While warehouses themselves are growing, the cities in which they are located are shrinking. With land and investment opportunities in short supply in the major markets, the cheap land, low-cost labor and attractive economic incentive packages of smaller cities are luring investors and developers, not to mention corporate users hoping to cut their logistics costs without sacrificing accessibility.

“Outside the major markets, you can get the same logistics network, but your rents, taxes and operating costs are lower,” observes Marc Poggioli, regional vice president of Chicago-based Higgins Development Partners. “Recently, there's been a trend to go to more remote locations due to the efficiencies.”

Swedish furniture retailer IKEA, for example, chose to locate its 1.7 million sq. ft. West Coast distribution center in the Tejon Industrial Complex in Kern County, Calif., north of Los Angeles. The location offered a savings of $18 million over the course of a 10-year lease when compared with the nearby Inland Empire area, where many major companies have distribution hubs.

And although the location sacrifices quick access to the Port of Los Angeles, the operational savings achieved by locating in Kern County make the trade-off worthwhile, IKEA officials say. Labor is 30% to 35% lower, rents are four to seven cents less per sq. ft. on a monthly triple-net basis and the average asking price for industrial land is $2 to $2.50 per sq. ft., compared with $4 to $6 per sq. ft. in the Inland Empire, says John DeGrinis, senior vice president in the Encino, Calif., office of Colliers Seeley.

In the past, national investors feared that it would be difficult to fill space in a secondary market if a tenant defaulted. Now there is a steady stream of major customers such as IKEA that want to locate in secondary markets, and major developers are lining up to accommodate them. For example, Quadrangle Development Co., a national developer based in Bannockburn, Ill., near Chicago, is poised to break ground on a 442,000 sq. ft. spec distribution center outside Indianapolis. The project will cost about $5 less per sq. ft. than it would to build the same project near Chicago.

“The cost of playing the game is less [in a secondary market],” says Christopher Noon, president of Quadrangle. “We can do more with less, and there's generally less competition for land.”

Pro-development municipalities and plump economic incentive packages, which include tax abatement programs, or TIF (tax increment financing) districts, also play a significant role in attracting big names. “Companies are approaching site selection on a regional basis,” explains Jay Archer, senior vice president with Indianapolis-based Duke Realty Corp. “You have to offer incentives to attract users.”

Topeka, Kan., succeeded by doing just that. Discount retailer Target decided to build an $80 million, 1.3 million sq. ft. distribution center there largely due to the city's generous incentive package, which included land paid for by local tax dollars earmarked for attracting new development, as well as a 10-year tax abatement.

Bigger Doesn't Necessarily Mean Better

Not all secondary markets are viable alternatives to the country's five major distribution corridors of Los Angeles, Chicago, New Jersey, Dallas and Atlanta. Some smaller markets in the Southeast have softened considerably. Charlotte, N.C., posted a 14.3% industrial vacancy rate in the third quarter and Raleigh, N.C., hit 22%, the highest in the nation, according to the Society of Industrial and Office Realtors (SIOR). The national vacancy rate is 9.2%.

Likewise, Pennsylvania's Lehigh Valley, in the Allentown-Bethlehem-Easton corridor that lies west of New York City and north of Philadelphia, is feeling the pinch. The Valley, whose location puts companies such as U.S. Food Service and Tru Serve Logistics within reach of most Northeast markets, is suffering from an oversupply of industrial space. Construction has virtually halted in the 32 million sq. ft. market — a mere 200,000 sq. ft. of space will be delivered in 2002, reports the Lehigh Valley Economic Development Corp., compared with more than 2 million sq. ft. of new construction delivered in 2001.

And rental rates have dropped, too. Third-quarter rental rates for Class-A warehouse and distribution facilities in the region averaged $3.85 per sq. ft., down from $4.50 a year ago, according to New York-based Grubb & Ellis.

Even so, the Lehigh Valley region offers thrifty investors a cheaper alternative to the urban industrial space of nearby New Jersey. Third-quarter rental rates in central New Jersey averaged $4.75 per sq. ft., while northern New Jersey averaged $6.29 per sq. ft., reports New York-based Cushman & Wakefield. Another plus: labor is cheap in the Valley, where the workforce earns an average annual income of $33,046, compared with $44,576 in Trenton, N.J., according to the Lehigh Valley Economic Development Corp.

In addition, a smaller market can rebound faster, Poggioli observes. “I see smaller markets as more stable than the primary markets like Chicago, New Jersey or Atlanta,” he explains. “We might be statistically similar, but in Lehigh Valley, two or three deals will get us back to zero availability. In Atlanta right now, you'd have to do 25 deals to get there.”

Convincing the Lenders

Secondary markets are attractive to investors that have been unsuccessful at breaking into the primary distribution centers. “There are two kinds of investors in secondary markets: Reluctant buyers who can't get into the primary markets, and opportunity buyers,” says Geoffrey Kasselman, senior managing director in the Chicago office of New York-based Julien J. Studley.

High-quality properties also can be easier to acquire in less populous markets — a boon for investors hoping to avoid the competition for trophy properties in major markets, which lately has been exacerbated by the flood of capital from Wall Street into the relative safety of real estate.

However, small markets can be a tough sell to traditional sources of financing. Tremont Capital recently brokered a $54.4 million senior mortgage for the Santa Theresa Realty Trust, a private El Paso, Texas-based company that purchased an industrial portfolio located primarily along the Texas border, paired with manufacturing facilities in Mexico.

“This was a deal that took patience,” admits David Ross, senior director of Boston-based Tremont. “First, we had to get comfortable with it, then we had to repeatedly tell the story. The biggest concern was getting a handle on the markets because these are peripheral markets to national investors.”

Driving Development

Investors are confident that these smaller markets will continue to offer development opportunities for the foreseeable future. For example, Indianapolis — which is within a one-day drive of 65% of the U.S. population — has become the Midwest's new hot market. “We could buy a bigger or more prominent piece of land in Indianapolis, for the same money as we would have spent in Chicago,” says Noon.

And the location offers other advantages as well. “Our location works from a national logistics perspective,” says Peter Quinn, a partner with Indianapolis-based Summit Realty Group.

Vacancy rates in Indianapolis rose only slightly from 8.8% in the third quarter of 2001 to 10.3% in the third quarter of 2002, reports Los Angeles-based CB Richard Ellis. But according to Quinn, the higher vacancy rate is due primarily to an influx of supply, not a lack of demand.

Indeed, absorption rates indicate a healthy demand. St. Louis-based Colliers Turley Martin Tucker reports that Indianapolis' overall occupied space rose by nearly 7 million sq. ft. over the past year, from 210.8 million sq. ft. in June 2001 to 217.1 million sq. ft. in June 2002.

Developers are banking on a continued trend of positive absorption. Rosemont, Ill.-based Opus North Corp. is building a 552,000 sq. ft. speculative facility, and other major players are following suit. West Conshohocken, Pa.-based Keystone Property Trust is planning an 800,000 sq. ft. speculative distribution property, while Columbus, Ohio-based The Pizzutti Cos. plans 500,000 sq. ft. of spec development.

Is this a risky proposition — banking on rising absorption in a shaky economy? Not according to Quinn. “I'm actually concerned that we won't have enough product by this time next year.”

Margy Sweeney is a Chicago-based writer.