Occupancy and Construction Costs Taking On Increased Significance for Site Selectors
As the economy continues its downward spiral, site selectors are paying closer attention to occupancy and construction costs, and the results of Area Development's 2008 Corporate and Consultants Surveys reflect their concerns.
Jennifer LeClaire  (Dec/Jan 09)

The national industrial vacancy rate was 14.3 percent for the third quarter of 2008, according to Grubb & Ellis. That figure is expected to peak at 17 percent by the end of 2009. However, subleased space is seeing an uptick. "High occupancies will typically drive higher real estate costs and potentially a tougher labor environment," says Chris Brown, senior vice president of the investment team at Duke Realty Corporation in Indianapolis. "On the flipside, it also can confirm site selection objectives of other similar companies - making a particular location a safer selection."

Occupancy and construction costs ranked as the third-most important factor in the site selection process in Area Development's 2008 Corporate and Consultants Surveys. More than 90 percent say it's "very important" or "important" when making location and expansion decisions. How has the current state of the national economy created this increased focus?

Occupancy Trends
Occupancy is a key concern in any market, but the current state of the economy means there are deals to be had for companies with cash. The opportunity to tap into lower rents or lower construction costs can make a key difference for site selectors. "Construction costs are still high but only purpose-built facilities will require a user to consider construction," says Nancy Musselwhite, CEcD, a senior consultant at Geo Strategy Partners, a management consulting firm in Atlanta. "There is existing product all over the place so most relocating and expanding companies will focus their efforts on existing space first."

Corporate Survey 2008
Combined Ratings* of 2008 Factors
Site Selection Factors                   2008
Ranking
1. Highway accessibility 95.4
2. Labor costs 91.4
3. Occupancy and construction costs 90.4
4. Tax exemptions 88.6
5. Energy availability and costs 87.9
6. Availability of skilled labor 87.7
7. State and local incentives 87.2
8. Corporate tax rate 85.3
9. Low union profile 82.7
10. Available land 82.0
11. Availability of buildings 80.8
12. Proximity to major markets 78.7
13. Right-to-work state 76.6
14. Environmental regulations 76.1
15. Expedited or "fast-track" permitting 72.5
16. Proximity to suppliers 69.2
17. Availability of long-term financing 64.2
18. Availability of unskilled labor 62.9
19. Training programs 62.3
20. Raw materials availability 56.8
21. Availability of advanced ICT services 55.5
22. Accessibility to major airport 53.3
23. Proximity to technical university 38.4
24. Railroad service 27.2
25. Waterway or oceanport accessibility 15.7
*All figures are percentages and are the total of "very important" and "important" ratings of the Area Development Corporate Survey and are rounded to the nearest tenth of a percent.
Sophisticated companies are constantly evaluating the best after-tax cost of occupancy, according to Trevor Ragsdale, executive vice president of Jones Lang LaSalle's Supply Chain and Logistics Solutions team. "In the current market, financing costs and capitalization rates - the percent return that most developers target on a build-to-suit lease to help set rental rates - are increasing rapidly; however, corporate bond yields are increasing ever faster," he says. "We continue to see most companies lease all but their most core facilities on an operating lease basis."

"It may be less expensive to purchase an existing building versus building, or leasing a building may be more attractive than purchasing," says Katie Culp, senior vice president of the Location Advisory & Incentives Practice for Colliers Turley Martin Tucker in Indianapolis. "In either case, the availability of product is a key driver. We've seen a number of our site selection projects begin with a survey of available product in the preferred markets."

Taking a Back Seat

The construction and occupancy category always takes a back seat to labor. At some level, this seems counterintuitive, since labor can be recruited from surrounding areas while occupancy cannot and construction costs can stymie a deal in a down economy. But often it's the cost rather than the availability of labor that site selectors examine. Highway and labor concerns are typically much more significant components in the cost structure of a product than occupancy costs, and construction costs are less important today in site selection due to the limited availability of capital to build and borrow.

"The cost of not choosing the optimal location to minimize transportation expense can far outweigh any `opportunistic' deals that may be had on the occupancy side of the equation," says Ragsdale. "The cost of transportation can approach 40 percent to 50 percent of a typical distribution center cost structure while occupancy is usually less than 8 percent."

Les Cranmer, a senior managing director at Studley in Philadelphia, believes there are two ways of approaching the occupancy and construction factor. One is to find an existing building that can be occupied quickly to save time - and hopefully it will come with a labor force that can get the job done. "The alternative is to find a labor force that makes sense, and hopefully it will come with a building that you can occupy on time," he says. "And it's really the latter approach that wins out time and time again."

Re-examining Construction Costs
Construction costs are more important than a decade ago because the cost to construct has risen so rapidly. This is especially important if a company has already approved a capital budget for a project based on yesterday's construction cost environment. "There could be a large resulting cost gap between yesterday's budget and today's prices that must be overcome through other means," says Culp. "Fueled by ever-increasing construction materials [costs], many companies are turning to searches for existing buildings as a primary criteria for a location."

While decreasing commodity costs are helping to bring down the recent spike in the cost of new construction, development financing and stabilized debt has become considerably more expensive, according to Ragsdale. "This increase in financing cost has eroded any of the savings one might expect to see from decreasing or flattening hard costs," he says. "We are seeing the best occupancy costs driven out of using speculative or second generation construction."

The occupancy and construction market is dynamic - and not in a positive sense. Prices may be going down, but that puts a new pressure on cost-conscious companies to wait for the bottom. But there's also the risk of a global disruption that could drive prices up again, according to Mark Sweeney, senior principal at McCallum Sweeney Consulting in Greenville, South Carolina. "People talk about occupancy costs in the U.S. with a broad brush, but it's going to vary more than in the past, region by region and even market by market," he says. "Some markets that were hotter may see price collapses. Other markets that were stable may not be experiencing as big a downturn. The biggest challenge for companies is to understand the overall dynamics and be sensitive to the market differences."


Build-to-Suit Options
Some site selectors are still exploring build-to-suit options - if the terms are attractive. Risk management is key when few want to commit to long-term agreements. In a tenant's market, many may prefer to lock in favorable lease rates than build-to-suit, according to industry watchers. What's more, relatively few build-to-suit transactions can be completed in today's environment due to the credit crunch. "If a company is selecting a site today, existing building owners are highly motivated to do what it takes," says Brown. "If a company has the means or credit to finance new construction, construction pricing is at its lowest point in many years."

Of course, the build-to-suit option also depends on company's culture. Some companies will only entertain options that allow them to own the real estate, but many - especially public companies - prefer lease arrangements. Cranmer reports a tremendous slowdown in construction and in location decisions. Corporations, he says, are guarded about making long-term decisions in the current client. And the build-to-suit developers can't get the financing they need to complete projects. "I have seen more projects put on the shelf in the last two years that at any time I can remember," he says. "And I've been doing this 30 years."

Corporate Survey 2008
Combined Ratings* of 2008 Factors
Site Selection Factors                   2008
Ranking
1. Highway accessibility 95.4
2. Labor costs 91.4
3. Occupancy and construction costs 90.4
4. Tax exemptions 88.6
5. Energy availability and costs 87.9
6. Availability of skilled labor 87.7
7. State and local incentives 87.2
8. Corporate tax rate 85.3
9. Low union profile 82.7
10. Available land 82.0
11. Availability of buildings 80.8
12. Proximity to major markets 78.7
13. Right-to-work state 76.6
14. Environmental regulations 76.1
15. Expedited or "fast-track" permitting 72.5
16. Proximity to suppliers 69.2
17. Availability of long-term financing 64.2
18. Availability of unskilled labor 62.9
19. Training programs 62.3
20. Raw materials availability 56.8
21. Availability of advanced ICT services 55.5
22. Accessibility to major airport 53.3
23. Proximity to technical university 38.4
24. Railroad service 27.2
25. Waterway or oceanport accessibility 15.7
*All figures are percentages and are the total of "very important" and "important" ratings of the Area Development Corporate Survey and are rounded to the nearest tenth of a percent.
Sale-leasebacks may be an option for some industrial site selectors that do need to expand but don't have the access to capital to build a new facility, according to Ronald Pollina, Ph.D., president of Pollina Corporate Real Estate in Park Ridge, Illinois. "Sale-leasebacks are a creative financing vehicle and it doesn't have to be for an existing building," he says. "We have structured sale-leasebacks for buildings that are going to be custom-built for clients that allows them to get the best of both worlds."

Looking Ahead
Minimizing upfront investment costs is the name of the site selection game in the near-term. Opportunities that reduce upfront cash outlays will pique the interest of site selectors, according to Lawrence Moretti, a senior team member of Deloitte's Global Location Strategies and Corporate Real Estate Practices. "Credit is a lot tighter," he says. "Reducing occupancy costs is a key consideration."

Reducing occupancy costs could mean going green for some industrial sites. Greener is better, and that trend will continue to be more pronounced going forward, according to Ragsdale. While companies are still looking for such amenities as wider truck courts, off-dock wall trailer parking, off-street access roads to accommodate truck queuing prior to entering the property, and controlled access, he says that concerns over the environmental impact of these facilities is growing rapidly: "Many companies are looking at cost-effective ways to reduce carbon footprint, such as employing the use of bio-swales to capture groundwater runoff, using fluorescent lighting with motion sensors, and increasing the R-values of insulation in cold-weather climates."

The big "X factor" is the economy. So site selectors are facing business questions more than location questions until the economy settles down. In the meantime, Cranmer is seeing more financial feasibility of projects than in the past. "Due diligence is more important and more rigorous than ever," he says. "We've gone from the expansion mode we've experienced for the past 15 to 20 years and we're retrenching as we move to contraction mode. There will still be relocations, but it's a new world out there."

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