Just south of I-80 in Joliet, Ill., TCB Development Co. is building a 575,000 sq. ft. distribution center scheduled for completion in early 2007. While no tenants have signed on to the speculative project just yet, the Joliet development should succeed, says a confident Randy Tieman, executive vice president of TCB, a Chicago developer. “Industrial parks in the area have been very successful in recent years.”

The Joliet project is not the only speculative industrial development undertaken by TCB. The company just won approval to begin building a 2.5 million sq. ft. development in Mokena, Ill., near route I-80. The land will be divided into 25 lots that will accommodate tenants ranging from small entrepreneurial factories to big-box warehouses for major national companies. “Demand remains strong from many industrial tenants,” says Tieman. “Every major developer in the Chicago area is rushing to get product up.”

In fact, speculative building is occurring in several major markets, including Southern California and New Jersey. The wave of construction — 76 million sq. ft. should be completed in 2006, according to data provider Reis Inc. — is a sign that the industrial market is reaching a new phase in the cycle.

Shifting landscape

At a time when businesses are straining to meet global competition, companies are demanding more state-of-the art warehouses. That is pushing up prices. In some markets, land is at a premium. To meet the need and keep prices reasonable, developers are building farther and farther away from major cities.

Today's environment is a stark contrast from 2003, when construction sagged and builders faced a slowing economy and oversupply. For the next few years, developers proceeded with caution. But now with the economy growing and vacancy rates declining, developers are eager to break ground. “The market is healthy, and we should see vacancy rates dropping for at least the next year or so,” predicts Sam Chandan, chief economist with Reis.

The vacancy rate registered 7.3% in the first quarter of 2006, down 200 basis points from the fourth quarter of 2003, according to Reis. Net absorption totaled 42.9 million sq. ft. in the first quarter, and the near-term outlook is bright. “Any net absorption above 30 million square feet is pretty strong,” says Robert Bach, vice president of Chicago-based real estate services firm Grubb & Ellis.

Like other real estate sectors, industrial properties have been enjoying strong demand from investors. Cap rates, the initial return based on the purchase price of an asset, have dropped steadily from around 10% in 2001. Now some top properties command cap rates of less than 6%. Even at the high prices, bidding has been healthy. “For good-quality real estate in major markets, you are going to get 15 or 20 bids,” says Russ Blackwell, managing director of LaSalle Investment Management, a big owner of warehouses.

After reaching such low levels, cap rates are not likely to drop much further, say industry experts. Rising interest rates may discourage some investors from bidding aggressively, says Bach. The 10-year Treasury yield has climbed from 3.91% in June 2005 to about 5.11%. That should eventually put upward pressure on cap rates. “I don't expect rates to come down any further this year,” predicts Bach.

New geographic hot spots

With global trade expanding, Los Angeles boasts an industrial vacancy rate of only 2.1%, the lowest figure of any major market in the country, reports Grubb & Ellis. Other strong markets include Miami, with a vacancy rate of 4.4% and Long Island, New York with a figure of 5.1%.

In response to the demand for space, developers are more than eager to build. But in many metropolitan areas there is a shortage of land and stiff competition for remaining parcels from residential buildings. The upshot is that warehouse developers are moving farther and farther away from major cities.

Case in point: Atlanta-based IDI, a large industrial developer, is building a speculative 1.35 million sq. ft. distribution facility in South Brunswick, N.J., about 50 miles south of New York City. Known as Middlesex Center, the development is located off the New Jersey Turnpike at exit 8A. The project will serve logistics and retail companies that can't find room further north.

Decades ago, warehouses rose near exit 16 on the New Jersey Turnpike, a few miles away from midtown Manhattan. As the space became scarce, warehouse builders moved south, first building at exit 15 and then steadily moving on. Now IDI is building at exit 8A.

“In the last five years there has been a lot of development at exit 8A, and now there is not much land left,” says Matt O'Sullivan, executive vice president and chief development officer of IDI. “We are now starting to see development at exit 7 and exit 6.”

Part of what gives O'Sullivan confidence is that there has been strong growth in the market at exit 8A with 53.3 million sq. ft. of industrial space already built. Big tenants who have leased 600,000 sq. ft. or more in the area include Barnes & Noble, Home Depot, and Volkswagen of America.

To serve such high-profile customers, IDI's Middlesex Center will provide state-of-the-art features. A decade ago ceiling heights on warehouses ranged from 14 to 24 ft. Now Middlesex Center boasts a height of 36 ft. At a time when companies are straining to cut logistics costs and meet global competition, the extra height enables tenants to stack more pallets under one roof.

Taller ceilings enable employees to load and unload trucks faster. An abundance of loading doors also improves efficiency. The Middlesex unit features 279 loading doors, so that trucks will not have to wait to unload, a common problem in earlier warehouses.

Pensions' preference

Even if the IDI Middlesex project fails to attract tenants, the developer may still make a profit by selling the facility to an institutional investor. Because of strong demand and rising rental rates, big institutions have been buying eagerly at exit 8A. The roster of institutional investors in the submarket includes insurer Allianz of America, Morgan Stanley, and TIAA-CREF, a behemoth pension fund for educators.

Facing intense competition, many pension funds are working hard to increase their allocation to the industrial sector. According to the Pension Real Estate Association, industrial properties have been playing an increasing role in pension portfolios. In 2004, the last year for which data is available, the industrial category accounted for 16.2% of pension real estate assets as measured in dollars. That was up from 15.3% in 2002.

Other property types carry more weight, with offices accounting for 34.5% of assets, retail 20%, and multifamily 17.1%. One reason that industrial accounts for a small share of portfolios is that the assets are relatively cheap. While a pension can spend $300 million on one office building, it is hard to find warehouses that cost more than $50 million.

While institutions have long craved Class-A offices and retail properties, some buyers are making a special effort to focus on warehouses. “Warehouses are seen as relatively safe holdings,” says Bob Chapman, senior executive vice president of Duke Realty Corp., a giant industrial REIT based in Indianapolis. “If a tenant leaves a warehouse, the landlord doesn't usually have to spend on improvements before finding someone to take the space. With an office building, you may have to make improvements before a new tenant will move in.”

Taking more risks

In the past, pensions focused on Class-A properties in major markets such as Dallas or Atlanta. But lately, with the yields shrinking, some institutional investors have become bolder. Brokers say that in hot markets in Southern California and New Jersey, institutional investors have been buying vacant buildings, taking on the risk of finding tenants.

In the past, such conservative tenants would have focused on core properties, steady income earners with solid tenants already in place. “Some plans are seeking riskier properties because they are having a hard time getting the rates of return they need,” says Blackwell of LaSalle Investment Management.

Lee & Katskin Associates, a developer and broker in Teterboro, N.J., recently bought an empty building in South Hackensack, N.J. Formerly used by Staples, the office-supply chain, the building's ceilings were just 12 ft. high, and the facility only had six loading docks.

Because the property is a few miles from Manhattan, the sellers sought $66 per sq. ft., a hefty price for an out-of-date property. In many markets around the country, prices for new fully tenanted buildings range from $50 to $70 per sq. ft., according to Grubb & Ellis.

“A lot of people looked at the deal and walked away,” says Charles Katskin, chief executive of the company. “We thought we could tear down the property and put up a new building that will be a very good investment.”

To avoid high prices, some pensions are looking beyond the major cities. An area of strong development is California's Inland Empire, including San Bernardino and Riverside Counties, which are adjacent to Los Angeles County and about 20 miles from the Pacific Coast.

“In Los Angeles, land for industrial properties can cost as much as $50 a sq. ft., if you can find it,” says Chris Migliori, executive vice president of GVA Daum, a Southern California brokerage. “In the Inland Empire, the same land costs $8 or $10 a sq. ft.”

The Inland Empire is cheaper because more land is available. In addition, trucks in the Inland Empire face longer trips to reach California ports. Because of the lower land costs, an investor can buy a 100,000 sq. ft. building in the Inland Empire for $90 a sq. ft., compared to $150 per sq. ft. near the Coast, says Migliori.

One way for owners to hold down purchase costs is to buy a part of a building in a condo arrangement. Instead of taking a 300,000 sq. ft. building, a small manufacturer might buy a 50,000 sq. ft. unit in the property. (For more on industrial condos, please turn to the sidebar on Page 103).

Improving fundamentals

In the next 12 months, the bidding will remain healthy in California and around the country, says Blackwell of LaSalle Investment Management. Demand for warehouses generally increases along with growth in gross domestic product (GDP). While the rate of expansion may be slowing, economists say, the economy is nonetheless still growing.

Investors will see modest rent increases along the coasts and relatively flat income in the central part of the country where there is more room to build and tougher competition, says Blackwell. Throughout this decade, landlords have seen little improvement in effective rents, according to Reis. Effective rents hit $4.50 in 2000 and then dropped steadily, hitting $4.27 in 2003. Rents should finally top $4.50 this year, Reis estimates. In fact, rents are projected to rise 3.2% this year and 3.5% in 2007.

Part of what may be holding down average rents is the trend toward bigger warehouses. While warehouses used to be 200,000 sq. ft. or so, now many are more than 400,000 sq. ft., and a few speculative units like Middlesex top 1 million sq. ft. Because of economies of scale, giant warehouses tend to charge tenants less per square foot than small facilities do.

The move toward bigger facilities is part of an overall change in how companies handle logistics, says Leonard Sahling, first vice president of research for ProLogis, a leading owner of warehouses. In the past, a national company might have 20 small warehouses spread around the country, says Sahling. Now they will have only four big facilities.

The company will have the same number of square feet, but operations will be more efficient because there are fewer employees. “Companies are rethinking their entire warehouse operations,” Sahling says, “and they trying to cut pennies wherever they can.”

Stan Luxenberg is based in New York.

Condomania hits industrial properties, too

Much like residential condos, industrial condos are proliferating. They have become particularly popular in Southern California, says Chris Migliori, executive vice president of brokerage firm GVA Daum. By dividing a project into condo units, the sellers can increase profits. “A developer may pay $100 per sq. ft. for a property, and then sell off smaller condo units for $165 a sq. ft.,” says Migliori.

For buyers, condos hold many advantages. By taking part of a property, small businesses can get exactly the right size they need at a location that might not otherwise be available. Also, some condo buyers prefer to control their facilities and not worry about negotiating rent increases with landlords.

Even in strong markets, condo prices stand out. Condo developers are aggressive bidders willing to pay cap rates as low as 5%. “They don't really care about the price,” says Migliori, “as long as the debt service is reasonable.” While California remains a leader, industrial condos are appearing in other strong markets.

Opus Group, a national developer, is building Dulles Woods Business Park, a 248,369 sq. ft. project in Dulles, Va., near I-495 and one mile from Dulles International Airport. Belfort Furniture, a home furnishings retailer, will take 83,224 sq. ft. The rest of the space will go to two other companies that want to purchase condo units.

The condos come in a variety of sizes, ranging from units of more than 300,000 sq. ft. to small properties of less than 2,000 sq. ft. Venture Corp., a California developer, recently purchased 5.4 acres for $1.76 million in Palmdale, Calif. that will be used for offices and industrial condos. The condos will be designed for small businesses, with units ranging from 1,800 sq. ft. to 5,000 sq. ft. The tentative completion date is October 2006.

Some of the demand for condos in California stems from global trade and booming imports from Asia. But the California economy is broadly diverse, and demand for condo and other industrial properties comes from many sectors. The Golden State boasts an array of companies that need manufacturing space in the semiconductor and the steel fabrication industries, among others. Technology companies provide a growing source of demand for laboratory facilities.

Some businesses are willing to pay up to $225 a sq. ft. to buy space for their laboratories in university cities, such as Irvine, Calif., says Migliori. “In the last 18 months, rising construction and land costs have pushed up prices,” he says, “but so far buyers have remained eager to write checks.”
— Stan Luxenberg