Friday, February 13, 2009

Question & Answers on IE Industrial

I received an email from Kari Hamanaka of the California Real Estate Journal asking some questions on the Inland Empire industrial market.

I had to preface it with the disclaimer that the thoughts and views expressed on my blog are not exactly that of Colliers International.

Developers have been the best clients for my brokers, and their fates are closely intertwined. As such I was put a little on the defensive with some of these questions.

Developers are the agents of supply in this business, who are tasked with trying to gauge the demand for their products and plan accordingly. We could argue that greed took over their better judgement in the past few years, and that they overshot supply. In retrospect, we did not need as much leverage, we did not need as many buildings, we did not need to make as much money as we did when the times were good. We recommended the boom and we should own up to the bust.

Perhaps the silver lining is that now research, whose job it is of measuring demand and keeping track of supply, will be in higher demand. Research: when the s$*! hits the fan, you want to know how fast it is spinning.

Inland Empire Forecast Article Questions:

-You refer to the eastern Inland Empire region as a "flaming wreckage" in your blog post ("Inland Empire Industrial: Worse in 2009?," posted Jan. 14) – how would you describe the west?

The East Inland Empire was the hottest market in the United States for 2004-2007, leading the nation in both construction and absorption, but flaming wreckage is a bit of hyperbole. During that time it made sense to build these large speculative buildings because supply chains were long, there was tremendous demand for high velocity distribution centers and the only place near the San Pedro ports to build them was in the Inland Empire.

The West did not have the supply boom and related problems that the East had, so in that regard the West is in much better shape. Tenants in the West have been in their buildings for a number of years, and they are stable credit tenants (the definition of a credit tenant is changing now, however). The problem the West is going to have is to try to keep these tenants, to go into damage control and focus on retention.

And they are having a tougher time; in 2008 the West had -7.8 million SF of negative absorption. Tenants are leaving for other markets, downsizing, or going out of business. And the West in not only competing with the East anymore, tenants have the whole Los Angeles Basin to choose from as rents are coming down and vacancy rate are increasing basin-wide.

-What factors have caused the conditions in the east – was it all the spec development?

Supply and demand. At the top of the market, the only real constraint was land. Demand was more or less an afterthought in many of these properties as optimism ran high. This can be seen in many of the pro formas that were used to justify the spec developments, assumptions on rent growth and occupancy rates that no longer hold true.

This would not be the case if the demand side of the equation had held up, which it has not. Now is a scary time to be a tenant as business conditions are very shaky. So supply has increased, while demand has decreased and the only way to reach a new equilibrium is for prices (rents) to decline.

This problem is that a lot of institutional landlords are very sticky on their rents. These firms have diverse portfolios and incentives that go beyond the local market, they have investment criteria to meet and shareholders to account for so they are not as flexible as an individual landlord with a mortgage payment might be.

Spec development, the recession / reduction in tenant demand and the expectations gap between landlords and tenants have caused the current market conditions in the East.

-Do we just chalk up all the spec development built in the last few years as victims of poor timing, or should developers have been more cautious - or, did all signs, both from the standpoint of the economy and from user demand, point to yes, the region could support all of that industrial space?

I would say that the industrial building boom in the East Inland Empire is analogous to the office building boom that happened in the mid 1980’s and many of the factors that applied then also apply now.

For one, you have buildings that serve as investments for large institutions. The “value” of these (permanent) buildings to these investors is the rates of return these buildings deliver, which depend on market prices (which change based on supply and demand). These institutions do not need the space for their own use, they are at the mercy of the market and used significant leverage to increase their rate of return.

The problem occurs because unlike other investment vehicles (stocks etc), there is a significant lag between supply and demand, real estate cannot be moved, and it is difficult to distinguish between permanent and transient changes in market conditions. People assumed that what occurred in the past few years would carry forward for all time. A transient increase in lease rates (tight market conditions) sent the signal that additional investment was needed. It was unknown how much new space would be needed and developers built in anticipation of increasing rents and tight market conditions.

The problem is that real estate is not a perfect market; there is a lag time between when the signal to build more buildings occurs and the 1-2 years it takes to actually entitle and construct a building. All these developers were looking at the same information and drawing the same conclusions.

I cannot fault these developers, the signal to build existed very strongly in 2004 as trade exploded and firms looked to expand into the Inland Empire. The problem did not occur until conditions changed dramatically in 2007. This is the nature of the real estate business; this is an industry prone to booms and busts. There is tremendous potential during the booms, and cheap money then made it really easy to build more than we should have, but unfortunately we have to live with the busts as well.

The information in 2004 did support more construction, but imperfect information and imperfect markets led us to overshoot supply.

-Is this the end of spec development at least for the short-term?

-Based on what you're seeing in the market, are we seeing a return back to regional distribution centers and a move away from the big box industrial that the region is known for? If so, is this a short-term trend, or something that will impact development patterns long-term?

Gas prices had me really worried that we would see more of a regional distribution model (smaller, local warehouses). There is a tradeoff between transportation costs and warehousing costs and any saving companies had in a reduction in warehousing costs via a regional distribution center (economies of scale, modern facilities, cheaper rent, etc) were being destroyed by $140 a barrel oil. Companies were rethinking their supply chains and many less than truckload companies (which are more fuel intensive) went out of business.

I think the long supply chains that made the Inland Empire market possible, goods being manufactured in China and shipped to Inland Empire centers, peaked and will not return for some time. I think volatile fuel prices and falling demand have suppliers thinking about their profitability and margins more than in the past. When the economy was about consumption and the velocity of goods was high the regional distribution center made a lot of sense, since these centers were built to move good and not to store them. Now that goods are not moving at the same pace as they were in the past, the demand for these centers has fallen.

Hover, I think the regional distribution model is here to stay and here is why. Trade will remain focused on several global hubs, and Southern California is not only the largest trading hub in the United States, dominating US trade with Asia, but Southern California is a final destination for many of the goods entering the country. Southern California is also the largest manufacturing center in the US, and also has a very large apparel component, and those goods need to be stored and shipped elsewhere.

-What about factors such as activity at the ports and the environmental regulations for the trucking industry - how has that impacted industrial?

The Clean Truck Program, TWIC, and container fees can all be seen as taxes on the trucking industry. They raise the cost of business. This will further squeeze the margins of independent trucking firms who pass on the cost.

In a larger context these taxes make Southern California less attractive for importers, but with few other options in terms of importing goods, firms have to absorb or pass on those costs. We have to be careful, there is competition from Canadian and Mexican ports as well as the threat of container traffic passing through the Panama Canal to the East Coast ports.

-Is there anything to be learned from past recessions' impacts on I.E. industrial that can be applied to our current situation?

The early 1990’s is a good example for the Inland Empire. The West Inland Empire was the fringe of development at that time and when the recession in the early 1990’s started, buyers and users were nowhere to be found. It was normal to have a vacant building for 2 years at that time as demand for large warehouse space was non-existent. The market was prolonged negative absorption for big box space until around 1995 when momentum started to pick back up. Brokers survived from 1991 to 1995 by leasing small tenants and small owner users. It was not until 1999 that construction started to come back and the next cycle started.

The brokers who started out in the early 1990’s are some of our most successful brokers, due to surviving in these adverse conditions.

The lesson is that things will be tough as the market corrects, but those who can make it in this market will be in a very good position when it recovers. And it will recover.

-In your Jan. 14 blog posting you wrote, "I disagree when people say that this recession will be over by such and such a date. They do not know, and their guess is just as good as anybody." Rather than ask you when you suspect we will hit the bottom and when the recession will be over, what factors will it take to get I.E. industrial back up and running again?

For a large part, the Inland Empire industrial base is concentrated in logistics/ distribution. There are a lot of industrial users in construction related industries. To get these industries back up and running housing construction would have to return and the American consumer will need to get back to spending and imports will need to rise.

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