williams, CCIM, senior vice president of Grubb & Ellis/Harrison & Bates in Richmond, Va. By centralizing logistics functions, companies can realize greater cost efficiencies, serving more customers from one distribution center.

Technology and equipment advances make consolidation easier, Williams says. "You don't need as many people; technology allows [companies] to leverage their staffs." And driving these innovations is customers' desire for next-day delivery. "You don't make any money with products sitting in warehouses," explains Michael A. McMahon, CCIM, SIOR, owner of McMahon Properties in San Antonio. Just-in-time distribution mandates the ability to get goods in and out of storage quickly.

For example, new logistics software systems allow companies to better use a building's cubic capacity; however, such systems are expensive. "Small warehouses are just not economically feasible," says Sam Foster, CCIM, of Jones Lang LaSalle in Los Angeles. Yet since companies are consolidating into fewer buildings, they can afford to pay for such amenities. "It's a matter of function versus cost of space." For example, Toys 'R' Us recently built an approximately $30 million distribution center containing a Lockheed Martin-designed racking-and-picking system that allows workers to track individual items at any time, he says.

One other factor influencing building expansion is the move toward third-party logistics companies, or 3PLs, which handle warehouse, fulfillment, and distribution functions for manufacturers. "Companies are pushing their [distribution] requirements to logistics companies, which aggregate operations in specific markets," Williams says. "They co-locate several clients in one building."

What Users Want

Due to company consolidation and the preponderance of 3PLs, today's new class A warehouses are more functional than their predecessors. "Warehouse users are savvier than 10 years ago," Shear says, forcing developers to offer more flexible space to attract attention. 3PLs are very sophisticated tenants that build relationships with real estate investment trusts to procure the best deals for the best space, says David D. Nesbit, CCIM, president of Nesbit Development in Camp Hill, Pa.

Functionality is an important factor in space decisions. For instance, to accommodate heavy trailer traffic, tenants prefer cross-dock, or flow-through, setups in which docks are placed on both sides of the building, many experts say. Since mechanical upgrades allow warehouse users to stack products higher, tenants also look for ceiling heights up to 36 feet in some markets.

Due to the soft industrial market and consumers' desire for quick delivery, tenants demand flexibility in their leases as well. "Companies want to be able to move in and out of markets quickly, as well as the ability to expand to meet inventory," Williams says. Thus, short lease terms are in vogue. "Lots of tenants want three-to-five year leases or longer leases with the right to cancel," says Norman Khoury, CCIM, SIOR, a principal and vice president at Colliers Turley Martin Tucker in Cincinnati. Brett C. Preston, CCIM, a partner at RJL Real Estate Consultants in El Paso, Texas, recently closed a lease deal with three out clauses for a 200,000-sf building. Shear has encountered tenants wanting three- to six-month temporary space leases, especially for seasonal goods. Due to economic uncertainty and tightened budgets, "companies are pressured to reduce stored goods," he says.

Since many older warehouses do not offer the space and functionality that users desire, class B and C markets are faltering in many cities. For example, lease rates in San Antonio's class B and C properties are dropping because there is too much available product, while class A properties are commanding lease rates of $3.24 per square foot to $4.45 psf triple net, McMahon says.

Getting Close to Customers

Consolidation and quick product delivery also are changing the warehouse site-selection process. Since warehouses are an integral link in the chain between manufacturing and consumption, transportation, especially interstate access, seaports, and available intermodal systems, is a critical factor, Nesbit says.

Inbound and outbound costs can be about 60 percent of a company's annual expenses, so site-selection specialists must analyze where products are coming from and going to before determining where to locate warehouses, Shear says. The distribution operation's purpose also determines what transportation type is needed. For instance, since numerous companies have moved their manufacturing operations to Pacific Rim countries, West Coast port cities such as Long Beach, Calif., and Los Angeles are popular with distribution companies, he says.

Being near a large concentration of the population is another critical aspect. Distribution companies "need cities from which trucks can deliver goods [to other markets] within 24 hours," Foster says.

For example, 60 percent to 70 percent of the nation's total population is within an overnight truck drive of central Pennsylvania, making it an attractive distribution center location, Nesbit says. In addition, due to their accessibility, northern New Jersey, Atlanta, Chicago, California's Inland Empire, and Dallas-Fort Worth have snapped up two-thirds of the national distribution market in the past six years, according to Foster, citing Torto Wheaton Research statistics.

Surprisingly, the primary markets in these areas are not necessarily distribution companies' first pick. "A location can be prime without being near a 24/7 city," Nesbit says. In fact, that aspect sometimes works against a location because of increased traffic and higher land costs, he says.

Air transportation is almost as important as ground. For example, Cincinnati is gaining attention because the Cincinnati/Northern Kentucky International Airport is Delta Air Lines' most recent hub, and plenty of developable land exists near the airport, Khoury says. Hubs for package delivery companies such as UPS, DHL, FedEx, and Airborne Express also offer attractive locations, Nesbit says.

Warehouse developers also are encouraged by economic factors such as tax abatements, affordable and abundant labor, and inexpensive land. For example, Ohio offers both real estate and real property abatements to companies building warehouses there, Khoury says. Although Reno, Nev.'s $4.50 psf to $6 psf land sales prices are the highest in the region, warehouse developers are attracted to the city's 10,000 acres of available industrial-zoned land near the international airport, its diversified economy, and the state's right-to-work status, says David L. Schuster, CCIM, SIOR, senior adviser of Grubb & Ellis/Nevada Commercial Group's industrial services group.

Dare to Be Boring

Although REITs dominate the warehouse investment scene, smaller investors, especially people pulling money out of the stock market, recognize this property's potential. Even though they aren't glamorous, warehouses offer flexible space that owners can transform into different uses such as call centers or self-storage, McMahon says. Warehouses also offer a low cost of debt and steady appreciation, says W. Erik Foster, CCIM, a senior investment specialist with Marcus & Millichap in Chicago. "Dare to be boring - buy industrial," McMahon says.

In the Midwest, "I am seeing interest from all types of investors," Erik Foster says. "There is tremendous competition [in Utah] for buildings with long-term leases with credit tenants," Shear agrees.

Although warehouse users and developers may be willing to locate in secondary markets that offer cheap land, economic incentives, and transportation benefits, many of today's warehouse investors, especially institutional ones, are hesitant to stray from primary cities. Institutional warehouse investors want to have their money in the best place; then they spread out to secondary markets for cost and diversification reasons. "If institutional investors are not in a market, it probably is a tertiary market," Nesbit says.

"Institutional money is consolidating into major markets,' Williams says, because the depth of such markets makes investing safer. Also, investors can expect to receive greater returns from properties in primary markets due to risk-adjusted capitalization rates. "Assets are more valuable in bigger markets," Erik Foster says.

For example, last year First Industrial Realty Trust sold its high-performing warehouses in Milwaukee and Indianapolis because analysts said they would treat the REIT more favorably if its portfolio contained only properties in primary cities with less economic risk, Sam Foster says.

However, "the factors that make a market secondary or tertiary for office investment are different from those for warehouse investment," Nesbit says. Geographic location, building construction quality, and high-credit tenants are more important factors to warehouse investors.

For instance, most office investors would consider Reno to be a secondary or even tertiary investment market, but it's an ideal distribution hub, Schuster says. Located on Interstate 80, the city easily serves truck traffic going to the western states. A main Union Pacific railroad line runs through Reno, and the city is UPS' western regional hub.

Still, tertiary markets must offer amazing benefits to attract national attention. Institutional investors "won't even look at an El Paso warehouse without at least a 10 percent cap rate," Preston says. Luckily for that city, ground-lease properties currently offer an 11 percent cap rate. Yet Preston thinks some investors like the stability tertiary markets offer: "You can get pretty good returns compared to primary and secondary cities," he says. For example, East Group Properties purchased an El Paso warehouse several years ago and have expanded their presence in the city ever since.

Warehouses of the Future

Even when the economy strengthens, industrial experts don't expect the consolidation trend to cease. "Companies can save on operating costs by combining several warehouses into one and still serve the same markets with technology and transportation refinements," Nesbit says.

However, "At a certain point, size breeds inefficiency," Shear says. Until technologies and material-handling equipment become even more refined, warehouses in the 2 million-sf range are just a developer's pipe dream.

Gretchen Pienta

William T. Adams, CCIM, CRB, is owner of Adams Realtors in Atlanta. Contact him at 404.688.1222 or wtadams@ccim.net.Gretchen Pienta is associate editor of Commercial Investment Real Estate.

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