Republished with permission from connectcre.com.
For both industrial real estate owners and tenants, managing costs is top of mind in the current market, while for tenants, an additional key challenge is finding suitable space in a tight market. These are among the conclusions to be drawn from a cross-section of SIOR industrial brokers who Connect CRE sounded out recently.
The responses below deliver valuable insights from Christopher Masino, SIOR, founder of Masino Commercial Real Estate Services in California’s Inland Empire; Alessandro Conte, SIOR, executive vice president and principal of the Blau & Berg Calessandro conteompany in Short Hills, N.J.; Kevin Stratman, SIOR, industrial and land broker with Investors Realty in Omaha, Neb.; and Faraz Cheema, SIOR, investment sales specialist with Coldwell Banker Commercial, Potomac, M.D.
Q: What concerns are industrial owners bringing to you in the current leasing environment, and how are you advising them?
Masino: Our clients are most interested in preserving and increasing their free cash flow. The vacancy rate in our market remains historically low and tenants are unlikely to find suitable alternatives to their current locations. We’re advising our clients to pursue lease renewals of all tenancies, at market rates, in order to keep their overall transaction costs to a minimum. Also, any vacancies that occur must be promoted and delivered to the market in a first-class condition. This means that vacant space is clean and ready for immediate occupancy, without deferred maintenance or other repairs.
Conte: The most common concern has been the slowdown in the number of showings and offerings. Twelve months ago, we were putting offers on spaces before the existing tenants even vacated; today, unfortunately, we are courting tenants and trying to persuade them to choose our building vs. another. Our advice to our landlords has been to “ink the deal in hand” rather than wait for a higher rent or credit, as there are fewer tenants in the market today, and more available spaces.
Stratman: The thing I’m hearing most is the concern over the cost of tenant improvements. Landlords are happy to hear current market rents, but when they learn about the cost of doing buildout, their excitement starts to dissipate. This has been an issue for a while now, but in the past few years owners were able to potentially justify more investment in TI because their values were skyrocketing with low cap rates. Now, with interest rates moving cap rates in the other direction, the deals are just a lot harder to do.
Cheema: As of right now, it's still a landlord's market vs. tenant market in the industrial space. Vacancy rates are still at record lows; rent has increased as much as 50% if not more pre-COVID, with manufacturing, storage/distribution, and R&D still thriving. The real challenge for owners is acquiring new assets, as evaluations have skyrocketed while build-to-suit is still expensive (with some ease in construction costs), but the biggest factor is finding areas where industrial zoning is permitted. In the large urban areas, industrial zoning is being changed to mixed use as there is a call to increase the housing supply. Then there's the issue of communities not wanting large industrial complexes close to where they live.
Q: What concerns do industrial tenants have (e.g., limited supply of space) and how are you working with them?
Masino: Industrial tenants are in most cases concerned about growth in rental rates and limited selection for expansion. Given limited supply, we recommend tenancies expand their geographic area of search. This allows them to choose from a greater number of suitable alternatives and provides a broader baseline to establish property value. Tenants who were considering buying a building in lieu of leasing are now reconsidering their options due to the increased cost of capital. We recommend tenants move quickly to secure a property if they really find what they need.
Conte: The biggest concern we see today from our tenant base is paying too high a rent per square foot. The market has slowed down a bit and pricing has stabilized; however, tenants are concerned to pull the trigger today as they feel lease rates may come down.
Stratman: Without question, the biggest challenge facing tenants is cost. They are getting increases in occupancy cost in every column. Rent is up; cost of tenant improvements is up; interest rates are up; insurance costs are up; and property tax valuations are starting to increase. It has become a very expensive time to be an occupier of industrial space. There isn’t a lot that can be done here, at least in my opinion, because none of these factors are in their control.
[Stratman, continued] Still, the biggest conversation I’m having is about what their true space requirement is. Do they really need as much office build out as they say they do? Do they really need that overall square footage size? Can they reduce their footprint by managing inventory better? Second on that list is competing for space. Sometimes it takes losing out on a deal or two for tenants to understand that in a tight market, they can’t get everything they ask for. When asked to respond to something, they won’t be waited on. I think the best way to contend with both concerns is to get out in the market as early as you can. Costs might not be going away, but at a minimum, time will allow tenants to understand what their true occupancy cost will be and better plan for it. Knowing that they might miss out on a space or two should add to that need.
Cheema: As mentioned, inventory is already tight in the market space and once a certain special requirement is added, there may be slim-to-none to select from. For example, a partner and I rep a regional 3PL user that takes up 40,000 to 60,000 square feet. Ceiling height did not matter as the tenant was floor-stacking their goods, but they needed a minimum of five dock doors to support 53-foot trailers. Once that requirement was added, this was the result: Harrisburg, PA - 2 spaces; Rochester, NY - 2 spaces; Philadelphia, PA - 1 space; Baltimore, MD - 2 spaces; Richmond, VA - 0 spaces; and Columbus, OH - 1 space.
Q: New deliveries of industrial space have continued this year at a near-record pace. Are you finding that tenants insist on the most modern space, or are there users for whom Class B space may be preferable?
Masino: New deliveries are the most expensive options available in the market. For some occupiers, a new building offers many advantages in terms of location, design, and amenities. Given how low our vacancy rates are, new properties in many cases represent the only available option. However, second-generation space is clearly still in demand and in some cases offers the benefit of having been previously occupied (i.e., electrical runs or upgraded office space). Price is always a major consideration and for those looking to achieve cost savings, second-generation space will do just fine.
Conte: Most tenants prefer the Class A space and given that the delta in price between A and B is marginal, most opt for Class A space when available.
Stratman: I actually think the best thing that’s happened to Class B industrial owners has been the amount of new modern spec. With lease rates on new builds increasing in conjunction with the cost of construction, owners of Class B buildings have been able to push rent as well. Sure, the rent isn’t as high as modern warehouses, but you can raise rent and look cheap by comparison. I also think the cost of buildout in modern warehouses is causing some tenants to potentially consider Class B when they might not have otherwise. Can you stack as much in a 1980s-build Class B compared to a modern class A? Do the savings in buildout costs outweigh the functional obsolescence? Potentially.
Cheema: Depends on the tenant. The hardest thing right now is finding space for tenants with either column spacing, ceiling height, dock, or yard requirement; beggars can't be choosers. For easy requirements, I have tenants that would pick a Class B space to save on cost because they just need a box; on the other hand, I have clients that will pay a premium if there are cross docking capabilities. Finally, I have a listing that is Class C for sale: not ideal for an investor as offers can come in low, but I did have an owner-user that came very close to asking because they need the space for operations and there is no inventory for sale.
Q: With the niche categories of industrial that have come into prominence in the past few years (e.g., cold storage, data centers), are you finding that SIORs in the industrial space need to become familiar with a variety of product types or are they better off specializing?
Masino: Niche industrial markets, such as cold storage or data centers, are not in high demand in our market by a wide variety of occupiers. If one were to specialize in only cold storage in our market, one would be hard pressed to succeed absent understanding other industrial property types. As a brokerage professional in our market, the better decision is to thoroughly understand a range of industrial property types in order to provide solutions for diverse requirements.
Conte: I find that having a strong understanding in all niche categories proves most helpful. Knowing the best professionals who specialize in the actual inner workings such as refrigeration, IT, etc. is where we as SIORs can separate ourselves from non-SIORs. I maintain that one specializes in a market and not a sector.
Stratman: In Omaha, data centers have been huge. Data centers alone have absorbed 2,400 acres in the Omaha metro over the last few years. If you are a broker listing industrial land in our market, you have to be considering whether the site is a good potential fit for a data center. This might mean having a deeper understanding of power availability or redundancy. I’m not quite sure in Omaha it makes sense to specialize in data centers alone, but you certainly need to be mindful of their needs when representing a landowner.
Cheema: For me, I focus on 3PL, manufacturing and distribution. For cold storage, specialty R&D or data centers, I will bring in a fellow SIOR who has expertise in the subject matter.