This was from this week's California Real Estate Journal:
Fuel Prices Challenge Industrial User, Development Trends
Transportation costs, while always an issue, are now center stage in site selection process
By KARI HAMANAKA
CREJ Staff Writer
Victorville City Councilman Bob Hunter called the event a "symbolic gesture thumbing our nose to the word 'recession.'"
However, if current economic conditions persist, the rising cost of fuel stands to shake the foundation upon which the supply chain and industrial real estate have come to rest. The cost of fuel, while tied to overall drayage costs, is forcing those in the industry to question its effect on everything from industrial user demand to development patterns and the implications for properties near rail or intermodal facilities.
"People are going to keep buying things, so I think the outlying areas will be profoundly affected if fuel prices move upward, and that's more than obvious," said Dennis Higgs, president and chief executive officer of Newcastle Partners of the Inland Empire. "We already see a stoppage of demand in outlying areas, and it will take a while for it to sort itself out. It will slow down development a lot for the short term and mid-term."
A Grubb & Ellis second-quarter 2008 market snapshot placed vacancies highest in outlying, eastern Inland Empire submarkets such as Moreno Valley/Perris and Redlands/San Bernardino, which reported vacancies of 21.9 percent and 17.6 percent, respectively.
Newcastle is developing two industrial projects in Redlands. One, the Almond Industrial Center, totals 180,000 square feet. The other, the Alabama Industrial Center I & II, is a 600,000-square-foot warehouse distribution project. The project is entitled, but construction will not begin until the market improves.
Although the discussion of the implications of additional fuel costs is nothing new, it has been more significant in recent discussions of where to locate or where to develop an industrial property.
"It's something that's going to be considered," said Walt Chenoweth, senior vice president in the Ontario CB Richard Ellis office. "Companies are going to be looking at it closely. There's more emphasis on transportation costs now than in previous years."
Chenoweth, along with CB Richard Ellis Executive Vice President Frank Geraci, recently represented Shea Center Ontario LLC in three lease renewals totaling $27 million and 1.3 million square feet at its Shea Center in Ontario.
All three tenants made the decision to stay in their western Inland Empire location. Although fuel costs were not the sole reason for whether any of the three Shea Center tenants decided to renew their leases, drayage costs, which include fuel, go into any tenant's decision when leasing a building, Chenoweth said.
"It depends on where the client is bringing their product in from or sending it to," Chenoweth said. "Because of the additional mileage and associated costs from the port to San Bernardino/Riverside versus Chino or Ontario, transportation costs are a factor in any location decision. How these transportation costs are handled depends on who's paying the cost of the freight. Sometimes the cost is paid by the supplier or passed on to the end client, and sometimes it's absorbed by the company warehousing the product."
Location vs. Access
Location always has played an important role in where an industrial tenant wants to lease space. If fuel prices continue to increase in the future, some are speculating that it will change the dynamics between the Los Angeles port markets and the Inland Empire. For some time now, companies have been moving to the Inland Empire for larger buildings and lower rents, a move enabled by lower fuel costs.
At the end of the second quarter, the vacancy rate for the Los Angeles County industrial market was 1.8 percent compared to the 7.9 percent vacancy for the Inland Empire, according to Grubb & Ellis.
For the few that would be able to squeeze back into the Los Angeles market the question now is if they could, would they?
"It's always a balance between the cost of rent and the availability of properties," said Tim Feemster, senior vice president and director of global logistics at Grubb & Ellis. "If you want to get a 1 million-square-foot building near Los Angeles/Long Beach, there's nothing. If you need 1 million square feet, you're going to have to pay the cost of the drayage to be in the Inland Empire."
The issue is the same on the development side when developers consider where the next wave of industrial development will occur.
"The challenge is there aren't vacant land parcels in the areas closer to the ports and even, for that matter, in the Ontario Airport marketplace," Chenoweth said. "While people may say we need large warehouse development closer to the ports, if there isn't any land to acquire to build in the Ontario marketplace, developers will have to go east or up to the High Desert."
MGA Entertainment recently decided to go east, leasing 749,000 square feet of space in AMB Property Corp.'s AMB Redlands Distribution Center, a move that consolidates its distribution operations. MGA expanded its operations with the deal and went to an area of the Inland Empire where lower rent and other concessions are the norm.
Feemster said higher fuel prices could exacerbate the balancing act between the cost of rent and the availability of properties. This upset could potentially lead to higher rents in the Inland Empire.
Additionally, he said some companies may be forced to have more market center distribution points than one regional point, which would run counter to the trend in consolidation that has been taking place over the last 10 years.
While some companies may decide to go against the consolidation movement or move closer to the ports to cut transportation costs, others are questioning if location is as important as access to various transportation modes.
Global Access, the multimodal facility in Victorville that held its wall-tilting ceremony last month, is a prime example of how access could trump location for some industrial users. Victorville is not a port market, but the fact that Global Access offers air, rail and trucking options could be appealing to some company's business models.
"Before, you would see goods being loaded onto trucks at West Coast ports, but with diesel so high, we're starting to see companies use a combination of truck and rail, and a lot of it is still up in the air about how serious this trend will turn out," said Luciana Suran, an economist at Torto Wheaton Research.
Magic Formula
With any trend that has the potential of being born out of the fuel discussion, it will depend on a company's business model. In the case of the intermodal trend, the need for rail is not for every company.
"If you're getting goods from domestic sources closer to your location, being closer to the rail or an intermodal facility is not a requirement for you," Feemster said. "But where you locate needs to be driven by the total cost of the supply chain - not just one individual element."
Transportation costs account for 50.3 percent of total logistics costs. Rent, on the other hand, accounts for 4.3 percent of total logistics costs, according to the logistics operating cost formula used throughout the industry. Other costs include inventory at 21.8 percent of total logistics costs and labor at 9.5 percent of logistics costs.
"What sometimes happens when people look for real estate is, depending on whether its the operations people or the real estate people, the real estate people are not necessarily aware of the 50 percent [transportation costs] or the 9 percent [labor costs]," Feemster said. "They tend to be motivated by free rent, low rent and incentives, but the poor operations person has to live with those drayage costs from the ports, so there has to be that balance."
Port activity is yet another factor in the discussion of development patterns in inland markets versus port markets.
"A lot of it has to do with geography," Suran said. "It's not just higher fuel prices; it's also a slowdown in import traffic that has to do with the value of the American dollar."
Suran said the belief many people have that export growth will offset the decline in imports is not true for most markets.
"Imports have a stronger effect even though exports are growing at a fast rate," she said. "It's not going to replace the loss of demand from the slowdown in imports."
Port traffic will be an important factor in analyzing industrial tenant demand and development in port markets if consumer spending starts to ramp up. This interest is based on two factors intertwined: consumer spending and increasing diesel prices.
Toronto, Canada-based CIBC World Markets Inc. released a transportation costs report in May stating that current transportation costs are the equivalent of a 9 percent tariff rate, leading some to speculate on a more global scale.
According to the report, some U.S. companies are moving their businesses from Mexico to China. Currently, U.S. importers spend 150 percent more to ship product from East Asia than they do to ship product from Mexico to the East Coast, the CIBC report said.
Despite a slowdown in import activity, Suran said she did not see a slowdown in new industrial supply at the national level in the first half of the year. According to Suran, Riverside alone accounted for 20 percent of the industrial completions in the nation despite posting negative absorption.
"In the future, if fuel prices continue to rise, we're not going to see such strong completion rates on the West Coast," she said. "It's really too early to say. We're pretty much on the cusp of a trend, and oil prices seem to be stabilizing, but it's too soon to tell."
As economists tracking the Los Angeles Basin industrial market, Thomas and I have spoken at length about the changing economics of the logistics industry. Basically, the entire economic model of the logistics industry since the early 1990s has been based on low fuel costs. With the recent and continued rise in fuel, many industrial users are re-evaluating their entire location strategies. While no one really knows how the industry will look like in the era of $200/barrel gas, we do expect over the long-term that manufacturing production will probably locate closer to final points of consumption and the decade-long trend in industrial consolidation to slow if not end entirely.
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