Roger Qualman on Northwest USA Industrial Real Estate

As an asset class, industrial property tends to be less exciting than other categories, with little change in rents or values, boxy designs, lots of concrete and pavement, and minimal sex appeal. However, several trends are now in play which will make the industrial segment more interesting in the years ahead. In this overview I will discuss those major trends generally and then how they apply to our local market for industrial property.
Bigger is Better
With the increase in foreign manufacturing and the importation of off-shore goods, major firms have established global supply chain management systems to speed the transport of goods to market. As a result many firms, especially large retailers, have located large distribution centers in strategic locations around the country.

Distribution Centers
So that you can understand what this trend to size means to us in the Pacific NW, here is a map of major companies that have established distribution centers in the region. Totaling over 11 million square feet of space, most of these facilities are close to I-5, on sites larger than 50 acres, and utilize fairly square building configurations.

From Chehalis, WA on the north to Albany, OR on the South, it is clear that as a region we are essentially out of the distribution center business for the foreseeable future. This is because we have few adequate sites accessible to I-5. New projects like those proposed by the Port of Portland’s Troutdale site or the State of Oregon’s Mill Creek site in Salem do offer some hope, but we remain severely challenged for sites 50 acres and larger. Wal-Mart has searched I-5 for a one million square foot distribution site for the past four years, to no avail.

In addition to the distribution center trend, the size of warehouses being built is increasing overall. The average size of warehouses under construction rose from approximately 120,000 square feet in 2002 to 216,000 square feet in the first half of 2006. The relocation of manufacturing jobs to low-cost destinations offshore has given rise to the modern logistics industry and the need for larger, more sophisticated distribution buildings.

Warehouse Average Size Trend
Size matters after all. The trend to bigger facilities means bigger floor plates and higher ceilings, and enables more automation in the warehouse.

Ownership vs. Leasing
Another major trend that has emerged in the past several years is the preference for ownership vs leasing. Probably as a result of the low interest rate environment, more business owners who use manufacturing and warehouse space have chosen ownership. Since industrial triple net leases have the tenant already paying all the cost of occupancy, the conversion to ownership has been simple. The only difficult part has been the shortage of product, and that has led to a new industrial offering; the industrial condominium. These buildings are available throughout the region now, at prices from $90-110 per square foot. Size ranges are from 6,000-10,000 square feet and can be combined to make larger spaces. While the jury may still be out on the ability to resell industrial condos, it appears to be a concept whose time has come.

The inevitable march of technology will continue to change day-to-day business. We are already way beyond trucks with transponders and the embedded identifier chip at the pallet level and are headed on to an identifier chip on every piece of every box on every pallet on every truck. RFID, or Radio Frequency Identification technology is here, with Wal-Mart, Department of Defense, Target, and others requiring RFID of its largest suppliers at some level. These invisible tags will aid inventory control and track product from raw material to finished goods. RFID makes further automation of warehouse facilities possible even sooner, adding to the necessity of bigger buildings and higher ceilings as noted previously.

Technology has made rail transportation more efficient and effective in recent years. Now that they know exactly where their cars are, virtually all operating railroads today, slimmed down by mergers and acquisitions, are profitable and growing. Long the stepchild to trucks and highways, rail has made a remarkable comeback. The result is that rail-served industrial property can command a premium price, and many more client requirements for industrial land include the necessity of rail access.

Regional Economy
That is the view from 30,000 feet. Now let’s see how our area is faring. The Portland/Vancouver regional economy is bringing together powerful forces into a virtual ‘perfect storm’ that promises to raise the cost of doing business. Industrial real estate, meaning manufacturing and distribution space, is being leased and sold to users at a velocity that will soon create very short supplies. The three converging ‘storms’ referred to here are: 1.) restricted land supply; 2.) rising construction costs; and 3.) unprecedented demand.
The Portland Metropolitan area, which includes Southwest Washington, is renowned for its comprehensive land use planning and urban growth boundaries. While land use laws are different in Oregon and Washington, they result in land supply restrictions in both states, nevertheless. Currently there are only two industrial sites in excess of 100 acres available in the region, obviously not much to choose from for a company considering a new plant location here. Genentech, which recently purchased an 80 acre site in Hillsboro, had only three sites to choose from in the area. Short supply means that land prices are high in relation to cities in the Midwest and Southwest. For example, Dollar Tree Stores paid twice the amount per acre for their 58 acre site in Ridgefield, WA, than they did for a comparable site in the Chicago area. Coastal cities tend to have restricted supply problems anyway, and correspondingly higher prices. Industrial land reached the $7.25/sf level in 2006 on a specific sale, and we see values moving upward in all area submarkets.

Meanwhile, construction costs are on the rise, adding to the upward pressure on prices of finished industrial space. Local general contractors specializing in industrial buildings report that the combination of higher prices for concrete, steel, copper, and all things made of petroleum products, such as roofing, paving and plastics, has combined to produce a 20-30% increase in the cost of construction over the past 24 months. In addition, add the regional adoption of the International Building Code in 2005, which adds cost to many tenant improvement projects. This is all in the name of progress, presumably, but costly to the end user paying the bill. Little has been constructed in the past year as a result of the higher cost, forcing developers to seek ‘build to suit’ or pre-leased projects. About 1,206,165 square feet of industrial space is under construction currently, under 1% of the total inventory.

Construction Costs Trend
The next storm to introduce into the formula is a tidal wave of demand, characteristic of a growing economy. In the past 4 quarters, the area’s industrial real estate supply measured by its vacancy rate, has plummeted, from 12.1% to 9.7%. Absorption, the number by which leasing exceeds new supply, is up substantially in the region, over 1.5 million square feet in 2006. NAI Norris, Beggs, & Simpson’s market research department predicts that industrial vacancy levels will fall all the way to 7% in the Metropolitan area in late 2007, which will trigger a new development cycle and higher rents across the board.

Portland Metro Absorption Trend
Looking ahead in 2007 and beyond, you can bet that the price of industrial space will increase – not just by the inflationary rate, but by an amount that will reflect the perfect storm. A shift in price will be caused by the construction cost increase. Look for rents of warehouse/distribution buildings to be around 30 to 40 cents per square foot, accounting for the 30% increase in the cost of construction which allows the developer or investor to realize a reasonable return on his investment.

Perhaps the industrial market will have more sex appeal in the future. Of course, market participants can take matters into their own hands rather than be controlled by market forces. Early renewal of existing leases will help secure more favorable rental rates. The trend to ownership versus leasing is another way that business owners can control costs. Finally, efficient use of space is always a goal, aided somewhat by technological advances that promise great things. In spite of all these factors, the price of industrial real estate in the Portland/Vancouver area is definitely on its way up, with fewer choices available.

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