On the cusp of a new millennium, everyone expects change. Nowhere is that more apparent than in the normally steady, bread-and-butter industrial real estate markets. Sure, technology continually transforms the way every company in the world does business, but industrial/distribution real estate faces myriad possibilities and potential changes created by e-commerce and Internet retailing. With Internet sales expected to grow from a projected $20.2 billion this year to $184.5 billion by 2004, according to Cambridge, Mass.-based Forrester Research, some predict that every $1 billion in Internet sales creates demand for 500,000 sq. ft. to 1 million sq. ft. of industrial space.

But with possibilities comes uncertainty. If infant e-commerce companies have not ironed out their distribution details, real estate providers cannot grasp their needs. Although many Internet companies have massive market caps, actual profits can be a mystery. It begs the questions: How do you underwrite a client that, by traditional accounting standards, is not profitable? Further, what markets will benefit from e-commerce, and what markets could be left behind like a horse-drawn carriage?

As far as markets go, many have far different outlooks, but some areas - Chicago and Los Angeles, for example - are considered sure bets. Dallas, where overbuilding storm clouds brewed in 1998, continues to beat pessimistic expectations. In spite of - or perhaps because of - many markets experiencing strong absorption during the past 18 to 24 months, most industry experts expect at least a slight downturn because they do not expect their markets to be able to keep up such a torrid pace.

Debate also centers around distribution strategies and building sizes. As long as the economy continues to hum, big-box, centralized distribution centers are expected to rule the day. Still, secondary and tertiary markets have their place as well, and can provide solid investment opportunities.

The current and next big thing Conventional real estate wisdom states that industrial/distribution will benefit from e-commerce, while retail will wane. San Francisco-based AMB Property Corp. went so far as to sell the majority of its $1 billion retail portfolio in March to a joint venture between CaLPERS and San Diego-based Burnham Pacific. AMB has disposed of about half of its retail holdings so far and plans to complete the sale by early 2000. The sale allows AMB to take money from lower-yield retail properties and apply it to higher-yield, high-throughput distribution developments. AMB has also invested in a number of real-estate- and logistics-intensive e-commerce companies, though the company is reticent to discuss these investments in detail.

According to AMB president and CEO Hamid Moghadam, e-commerce accelerates trends already in motion: the replacement of information over actual inventory in a distribution system, thus enabling just-in-time delivery.

"The bottom-line impact on industrial real estate is that you probably need fewer industrial buildings and less square footage devoted to industrial distribution use," says Moghadam. "But the nature of the square footage will be very different than the old square footage. The old square footage had a high storage component where goods just sat around a warehouse for long periods of time. The new economy has a much greater need for what we call 'high-throughput' space where storage is not the most important function, but throughput and distribution are the important functions that take place in these buildings.

"As a result, buildings are going to need to be more flexible and designed for faster movement of goods as opposed to the old days where they had to be designed for minimizing storage costs," he adds.

Unless someone invents Star-Trek-like technology, developers expect e-commerce to bring surging demand.

"We're going to see a tremendous growth in warehouse space as e-commerce grows at the expense of retail space," says Thomas Senkbeil, executive vice president and CIO of Indianapolis-based Duke-Weeks Realty Corp. "The Web is e-commerce's retail outlet. Until somebody figures out how to e-mail peanut butter, we're in good shape.

"When they get to that stage," he adds, "we're all out of business."

Adds Jim Connor, Duke-Weeks senior vice president for Chicago industrial, "If you just look at some of the historical growth in various technological industries - whether it's personal computers or cell phones - and you start to look at the implications over the last 10 to 20 years and apply a fraction of that toward this industry, you're looking at billions and billions of dollars."

While many e-commerce companies are still figuring out their distribution strategies, a few cities currently have an edge in e-commerce related development. With their access to overnight carrier hubs, Louisville, Ky., Memphis, Tenn., and Cincinnati and Columbus, Ohio, are the early leaders.

Overbuilding concerns have been raised in each of those markets. Still, developers continue to flock to Louisville, Memphis and Ohio.

"You will see some cities emerge as winners vis-a-vis other cities, but this is still a very small percentage of the overall commerce conducted today," says Walt Rakowich, CFO of Denver-based ProLogis. "We think those cities in particular will benefit because companies that get an online order at 10 p.m. or 2 a.m. that need to get an order to your house tomorrow need to have a facility that is close to that UPS hub or that FedEx hub. We've actually seen a substantial pickup in our business in those cities, again in the short run.

"Bottom line is, these companies are going to look for strategic locations where they can distribute their product very quickly," he adds.

Initially, e-commerce scoffed at the notion that such high-tech, cutting-edge entities might actually need a sophisticated distribution network and bricks and mortar. "Let the manufacturers handle it," many said, only to find that, to avoid headaches and ensure rapid delivery, they had better figure it out themselves. That process provides another challenge for developers and brokers.

Of course, some e-commerce companies have begun to get a handle on their distribution network and needs. Seattle-based Amazon.com is building nearly 3 million sq. ft. of warehouse space this year divided between McDonough, Ga., Fernley, Nev., and Coffeyville, Kan. ProLogis is also developing two buildings near London, England, totaling 728,000 sq. ft. for the e-commerce giant. In October, LaMesa, Calif.-based barnesandnoble.com leased 380,000 sq. ft. in Memphis from Atlanta-based Industrial Developments International (IDI) for e-retailer's eastern U.S. distribution center.

Amazon.com's 10-year, 800,000 sq. ft. lease in McDonough, south of Atlanta, was Chicago-based First Industrial Realty Trust's first big e-commerce deal. First Industrial began building a 400,000 sq. ft. spec distribution center in October 1998, but Amazon.com entered the picture and asked First Industrial to double the building's size. Although it is early in the game, every other developer and landlord wants to get their disproportionate share of the e-commerce distribution pie.

"Every segment of the economy is going to be affected by e-commerce, and each specific segment will have different logistics needs," says Gary Heigl, COO of First Industrial. "That's the fun part. It's so awesome that it's hard to get fully in front of. It's fun to figure out."

Underwriting difficulties Figuring out how to underwrite e-commerce tenants presents a less fun and more pressing problem.

Developers and lenders - especially in Northern California - have taken stock warrants to guarantee credit, but Carl Panattoni, managing partner at Sacramento, Calif.-based Panattoni Development Co., sees this as a passing fad, especially with high-tech startups becoming more stingy with stock options due to lucrative IPOs.

In many cases, landlords are requiring larger security deposits when dealing with Internet companies. At times, brokers will give potential landlords information about who an Internet company works for. If the e-company can show a list of blue-chip, Fortune 500 clients, that can often smooth the way.

Another deal greaser: High-level venture capital backing or the blessing of a parent company that can show credit worthiness under normal accounting circumstances.

"They [e-commerce companies] don't have what we call profits and what the accounting world calls profits, so you have to understand that," says Greg Gregory, president and CEO of IDI. "When we build and lease them a building, we have to believe in their credit worthiness on some basis. Investors that eventually will own these buildings, whether it's next year or 10 years from now, have to understand that these are still tenants and how to underwrite them.

"We're trying to understand those things, and it's a challenge," Gregory continues. "We also have to understand as we dialog with e-commerce that e-commerce itself is evolving and trying to understand itself. It's very, very exciting."

E-commerce has also added fire to the already burgeoning logistics business. Internet companies are not the only ones turning to a third party to handle their logistics concerns. Companies such as Akron, Ohio-based Goodyear Tire and Rubber Co. and Scottsdale, Ariz.-based Dial Corp. are prime examples. Some logistics companies are signing 10-year leases where they only have five-year contracts because they are confident that demand for their services will remain high, according to Tom Boyle, vice president at The Alter Group, Lincolnwood, Ill.

In response to the logistics trend, Chicago-based Hiffman Shaffer Associates Inc. created HSA Logistics Group early last year. HSA Logistics is finding that many logistics companies are locating distribution hubs in smaller markets such as Dekalb, Ill., north of Chicago, and Granite City, Ill., near St. Louis. This trend is keeping brokers on their toes, as they have to know everything going on in a 100-mile radius or more of their base.

"As companies have analyzed their logistics network, many have determined that they are able to locate these distribution facilities in smaller, tertiary markets where the cost of land and, subsequently, the cost to lease or own a building is significantly less than buildings in, for instance, the immediate Chicagoland market," says Gerard Keating, senior associate at HSA and head of the company's Logistics Group.

"As they've analyzed where their product is sourced and where it is being distributed to, they determine the optimum place for a distribution facility and, in many instances, that is the smaller market. That has changed the real estate development business in the sense that many investors now have to analyze the risk of owning facilities in these outlying areas, and it's forced the brokerage industry to educate themselves on these submarkets," says Keating.

Disproportionately punished So, e-commerce is the good news for industrial real estate. Who gets the bad news? For private companies, there is very little bad news. Their public brethren, on the other hand, have taken a beating. A September 29 report from New York-based Salomon Smith Barney says that Duke-Weeks, the nation's largest industrial-office developer, has been "disproportionately punished" in the stock market and offers a plum buying opportunity.

A few weeks earlier, New York-based Deutsche Banc Alex. Brown issued a strong buy rating for First Industrial and AMB and a buy rating for ProLogis.

Because the private industrial developers do not have to deal with Wall Street, they can breathe a sigh of relief and get on with the business of building, leasing and selling industrial product without worrying about analysts and shareholders. IDI, a private developer, owns stock in several REITs, but Gregory says an IPO is not the thing for IDI.

"I can ignore Wall Street, and I get great satisfaction in doing that," he says with a laugh. "I don't give Wall Street a second thought. In fact, I don't give them a first thought.

"That's not to say that being a public company is not the right thing to be because there are a lot of advantages to being a public company," he adds. "It's just something we've chosen not to do. Well-managed REITs - managed by good real estate people - are good long-term investments."

With the REIT slump and the overall tightening that resulted from last year's credit-market collapse, solid private developers - the Alters, IDIs and Panattonis of the world - can take advantage of financing opportunities that their public brethren may not have right now.

"One thing is access to capital," says Boyle. "A private developer with a proven track record has access to capital, so we can make deals happen. The other thing is our decision tree; it's not multi-layered like it is in some public companies."

While Moghadam says his company is not pursuing any M&A activity on the public side, he would like to see more REIT mergers in order to narrow investors' and analysts' focus. He also does not expect the current REIT stock price slump to go away any time soon, even with strong investment ratings.

"Mergers and acquisitions are a good thing for the REIT sector because there are way too many companies that detract the attention of analysts and investors," he says. "This industry needs to have fewer competitors and bigger, more substantial competitors, generally. A lot of these growing-up problems we've seen in the real estate industry have to get worked out.

"The market needs to perceive the leadership of real estate companies as mature, and I think we're a few years away from that," Moghadam continues. "We're going to be at pretty depressed levels for a while. There's no compelling reason that I hear from investors that they're ready to jump into the real estate sector with both feet and pop the prices 20%. It will probably take something of a bearish stance in the market to get people more focused on value stocks and stocks that provide a high level of dividends rather than yields. REITs are out of favor, and it's going to take a correction or maybe something bigger than a correction to get people back focused on the fundamentals."

Big sales and big markets >From east to west, the industrial sector appears healthy. Many expect a slight drop-off in development and demand, but that is after two record years for several key markets.

On a rampage for the past two years, California remains strong. Northern California sports an 8.3% vacancy rate, 16.6 million sq. ft. leased and 1.6 million sq. ft. sold through the first half of 1999, according to New York-based Cushman & Wakefield. The Los Angeles basin and Inland Empire report a phenomenal 5.2% vacancy rate, with 33.8 million sq. ft. leased and nearly 5 million sq. ft. sold through the first half of 1999, Cushman & Wakefield reports.

"We've all been looking for warning signs, and, perhaps, in other parts of the United States they're feeling a slowdown," says Paul Marshall, senior vice president in the Irvine, Calif., office of Phoenix-based Opus West Corp. "We've always said we're a little more insulated than some, but it would be pretty naive to think that we can keep the pace we've had. I would expect a little slowdown, but I don't think anybody's forecasting a near-term downturn in this part of the world.

"We've just been on such a tremendous pace the last two or three years. We've seen tremendous growth."

First Industrial entered the Los Angeles market in September with the $64 million acquisition of a 40-property portfolio from Marina Del Rey, Calif.-based Pacifica Capital Group. First Industrial acquired the 1.2 million sq. ft. portfolio at below-replacement cost with rents that are currently 20% below market value. Within the portfolio, 40% of the rents roll over in 2000. The company also retained the five-person team that managed the portfolio for Pacifica.

"The right deal made it the right time," says Michael Brennan, president and CEO of First Industrial. "However, it's long been our desire to find a large Southern California portfolio and one in which we could retain the local managers that ran and operated that company or portfolio. We found both of those in the Pacifica transaction."

Moving east, Dallas continues to defy expectations with about 10 million sq. ft. of new product every year since 1996. Last year, overbuilding was a huge concern for the Metroplex, but Dallas posted a 5.8% vacancy rate, 9.7 million sq. ft. leased and 3.5 million sq. ft. sold in the first half of 1999, according to Cushman & Wakefield.

Intermodal rail shipping and a FedEx hub at the Alliance Airport in Fort Worth are key factors in the Dallas-Ft. Worth area's success, says Jack Fraker, managing director with Cushman & Wakefield of Texas Inc. During the last six to seven years, the Alliance submarket has absorbed approximately 13.5 million sq. ft. of distribution space, he says.

"Despite all the square footage, we've not only absorbed all the new construction and any lag vacancies out there, but our vacancy rate has stayed constant," says Fraker. "We're not getting as much double-digit growth now because supply and demand is more or less at equilibrium, but we're experiencing rental rate growth in excess of inflation."

A similar circumstance exists in Chicagoland. Chicago's leasing totaled more than 19 million sq. ft. in the first half of the year, leaving a 5.6% vacancy rate. Nearly 5 million sq. ft. of industrial space was sold in Chicago in the first half, and another 7.9 million sq. ft. was under construction through June 1999, according to Cushman & Wakefield. Chicagoland also reported 4.1 million sq. ft. of build-to-suit industrial development, according to The Alter Group's first-half build-to-suit survey.

DuPage County holds the preeminent position in Chicago's industrial landscape, but far northwest and far southwest counties are catching up because of lower land costs, says Boyle. Cook County is resurgent, especially for build-to-suit, because of lower labor costs than in the suburbs, he notes. The I-55 submarket may be a trouble spot, with approximately 3.1 million sq. ft. of vacant industrial space.

"That's a lot of product, but this market has always rallied the last three or four years," says Boyle. "The rate of absorption is making a lot of developers look brilliant because demand comes from nowhere in certain instances and gobbles it up."

Boyle expects leasing and development to pick up through the end of 1999, but, over the next year, he, too, predicts a slight downturn. "It will be a little off," he says, "but last year was still a great year, so we'll be fine."

On the East Coast, Central and Northern New Jersey's 720 million sq. ft. industrial market also reports a strong first half, with a vacancy rate of 7.6%. Central and Northern New Jersey's first half leases total 12.1 million sq. ft., with 2.3 million sq. ft. sold and another 3.2 million sq. ft. under construction.

Local and national players are driving the New Jersey industrial market, which centers around Exits 10 and 8A on the New Jersey Turnpike. Although older buildings are harder to move, the volume of new, big-box projects and a number of pending deals have created an optimistic mood in New Jersey, says Don Eisen, executive managing director for the New York area for Cushman & Wakefield.

"We're seeing very big large-building demand," Eisen says. "I think there's a kick-up in activity. It's been a little slow, sure, but we see a huge number of potential transactions."

Will the South rise again? Down South, Atlanta contradicts conventional wisdom. Although some Atlanta submarkets have shown signs of oversupply, IDI has leased more than 1 million sq. ft. at its Shawnee Ridge development this year. Atlanta-based McDonald Development Co. has also leased more than 1 million sq. ft. of industrial product since the beginning of the year, and anticipates building an additional 1 to 2 million sq. ft. through the end of 2000.

Though concessions are being offered in some submarkets, McDonald president John McDonald expects 1999 Atlanta absorption in the 10 million to 11 million sq. ft. range and vacancy rates to stay around 8%. McDonald also points out the rebound of Atlanta's south side after a number of big-box buildings that were vacant in 1998 were absorbed over the last year.

"I don't see any reason why that will not continue, but I don't believe there are going to be as many buildings built over the next 12 months as there were in the previous period," says McDonald. "I think it's going to stabilize."

With healthy major markets and Corporate America's continuing centralized distribution strategy, how will smaller markets fare? Construction will probably decline, but that may not be a bad thing for secondary and tertiary markets.

"You'll gradually see a slowing down and minimal new construction in those types of markets," Fraker says. "Existing space that is already leased won't go down in value. In fact, it might go up because the supply will be constant and not increasing.

"It could have a favorable effect on secondary markets in terms of existing buildings," he continues. "They're going to be more stabilized. With their constant supply and any kind of increase in demand, their values and rents will go up."

The good, the bad and the end So, what does the future hold for industrial real estate? While discussing his own company's underwriting standards and how IDI completes deals and financing, Greg Gregory presented a solution to overbuilding. It seems simple enough, but developers - and subsequently lenders - have continued to make the same mistakes over the years and cycles.

"Too much of the development business is capital-driven rather than market-driven," says Gregory. "If we stay market driven, which we are, then the capital is easy for us to access. We are really more disciplined in our internal underwriting than any of our external underwriting."

Gregory's comments directly tie into Carl Panattoni's view of the future. Panattoni predicts that industrial development will be market driven and correspond with the macroeconomic big picture.

"The main trend in the future is going to be that industrial markets will grow with the national economy," he says. "Instead of swinging way ahead of the economy in up periods and way below in down periods, the cycles for the general economy and the cycles for industrial growth are going to coincide much more closely."

So how do e-commerce and other high-tech sectors fit in?

"You're going to find a lot of e-commerce companies that are going to outsource distribution," says Eisen, "and a lot of the distribution construction is going to be driven by a new business model: I want it today; I'm going to type it in, and I expect it within 48 hours at the latest."

Adds Moghadam on e-commerce, "It's an enabler, something that's going to accelerate existing trends, which have included higher information content replacing inventory in the system."

And beyond a market-driven approach and all the changes high-tech brings about, the game is changing. The old school - build it, sit on it and pass it on to the kids - is in the past, Eisen adds.

"I don't care how successful you are," he asserts. "You either have to have a partner to supply the equity, which I think is the direction that several developers are going; or you have to be a REIT where you have a public source of money; or you have be an Opus who takes their buildings and sells them. There are different rules and different ways of doing business, just not the old [practice of], 'put them up and the bank will finance them.'

"That game is gone," Eisen adds, "and it's not likely to come back soon."