Nobody can get particularly excited about the Dallas/Ft. Worth industrial real estate market these days. The vacancy rate, after all, is running over 12% — up from less than 7% in 2000 before the recession hit. Meanwhile, rents have been flat, construction costs are soaring and tenant prospects remain scarce. Even so, that hasn't stopped big development names such as IDI, Trammell Crow Co. and Duke Realty Corp. from plunging ahead on new speculative construction projects.

“The market isn't very good,” admits Douglas Johnson, regional development officer for IDI in Dallas, which completed a 295,000 sq. ft. speculative warehouse in the Dallas-Ft. Worth Trade Center, adjacent to the airport, back in December 2003. In 15 months, IDI has leased all of 50,000 sq. ft. in the building, though Johnson is not entirely disconsolate.

“We built the facility at a low price and so it hasn't been hard for us to carry,” explains Johnson. “The feeling in this market is that you have to have some kind of product available to show tenants. You can't sell from empty wagons or sit on your hands forever. Either you maintain your market presence with buildings ready to go, or people will forget about you.” IDI delivered another 250,000 sq. ft. building in the Pinnacle Park off Interstate 30 last year, and still hasn't filled that either.

National trends raise eyebrows

A similar attitude of “damn the torpedoes and keep building” has gripped most of IDI's competitors around the country. With the notable exception of the Inland Empire near Los Angeles and pockets of the central New Jersey market, industrial vacancies remain stuck at stubbornly high levels in many markets, and the recovering economy has not yet unleashed a torrent of tenant demand for space.

In Atlanta, Blaine Kelley, a first vice president with CB Richard Ellis, reports vacancies running close to 17% in many submarkets, with rents flat for three years running and new leasing activity in 2004 totaling around 30 million sq. ft., less than half the approximate 75 million sq. ft. level of 2000. Still, there are spec projects everywhere, with locally based John W. Rooker Co. building an 800,000 sq. ft. facility in Jefferson, northeast of Atlanta, and IDI seeking approvals for a 400,000 sq. ft. project west of town along Camp Creek Parkway.

The nation's largest industrial owner, ProLogis, finished work on a 570,000 sq. ft. spec building in the Greenwood Industrial Park south of Atlanta two years ago. The first tenant, taking 250,000 sq ft., was just secured. Now, a suddenly encouraged ProLogis is laying plans for an addition to take the original structure to over 1.1 million sq. ft.

The pace of new construction has left some local Atlanta real estate veterans in disbelief. “Maybe it's because of the low cost of capital or for tax reasons, but we are already in an overbuilt market in Atlanta and local developers are deciding to build even more,” says Kelley. “It's going to take at least a couple of years to burn off the vacancy we already have and get back to a reasonable 10% vacancy rate. But if this spec construction continues, the vacancies could stay high for a lot longer.”

Underlying factors

Many developers, who shut down their spec construction programs in the aftermath of 9/11 nearly four years ago, are erecting new buildings again, some of them monster boxes of 500,000 sq. ft. or more. These developers are counting on somehow filling these spaces later this year as the new product comes on line. Will some of these developers be disappointed? Maybe, but most have underwritten their pro-forma budgets conservatively. At IDI, Johnson told his lenders to expect a full 24-month lease-up period and advised them to have few illusions about the economy returning to the excesses of the late 1990s.

So far, unfilled spec capacity doesn't seem to be causing any great pain or hardship within the developer community. Unlike the great real estate recession of 1990-91, when industrial vacancies in many cities exceeded current levels, lenders this time around have not been stepping in to seize struggling assets. Developers today have deeper pockets and more institutional backing than they had in past cycles plagued by vacancies.

Still, developers may be taking on significant risk in some of their spec investments, and in some cases they are plainly getting out in front of actual demand for new space.

J.D. Salazar, managing principal of Champion Realty Advisors in Willowbrook, Ill., says that vacancy rates are running 25% and higher in some Chicago submarkets, but developers appear undaunted. “Some of the institutional developers I'm working with are operating in a state of euphoria. If the economy reverses anytime soon, you'll see this spec work come to a halt pretty quickly.”

Perhaps so, but throughout the industrial sector there is a general confidence that the economy will keep growing this year, and imports of new merchandise from places like China will keep climbing, contributing to a need for new and ever larger distribution facilities.

Vital signs mixed

For now, developers are managing their risk intelligently. Barring a collapse in the economy in the near term, the consensus is that the splurge in spec construction will eventually be absorbed, though patience may be required.

Today's industrial market is certainly not for the faint of heart. National statistics bear out that conclusion. CoStar Group reports that the national industrial vacancy rate registered 10.1% at the end of 2004, with 1.2 billion sq. ft. vacant across the U.S. — three times the vacancy total in early 2000. New construction deliveries rose almost 14% last year, to 118 million sq. ft. from 104 million sq. ft. in 2003, according to CoStar. But absorption also rose, leading the research firm to predict that vacancy rates will fall into single digits by this summer. CoStar notes another positive sign: asking rents for warehouses last year edged up 2% to $4.80 per sq. ft. on a net basis.

The price is right

Why are developers pushing ahead on new construction? The overheated resale market is one reason, leaving developers greater margin for error. In the first nine months of 2004, there were 4,067 industrial sales transactions at an average price of $51.10 per sq. ft. That was up from 3,638 transactions at an average $47.50 per sq. ft. in the same period of 2003.

In some markets, buyers are falling all over each other, bidding on even marginal assets. Chicago-based Bridge Development Partners LLC put up a 400,000 sq. ft. spec warehouse on Illinois Highway 41 in North Chicago that was finished nearly 20 months ago. It borrowed 75% of the $16 million construction cost. The building sat with no tenants in sight until locally based CenterPoint Properties Trust, which doubtless had a tenant prospect in its pocket, came along in January and bought the building from Bridge. Neither side will reveal the sale price, but Steven Poulos, a principal at Bridge, says “we made out just fine” with a return on investment in the mid-teens.

With many investors willing to accept a market capitalization of 7% and even less on industrial acquisitions these days, Poulos believes the industrial spec formula is nearly foolproof. Put up a building for $40 per sq. ft. in construction cost, borrow $30 of that cost, and then sell it off to a buyer willing to pay a 20% premium or more for your work in getting the site zoned and managing the construction. Find a rich tenant willing to pay full price for a lease, and the return on equity can reach 70% or more in some of these deals, says Poulos. “Buyers of industrial property are so hungry for assets that much of the development and construction risk is averted.”

At the end of last year Alter Group Ltd., a development firm based in Skokie, Ill., finished up work on an 830,000 sq. ft. spec building off the Interstate 10 freeway in Rancho Cucamonga, in the Inland Empire east of Los Angeles.

Alter didn't find a tenant immediately, but that hardly seemed to matter. The firm and its partner, RREEF Funds, were bought out by the pension fund advisory division of CB Richard Ellis for about $46 per sq. ft. That amounts to more than $38 million. For its 14 months of work on the building, Alter got “a return that exceeded our expectations,” according to Patrick E. Gallagher, a senior vice president at Alter.

Amid rising sale prices, the company began work on a second spec project, spanning 530,000 sq. ft. in Fontana, just two miles from Ontario Airport. Alter was originally asking for $3.44 per sq. ft. in net rent, but boosted that to $3.68 as completion neared.

Numbers can be deceiving

According to a recent survey by Colliers Bennett & Kahnweiler Inc., its hometown market of metro Chicago has an industrial vacancy of 9.5%. But in the hottest new development submarket — the southwest suburbs around I-55 — the vacancy rate stands at an unhealthy 17%. Still, that hasn't stopped Malvern, Pa.-based Liberty Property Trust, which has a national industrial portfolio of 43 million sq. ft., from entering the market for the first time. Liberty broke ground on a 607,000 sq. ft. spec building this past October in suburban Aurora.

Chicago is littered with new spec construction at the moment, but William Hankowsky, president and CEO of Liberty, isn't worried. Developers like him, he says, are building in the face of swollen vacancies in part because they don't trust the survey data. “The published vacancy rates typically include the obsolete space, such as buildings with 18 ft. clear ceiling heights with no sprinkler systems that a broker might be lucky to rent for a buck a foot,” Hankowsky says. “New spec space like ours with 32 ft. clear ceiling heights and the latest ESFR sprinklers don't compete with a lot of the older vacant space.”

There is another reason the older spaces don't compete with the latest spec construction. Lynn Reich, executive vice president of Colliers Bennett & Kahnweiler, observes that today's spec product is important for more than just its sheer size. More and more tenants, she notes, are demanding extra trailer parking. “In some cases, the newest spec buildings are customized with more parking capacity, which gives them a real advantage over older-generation spaces,” she says.

Liberty was an active spec builder up until 2001, when it shut down its new-construction program. The firm reinitiated spec construction last year when it saw prices zooming upwards for older assets. “The acquisition market has become so tough,” Hankowsky says, “that it now makes sense to create your own product, particularly as the economy improves.”

Minneapolis-based Ryan Cos. currently has four business parks in Chicago with spec space available in three of them, including a 471,000 sq. ft. building completed last May that remains vacant. “That building is the first in a new 85-acre business park. It's true that the park is behind schedule, but we're not ready to hold any fire sales,” says Tim Hennelly, vice president of development for Ryan.

Speculative construction, he adds, is a fact of life in any large-sized park these days. Build-to-suit deals represent less than 20% of all industrial development around Chicago today. “At least 80% of deals involve tenants making last-minute decisions who require space within three months. To serve the market, you have to have space available at all times. If you've got an empty park with no buildings, you're not an industrial player in Chicago,” Hennelly says.

Of course, there's a reason that build-to-suit deals have become so rare in Chicago and elsewhere: “Why wait for build-to-suit when you have so many spec buildings to choose from?” says Salazar of Champion Realty.

In the 1990s, a good-sized spec building was 400,000 to 500,000 sq. ft. Today, many new projects are 700,000 sq. ft. or larger. Heller Industrial Parks Inc. of Edison, N.J., which owns 15 million sq. ft. of industrial inventory around the U.S., recently started work on a 700,000 sq. ft. building in its Heller Park North in Edison, due to be finished late this year.

If that leases up, President Jeff Milanaik is ready to embark on his biggest project yet, a 1.6 million sq. ft. spec monster next door. The cost is likely to be over $70 million, but Milanaik is philosophical about the scale and risk involved.

“I could just sit back and wait for build-to-suits, but it would take me twice as long to build out my corporate parks that way,” he says. There is also the issue of price. By splitting up his biggest buildings among multiple tenants, Milanaik hopes to get close to his asking rent of $4.50 per sq. ft. net. On his last build-to-suit, the tenant negotiated the price down below $4.

California is a trailblazer

If there is a bulletproof market anywhere in the U.S., it's Southern California and the Inland Empire, where vacancies are running under 8%, despite the fact that the total inventory of space has jumped 28% in the past five years to 343.5 million sq. ft. Empty land to build on is so precious that as soon as a developer can get entitlements on a site, a spec project is almost certain to follow in short order.

Sares-Regis Group of Irvine, Calif., will complete a 435,000 sq. ft. spec building in May in Rialto, and then immediately break ground on a 715,000 sq. ft. building next door. By the end of the year, Sares-Regis hopes to be ready to start work on two more buildings in the same business park, ranging from 350,000 sq. ft. to 385,000 sq. ft.

All of this industrial development is occurring on what were once grape vineyards. “The Inland Empire is so desirable right now that it's almost impossible to get out in front of demand,” says Bruce Bearer, a vice president at Sares-Regis.

Over the past 10 years, his company has invested in suburban office and multifamily assets, but its focus lately has been almost entirely on industrial. “Industrial development is the lowest-risk investing there is right now in commercial real estate,” Bearer says.

Much of the spec phenomena has been led by the biggest industrial developers, and that's no accident, according to Larry Harmsen, a senior vice president with ProLogis in Santa Ana, Calif. ProLogis will complete work on a sprawling 850,000 sq. ft. building near Fontana, right off Interstate 10, in June.

There are no tenants yet, but Harmsen shrugs that off. His company is also working on a 1.2 million sq. ft. spec building nearby in Rialto that will deliver in the fourth quarter of this year.

Harmsen keeps the development activity in perspective. “Add up all the spec activity in the Inland Empire right now and it's probably about 5 million sq. ft. or so. But the entire marketplace is well over 300 million sq. ft., so this is a pretty small percentage and easily absorbable,” he insists.

What about the risk to the balance sheet of ProLogis? “We have over 300 million sq. ft. in our industrial portfolio worldwide, so one or two buildings here can't make that big of an impact,” Harmsen says.

Potential ramifications

If there is one universal concern of developers, it is spiraling costs. In 2000, the finished cost of an industrial building — with land and construction included — in the Inland Empire was slightly higher than $30 per sq. ft. But raw land values have soared since then just as construction costs have jumped 25% over the past year. Everything from cement to steel has climbed in price. As a result, Inland Empire buildings today are delivering for upwards of $50 per sq. ft.

“The pricing has gotten astronomical in industrial of late,” complains Frederick Wehba Jr., vice chairman of Bentley Forbes LLC in Century City, Calif. Wehba's company, a private equity fund with a real estate portfolio valued at $1.2 billion, has been buying more office assets of late while it weighs the risk/returns in industrial.

But the risk/return formulas in industrial are never very precise, and are liable to change with the shifting sands of the New York Stock Exchange each week.

Buchanan Street Advisors LP in Newport Beach, Calif., which controls more than $1 billion in private equity, is investing in a 600,000 sq. ft. spec building on a 26-acre site in Paramount, another Los Angeles suburb. Construction hasn't even started yet and there are no tenants in view, but Buchanan is already fielding offers from a bevy of investors who want to acquire the parcel.

“We have a piece of dirt and a rendering, and that's it. All this interest amazes me,” says Timothy Ballard, managing partner of Buchanan. What will he do? He's not sure. Many speculative developers are determined to hold onto their assets for the long haul, but Ballard isn't convinced that's always a good idea.

“Who knows what the market will be like a year or two from now? The economy might be down, interest rates up and these spec buildings may not seem nearly so valuable as they are today,” Ballard says. “There is both some science and some art in trying to calculate the right time to build speculative industrial. Too many people think they can make it pure science, and they get it wrong,” emphasizes Ballard. “Mistakes are made all the time.”

Lee Murphy is a Chicago-based writer

VITAL SIGNS BY SELECT MARKETS (Year-end 2004 figures)
Market Vacancy Rate Net Absorption (Total Sq. Ft.) Under Construction (Total Sq. Ft) Quoted Rates (Per Sq. Ft.)
Atlanta 12.7% 11.28 million 5.4 million $4.13
Chicago 10.9% 7 million 7.7 million $5.54
Dallas/Ft. Worth 12.4% 2.53 million 3.48 million $4.77
Detroit* 13.6% (142,733) 860,444 $5.55
Inland Empire (Calif.) 6.1% 17.89 million 15.3 million $5
Northern New Jersey 7.4% 647,379 7.4 million $5.97
* Indicates negative absorption
Source: CoStar Group