When Omron Manufacturing of America explored sites for a new electronics production and assembly line in its hometown of St. Charles, Ill., the space options were limited. If the manufacturer were to leave its home base, then most of the company's hourly employees would quit rather than commute, management reasoned. But finding land on which to build in the heavily developed area west of Chicago was nearly impossible, and most new construction in St. Charles favored distribution rather than manufacturing.

Omron found its solution only a block away from its existing distribution center, in the form of an outdated 50,400 sq. ft. warehouse. After a preliminary analysis, Omron bought the warehouse for $2 million and hired Krusinski Construction Co. of Oakbrook, Ill., to prepare the structure for Omron's manufacturing lines.

“The biggest advantage is that 60% of our trained workforce is located around this area,” says Omron assistant general manager Roger Saltzman, who is convinced that keeping the operation in St. Charles was well worth the $1.7 million the manufacturer spent on the rehabilitation. “Even though it's an older building, its construction is probably better than a newer building we would have gotten somewhere else.”

Omron is one of a growing number of companies and investors rehabilitating outdated manufacturing and warehouse properties to acquire space in prime locations. Patrick Gallagher, senior vice president at The Alter Group of Skokie, Ill., says the trend hit Chicago about 14 months ago and reflects increasing land values, which have soared nearly 200% near O'Hare International Airport, rising from $5 per sq. ft. a few years ago to about $14.50 today. “You've got obsolete buildings in great locations, and land value has gotten to the point that it justifies tearing them down,” says Gallagher.

Institutional players such as real estate investment trust AMB Property Corp., pension fund adviser Principal Financial and others are pouring capital into a number of rehabs in the land-constrained markets of Chicago, New Jersey and Los Angeles, and will continue to do so while demand for new bulk warehousing remains, according to Gallagher. Researchers at Delta Associates, an affiliate of Transwestern Commercial Services, expect that demand to escalate as a growing U.S. population requires freight companies to transport more and more food, clothing and material goods to meet its needs.

Perils & Profits

Despite its obvious benefits, redevelopment isn't for everyone. Most properties carry the risk of unforeseen costs that could make rehabilitation financially unfeasible. “The risks are huge, because it's very difficult to quantify your costs,” says James Camp, senior vice president of development and acquisitions at Newport Beach, Calif.-based Voit Development Co. “It's guaranteed you're going to have additional costs.” Last year in the Los Angeles suburb of Tustin, Calif., Voit rehabilitated half of a former Steelcase office furniture plant for a new user and scraped the rest of the original 1 million sq. ft. structure to make way for 19 new industrial buildings.

Redevelopment has its greatest appeal in tight submarkets such as Tustin, where the rent or sale potential brought on by unmet demand outweighs additional costs. The national industrial vacancy rate registered 9.7% at midyear, according to Grubb & Ellis, but availability is far more limited near many of the specific labor and transportation centers on which distribution companies rely.

In central L.A., for example, industrial vacancy is 1.6%. So for developers willing to deal with the added headaches, rehabilitating outdated structures can produce prized space in submarkets with few competing properties.

A rehab that introduces modern space in tight submarkets will generate higher rent than a typical development erected on raw land. Gallagher says a state-of-the-art distribution space at O'Hare Airport, for example, rents for as much as $7 per sq. ft. per month, compared with the $4.20 per sq. ft. average along Chicago's I-55 Corridor.

Industrial stock in the San Fernando Valley is primarily manufacturing space dating from the World War II era with mere 16-foot ceilings, says Ron Feder, principal at the LA North/Ventura office of Calabasas, Calif.-based Lee & Associates Inc., a commercial real estate firm serving the San Fernando Valley and surrounding areas. That doesn't fit the needs of today's distribution users, who generally need at least 24 ft. clear heights to allow product stacking.

Demolishing such outdated structures is often the only way to obtain a site for construction. “There's just no more land in the Valley,” Feder says. “We need new product, and all we're left with now is the replacement of older, less useful facilities.”

Replacing existing stock is the only option in some sections of Chicago as well. “We kid in the office that they don't make any more land,” says Jerry Krusinski, president and COO of Krusinski Construction. “There is a huge appetite to buy into the market [around O'Hare] right now and there's just not a lot of good buildings available, so developers are finding these old obsolete buildings and creating a higher-value piece of real estate.”

Gateway to the Future

In central L.A., where redevelopment is the standard route to new space, rent averages $5.40 per sq. ft. compared with $4.67 in the newer Inland Empire industrial area, where vacancy is 5.6%, according to Grubb & Ellis.

Near L.A., Voit Development stands to reap a substantial profit with Tustin Gateway Business Park. Voit acquired the 1 million sq. ft. former Steelcase building for $29 million in February 2003 and immediately removed half of the massive structure to open up 15 acres for future construction. Eight months later, the developer sold the scaled-down, renovated 500,000 sq. ft. that remained of the original Steelcase building to Bedrosians Tile & Stone, recouping $26 million of the $32 million the developer had spent on acquisition and renovation.

Now, Voit is developing the remaining 15 acres at Tustin Gateway into 266,666 sq. ft. in 19 buildings that measure from 3,800 sq. ft. to 37,000 sq. ft. Asking prices range from $120 to $190 per sq. ft., well below the $250 per sq. ft. that flex buildings sell for in the vicinity. “We have increased prices on this project three times since we originally did our pro forma, and we are still the most competitively priced new product in the Irvine business complex,” Camp says.

Location is King

Chicago, L.A. and New Jersey top the list of the best markets for infill redevelopment, due to a lack of available land for new construction. “The biggest driving factor is land-constrained markets,” says Jim Connor, regional executive vice president of Indianapolis-based Duke Realty Corp. “In a lot of cases you can create a new, state-of-the-art product in an area where it doesn't exist.” That's what Duke accomplished with Northlake Distribution Center in Northlake, Ill. Duke acquired the 23-acre site and replaced a 240,000 sq. ft. building on the property with 413,000 sq. ft. of modern distribution space. The complex was 100% leased by the end of its 18-month reconstruction.

Redevelopment is often the only option for industrial requirements around New York City, says Chuck Tabone, managing principal at Newmark & Co. Earlier this year, Tabone brokered the sale of a 150,000 sq. ft. building in Hicksville, N.Y., to Simone Development Cos., then brought in Allied Building Products Corp. to lease 70,000 sq. ft. of the project after extensive renovations by Simone. “Simone made it a [modern] building and did it in an area where you realistically can't buy land and build. If you need a building in that county, you have to deal with the existing stock,” Tabone says.

Even where vacancies are higher, obsolescence may provide a market for new or renewed space, says Scott Price, director of research for Delta Associates. Price defines modern bulk distribution space as having clear heights of at least 28 feet and measuring at least 200,000 sq. ft. “Modern bulk facilities only represent about 8% of all warehouse product,” Price says. “You're still going to have new construction, just because the existing stock is obsolete.”

Price says a growing population drives demand for material goods and warehouses to store those goods. Current growth rates will expand the U.S. population by 18.5 million over the next six years to reach 309 million by 2010. A recent forecast by Delta Associates shows that population growth already merits new warehouse construction in the Los Angeles Basin, Seattle, New Jersey, Denver and other prime distribution markets.

And despite a temporary oversupply resulting from the economic slump since 2001, researchers anticipate most major markets will need new space by the end of 2005. Gallagher of The Alter Group says demand will continue to fuel rehabilitation activity in tight markets.

No Cookie-Cutter Approach

So why aren't more developers snapping up aging manufacturing sites and warehouses for rehabilitation? One reason is the difficulty of taking a uniform approach to multiple rehabs. Camp of Voit Development compares rehabs to peeling layers from an onion, and says some of Voit's projects have involved such costly surprises as the relocation of utilities and sewer lines not shown on building plans.

On the bright side, developers say difficulties associated with industrial rehabs reduce the number of competitors. “A lot of developers don't want to do this kind of work,” Camp says. “It's harder to quantify and it's sometimes harder to understand” than development on raw land.

As much as possible, developers calculate specific reconstruction costs before completing an acquisition for rehab. Typical projects may involve reducing the number of support columns cluttering a space, or perhaps removal of an out-building to provide land for a catch basin to collect and filter storm water. Truck courts at many outmoded facilities must be expanded to accommodate today's longer trailers, while additional loading docks will allow faster loading and unloading. Before users can stack goods beyond a certain height, building codes usually require installation of expensive fire suppression sprinklers.

But updating aging buildings to meet modern building and safety codes provides peace of mind for surrounding communities, builder Krusinski says, and that can make the process of acquiring permits and other approvals easier than securing permits for new construction. “The communities love it because we're taking these old, less desirable buildings and creating a new facility,” he says. “Aesthetically they're more appealing and they comply with new codes and ordinances.”

Communities benefit because industrial rehabilitation reduces the potential for fire or other accidents that could endanger those outside the property, says Bob Vann, building and zoning commissioner for the City of St. Charles, where Krusinski converted Omron Manufacturing's purchase for re-use. “If they're in close proximity to other buildings, then that [rehabilitation] adds to the safety of the building and community,” Vann says.

Community acceptance of infill projects can mean a shorter construction period than similar development on raw land, particularly in parts of California, New Jersey, Florida and other areas resistant to new development. “In a lot of instances, you can be in and done with the [rehab] in less time than it would take just to entitle the land site for new construction,” says Connor of Duke Realty.

Gene Riley, executive vice president of development for San Francisco-based AMB Property Corp., says the increasing difficulty of entitling raw land for development is the chief reason his company has expanded its industrial rehabilitation work. The corporation is currently redeveloping seven properties for a total of 2 million sq. ft. at a cost of approximately $120 million. That equates to 2% of AMB's 100 million sq. ft. portfolio in the United States.

Balancing Expenses and Expectations

Developers say the key to successfully converting an obsolete building into a profitable industrial gem is painstaking analysis of the property and a careful balance of rehabilitation costs with the anticipated rent or sale price. Creative problem solving can make or break the deal.

In the case of the rehabbed Steelcase plant, Voit executives knew upfront that the building's 22-foot clear height ruled out most distribution users as potential tenants. But when the team discovered that half of the 1 million sq. ft. building had once been a freestanding structure, the company was able to identify a user for the smaller space that didn't require a high ceiling.

Only then did Voit proceed with the acquisition. “We had our buyer committed with a lot of money,” Camp says. “With that part of the property committed, we were able to get very aggressive with our bank.”

In another example, careful calculation helped Duke Realty identify a redevelopment opportunity in an area that doesn't fit the general rehab criteria of being a land-constrained market. Duke purchased what had been Johnson & Johnson's first disposable-diaper manufacturing plant, a 450,000 sq. ft. structure on 40 acres near Chicago in Bolingbrook, Ill. Available land enabled Duke to add truck courts on opposite sides of the building while updating the interior.

“Because we were able to buy it at a good price, we were able to redevelop this 30-year-old building into a functional distribution center and still undercut the market by about 10%, or 25 cents per sq. ft.,” Connor says.

The success or failure of a rehab often comes down to total occupancy costs for the end user. Krusinski, the contractor who completed Omron Manufacturing's warehouse conversion, says developers that manage to secure tax incentives or other savings for tenants as part of revitalization will be able to charge higher rent, for example, while keeping overall user costs competitive. As Krusinski says, “There's a little bit of magic to this.”

Matt Hudgins is an Austin-based writer.

URBAN INDUSTRIAL SUBMARKETS ARE IN DEMAND

Select submarkets in major industrial centers such as Los Angeles, Chicago and New Jersey are highly desirable because of their location and available workforce. As of mid-year 2004, such submarkets commanded much higher rental rates than outlying areas.

Vacancy Rate Monthly Asking
Rental Rate
Los Angeles
Central L.A. 1.6% $5.40
Inland Empire 5.6% $4.67
Chicago
O'Hare International Airport 8.0% $4.68
I-55 Corridor 17.1% $4.20
New Jersey
Northern N.J. 8.7% $6.08
Exit 8A 11.2% $4.43
Source: Grubb & Ellis


Low Ceilings Present Tall Challenge

Engineering can't overcome every obstacle in an industrial rehabilitation, and the king of deal killers is a low ceiling that severely limits the ability of distribution space users to stack product.

Modern bulk warehousing relies on stacked inventory to reduce the distance between goods and loading areas, with typical users looking for clear heights of at least 28 ft. The standard in new construction is 32 ft., “and that envelope keeps getting higher,” says Patrick Laughlin, associate broker in the Atlanta office of tenant representation firm The Staubach Co.

Manufacturing space and most warehouses built before the mid-1990s literally fall short of that requirement with ceilings ranging from 18 to 24 ft. “Everyone is trying to figure out an economical way to raise the ceilings on some of these old buildings, but nobody's figured out a way to do that yet,” Laughlin says. In most cases, only demolition and new construction can correct an unacceptably low ceiling, say industry experts.

Lower ceiling heights will work for many manufacturers and even some distributors when tall stacking isn't required. For example, Bedrosians Tile & Stone was able to utilize a former manufacturing space with 22 ft. ceilings in Tustin Gateway Business Park in Tustin, Calif. The stone products company doesn't use ultra-tall stacking for its weighty products.

Developer Simone Development worked around a low ceiling that could have handicapped leasing efforts for its redevelopment of One Enterprise Place in Hicksville, N.Y., according to Chuck Tabone, managing principal in the Long Island office of real estate services firm Newmark & Co. As part of renovation efforts for the 150,000 sq. ft., one-story building, Simone successfully negotiated with city officials to allow exterior storage on the property.

Allied Building Products Corp. couldn't have used the 70,000 sq. ft. it leased in One Enterprise Place without the provision to stack inventory outside the structure due to a low ceiling height of 15.5 ft., according to Tabone. “The building didn't give what Allied normally would look for, but the combination of outside space and inside space gave Allied what they needed.”

Companies able to function with lower ceilings have a clear advantage in culling obsolete properties to convert for their own use. But that's not an option for speculative developers appealing to a wide range of users, particularly in markets where distribution is the dominant industrial activity.

The ceiling itself isn't the only barrier to high storage in many older warehouses, says Patrick Gallagher, senior vice president at privately held developer The Alter Group in Skokie, Ill. Even if there were an economical way to raise a ceiling, he says, slight dips or rises in the floor prevent high stacking due to the “leaning-tower” effect. A slope that was inconsequential for the shorter pallet stacks of earlier decades may topple inventories stacked to today's standard heights of 28 or more feet.
— Matt Hudgins