Michael Brennan, president and CEO of First Industrial Realty Trust Inc., knows a sell signal when he sees it. When he saw prices for industrial properties jump an average of 8% last year, he quickly sold $360 million worth of buildings from his portfolio. “In my 24 years in this business, this is one of the largest increases in price I can remember,” he says. “It's a great time to be a seller of industrial property.”

But there aren't that many Brennans in the market. There are more owners, in fact, who are holding out for more or who can't figure out how they could do better on their money than the 16% annual returns afforded by industrial properties. The resulting scarcity of product on the market — coupled with increasing demand by institutions and investors looking for a safe haven in real estate — has pushed prices even higher. Capitalization rates that routinely approached and exceeded 10% in the late 1990s have now declined to 8% in some markets.

In fact, total industrial sales nationwide sank to $16.3 billion last year, from the pre-recession peak of $18.9 billion in 2000, reports Bethesda, Md.-based CoStar Group Inc. “Investment in industrial actually lagged behind all other sectors including office and retail last year,” says Robert White, president of Real Capital Analytics Inc. in New York, which tracks investment sales above $5 million. “Institutions typically like to buy large office parks, but that volume has been down considerably.”

Of course, not all markets are created equal. Big corporations and the logistics companies that serve them continue to consolidate their warehouse and manufacturing facilities, particularly in major markets such as Chicago, Los Angeles and New Jersey. But peripheral industrial destinations have suffered.

And smaller towns like Fargo and Des Moines, where the acquisition interest is chiefly limited to local investors, aren't likely to grab the spotlight away. “Cities like Columbus and Cincinnati have struggled with high vacancy rates in the past year,” observes Pamela Zoellner, a senior managing director of industrial services at Cushman & Wakefield Inc. in Atlanta. “You won't find too many institutional owners willing to build in peripheral markets today. There is too much uncertainty.”

In the past 12 months, the greatest transaction velocity has been evident in Los Angeles, Chicago, Cleveland, central and northern New Jersey, and the San Francisco Bay area, according to John McDermott, national director of office and industrial properties for the brokerage division of Sperry Van Ness in Irvine, Calif. That didn't stop SVN Equities — Sperry Van Ness's investment division — from paying $49 million in late December for a 15-property, 1.86 million sq. ft. portfolio in Grand Rapids, Mich., owned by First Industrial. McDermott won't divulge the cap rate on the deal, but he does say his firm has searched extensively for available assets. Although the leading markets have more for sale than the smaller markets, the larger markets have less product available than in past years. “Most industrial owners just won't sell,” he says. “It's been a frustrating time for buyers.”

A Few Motivated Sellers

So, who is parting with industrial assets? One seller is Lennar Partners in Irvine, Calif., which is marketing a 700,000 sq. ft. building in the Philadelphia Place industrial park near the Ontario International Airport. Constructed four years ago as a build-to-suit for the retail chain Pier One, the building will change hands at a cap rate of about 8%, based on a price of almost $50 per sq. ft., says Michael Morris, vice president of commercial development for Lennar.

“Prices are up and cap rates have inched down about 50 basis points in Southern California in the past year,” he says. “We always had it in our business plan to sell this building, and with prices high now was the time to do it. We'll redeploy the capital into new development deals.”

Foremost among those, he adds, is the pending redevelopment of the former March Air Force base in nearby Riverside, where Lennar is starting work on a 300-acre business park called Vantage. It will eventually house 16 million sq. ft. of industrial space. “There's a big push east in the Inland Empire area as land becomes harder to find in the west. It's almost impossible anymore to find parcels as big as what we've picked up at March,” Morris explains.

CIP Real Estate, also based in Irvine, sold four California assets last year, including a 161,000 sq. ft. multi-tenant distribution building in Fullerton for which a private investor paid $10.8 million, amounting to an 8.75% cap rate. “We see investors willing to buy at a cap rate of, say, 8.5% and borrow at 5.5% and then arbitrage the 300-basis point difference as their cash flow. And they see upside down the road when the economy improves and rental rates begin to rise again,” says Eric Smyth, a CIP principal who hints that CIP might have been moved to sell out of frustration over flattening lease rates.

“Between 1995 and 2001 we saw rental increases of 3% to 5% a year in Southern California,” he continues. “But there were no increases in 2002, and I think you'll see more of the same in 2003.”

Industrial developers have been hemmed in by rapidly escalating land prices. In south Orange County, land that was valued at $7 per sq. ft. as recently as 1997 now fetches between $12 and $20 a foot, brokers say.

Still, developers continue to build wherever they can and on spec. Tejon Ranch Co., for instance, is developing a 1,500-acre business park on a cattle ranch south of Bakersfield, Calif., where the Swedish furniture retailer Ikea is expected to have 1.7 million sq. ft. of warehouse operational by June. Newport, Calif.-based Master Development Corp. is building a speculative 72,000 sq. ft. warehouse in Rancho Cucamonga to be completed in May. In Corona, Master Development has completed a nine-building spec complex of more than 225,000 sq. ft. in partnership with GE Capital.

“We'll probably hold onto the property in Rancho Cucamonga but sell everything in Corona,” says Bryan Bentrott, vice president of Master Development. “Generally in building spec, if we can lease a building up with a good tenant we'll take it to market.”

Meanwhile, prices continue to rise. John Owen, a managing partner at Voit Commercial Brokerage in Anaheim, Calif., says he has seen industrial properties that sold for 80% of replacement cost in 2000 change hands at 100% today. With little sign of rent increases on the horizon, it's hard to understand how some acquirers will make any money, says Owen. But the buyers keep coming: “For every asset offered for sale, it seems there are a half-dozen or more bidders, and some of them are willing to be very aggressive in their underwriting,” he says.

Barry Hibbard, vice president of Tejon, says that the fundamentals of California's economy make industrial development a reasonable bet. “Demand in California hasn't gone away,” he explains. “This state is adding 900,000 new residents every year, and retailers need more capacity here all the time to get their products distributed to them.”

Mixed Results on the East Coast

The East Coast, meanwhile, has been a mixed bag for industrial. The New Jersey market continues to boast abundant infill opportunities. Keystone Property Trust and Barrett Builders LLC are teaming up to build spec buildings of 343,000 sq. ft. and 181,000 sq. ft. in the Greenville Yards, a former rail hub in Port Jersey.

Tom Barrett, CEO of his eponymous Fort Lee-based firm, sees sound economics in spec investment. Some 20-year-old buildings in the marketplace are fetching $63 per sq. ft. in sales transactions. Barrett can erect a state-of-the-art, high-cube facility for under $40 per sq. ft. “Even if the developer pays $500,000 an acre for the land, we can still come in cheaper with a new building,” Barrett says. “The problem is that land assemblage is complicated.”

Barrett tried to acquire a closed factory on a 38-acre site in Bergen County, N.J., after soil contamination was discovered. Then the municipality decided it wanted offices on the site anyway. Barrett eventually walked away from the parcel.

Near Baltimore, SSR Realty recently sold a $50 million portfolio of mid-sized buildings comprising more than 1 million sq. ft. adjacent to the Baltimore/Washington International Airport. The sale price translated into an 8.8% cap rate, and the buyer was a California pension fund. “This was a little unusual, because in this area the guys with the gold are holding onto the gold. There is very little churn in the marketplace,” says Timothy Cahill, senior managing director of CB Richard Ellis Inc., which brokered the SSR property. A dozen bidders were competing for the portfolio, he says. “Five years ago, we might have seen two or three bidders for assets like that.”

Atlanta, along with Phoenix, Ariz., and Austin, Texas, may be one of the weakest, most overbuilt markets in the country. Vacancies have been running above 14%, up 2% from a year ago. And for the first time in a decade, according to Stephen Grable, vice president with Atlanta-based Colliers Cauble & Co., owners are offering free rent. “Meanwhile, spec activity has shut down. It's a great time to be a tenant because you can drive your own deal,” he says.

Nevertheless, build-to-suits are still being completed in Atlanta. Cereal giant Kellogg Co. constructed a 900,000 sq. ft. building last year and Office Depot now occupies a new 500,000 sq. ft. building. The Kellogg building, developed by Majestic Realty, is quietly available for sale, according to sources. The likely price will come in at a cap rate of 8% or less, evidence of demand for assets in the Southeast.

Buy Now, Build Later

Many buyers are now motivated by more than sheer profit. Dirk Mosis, vice president of real estate investment at San Antonio-based USAA Real Estate Co., says his firm will often buy existing buildings to get a foothold for build-to-suit deals later on.

“Development is still a local business,” Mosis says. “If you're not in a city with some land and assets, you won't get contracts for build-to-suit projects. People have to see you as an active participant.”

That approach worked well for USAA in Chicago, where the company last year won deals to construct two buildings, one an 860,000 sq. ft. building for Kraft Foods Inc., and the other a 900,000 sq. ft. building for Sweetheart Cup Co. Both deals stemmed from USAA's aggressive investment in raw land.

Spec development is still moving at a decent clip in metro Chicago. Panattoni Development Co. is building a 500,000 sq. ft. cross-docked facility in southwest suburban Romeoville. The project is scheduled for completion in July, but has no tenants signed yet. The company also is building smaller spec spaces of 45,000 sq. ft. and 66,000 sq. ft. in the north suburb of Waukegan. The latter are being marketed for lease or sale.

“Financing costs are so low now that many small business entrepreneurs are deciding they'd rather own than lease. Owning is as cheap as renting — this is an amazing time in the cycle in that regard,” says Michael Murphy, a Panattoni partner.

Much of the latest activity is spreading into Chicago's suburbs. Oak Brook-based CenterPoint Properties Trust recently completed a 250,000 sq. ft. distribution facility for Volkswagon north of Chicago in Pleasant Prairie, Wis. The firm also built a 408,000 sq. ft. building for Potlach Corp. in a railroad intermodal center on the site of a former Army Arsenal near Joliet.

Next up: CenterPoint is developing a 1,000-acre intermodal hub in Rochelle, 75 miles west of Chicago. The industrial giant also has acquired 700 acres next to the intermodal for a future business park.

John Gates Jr., chairman and CEO of CenterPoint, believes that intermodal needs will continue to drive industrial development.

“There is a shift in manufacturing of consumer goods from North America to the Pacific Rim,” Gates explains. “A lot of those goods are put in containers and sent to America. They arrive via train in distribution centers like Chicago, which is unique in that all six major U.S railroads come together here. We are the third largest container hub in the world after Singapore and Hong Kong.”

CenterPoint owns 36 million sq. ft. of industrial space and 1,900 acres, and almost all of it is for sale at the right price, he says. “Investors like Chicago because this market is liquid. You can readily sell a building here in 90 days if you have to. Chicago and L.A. are the two most liquid markets in the country, in fact,” Gates says.

While vacancy rates in Chicago have risen to almost 10%, Douglas Kiersey, a senior vice president with ProLogis Trust of Aurora, Colo., says that few alarm bells are going off, in Chicago or elsewhere. “In the 37 urban markets where our company operates, we saw 142 million sq. ft. of new development in 2000, which was the high water mark for construction activity,” Kiersey says. “Last year that total fell to 55 million sq. ft. in those 37 markets. There has been significant supply-side discipline in industrial building. That's why these markets are holding up fairly well.”

In Minneapolis, Ryan Cos. has cut back its spec program. It will deliver a 108,000 sq. ft. building in the Midway district in August. Last year, the company completed build-to-suit projects in Wisconsin for both tractor-maker Deere & Co. (650,000 sq. ft. in Janesville) and Ford Motor Co. (200,000 sq. ft. under construction in Menomonie).

Ryan develops product in other real estate sectors, but the company likes industrial at the moment. “Industrial provides steady returns. It doesn't go through the cyclical swings of office,” says Kent Carlson, Ryan's vice president of development.

Some observers anticipate increased demand for industrial space in coming months. DP Partners in Reno, Nev., has embarked on big speculative projects in markets as disparate as Las Vegas and Allentown, Pa., for clients such as PepsiCo.

“I think we're coming out of a prolonged trough that started in late 2000,” says Aaron Paris, executive vice president and COO of DP. “We're seeing excellent activity from tenants who want to take occupancy in late 2003 or early '04. This is a good time to be developing and acquiring industrial assets. The market is only going to get better.”

H. Lee Murphy is a Chicago-based writer.