Six Predictions Regarding the Industrial RE Market Recovery and How They Have Played Out
While several predictions about the shifting industrial real estate landscape have been borne out and others remain fluid, it seems that this real estate sector will continue to grow faster than others.
Our team recently completed a report that uses actual performance and continuing forecasts to assess how closely the industry is tracking to expectations. We reviewed a number of those initial predictions and tracked the outcomes, with an eye toward seeing how their performance could, perhaps, have far-reaching implications for the way companies should plan for the short-, medium-, and long-term.
Prior Prediction #1: To meet increasing customer delivery expectations, distribution centers (DCs) will be located closer to urban centers.
The growth of e-commerce has fueled new DC projects in major hubs and key markets measurably. This is particularly true in and near higher-density metro areas. For example, regions like Dallas, the Inland Empire, and Chicago have 16.5, 14.8, and 6.0 million square feet under construction, respectively. Each of these markets recorded more than eight million square feet of e-commerce deal volume during the last three years. New Jersey registered the greatest e-commerce activity as a percentage of new projects (including deals in excess of 200,000) — 32 percent since 2011. This is unsurprising, given that state’s sweet-spot position within the most densely populated region of the U.S.
Still, while big-box DC construction has been the big e-commerce story lately, it is not the only one. As e-commerce operations are being established for next-day and same-day fulfillment in large metro areas, the demand for smaller, infill facilities is also on the rise. Not only do shippers covet the proximity to FedEx/UPS ground-shipping centers these locations often bring, they gain the ability to fulfill and deliver orders to a large number of customers quickly.
The need to improve supply chain efficiency to save time, money, and fuel is a driving force behind the rise of giant DCs, which allow companies to experiment with different fulfillment strategies and respond to the demands of high-turnover online retailing.
Multiple smaller and mid-size distribution centers that are well placed in urban infill locations minimize the time and distance spent on the final leg of delivery. Such centers are being used by major retailers as satellite locations and by small- and mid-size retailers as primary online fulfillment centers. Changing service requirements, elevated transportation costs, and access to labor are some of the reasons why concentrating around major population centers will continue to be a focus for these businesses. This is a trend still in motion, with the story incomplete. — Prediction Grade: B or Incomplete
Prior Prediction #2: Warehouse/distribution centers will continue to grow.
Large is indeed big right now. Industrial buildings are setting new records for scope, as distribution centers greater than one million square feet become more prevalent in several markets. Half of these mega-projects have been constructed since 2000, with a quarter of the total inventory added since the beginning of 2007.
The need to improve supply chain efficiency to save time, money, and fuel is a driving force behind the rise of giant DCs, which allow companies to experiment with different fulfillment strategies and respond to the demands of high-turnover online retailing. To this end, Amazon, Procter & Gamble, TJ Maxx, Home Depot, and Walmart all moved forward with mega-sized distribution centers in 2013.
Because these mega facilities and the operations within them often require significant land parcels to accommodate larger truck courts and parking areas, there is an inherent conflict limiting how much further this trend can continue; major parcels, in major markets, closer to an urban core are limited and, ultimately, finite. - Prediction Grade: A-
Prior Prediction #3: Clear heights will rise.
Not only has the total square footage of new buildings increased substantially, but also the average clear heights have indeed risen. As direct-to-consumer sales require retailers to consolidate online and store-based fulfillment operations under one roof, higher ceiling height improves racking options, maximizes pallet capacity by 12 to 25 percent (in comparison to 32-foot clear height), and increases cube capacity by 7 to 15 percent. Another factor pushing distribution centers to the 36–40-foot range is the ability to incorporate mezzanines that facilitate order picking.
As facilities grow, so does the adoption of automation to meet order fulfillment labor, speed, and accuracy. For example, e-commerce providers are harnessing radio frequency identification systems (RFID), which allow machines to store and retrieve goods on the basis of the label number assigned on the package. After big increases in 2012 and a modest slowdown in 2013, MHI data now shows 2014 rebounding with strong increases in both orders and shipments of material-handling equipment. Beyond operational advantages, these higher ceiling heights also provide strategic real estate benefits. Tenants can maximize their square footage, which may enable them to expand in place rather than relocate to accommodate growth.
Many of the large new facilities rising today are build-to-suits. Developers are, however, getting in on the act by building some speculative product to higher specifications. In the Inland Empire, five new speculative construction projects with a 36-foot clearance are under way. And in the Dallas/Fort Worth market, seven new spec projects totaling 7.2 million square feet offer clear heights greater than 36 feet. - Prediction Grade: A
Prior Prediction #4: Supply of large, modern warehouse space will be constrained in prime hubs, pushing development activity into secondary markets.
The jury may still be out on this one. Although it is true that secondary markets have seen an increase in development, activity in primary markets remains stronger, particularly in core markets like the Inland Empire, Chicago, Dallas/Fort Worth, Houston, and Central New Jersey. But if top markets are not yet constrained, they likely soon will be — which means that secondary markets will see their fair share of development in the midterm.
Companies seeking good highway access, proximity to intermodal or ports, and strong labor are finding it increasingly difficult to secure the right site in top markets. Limited availability and high land prices are making urban facilities more expensive, and neighboring submarkets are becoming increasingly land-constrained.
Companies seeking good highway access, proximity to intermodal or ports, and strong labor are finding it increasingly difficult to secure the right site in top markets. Limited availability and high land prices are making urban facilities more expensive, and neighboring submarkets are becoming increasingly land-constrained. Some tight markets will likely see some older stock demolished and rebuilt to meet some of the demand (examples can be found in Los Angeles, Oakland, and Orange County, California), but development also will spill into markets with land ready for construction, such as Phoenix and Indianapolis.
It is interesting to consider the percent of industrial construction completions that occur in the top 10 markets, compared to all other markets, and use that data to discuss how this dynamic might help predict business cycle strength and duration. During the last significant real estate cycle we saw the percent of construction completions in top markets rise to near 83 percent at the peak in 2006, but then fall to 67 percent at the bottom of the cycle in 2009. In 2012, the percent of construction completions in top markets had risen back to 81 percent. By mid-year 2014, the level had fallen marginally, to 75 percent. We believe the fact that this ratio remains relatively high a few years into the current cycle is a sign that it still has plenty of room to run. Development capital will certainly move toward secondary markets as a business cycle matures. - Prediction Grade: B+ or Incomplete
Prior Prediction #5: Rising construction costs will present big challenges for new development.
The first part of this prediction — that construction costs will rise — certainly has come true. However, new development is booming, with projects getting built and deals getting done.
Construction costs for industrial product vary by city and market. Chicago, northern and central New Jersey, Los Angeles, and northern California are among the most expensive. Both New York/New Jersey and Chicago have seen the most significant average increases in construction costs (10 and 5 percent, respectively) in the last year. Material costs for construction of warehouse/distribution projects, in general, have inched marginally upward in recent years. And, as the size of the potential site increases, some hard cost totals, on a per-square-foot basis (site work, foundation premiums, offsite improvements, shell), may see notable drops. According to Oltmans Construction, the building cost for a one-million-square-foot CTU building with 32-foot clear ceilings and ESFR sprinklers can be approximately $21.25 per square foot in southern California, compared to $30 per square foot for a 200,000-square-foot building.
So, why are costs trending up? Rising labor costs and land constraints are the main culprits. Considering that construction labor costs have risen 2.8 percent in the last year alone, and that demand for industrial product has reached a recent high, we expect overall development costs to continue growing.
Yet, within this context, virtually all of the top markets are seeing construction pipelines return to pre-recession levels. At mid-year 2014, Dallas/Fort Worth and the Inland Empire were leading the way, with 16 million square feet and 13.4 million square feet under development, respectively. As a market, Dallas absorbed more than 15 million square feet in 2013, and is set to add more than 20 million square feet in construction by the end of 2014. By the end of the year, new industrial construction nationwide will total 119 million square feet — more than double last year’s volume and the highest since 2008. - Prediction Grade: C
Prior Prediction #6: Reshoring will bring more jobs, capital investment, and subsequent demand for industrial space back to the U.S.
We have good news here, but just how much remains unclear. While the debate still exists regarding how much manufacturing has returned to the U.S. from offshore locations, manufacturers are at the very least examining their options more closely.
Not long ago, the labor cost advantages of China and India made them prime focuses for outsourced operations. Now locales like Mexico, Canada, and the southeastern U.S. are getting stronger consideration. In a 2012 Boston Consulting Group (BCG) survey, 37 percent of U.S. manufacturers with sales above $1 billion said they were considering shifting some production from China to the United States. Of the very biggest firms, with sales above $10 billion, 48 percent were considering reshoring. Respondents cited factors including rising wages and benefits in China, as well as stricter labor laws and more frequent labor disputes and strikes.
At the same time that wages are rising in places like China, other supply chain costs are growing. BCG projects that, as soon as 2015, it will cost about the same to manufacture goods for the U.S. market domestically as it will in China for industries like computers and electronics, machinery, appliances, electrical equipment, and furniture. That inclusive calculation takes into account a variety of direct costs (e.g., labor, property, and transportation), as well as indirect costs such as the expected impact of greater supply-chain risks.
Such factors were behind Apple’s recent initiative to bring manufacturing back to the U.S. In 2013, the company started manufacturing the new MacBook Pro models in Austin, Texas. This $100 million investment creates a closer-to-home supply chain. Components are made in Illinois and Florida, and the Macs will rely on equipment produced in Kentucky and Michigan. Apple also recently acquired a vacant 1.3 million-square-foot factory in East Mesa, Arizona, where it plans to manufacture sapphire glass for its products. This new plant represents a $1.5 billion capital investment, creating more than 2,000 jobs in engineering, manufacturing, and construction.
Apple is not the only example. Electrolux selected Memphis as the location for a new 750,000-square-foot plant, where Electrolux and Frigidaire cooking ranges and ovens are now rolling off the line. The plant, a $100 million investment, employs 550 people and 700 more will be added in the next five years as production nears top levels. Additionally, GE has moved some appliance production from China and Mexico to Louisville. As a result, GE has doubled its workforce in Jefferson County, Kentucky, to about 6,000 since 2009. - Prediction Grade: A
Clearly, several industry predictions have proven true, a couple remain fluid, and one, perhaps, missed the mark (but only because the overall demand for space has been strong enough to power the market right through cost concerns). As e-commerce adoption continues to grow at about 15 percent annually, and as manufacturing continues to be more cost- and service-justified where demand is strong (like here in the U.S.), it seems likely that the market for industrial space should remain resilient.
Here is a new prediction to end this discussion: the shopping and retailing evolution, shifting demand and service paradigms, current demographic market forces, and global growth dynamics will continue to drive growth in industrial real estate. While nobody can be sure how long this current economic expansion will continue, it seems to us that these factors will drive the development of industrial real estate faster than other property classes. Let’s agree to grade that prediction later.
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