A slow recovery in the US industrial sector has finally started to pick up pace. Stephanie Schwartz-Driver reports
The slow recovery in the industrial sector that emerged in 2010 has finally picked up pace. As vacancy rates decline, rental growth is on the horizon and investor demand is warming – but how far is there to go before the market overheats?
There are three major drivers of logistics: global trade, consumption, and supply chain reconfiguration. In the US, indications are that all three are moving in the right direction to boost growth and development in the sector.
Nationally, vacancy rates stood at around 12% at the end of the first quarter of 2013, with some key markets faring better than others, according to CBRE. But during the same period the sector saw its sharpest declines since the recovery began in 2010.
It is an important turning point for the sector. “The recovery to date has been a cap-rate recovery, and the recovery going forward is going to be more fundamental,” says Guy Jaquier, CEO of Prologis Private Capital.
David Confer, director and head of the industrial sector at Clarion Partners, says: “From a valuation perspective, supply and demand fundamentals have been exhibiting strength.
The next signal will be rental rate growth, which we are now beginning to see in certain markets. We expect this to gain momentum in 2014, 2015, and 2016,” he says, “as long as supply remains in check.”
Investors are taking notice of the strong fundamentals. “Industrial is very popular among the investment community in 2013,” says Paul Boneham, executive vice-president at Bentall Kennedy. “There is a perception that demand from users is turning a corner. Between 2008 and 2012, owners and investors were in more of a defensive position.”
The industrial sector is benefiting from several macro trends. Global trade has risen by more than four times GDP in recent quarters, and consumer consumption is on the rise. At the same time, firms are renewing their focus on distribution and the growth of e-commerce is creating a need for new and different industrial facilities. And housing recovery is on the horizon, which will increase consumer consumption.
Another factor that is driving value in the sector is a renewed focus on distribution by retail tenants, according to Jack Cuneo, president and CEO of Chambers Street Properties. “A lot of companies are re-examining their distribution policies because it is seen as an area to achieve cost savings and efficiencies,” he says. “There is a focus on getting goods to market quickly, and we are seeing companies consolidating into larger, better located, more efficient facilities.”
Overall, larger facilities outperformed smaller assets thus far in the cycle. Not only have they met the demand of tenants better, but their tenants also tended to be better established companies that were able to withstand the economic downturn. During 2012, rents for larger facilities rose much faster than for smaller properties. Recovery in the housing market will help raise demand for smaller units in particular.
Boneham agrees with that assessment. “Over time, we have seen an evolution from more, small distribution centres to fewer larger centres. This keeps costs low but services high.” But he adds: “We can assess today what major users want, but that does not mean it will be true in three or five years.”
In general, however, industrial is a stable and low-maintenance real estate sector.
“Tenants rarely move,” notes Confer, and properties have a longer life. Some of the properties in Clarion’s portfolio are not necessarily of recent vintage. “They are built of concrete and can stand for a long time. If they’re functional, older properties can have a long, useful life,” he says.
Development is also reasonably trouble free. The permitting process is simple, and the facilities are easy to build. “The development period is uniquely short,” says Boneham.
“From the moment of seeing an opportunity to have a finished product is around 12 months.”
New construction is at a 10-year low, according to Cuneo, and making good acquisitions is getting tougher. “It was easier to make acquisitions in the downturn. We had cash then and made some great acquisitions,” he says. “Today we still have cash but the market is much more competitive.”
Competition is coming from several different quarters. The rising demand for industrial development is not all domestic, Prologis has seen growing interest from European capital, according to Jaquier, as well as Canadian and more recently, Asian investors.
“Numerous investors are looking to place money,” agrees Wes Ahrens of Bentall Kennedy, who notes that it is not easy to enter the market and build up relationships and reputation. In his view, sellers prefer to work with buyers they know. “Sellers are looking for the assurance of the close – as a seller, if you elect to move forward with someone and they fail to perform, there is usually a cost to that.”
Although acquisitions are more challenging, many markets are not ready for speculative development, says Jaquier. “Rational people will not develop until rents ensure a return on capital. Rents need to be 25% higher to justify new construction,” he says. He estimates that 25% rent growth, over four years, will return 2001 rent levels. “People forget that rents came down that much.” Prologis is seeing good opportunities in build-to-suit development, on land already held.
Confer expects that speculative development will start to take off in 12-18 months, although his firm is actively building to suit in southern California, Dallas, and Atlanta.
“There has been an interesting evolution of opportunities in the sector,” Confer notes. “A lot of folks had been acquiring core properties at a discount. Today investors seeking strong returns need to cast a pretty wide net to identify markets with strong potential.” He points out that several secondary markets look strong, including Indianapolis, Indiana, and Louisville, Kentucky.
Prologis is taking a different tack, looking at major market infill locations. “Major markets tend to outperform,” says Jaquier, “and infill sub-markets tend to do better because there is not as much supply.” His colleague, Chris Caton, shares the company’s view that the strongest markets now are Greater Los Angeles, Houston and Dallas, south-east Florida, especially Miami, and Seattle.
Industrial values are in a large part determined by local infrastructure, and changing conditions can affect value. For example, Chambers Street is focused on net-lease properties of around 250,000sqft, with single, long-term tenants. “We look more at the credit of the tenant,” says Cuneo.
One of the key areas of focus is the East Coast, particularly ports that will benefit from the widening of the Panama Canal, due to be completed in 2015. “Changes in the network of ports, rail, and highways drive the value of locations,” says Cuneo. Intermodal facilities are particularly attractive because they represent huge cost savings for tenants.
“The fact that the Panama Canal is being upgraded will have an impact on East Coast ports,” agrees Boneham. “A disproportionate quantity of manufactured goods come into the US from the Far East. We have heard that as costs improve for East Coast ports, railroads will lose business for moving those goods cross country.”
Industrial space in East Coast ports that can receive ships after the Panama Canal has been widened will rise in value. However, to make that possible, harbours might have to be reconfigured, including bridges being raised and harbours being dredged to deepen them. Rail connections will also have to be examined, with some bridges being raised to allow the passage of containers.
This sector is also evolving because of the growth of e-commerce and the development of its fulfilment model.
“Ten years ago, the model was to locate on the cheapest land, for example in the desert in Nevada, and offer two to three day delivery to customers,” says Jaquier. “But to compete with same-day delivery, distribution centres need to be within range of cities. The retailer is paying more but can deliver very quickly. This change is driving a lot of space demand.”
Confer agrees that e-commerce is changing the landscape. “Historically a lot of e-commerce was run out of existing warehouses, but e-commerce and traditional fulfilment are two completely different operations, and today e-commerce is moving into specialised facilities.” They tend to need a higher clear height, but also more parking, and to be located in proximity to workforce, because the distribution process is more labour-intensive. According to Prologis, e-commerce requirements accounted for more than one-third of all US build-to-suit in 2012.
All these changes mean that there is still significant room for growth in the industrial sector before there is any risk of overheating. One sign of confidence in the sector is that CalPERS has given Bentall Kennedy a sizable mandate to build a core industrial portfolio that can grow to as much as $3bn over the next four to five years.
Bentall Kennedy is focused on bulk distribution in a dozen key markets. In acquisitions, says Boneham, “we look very closely at features of the building, buying or developing product that will be flexible and functional for the longest time.”
Some differentiators today are the clear height – current standards are up to 32 feet but some go as high as 36 feet – as well as on-site trailer storage and LEED certification.