Industrial Strength: This sector's durability gives it long-term investment advantages.

By Steve Poole, CCIM, and Jennifer Norbut
Commercial Investment Management Insight Magazine

Listen to Steve Poole's podcast for more insights on the industrial market's recovery.

Like all investment property types, industrial real estate is attempting to hold its own through the economic recession. These three articles examine the highlights and lowlights of this evolving sector.

A seismic drop in activity characterized the nation’s first-quarter 2009 industrial trends. Leasing activity fell 41 percent from one year ago, driving average vacancy to 9.5 percent — the highest point in 4.5 years. Net absorption plunged to a negative 39.8 million square feet during 1Q09 as cutbacks across all sectors led to diminishing activity. Construction volume dropped to 40 million sf, the lowest volume since the early 1990s.
The 1Q09 average asking rate for all types of industrial space was $5.57 per square foot triple net. This represents a decline of 1 percent from year-end 2008 and 3 percent from 4Q07. Effective rental rates declined by a larger margin of 15 percent as concessions increased. The greatest rate drop was seen in warehouse properties, where asking rates fell by 4.9 percent year over year. Research and development/flex space rates declined by 2.2 percent, while manufacturing space rates actually rose by a slight 1.6 percent. Warehouse rents were influenced by a larger construction pipeline as well as a greater downturn in retail and home building, which are warehouse-intensive industries. The average rental rate increase for general industrial product was likely due to a lower overall vacancy for this property type — 6.9 percent versus 10.9 percent for warehouse/distribution space.

Industrial’s Hidden Strength
The current recession has cut across all economic segments including those that feed industrial growth. On the job loss front, manufacturing has taken the largest hit in terms of layoffs, losing 1.3 million jobs during the past 12 months. Construction, another strong industrial sector, ranks third with nearly 1 million jobs lost. Wholesalers and retailers, significant warehouse and distribution players, also lost a combined 581,000 jobs during the past year.

Despite the significant job losses, the industrial market has a key competitive strength when compared to the retail and office sectors. Industrial development can be turned off fairly quickly given the 9- to 12-month construction cycle, while office development continues to roll through the cycle for up to two years as vacancy continues to rise. A little more than 26 million sf of new industrial space was delivered during 1Q09, with another 39.7 million remaining under construction. Only 27 million of this represents speculative product, and nearly all will be delivered later this year. This lack of overbuilding means that while vacancy rates are nearing a decade high, product remaining in the pipeline will not continue to flood the market. In contrast, the office market vacancy rate will rise by an additional 140 basis points nationally based on deliveries alone. It may well set a new record by Grubb & Ellis’ historic calculations.

Best-Performing Markets
While there are no truly optimistic markets in the current recession, some markets have had a lesser industrial decline than others. The submarket with the lowest overall vacancy rate is Los Angeles County at 2.7 percent. Reno, Nev., posts the highest vacancy rate, above 15 percent. It and the other hardest hit markets — Orlando, Fla., Phoenix, and Las Vegas — are victims of the housing industry slump. Detroit also is suffering from significant vacancy increases resulting from auto industry fallout.

Some cities did experience positive absorption for 1Q09, including tech hotbed Boston and middle-America cities such as Cleveland and Oklahoma City. Long term, port cities will rebound as global trade bounces back. Current port volume is down and 2008 volumes were off significantly for large ports, such as the 5.3 percent decline in Los Angeles and 10.1 percent in Long Beach, Calif. Only Houston and Jacksonville, Fla., saw significant increases in port activity, partially due to the energy industry activity in these areas.

The top 10 cities to watch include areas poised for growth, cities with developable inventory already planned, as well as cities that can capitalize on shifting port demand. Port cities with efficient on-dock rail capacity such as Savannah, Ga., and Norfolk, Va., will gain market share. (See sidebar, “Regional Updates Southeast.”) Other cities are investing significantly in port infrastructure and also will likely gain from added capacity. Examples of this include Houston, Northwest Ohio, Joliet, Ill., and Jacksonville, Fla. While Los Angeles will remain a market to watch given sheer volume of transactions, the trend toward East Coast versus West Coast shipping will favor more significant growth in markets such as Dallas and improved eastern ports.

Investment Activity
Investment spending plummeted in 1Q09. Total investment spending for all industrial properties totaled only $1.3 billion, or only 10 percent of spending nearly a decade ago in the first quarter of 2001. Industrial capitalization rates remain the highest of any property type, rising to 8.2 percent. This is up 100 basis points from a year ago, 150 basis points from the 2007 peak, and 30 basis points over the offering cap rate for new properties on the market.

This meager investment volume represents only 9 percent of peak spending, and offerings outpaced sales six to one, demonstrating the remaining distance between buyers and sellers. Buyers are changing as well, with seller or assumed financing responsible for 55 percent of transactions and commercial mortgage-backed securities and Wall Street financing notably absent. During 1Q09, industrial properties represented 18.5 percent of properties sold and 15 percent of spending.

Looking to the future, investment potential is excellent for those with immediate access to internal or private capital. Underperforming real estate investment trusts with limited or no access to reserve funds are a prime target. Solid investments will include properties in markets with limited need to absorb existing product and those with expanding tenants in the renewable energy and medical device sectors. Functionally strong industrial product with modern clear height, loading, accessibility, and energy efficiency will retain value in the long term.

On a fundamental level, look for rental rate declines to taper off and vacancy increases to slow once construction activity has halted. Reductions in landlord concessions will begin in mid-2010. As mentioned, there will be a resurrection in U.S. port volumes. The April consumer confidence shift is extremely positive news for the retail and shipping sectors, especially as the forward-looking component was the highest. R&D/flex space will likely take a hit in the short term as tenants are able to flee to higher quality office spaces for lower rates.

Industrial Markets to Watch
Columbus, Ohio
Dallas
Houston
Indianapolis
Jacksonville, Fla.
Joliet, Ill.
Los Angeles
Norfolk, Va.
Northwest Ohio
Savannah, Ga.

5 Ways to Improve NOI
Increase industrial property value in slow market conditions.

by Jennifer Norbut

Improving industrial property value may seem impossible in an environment where sales prices are plummeting and tenants are demanding concessions just to stay put. But there are ways to improve a property’s net operating income, industrial market experts say, even in the bleakest economic conditions. These five tips can help industrial owners and managers plug spending leaks and improve their properties’ bottom lines.

1. Renegotiate Service and Supply Contracts. “It’s incumbent upon owners to push vendors and suppliers to lower costs in this competitive market,” says C. Mark Ambard, CCIM, president and principal broker of Ambard & Co. Commercial Real Estate in Kailua, Hawaii. Waste removal, landscaping maintenance, advertising, and security provide opportunities to lower routine costs.

Renegotiating service contracts to get the best rates possible also lays the foundation for future lease renewals, says Lee Y. Wheeler III, CCIM, president of Fidelis Commercial Real Estate Services in Beaumont, Texas. “Lowering rates keeps tenants happy and we stay in close contact with the providers to ensure top-notch service.”

2. Reduce Insurance Premiums. Unnecessary coverage adds significantly to a property’s insurance costs. A common — and expensive — mistake is to insure land where no risk of loss exists, “usually due to a misguided lender requirement,” says Nick Nicholas, CCIM, CRE, MAI, president of Nicholas Co. in Dallas.

Replacement cost insurance is another area for potential savings. “Replacement costs are generally priced from a manual or online pricing service. These numbers can vary greatly from reality,” Nicholas says. He’s successfully negotiated 50 percent reductions in replacement cost insurance premiums by providing credible cost figures from respected local contractors and proving the insured components are not “at risk.”

For example, in Dallas, tornadoes, wind, and fire pose the biggest threats to properties. “If you have 7 acres of concrete parking area and 3 more acres of concrete building slab on grade, there is no need to insure them against fire or tornadoes,” Nicholas says. Grading, site work, and underground utilities are other building development costs that are not at risk.

Finally, reviewing the policy’s deductible is a wise idea. “If the deductible is too low, the premium can be unnecessarily high. The goal is proper balance between risk and premium,” he says.

3. Reassess the Property’s Value. Commercial property tax valuations are subjective, thus leaving room for reductions. This is particularly true “if the property is located in a state that relies heavily on ad valorem taxation, which is an area of significant potential savings,” Nicholas says. In addition, many appraisers use a “mass appraisal” process to value parcels that present “an inadvertent opportunity for overvaluation.”

Owners can appeal their tax values directly or leverage the knowledge of experienced property tax appeal consultants, says Scott L. Reed, CCIM, managing director of Reed Realty Advisors in Portland, Ore. To maximize the process, owners and consultants must “craft a supportable valuation based on appraisals, market comparables, and in some cases higher vacancy and lower rents,” he says.

4. Green Your Space. Energy efficient strategies may not seem like windfall opportunities, but the benefits add up. For instance, replacing traditional interior warehouse lighting with T5 motion sensor fixtures has a payback period of two years with use of government and private tax credits, Reed says.

In addition, users report up to 50 percent energy savings. “Every dollar tenants save on energy reduces their occupancy cost as much as a dollar reduction in rent,” Reed adds. “Some owners have actually begun paying for lighting retrofits in vacant industrial spaces to improve their marketability.”

5. Lower Landscaping Costs. Landscape maintenance can wreak havoc on water and utility bills, experts say. To reduce these costs, “review landscaping against irrigation system zone design for compatibility with plant materials,” Nicholas says. “I reconfigured several zones at one of our industrial buildings where large turf areas were included on the same zone with planting beds that required much less water.” The result was significant water conservation and cost savings.

Xeriscaping, or using indigenous and low water-intensive plant species to reduce or eliminate costly irrigation, is another way to save. While using river rock or other xeriscape materials can cost up to 20 percent more than traditional landscaping, water and maintenance cost savings of up to 60 percent can be achieved, Reed adds.

Rail Returns
Intermodal development provides a route for today's energy-minded investors.

by Jennifer Norbut

High fuel costs and congested highways are putting the squeeze on traditional warehouse/distribution space. Intermodal rail-based projects, however, provide an energy-efficient alternative for suppliers in inland port markets. Commercial Investment Real Estate talked with Adam Roth, CCIM, a vice president with NAI Hiffman’s Industrial Services Group in Oak Brook, Ill., about the intermodal sector’s advantages in the current market. As a director of NAI Global Logistics, Roth focuses on providing real estate and supply chain solutions to distribution and warehouse companies worldwide.

CIRE: What are the biggest challenges facing the industrial real estate market right now?

Roth: Uncertainty in the banking community and the economy as a whole has forced the majority of corporations to restrict growth plans. This coupled with the aggressive speculative development that occurred in the last few years has halted nearly all new spec construction in the Chicago market. One of the few areas that is still seeing activity is the CenterPoint Intermodal Center, which is preparing to break ground on a 1.2 million-square-foot spec facility adjacent to Burlington Northern Santa Fe railroad’s Logistics Park — Chicago, located about 40 miles southwest of the city in Elwood, Ill.

CIRE: What’s driving intermodal projects in the current market?

Roth: With corporations now more focused on controlling costs, there have been more in-depth discussions about the entire supply chain. More corporations are talking in terms of landed cost versus lease rate or purchase price. In other words, studies show that transportation is typically five to seven times the cost of real estate. So if a company can effectively take a holistic approach to their supply chain, the result will be very different than operating in silos and solely searching for the lowest lease rate or purchase price.

CIRE: Have you applied this principle to any recent transactions?

Roth: We recently worked with a corporation that is saving more than $650,000 per year based on a nine-mile difference between two facility locations they were considering. Based on this company’s operations of 500,000 square feet, their savings translate into $1.30 per sf per year as well as greatly reducing their exposure to fuel costs.

CIRE: What factors make intermodal-related projects a wise choice for industrial investors?

Roth: Underscoring the significance of these developments is the ever-growing importance of rail — particularly with the class I rail providers. There are five critical factors facing the global supply chain for our nation: The state of our highway infrastructure, energy (fuel) cost increases, import volumes, concerns over truck driver shortages in the years ahead, and a focus on more green alternatives. Rail addresses all of these.

CIRE: What other key industrial property trends will emerge as the economy begins to rebound?

Roth: Midsize to small corporations will be more sophisticated in their supply chain strategies and will be taking the landed cost approach. In addition, third-party logistics, or 3PL, activity will continue to increase as it has in the current environment. Companies want to be able to flex their space and respond more quickly without long-term obligations. 3PLs have the ability to do that.