Moving on down the line
An import surge is driving demand for industrial warehouse and distribution space. No commercial property sector is hotter.
Yes, they’re flipping Florida condos and paying outlandish prices for downtown Manhattan lofts. But look beyond the headlines -- industrial property is also on a roll.
The sector includes factories and R&D space, but the dominant category is that of warehouse and distribution centers, which encompass more than half of the sector’s 10.3 billion square feet. U.S. manufacturing employment may be long past its prime and the demand for new factory space anemic, but imports are surging. Those goods need to be sorted and tracked and shipped from coast to coast.
“The dramatic increase in imports translates into a dramatic increase in demand for distribution and warehouse space, which more than offsets the decrease in demand for manufacturing space,” says Barney Upton, executive vice president and head of global industrial services for Cushman & Wakefield, a New Yorkbased commercial property brokerage and services firm. Demand is especially robust for the new generation of big-box distribution centers, which feature taller clearing heights (allowing more goods to be stacked), more loading docks and more-sophisticated technology systems.
In June, for example, Chicago-based First Industrial Realty Trust announced that it would build a 450,000-square-foot big-box distribution facility for retailer Pier 1 Imports in DuPont, Washington. Pier 1, which imports home furnishings and gift items, will use the facility to service its stores in the Pacific Northwest, Alaska and western Canada.
Although sales of all types of commercial property are up significantly this year, nothing is as hot as the industrial sector. Slightly more than $14 billion of industrial space changed hands during the first half of 2005 -- an 88 percent increase over the same period last year, according to New Yorkbased real estate data provider Real Capital Analytics. That compares with a 64 percent increase in sales volume for apartment buildings, to $33.2 billion; a 48 percent increase for office space, to nearly $43 billion; and a 10 percent increase for retail properties, to almost $21.8 billion.
In a high-profile deal that closed in July, Columbus, Ohiobased CalEast Industrial Investors, a joint venture of the California Public Employees’ Retirement System and LaSalle Investment Management, sold 22 million square feet of industrial space, roughly half of a portfolio it began amassing in January 1998. Real estate investment adviser Rreef, part of Deutsche Bank Group’s DB Real Estate, paid $1.3 billion for the package of properties. Rreef declines to comment, but Russell Blackwell, CEO of CalEast, says, “We were very satisfied with the price we got.”
The fundamentals of the industrial property market are much improved after a few years of relatively high vacancies, stagnant rents and little net absorption of space (the net change in physically occupied space). The downturn in the industrial sector began in the first half of 2001, amid the dot-com bust and the start of the recession. Demand for industrial space, not surprisingly, has a high correlation with industrial production -- typically, changes in the production index precede changes in net absorption of industrial space by six months. According to Northbrook, Illinoisbased real estate services firm Grubb & Ellis, the industrial property sector posted negative net absorption in 2001 and 2002; in 2003 the numbers turned very slightly positive.
“The industrial market up until recently has been really dour, and in general there wasn’t any industrial demand until about four quarters ago,” says Laura Stone Mortimer, managing economist at Torto Wheaton Research in Boston.
According to Grubb & Ellis, the market recorded nearly 95 million square feet of net absorption in the first half of 2005, compared with a less impressive 47.1 million square feet in the same period last year and just 24 million square feet in the first half of 2003. At the end of the second quarter, the national vacancy rate for industrial properties stood at 8.6 percent, 110 basis points lower than in the second quarter of 2004 and the lowest level in three years.
Rents have only recently begun to show signs of improvement, but in many markets they are nudging up: In the second quarter average asking rents for warehouse distribution space rose 15 cents per square foot over the prior year, to $4.41 on a triple net basis, meaning the tenant pays for such operating costs as real estate taxes, insurance and building maintenance.
As is the case with other property sectors (mostly retail and, to a lesser extent, office), corporations are increasingly opting to lease rather than own many of their warehouse and distribution buildings, preferring to use their capital for their core businesses. A company might lease an existing building or transact a sale-leaseback of a property it owns. The latter allows a corporation to free up capital otherwise invested in the real estate and, typically, lock in lease rates for anywhere from ten to 25 years.
Industrial capitalization rates (a property’s current income divided by purchase price, a critical measure of investment value) also look attractive relative to those of other property types, even if prices are on the rise. Investors paid an average $66 per square foot during the second quarter, up from $53 a year earlier. Industrial cap rates averaged 7.8 percent during the second quarter of 2005. That’s down from 8.3 percent a year earlier but still stronger than comparable values for office buildings, which averaged 7.6 percent; retail assets, which averaged 7.4 percent; and apartment properties, which sold at an average 6.3 percent cap rate.
Institutional investors particularly appreciate the stability of industrial property assets. Says Robert Bach, national director of market analysis for Grubb & Ellis, “Industrial property is the most stable and the least glamorous, but in the past few years, that’s what investors of all stripes are looking for.”
It typically takes six months to build a warehouse; it can take more than a year to construct an office building. Unlike office buildings, industrial properties do not usually require capital investments for tenant improvements, such as upgraded wiring, as office buildings often do. Industrial rents are usually offered on a triple net basis; office leases less frequently are. As a result, the industrial property sector tends to be more stable than other commercial property sectors.
Stability of cash flow is especially attractive to pension funds that are using liability-driven investing (Institutional Investor, July 2005), aiming to invest their assets to best meet their projected obligations. In mid-September, First Industrial announced a partnership with the California State Teachers’ Retirement System to buy a $1.01 billion portfolio of 216 core, institutional-quality industrial properties. “Since they contain a high level of current, in-place income, that’s a very suitable investment for pension funds, which are focusing more on liabilities,” says First Industrial president and CEO Michael Brennan.
“Industrial property is perceived as less volatile,” says Cushman & Wakefield’s Upton. “Having industrial in your portfolio along with the other property types is like having bonds in your portfolio along with stocks.”
Pension funds, real estate investment trusts and overseas investors have recently been the most active buyers of industrial properties. An unusual number of big deals is helping to drive overall sales volume as well as pricing; many investors are willing to pay a 10 to 15 percent premium for a large package of industrial properties.
Even before its deal with Rreef was completed, CalEast was busy making a new acquisition of its own; the company paid about $830 million for air cargo facilities at 25 airports around the U.S. and in Canada from a joint venture of Aeroterm, of Annapolis, Maryland, and Greenfield Partners, of South Norwalk, Connecticut.
Among the other deals made during the first half of 2005: Dividend Capital Trust, a Denver REIT, purchased for $607.5 million Boston-based Cabot Industrial Value Fund, which owns an 87 percent interest in a fund of 105 industrial buildings (located in 12 markets) valued at $695 million; and New Yorkbased real estate investment manager ING Clarion paid $474 million to acquire 30 properties in Dallas, northern California, Seattle and Portland, Oregon, from CalWest Industrial Properties, a joint venture of CalPERS and Rreef.
Not surprisingly, the most valuable warehouse distribution space is strategically located near transportation hubs. Industry leader ProLogis, for example, is building an 849,000-square-foot facility for Mohawk Industries, a floor coverings manufacturer and distributor, in an industrial park in Fontana, California, located at the intersection of I-10 and I-15, one of the most heavily trafficked interchanges in the state. In McDonough, Georgia, just south of Atlanta, ProLogis leased more than 1 million square feet of distribution space to Home Depot in a development that offers proximity to East Coast transportation route I-75 as well as to rail service. And in the Inland Empire submarket of southern California, the REIT leased more than 882,000 square feet to Solo Cup Co. in ProLogis Park I-210, located near a BNSF Railway Co. facility in San Bernardino and easily accessible to the seaports of Los Angeles and Long Beach, the country’s busiest.
“A lot of people say, ‘Manufacturing is moving to China, so how is it that your industrial properties are even more valuable today?’” notes Walter Rakowich, president of ProLogis. “While the facilities we invest in are hardly ever located next to manufacturing plants, they are located at key transport nodes -- ports, airports, major highway intersections -- close to major population bases and near the consumer.”
And despite the secular decline of U.S. manufacturing and the swollen trade deficit, exports and imports are on the rise. In the first half of this year, exports totaled $443 billion, up from $399 billion in the first half of 2004. During the same period imports reached $809 billion, up from $707 billion in the 2004 period. Last year imports added up to $1.5 trillion and exports to $819 billion.
In addition, notes economist Catherine Mann, a senior fellow at the Institute for International Economics in Washington, an increasing amount of cross-border trade involves “round trips of so-called intermediate products.” She explains: “Think of it as a computer chip goes overseas, gets put on a motherboard, comes back here and gets combined with another product in the U.S. Then it gets shipped out again as an export. All of this round-tripping augments the role for warehousing and distribution.”
Although strong net absorption rates suggest that demand for industrial space is staying ahead of supply, since the beginning of 2004 more and more new industrial space has been coming onstream. In the second quarter of 2005, 87 million square feet were under construction. That compares with a high of almost 122 million square feet in the fourth quarter of 2000 and a low of 52 million square feet in the last quarter of 2002. The vast majority of space under construction is speculative -- that’s the norm for the sector -- and some observers warn that it may begin to stymie rental growth.
“Demand for industrial space is good -- not off the charts, but good,” says James Hendricks, the Dallas-based head of ING Clarion’s industrial property group. “Development has ramped up, probably a lot of which is being pushed by what people will pay for completed properties once they’re up and leased. I don’t think it’s at an alarming level, but it’s certainly at a competitive level.”