All real estate is local. While that paradigm holds true for warehouses, the most interesting aspect of industrial real estate is that the opposite is also true. It is the only property type in which an Ohio manufacturer who outsources production to China can end up creating demand for logistics space in Southern California’s Inland Empire. That is exactly what has happened during the last decade.
The Inland Empire attests to this better than any other market. When China entered the World Trade Organization in 2001, the Inland Empire had about 230 million square feet of logistics space. Today, that number stands at just over 400 million square feet, and Property and Portfolio Research’s (PPR’s) forecasts call for an additional 77 million square feet of new deliveries there through 2018.
While outsourcing and international trade are the big story of the first 10 years of this century, they won’t be the primary drivers of demand during the next decade. The graph at right clearly demonstrates that the number of loaded inbound containers entering the U.S. grew nearly 10 percent per year for several years before the recession — triple the growth of GDP. During the last three years, however, twenty-foot equivalent unit (TEU) growth averaged just 1.6 percent, a rate so weak that it cannot even keep up with the extremely slow and frustrating economic recovery. While the jury is still out on near-shoring and on-shoring of manufacturing, most of the low-hanging fruit already has been outsourced. So even if manufacturing fails to come back to the U.S., national TEU growth will more closely match the rate of consumption, which won’t be the three-times-GDP number we became accustomed to seeing in 2004-2007.
But that hardly means that the era of industrial real estate is behind us. In fact, what has been brewing is even more interesting, with implications across a wider array of markets. The driver of demand for warehouse space is switching from the place of production to the place of consumption, and the mature eastern third of the country is starting to look “sexy” again. Containerized cargo entering the Gulf and East coast ports and e-commerce are the two drivers of this change.
Shifting Ports of Entry
The expansion of the Panama Canal gets credited with a U.S. port realignment at the expense of the West and to the benefit of the East, yet this process has been going on for the past 10 years. The East Coast’s share of total U.S. imports, as measured by loaded inbound TEUs, stood at around 38 percent in 2003, grew to around 42 percent in 2011 and ended 2013 at 46 percent. This shift is not surprising: About 57 percent of the U.S. population lives within 500 miles (a day’s drive) of the Gulf and East coasts.
What is most interesting is not which ports are the “winners,” but which new distribution markets are starting to emerge as a result. The top map on this page shows the key distribution hubs of import goods, assuming a purely West Coast entry point. The hubs are few and in already well-established markets. The map below, however, shows distribution hubs with an entirely East Coast entry point. The most important difference between the two is not the industrial powerhouses of Chicago, Dallas and Southern California, which play a role in both strategies, but rather all the new hubs that emerge on the East Coast entry map. Suddenly Virginia, North Carolina, Ohio and Pennsylvania become much more attractive regional distribution markets. The West looks a bit different as well: Salt Lake City, Phoenix and Northern California gain importance, and historically overlooked markets such as Albuquerque and Oklahoma City start to appear on the radar.
While East Coast-bound TEUs will be an agent of gradual change over the next few years — even after the Panama Canal expansion is completed — e-commerce is changing the industry nearly overnight. The impetus of this rapid change differs by retailer type. The ultimate e-commerce “pure play,” Amazon.com, has been growing its supply chain to shift from competing on price to competing on convenience and selection, while reducing delivery times to next-day and same-day delivery in some locations.
The result is more distribution nodes, which are large buildings located close to population centers. Amazon added nearly 9 million square feet annually in 2011, 2012 and 2013, and some of its space found its way into markets that would not have been considered in the past.
Two million square feet were completed in Richmond, Virginia at the end of 2012, when Amazon single-handedly grew the market’s total logistics stock by more than 5 percent. This development not only created jobs and strengthened the local industrial market; it also turned Richmond into a core investment market. Cole Corporate Income Trust acquired one of the two buildings shortly after completion, along with another Amazon asset in the Nashville market, at a sub-6 percent yield. These new investment opportunities also can be found in Columbia, South Carolina; Charlotte, North Carolina; and Middletown, Delaware. And Amazon is not slowing down in 2014. It is planning and building large distribution hubs in the Inland Empire, Baltimore, Tampa, Hartford, Southern New Jersey and Kenosha, Wisconsin, markets as well as in its home state of Washington.
Duke Realty’s 680,160-square foot Building 300 in the Park 840 East Logistics Center in Lebanon, Tennessee, is leased by Starbucks Corporation and was completed in 2013. Photo courtesy of Duke Realty
Traditional retailers also are driving this change. The commonly floated number in the industrial real estate industry is that 30 percent of all space requirements are e-commerce related. But Cushman & Wakefield Executive Managing Director John Morris, head of industrial, Americas, believes that number to be even higher. “More than half of what we are seeing in the U.S. today includes an expectation on the clients’ part that a significant portion of the orders filled from the facility will be filled directly to the consumer.” And this is still just the beginning. Today, approximately a third of all shipments go straight to the consumer, and that figure is projected to rise to about half within the next five to seven years. Because a typical industrial lease is five years (and leases for the largest facilities are two to three times that long), all retailers that currently do not have an e-commerce presence but plan to have one within that time frame need to incorporate that thinking into their industrial real estate supply chain today. As a result, a growing number of new space requirements by retailers will have an e-commerce component.
While new markets hitting the radar are half of the equation, building sizes and configurations are the other half. In the mid-1990s, a 500,000-square-foot warehouse was considered a big building even in markets like Chicago and Dallas. A 1 million-square-foot building was more of an anomaly; according to the CoStar database, between 1995 and 1999, only 15 warehouses larger than 1 million square feet were completed. In the next five years, 37 delivered, a number that grew to 56 in the second half of the last decade. The last recession took a serious bite out of the construction market and building counts went down. But on a percentage basis, 20 percent of total square footage built since the recession was in 1 million-square-foot-plus buildings, compared to only 8 percent just prior to the recession. Building size is not the only aspect in play, however. Clear heights are climbing, column spacing is widening, truck courts are deepening and site coverage is shrinking.
That is precisely what makes building e-commerce buildings on spec more difficult. Liberty Property Trust’s 1.2 million-square-foot speculative project in the Lehigh Valley, which it eventually leased to Walmart.com, is a good example of a spec building that sat vacant for a year because it did not have the right clear height. Bob Savage, president of KTR Capital Partners, said that before e-commerce, “the million-square-foot building would have the classic cross-dock configuration with optimized column spacing and building depth, gobs of excess trailer parking, and it would be designed so it could be quaded [divided into four separate units] in a downside, multitenant scenario. With that configuration, the developer would get it 90 percent right.” Now, for e-commerce buildings, “the emphasis is more on employee parking and away from trucks; loading is more likely to be done from just one side, so the building becomes a giant rear-load warehouse; and the buildout inside is different and includes more office space, and much more mezzanine space.”
Duke Realty completed this 1.02 million-square-foot Amazon.com fulfillment center in Dupont, Washington, in 2013. Photo courtesy of Duke Realty
Don Chase, a partner at KTR, sees the traditional warehouse as being like a standard pickup truck, while e-commerce facilities are the Cadillac Escalade with heated seats and a state-of-the-art stereo system. These buildings have a different feel and are used in different ways. “It is more expensive to build e-commerce facilities, but the tenant is also making a huge investment in the building, so they do not want to make that kind of a commitment to a second-generation space,” said Chase. To pick just one example of increased costs, consider the smoke evacuation system. “E-commerce tenants are starting to use mezzanine space for actual production uses like picking, labeling and weighing, and suddenly there are people 25 feet in the air. This requires a different way of handling smoke and fire suppression than in a traditional warehouse.” There are many such examples, and together they can increase total project cost by as much as 100 percent. And these requirements keep changing. Even Amazon has multiple prototypes, each with a different ceiling height requirement. Jim Connor, chief operating officer of Duke Realty, noted that each time Amazon constructs a new building, “it is the next generation.”
Look to the Future
Industrial developers and investors must avoid getting fixated on any present trend. As the world of logistics technology evolves, retailers and distributors will change with the times. Building mega-distribution hubs is a good starting point; it significantly shortens delivery times, which is the name of the game today. But it does not win the ultimate prize — to become a perfect substitute for in-store shopping, which requires better-than-same-day delivery. Retailers with brick-and-mortar locations already are starting to use their stores as mini-fulfillment centers, and buying a product online and picking it up in the store within a few hours or even minutes has become fairly commonplace across the retail spectrum, from electronics (Best Buy) to lumber (Lowe’s). This suggests that once the e-commerce pure-play big network is fully built out, smaller buildings will be back in fashion to plug up the holes in that network. The best example of an expansive, locally oriented distribution network is Grainger’s more than 350 mini-distribution hubs across the nation, consisting of buildings between 15,000 and 50,000 square feet, even in a market as large as Chicago.
While Connor does not believe that e-commerce buildings carrying thousands of SKUs can ever get that small, he already is seeing facilities as small as 250,000 square feet. Duke Realty recently leased one speculative project just like that to Amazon in northwest Houston. “The first concentric ring around large population centers is having its revenge,” said KTR’s Savage. He sees e-commerce tenants looking for infill locations and focusing on overall operational costs, willing to take on buildings that require retrofitting. In other words, for this second level of the e-commerce supply chain, location is trumping building characteristics. Cushman & Wakefield’s Morris expects a two-tier model, with inventory storage and picking separate from order consolidation and outbound shipping, which means “the million-square-footer being located further out where labor and land are more affordable, but supplemented with smaller, high-throughput, cross-dock facilities that are highly automated and located closer to cities.”
The 882,230-square-foot Rialto I-210 DC #1, a modern cross-dock distribution center in Southern California’s Inland Empire, is occupied by a company in the consumer products industry. It features 32-foot clear ceilings and 198 dock doors, and was completed in 2004. Photo courtesy of Prologis
Thus, while there clearly is no such thing as a perfect, universal industrial building, there may not even be a perfect e-commerce fulfillment strategy. Omnichannel is one strategy some retailers are trying. Duke’s 800,000-square-foot Carter’s distribution warehouse in Atlanta is a perfect example.
“Half of the warehouse is set up to support Carter’s major customers: Target, Babies R Us, Macy’s,” said Connor. That section is set up and operates totally differently from a second section of the warehouse, which supports Carter’s own retail operations, 1,500-square-foot stores in malls and fashion centers, which carry much less inventory. A third section, the e-commerce fulfillment center, operates totally differently from the other two. These three facilities under one roof offer operational flexibility, since they represent separate businesses that may grow at different rates, as well as economies of scale from being in one giant warehouse. Meanwhile, Wal-Mart, the world’s largest retailer, with more than 100 million square feet of distribution space across the U.S., is going the other route, building out a dedicated e-commerce network to compete head-to-head with Amazon.
We do not know yet what the final national e-fulfillment network will look like, but a lot of change is still coming to the industrial sector. Said Connor, “Evolution of e-commerce in the industrial real estate business is still somewhat in its infancy.” This also applies to developers, who often are caught off guard by how fast some of these requirements emerge. After all, e-commerce warehouses are substitutes for retail locations, so “if the new fulfillment center cannot be operational by the holiday rush, it may as well wait until the spring,” said Chase.
What we do know is that this trial-and-error evolution has been a huge boon for the industrial market. According to PPR, by the end of 2013, the national industrial vacancy rate stood at 7.6 percent, a level not seen since the Internet bubble nearly 15 years ago. Furthermore, demand for large, modern distribution space has been mostly recession-proof. Even during the depths of the worst recession in memory, as smaller buildings saw tenants disappear, demand for logistics space remained positive. Supply chain reconfiguration is good for industrial real estate and so is growth. Today, the market is benefitting handsomely from both. Let the good times roll.
Don’t Forget About the Little Guys
Million-square-foot buildings are newsworthy; there’s no surprise in that. But what may be surprising is how few of them exist in the U.S. CoStar’s property database currently tracks about 605,000 industrial buildings, of which only 868 are 1 million square feet or larger. This number falls to 417 when just warehouse and distribution buildings are counted. In other words, just seven-hundredths of 1 percent of all U.S. industrial buildings are logistics buildings larger than 1 million square feet. So how does the rest of the industrial universe break down?
This Restoration Hardware distribution center in West Jefferson, Ohio, was originally developed by Duke Realty as a build-to-suit project in 2008. The 805,810-square-foot building was expanded by 417,970 square feet in 2013. Photo courtesy of Duke Realty
Approximately 0.7 percent of all buildings and 8 percent of all space consist of distribution buildings. These are large rectangles, generally larger than 250,000 square feet, with high clear heights, deep truck courts and plenty of loading, often in a cross-dock configuration (generally less than 10,000 square feet per loading dock). All new e-commerce fulfillment space falls into this category.
Approximately 8 percent of all buildings and 26 percent of total square footage are warehouse buildings, which are primarily smaller versions of the larger distribution buildings. They can be as small as 50,000 square feet, but there is no actual upper size limit. The principal difference is their loading capacity, which can be as high as 15,000 square feet per dock. Otherwise, they are very similar to their distribution cousins.
Light industrial buildings are the most plentiful, representing 63 percent of all buildings and 31 percent of all space. They are most often occupied by multiple tenants, as their nonrectangular shapes make them inefficient single-tenant facilities. Their ceiling heights tend to be lower — 22 feet often works — and their loading capacity is not the chief concern.
Manufacturing buildings are the most varied building type. They account for 4 percent of buildings and 15 percent of space. Since they usually are built to house a specific process, no hard and fast rules govern their shape, size, height or loading requirements. They do, however, often require heavy power and cranes, and tend to be rail-served. These buildings are most often user-owned.
Light manufacturing buildings have a much smaller share of the market — 2 percent of buildings and 7 percent of space — and many are owned by investors, even institutional ones. They can be converted relatively easily to warehouse space; their overall physical characteristics resemble those of Class B or C warehouses, with higher ceilings and the ability to offer sufficient loading, even if that means punching out docks.
Flex is the least industrial subtype. The best way to identify a flex structure is by initially confusing it with a single-story office building. Its rear area’s more significant loading capacity gives it away, however. Flex buildings have more office space (at least 50 percent), lower ceiling heights (22 feet or even less) and much nicer landscaping and front facades. More of the site is dedicated to car parking rather than truck courts and trailer parking. Flex represents 12 percent of buildings and 7 percent of space.
Additional but less dominant industrial subtypes include truck terminals, service buildings, showrooms, food processing facilities and multistory buildings. To a large extent, data centers also can be considered industrial.