The View from Development ‘13: Continued Recovery Sparks Tempered Optimism

Winter 2013
Development ‘13 attendees enjoyed networking and opportunities to meet with exhibitors at receptions and breaks between program sessions.

If Sigmund Freud were alive today, his signature question might not be “what does a woman want?” Rather, it might be “what do the millennials want?” Underlying the optimism expressed at NAIOP’s Development ‘13: The Annual Meeting for Commercial Real Estate about recovering markets and revived demand — particularly for industrial property — was a clear sense of uncertainty about what changes might be afoot in both office and industrial space demand and design owing to the growing presence of millennials in the workforce. Many of the conference attendees who gathered in San Diego on October 8 and 9 also expressed interest in how advances in technology are changing the way all generations live, work and shop.

The term “creative space” — office space designed to encourage collaboration and promote productivity through technology — was bandied about throughout the conference, though there was no consensus about precisely what it means. Conference speakers also addressed the implications of looming changes in retailing, as e-commerce grows as a total percentage of retail sales, and in the industrial market, as this growth in e-commerce affects retailers’ preferences regarding warehouse/distribution/fulfillment center location, size and design.

Though nary a word was said at the conference about the federal government shutdown and the then-looming debt default, the prevailing sentiment about the economy was upbeat. Keynote speaker Hans Nordby, managing director of PPR/CoStar, asserted that “the economy is firing on all cylinders. The bad structures in the economy have been fixed. Government spending is not the end of the world. The government spending drag is manageable.”

speakers at a conference session

At the session “Campus Goes Urban,” panel members Dean Rostovsky, A-P Hurd and others discussed how urban locations are attracting more companies — and what this means for office developers and building owners.

The State of the Office Market

Nordby told conference attendees that the office category has had the best occupancy gain story of the major commercial real estate product types. “We’re only halfway through the occupancy recovery,” he said. “In the next six quarters, there will be no new supply.” But, he warned, efficiency in space use will take its toll on demand. The big winners will be Class A buildings, Nordby added, because “the best space will be required to get the best talent.”

At a session titled “State of the Office Market,” Michael Knott, managing director of Green Street Advisors, said that the office recovery has been more anemic than in past post-recession periods. Some markets are hot; many are not, but office cash flow should improve soon, Knott added.

Urban locales are drawing more companies — particularly technology and media firms — because cities are where the millennials want to be. In a session titled “Campus Goes Urban: Technology, Tenant Requirements and the Evolving Workplace,” A-P Hurd, vice president of Touchstone, referring to the central thesis of Charles Fine’s book “Clockspeed,” said that urban locations encourage the kind of “brain collisions” that are necessary for companies to innovate and keep on innovating in order to thrive.

people networking at a conference

“You want people to bring their whole selves to work,” she said, “not just their work selves,” in contrast to the way the millennials’ parents and grandparents may have compartmentalized their work and home lives. 

So, whither the suburban office park? At “The Future of the Suburban Office Park,” Alex Rose, senior vice president of development for Continental Development Corp., said that as long as an office park is in an area with strong economic drivers and nearby transportation, “you have a very viable asset for the long term.” Continental is in its fifth decade of repositioning one asset and in the second decade with another, he reported. “Viability is a function of what’s going on in the regional market.” For example, in Torrance, Calif., the company repositioned a former office project adjacent to a medical center into a medical complex.

David Millard, a principal with Avison Young, pointed out that 61 percent of the office buildings in northern Virginia are at least 20 years old. Vacancies at older office parks have gone up, in some cases significantly; Millard cited three at which vacancies had risen from zero, 11 percent and 13.1 percent in 2000 to, respectively, 22.5, 18.6 and 15.1 percent today. Among the challenges facing these older campuses are technical issues such as column spacing, ceiling height and parking. In addition, the shift to a younger workforce makes it important to offer daycare and access to retail amenities.

people networking at a conference

The opening general session breakfast gave meeting attendees a chance to visit with busy colleagues before learning about NAIOP’s 2013 Developer of the Year — Vulcan Real Estate — and listening to Hans Nordby’s keynote presentation, “The Economy and What It Means to Commercial Real Estate.”

Tom Bak, a senior managing director at Trammell Crow Co., agreed, noting that amenities at a 230,000-square-foot Trammell Crow build-to-suit office project in Plano, Texas, include a fitness center, full-service cafe, sand volleyball court, jogging trail, outdoor patio with fire pit, mini golf course and plug-and-play capability out-doors. “This will continue,” he said. “High-quality office space will replace functionally obsolete suburban office space.” But the suburbs will retain their appeal, in large part because “parents still want to send their kids to good schools.”

The (Hot!) Industrial Market

Panelists at the “State of the (Hot!) Industrial Market” session agreed that industrial market fundamentals are excellent. The amount of new space being built is “way less than we’ve seen in a long time,” said Mike Curless, chief investment officer for Prologis. The limited supply (two thirds of which is built-to-suit, he pointed out), coupled with robust absorption numbers, creates dynamics that “we haven’t seen in 33 years,” Curless added. “The fundamentals are as good as they’ve been in a long time.”

speakers at a conference session sitting at a table

Panelists Chris Riley, Stanley Alterman and Mike Curless discuss industrial demand, projections and investment at the session “State of the (Hot!) Industrial Market.”

Panelists also agreed that the current climate makes it more difficult for private developers to find opportunities, although they can find them, as long as they understand that it will be a tough search, might require more equity and might require finding equity partners to complete a project.

Chris Riley, vice chairman of CBRE, asked the panelists this question: “Would you buy a warehouse/distribution center in Cincinnati at a 7 cap rate, or one in California’s Inland Empire at a 4.5 to 5 cap rate?” In other words, would they choose a “gateway,” primary or secondary market? Stanley Alterman, executive managing director of USAA Real Estate, said that primary and secondary markets offer better total returns (than gateway markets), and noted that he likes Atlanta, Dallas and other markets tied to UPS and FedEx hubs. Curless noted that 12 percent of his company’s portfolio is in regional markets. “If you have the right people on the ground, you can beat the odds. You can make money on the buy.” Dwight Merriman III, CEO of Industrial Income Trust, said that 72 percent of the 60 million square feet of industrial space the company has acquired in the last 36 months is in the top 10 markets. In secondary markets, he said, “the risk/reward is there if you buy new product.”

Jim Sullivan, managing director of Green Street Advisors, offered a different perspective: If you’re buying Class B properties, he said, the question is, at what price? He stressed the importance of looking at long-term net operating income (NOI) growth. The gap in NOI growth between Class A and B industrial properties is smaller than it is for other property groups — perhaps 100 basis points, he noted. Why? Any time an industrial market experiences rent growth, “here come the shovels,” he said, and new construction impacts everyone’s ability to raise rents. “That happens frequently and more quickly [for industrial] than for other property types.” So, he said, “I’ll take the 7 [cap rate] all day long.”

people networking at a conference

Panelists noted that interest rates and cap rates should remain stable for the immediate future. Merriman remarked that it is hard to predict cap rates because there is so much capital chasing the industrial market — with everyone seeking deals in the same 20 geographic markets — that there is not likely to be upward pressure on cap rates.

Sullivan pointed out that “if interest rates rise, you have to ask why.” If they rise because of a robust economy, is the pain mitigated by rising occupancy levels and rent rates? Or do they rise because of a messy unwinding of quantitative easing, with no robust economy and therefore no subsequent occupancy and rent improvements?

Supply Chain Loaded with Risk, Uncertainty

The old adage that the only constant is change applies more than ever to trends in the global supply chain, according to speakers at a Development ‘13 session titled “Supply Chain/Goods Movement: Trends and Innovations.”

Panelist Jon DeCesare, chief executive officer of WCL Consulting, said that he has been involved in the supply chain world for 35 years and has never seen so much change. “If we were able to take a satellite snapshot of what is going on in the global arena today, it is loaded with risk and uncertainty from increasing customer demands, the unpredictability of those demands, increasing U.S. regulations, mega vessel construction and rising labor costs.”

This world of risk, he added, has transitioned into the North American site selection process, as customers take longer to make decisions about warehouse placement. Customers want to be very comfortable with both the building and its location in order to minimize risk.

DeCesare and other panelists cited the following trends:

The search for ideal ports of entry. Importers are pressuring supply chain executives and vendors to pick the optimal port for their goods. The most common mistake made when ports are discussed, according to the panel, is that executives typically talk about the depth of the port and the size of the cranes doing the unloading — but those are only two of 25 factors that should be used to evaluate ports.

people networking at a conference

Megaship-building programs. The impacts of new vessel-building programs now underway are rippling down through the supply chain. Bigger ships are being built to maximize use of the expanded Panama Canal when it opens in 2015, but a more important reason for the new vessels is they provide economies of scale for carrier fleet owners, resulting in a decrease in their slot cost, which is defined as the cost to ship one twenty-foot equivalent unit (TEU). Shippers must achieve greater efficiencies because shipping rates have not increased much in the past 10 years.

Increasing investment in North American port infrastructure. These bigger ships are having a cascading effect on ports. Many East Coast ports are dredging their channels to 50 feet to handle the big ships. For the distribution world, this means that the East Coast will continue to be a viable gateway. According to the panel, East Coast ports will grow, but the West Coast will remain the No. 1 gateway. For more information, see the upcoming NAIOP Research Foundation report on land and water-side changes at U.S. ports.

Intermodal increases in importance. The trucking industry has been hit by problems recruiting truck drivers and greater regulation, which is causing shippers to move toward other means of transporting goods. The railroads are ready, having invested $50 billion in infrastructure over the last five years across the railroad network. They have raised overpasses in order to move double-load trains.

Near shoring grows. “Near shoring” — sourcing goods from locations closer to their final destination — is being driven by rising labor costs in China, which are increasing 15 percent a year. That is making labor in Vietnam, Indonesia and Mexico more competitive. The panel noted that when it comes to near sourcing for the U.S., Mexico is the perfect solution, because it offers speed to market, lower inventory costs and more flexibility.

Chasing After That Liquid Gold

In his Development ‘13 keynote address, “The Economy and What It Means to Commercial Real Estate,” PPR/CoStar Managing Director Hans Nordby touched on the impacts of growth in the U.S. energy sector. Development magazine asked Nordby’s colleague, Rene Circ, to expand upon those comments. — Editor

It may come as a surprise, but the more than four-year-old domestic economic recovery that most are complaining about has put the U.S. among the fastest growing developed nations in the world. The three other sizable top-performing countries are Australia, Canada and Germany. Net exports continue to drive the German economy — as the Germans have figured out how to make expensive things that others actually want to buy — while Australia and Canada, net importers, decided to invest heavily in the exploration of natural resources. The word Canada triggers the image of Alberta’s oil sands, while Australia is all about mining. Here in the U.S., manufacturing and energy are areas that can accelerate domestic economic growth, as neither is now running near capacity.

The good news for the U.S. is that progress is being made, especially in the natural gas arena. Between 2002 and 2012, investment in oil and gas increased more than fivefold, resulting in infrastructure and equipment investment that is driving employment growth. After declining by 52 percent between 1981 and 2003, energy employment rose by 49 percent from 2004 to 2012. However, energy is not a terribly labor-intensive industry, so the jobs added total just 44,000. The upside is that natural resources and mining salaries average $56,000 per year, and engineering salaries for this industry are in the six figures.

Even better news for the U.S. is that energy output is up and imports of petroleum are down. Between 2004 and 2012, total energy production rose by 11 percent. The increase should be “environmentalist approved,” since the extraction of dirty coal is down 10 percent, while natural gas and crude oil production is up by 33 and 25 percent, respectively. Meanwhile, the trade deficit in petroleum has more than halved, falling from a quarterly peak of $72 billion in the fourth quarter of 2005 to $34 billion in the second quarter of 2013. This trend is positive for the U.S. and likely to continue.

Despite all the promise, it is not all that easy for the commercial real estate industry to play in the energy space. Much of the exploration occurs in markets that cannot even be considered tertiary. But instead of focusing purely on energy-producing geographies, investors can focus on markets that house headquarters operations for energy companies. Texas is the clear winner; just look at Houston, which hardly had a recession. And the industrial cap rates in Dallas look an awful lot like those in Los Angeles. Denver is another market where a bargain is hard to find. But other promising areas exist further out on the risk spectrum, including Pittsburgh, Oklahoma and even Salt Lake City.

Some difficult debates lie ahead. Energy production — especially carbon-based energy production — is not met with open arms everywhere. But as long as the free market is left to operate, this expansion has legs, as cheap energy helps consumers and manufacturers — both of which are very important to all sides of the political spectrum.

By Rene Circ, director of research – industrial, PPR/CoStar