Industrial Roundtable Q&A – 2017 Annual Real Estate Magazine
Industrial proves flexible
KENT DARR Apr 24, 2018 | 5:50 pm
19 min read time4,456 wordsBusiness Record Insider, Real Estate & Development
Industrial property has moved out of the shadows of commercial real estate.
Small businesses are growing and need larger spaces. Local builders are adding nearly 2 million square feet of new space to the market, and yet vacancies are low.
If you can find a property for sale, buy it. The former Townsend Engineering site in Des Moines has been repurposed to a range of uses by new owners, and its former occupant, Marel, has converted other space closer to downtown into a high-tech manufacturing facility.
It’s all a sign of a bustling Greater Des Moines economy. With the growth comes some anxiety. Data centers are pulling in material and workers and driving up costs. Increases in construction and renovation costs make leases more expensive, in some cases pushing rents into the retail range.
Even with an anticipated glut of space coming onto the market, few predicted a downside for the industrial sector in the coming year. Why? What’s happening in the sector speaks to “how robust our economy is,” said Morey Knutson, of CBRE|Hubbell Commercial.
Knutson joined in on a roundtable discussion the Business Record hosted earlier this year on the industrial market. He was joined by Marcus Pitts of JLL, Jeff Saddoris of Anderson Properties and Terry Vorbrich of the city of Des Moines.
What do you see as the predominant trend in the industrial sector for 2018?
Marcus Pitts The bigger blocks of space are coming off the market. With that space coming off the market, that’s what you would probably call class B, not because necessarily the facility would be class B, but because of the rental rates that they were asking. So with some of those lower rental rates coming up in the market, a lot of the new construction stuff I think will continue to strive here in 2018 and be able to push rental rates. More users will focus on new construction as opposed to the second-generation product.
Morey Knutson I think it’s interesting to note that of the four largest lease transactions last year, three of them were expansions of local manufacturers, Daimler Trucks North America, with their 245,000-square-foot build to suit in Grimes, was the only new entrant into our market of large transactions. I think that’s interesting from the standpoint
of how robust our local economy is. I do see a coming glut of space.
Jeff Saddoris At Anderson Properties, we’re more focused on light industrial, where the only real difference between some of the bulk distribution stuff that’s going on is we’re not doing 32-foot clear-height ceilings. We’re doing 24-foot clear heights, smaller bay sizes. So we’re catering maybe to that smaller tenant, regional sized credit user. We’re looking for a 7,500- to 15,000-square-foot user, and in that particular part of the market those tenants usually are requiring, because they’re doing their office function and their warehouse function together, some office build-out. So we still see that part of the market growing. There’s still a lot of local businesses growing. Some of them have grown twice in this last go-round. We own probably 900,000 square feet of that flex, kind of the light industrial space. We’re completely full. We’ve got people looking for space every day. So we’re getting ready to kick off another building in Grimes that will be focused towards that smaller user.
Terry Vorbrich From the city of Des Moines standpoint, the industrial projects that we’ve seen and we’ve been working with have all been owner-occupied. They’ve been businesses that are located here in Des Moines that are expanding. They’re consolidating. They may have lease space. The projects tend to be probably between 60,000 to 100,000 square feet. A lot of it is just through natural growth of the companies as well as consolidation. They may have been leasing space in two to three different locations, and now with the economics where they’re at, they’re deciding to go ahead and build their own space and move into it on a permanent basis.
What’s happening in the space that they’re leaving?
Vorbrich Townsend Engineering, the old facility, is slowly being redeveloped into other uses. We’ve moved Marel down into the River Point West area. We took a building of flex space and actually redeveloped it into a combination of office and technical innovation and manufacturing space. We’re seeing a little bit more of that as far as the repurposing of what’s been traditionally office and maybe a little bit of retail space into something industrial. I don’t know if anybody else is seeing that. We’re probably maybe seeing more of that in Des Moines within our flex space areas simply because we don’t have the 200,000- to 300,000-square-foot warehouse facilities on a competitive basis within the city. We’re not fortunate enough to have that kind of landmass that can facilitate that. But we are starting to see more and more redevelopment emphasis. So it’s kind of case by case. A lot of it depends on zoning.
We’ve had some inquiries about taking some outdated inline retail spaces and potentially converting them to some industrial use, warehousing space, but there again that really is dependent on zoning. It doesn’t really work out too well for the way the neighborhoods and everything else are developed around it.
Just to follow up real quick on that. Will the new Des Moines zoning code affect that in any way?
Vorbrich The new form-based code doesn’t really affect the existing buildings unless you go to actually replace them. So if you’ve got a large warehouse facility that’s being used as warehouse that’s looking to expand and add additional space, then they’ll have to deal with the new codes and how the actual form of that space will look, but the existing space is unaffected as long as it continues to be used as it is right now.
Jeff and Morey, are any of your new spaces being built on a speculative basis?
Saddoris I think maybe the main difference is we have an existing base of tenants that are all growing and sitting in 3,000, 5,000 square feet, and those tenants want to go to 7,000, 10,000, so we’re almost pulling from our own portfolio to grow. And then it’s been very easy to backfill a 3,000-square-foot space. It’s very difficult to build those small bay spaces where you’ve got a very local or regional kind of company that is either coming out of their house or coming out of some other space that’s looking for 3,000 square feet with an overhead door. They need some office, but they don’t care what it looks like.
We’ve got somewhere around 250 tenants in flex space, so we do get a lot of them that are really trying to grow, and we’ve been successful with it. We built Legacy One to kind of accommodate some of that, but there was some existing demand that was already sitting there, so we took advantage of that, and Legacy Two will really be more focused on some of our other tenants as they grow.
Knutson I think Hubbell’s philosophy as it relates to our Grimes distribution center is it’s more of a traditional approach that once you achieve 60 percent to 70 percent occupancy in a new building, that will trigger the next phase. So right now we have four 110,000-square-foot buildings. As soon as we achieve 60, 70 percent in our newest building, then we will proceed with a fifth building.
Is there such a thing as a traditional user these days? Terry mentioned that some folks are approaching the city about converting retail to warehouse, but there are retail users that would be considered traditional warehouses.
Knutson Yeah. We did not expect at all that our lead tenant or one of our lead tenants in our first building (in Grimes) was going to be Sky Zone’s trampoline park. And of course the big issues that we have with entertainment or service users is parking, and industrial parking ratios don’t come close to that of retail or office, but we have three or four sports-related users now. We’ve had interest on the part of churches, but again we get into parking issues there. So we were very much surprised that what was going to be a light industrial or distribution center turned into an entertainment district, but it’s worked, and those kind of users, they need high ceilings. They need wide open space, and the rents are traditionally much lower than they would pay in a retail environment.
Pitts It seems like it kind of comes down to ownership preference because some of the owners, a lot of the locally owned real estate companies, they seem to have that mix just because that’s where those tenants have ended up. We do some work with Opus Group up in the Ankeny market, and their business model is different from that; they just want your run-of-the mill industrial user, industrial logistics, national creditor thereabouts, and then they come in and build these buildings, and then at the end of the day they sell them. So it just comes down to, I think, whatever the ownership preference is and what their business model is.
Knutson R&R didn’t expect to land Hy-Vee’s 150,000-square-foot tech requirement, and I think the biggest reason was that’s the kind of space they wanted. Wide open, high ceilings, more of an industrial feel. And again, Marcus brings up a good point about the landlord or the developer’s business model. For us and for R&R, we’re long-term holders. For an emergent builder like Opus, it’s institutional grade, institutional quality tenants; the credit is important so that they can sell and achieve a return.
Well, some of these competitors, in the fulfillment space anyway, does that create an opportunity here or are we enough of a transportation center to attract, if not Amazon, those other businesses? I know that R&R, one of their tenants is sort of a mini-fulfillment operation. It’s kind of a unique business model, but are you seeing any of that in this market?
Saddoris No. I think, and I’ve always tried to understand why Des Moines, at the confluence of Interstate 35 and Interstate 80, right in the heart of the country, has not become a major distribution hub, and the best answer I’ve received is we’re too close to Chicago. Chicago grows further and further west all the time, and we do have some large distribution centers. Target in Iowa, for example, but for Des Moines, we don’t see it. We don’t see those inquiries. The larger requirements that we deal with are tending to be more like manufacturing, but not distribution.
Pitts We’ve tracked every industrial transaction in the Des Moines market for the last four years, so we’ve got a really good database of records, and we’re expanding those metrics across the state of Iowa. Right now there’s about 2.5 million square feet of active industrial deals across the state of Iowa. These groups are coming in and they’re looking at Iowa, and Iowa is stacked up against Minnesota, North Dakota, South Dakota, Wisconsin, Illinois, but it’s usually a four- or five-state search … and these guys are looking at incentives. They’re looking at labor. They’re looking at all those things. There’s been a couple that have been in the works about three years now, but I think within the next year, maybe two, that one of those big ones will land in the Iowa marketplace. Once one hits, it’ll be interesting to see what that does to the market. How does that experience go? Were they able to staff it? Were they able to logistically distribute out of that as they thought, and what would that mean? Kind of like with the data centers.
What effects are construction costs having on the sector?
Knutson You’re in the trenches on that every day.
Saddoris Again, I’m sure Apple and Microsoft and Facebook, they bring great names to the Des Moines area. What we’ve seen just because of the size and the labor pool market in the Des Moines area, that has really driven costs up for the rest of the world. Those data centers are largely tilt-up buildings that they just pull in with flatbed trailers. They’re just pulling in a semitrailer full of computer equipment, and the determining factor a lot of times is just because we have inexpensive power relative to the rest of the country, but what that’s done to the construction cost market has increased it a fair amount, especially electricians. A lot of those buildings have a lot of electric infrastructure in them. You’re stuck when you’re going out to bid. Some of the smaller companies are trying to ramp up, but we’ve seen the cost of electric[ians] go up probably 20 percent in the last two years.
Des Moines is the size where it only has one precast panel manufacturer, so for our second building, Legacy Two, we had to reserve those panels back in November to be able to build it this year. It’s just a function of our market. Before all these people started coming for data centers, one precast manufacturer for tilt-up concrete was fine. You go south to Kansas City, they’re able to pour concrete on-site and tilt it up, which is much less expensive, but our weather conditions just don’t allow it here. So I can tell you from the 135,000-square-foot building that we built and just finished recently in Grimes … we’re 15 percent more expensive, not in land cost, but in building cost, to build here versus Chicago right now. It’s just a function of everything that’s going on in our market.
Knutson Right. And it’s things you don’t think about. For example, the impact that the hurricanes had in drawing labor away from the Midwest. And secondly, drywall. There is a chronic shortage of drywall, so drywall has become a commodity. You’ve got drywall futures now. So all of this adds up to some pretty surprising costs in tenant improvements. We used to quote for construction of tenant improvements 30 to 45 days, 45 on the high side. Now it’s 60 to 75 days just because of the labor shortage and the costs. The increases have been pretty alarming.
Pitts So to wrap that all up, where that leads to is higher occupancy cost for the tenants, and I think my opening point on some of those class B facilities, those spaces leasing, when those spaces that used to be in those $2, $3 net rent are now $3 to $4.50 net rent, and once that stuff goes, it’s all new construction. And they’ll constantly be flexing the market. It’ll be a 50,000-square-foot vacancy in Urbandale and someone will fill it. I think you’ve got sublease space out there at
$3 net rent.
Knutson To my earlier point of surplus of space, we have a 60,000-foot sublease at Interstate Acres, and they’re paying $4.60 a foot base rent. We haven’t had any activity on that. None. So we just lowered the base rent to $3. So Marcus’ point is correct. It’s going to drive up lease rates, which is always a difficult thing for more unsophisticated users, tenants. The base rent is getting higher. Expenses are always an issue. And then the tenant improvement cost. So you’ve got industrial rents that, depending on the amount of the build-out, and in many cases not extreme build-out, are approaching class B, C retail rates.
Saddoris Exactly. So we have some retail space, kind of neighborhood centers on 100th Street in Urbandale, and the first ones to fill are the ones that have an overhead door in the back. Why did we put it there, or someone put it there? We don’t know, but that is a big plus because you’re getting rents pushing retail and office in the flex market. A typical 3,000- to 5,000-square-foot space with an overhead door and maybe 15 to 20 percent office build-out 2, 2½ years ago was $556. That’s $775 today.
How does that compare to traditional retail?
Saddoris Some of that traditional retail space, we’re at $8 to $9.
Knutson The new construction flex space, flex product in Ankeny is in that, $8, $9, $10 range.
Does that all blur the lines so far as someone looking at the space as retail versus industrial?
Saddoris Yeah. We’re just seeing more, I don’t know if creative is the word, but much more flexible space. If we’ve got a building that can accommodate an overhead door and is a retail center or even a single-story office building, where we once thought that was ridiculous to put that in, we’re now looking at it to help lease it up a little quicker because the rents are getting that close. So just what’s been driving those costs is what we keep thinking about, and we don’t really see anything that’s going to slow those costs down. We once thought we’d see more drywallers come if the residential market slowed down a little, and I think it’s slowed down a little, and we’ve seen a little bit more competition in drywalling, but then it’s hard to get drywall, so it seems like there’s always something that’s creating that next issue of we’re waiting for those construction costs to flatten out a little bit.
But now with Apple coming, unless they’re going to bring their own construction crew over, we don’t see anything that’s going to slow this down.
What does this do to business planning for the user? It seems to me if you’re ordering, if you’re making your slabs in November, it’s pushing you way out front, isn’t it?
Saddoris Yeah, it is. We look at that daily, but the risk is you don’t build it and by the time you can start construction, what you always try to avoid in new construction is you try to avoid building through the winter and avoid winter conditioning cost because that can really increase. So the timing of when you do it has an impact on what the cost will be, too. So if you wait too long, you don’t want to be tilting concrete right now (in February). You don’t want to be doing dirt work right now, those kind of things. So our construction cycle in the Des Moines market is you come out of winter and it’s usually a wet spring so that’s difficult to get any kind of earth work done, but April, May, June,
July, August, September, October, and you’ve got to be wrapping
up in November.
Knutson I can remember in the not-too-distant past where if we were making a proposal to a tenant that involved tenant improvements, that if two or three months went by before you completed the transaction, those tenant improvement costs really hadn’t changed. Now we as a landlord need a decision on the part of the tenant because those tenant improvement costs are going up rapidly. So every 30 days it’s going to be a higher number.
Saddoris The fundamentals are still there, supply and demand. Right now there’s just a high demand for labor and construction, most of those trades, and at the same time there’s a large demand to start construction projects. So to Morey’s point, what we’ve been doing is when you talk about how someone has to plan or forecast, when we put a proposal out now, the proposal is usually good for a week, a week and a half. The pricing is good for 20 to 30 days, and we put that right in the proposal now because we’ve had to explain too many times as you work on deals why pricing keeps going up. So it’s going up monthly.
You mentioned small users that were needing smaller spaces and people who were growing into some newer space. Do you see that demand continuing?
Saddoris So a lot of them are a business that started up in the last five years, family-owned or a couple of investor-owned companies. The range of things they do are big in scale, but they’re just a small piece of it here, and they’re from here and they want to stay here, and they figured out that they can ship out of here because it’s just become easier to ship all over the world. I would say five to seven serious inquiries a week are coming into our office. “I need 3,000 square feet. I’m in 1,500 square feet. I need 3,000.”
Vorbrich We see that demand in the city of Des Moines. I think you see that demand for small-business growth just throughout the metro area. Unfortunately most of the product that you’re talking about is in the west or north suburbs. But that demand, quite frankly, small-business growth, is all through the Greater Des Moines metro market.
Do you hear from out-of-state users who still say property taxes are too high?
Vorbrich We hear that discussion every day. Obviously working for the city in the office of economic development, that’s one of the things that comes up in discussions, whether it’s owner-occupied, whether it’s competitive, whatever the case is. It is property taxes, and a lot of it depends on the type of business that we’re dealing with and whether it’s owner-occupied or competitive because Iowa has a single-factor corporate tax, so your corporate tax liability is on the profits that are generated through revenues, sales, in the state of Iowa. So if you’re dealing with a company that has 99 percent of its revenue outside the state of Iowa, only 1 percent is taxed from a corporate income tax standpoint.
So they take a look at that. They weigh that between property taxes. Now if you’re dealing with an industrial property, that’s going to be one of your major expenses, property taxes and utilities and so forth. They weigh that, and they look at their overall tax burden that their individual entity is going to have within the state of Iowa, and national studies continue to show that the state of Iowa is in the middle of the crowd, about 25 out of 50 states, when it comes to total tax burden. So you can’t really segregate out just property taxes as the main burden.
Do warehouses remain an attractive investment?
Pitts If you can find it, yeah. Des Moines traditionally has been long-term holders of real estate as investors as a broad sense, and when we have products that come up like, for example, Corporate Woods Building One when we sold that for Opus, that was at the 207,000-square-foot building. We had interest from groups across the United States, and we partnered with our capital markets team out of Chicago on that. The winning buyer ended up being an East Coast buyer, but that single-tenant, long-term, net-leased product in Des Moines is very tough to come by. You might be able to trip across a property that has a little bit of vacancy, maybe some more localized credit, for what the institutional buyer is looking for in Des Moines, that product is tough to come by. I think the Dr Pepper Snapple building on the northeast side of Des Moines, that sold recently. There’s a line of people that would like to get into the Des Moines market.
Knutson Oh, yeah. There’s no shortage of capital, number one, and the institutional investors have always had an interest in our market, and with the quality of the new product that we’re doing now and with long-term credit tenants, the pricing is very high. So the investor is achieving less of a rate of return, number one because of the competition for the product, and the demand.
Saddoris Yeah. The Daimler project that we put in Grimes, the 245,000-square-foot, it’s got a longer-term lease on it. We don’t want to sell it, but I have to tell you, some of the outside institutional money that’s looking at it from the coast, a 6 percent cap rate is a bargain to them versus what they can get on the coast right now. We’re getting a lot of looks on that building, but again, it’s just not something we’re interested in selling. And anything you’ve held on to for a while and started to depreciate, you might get a great price on selling it, but you’ve got to find a tax exchange to go into that you’re equally as comfortable, in our minds. So we always kind of come back to the opinion of let’s just keep what we’ve got. We built it. We know what we’ve got. Even though someone wants to pay us more than we think it’s worth, we’ve got the other problem of paying tax on it if we settle.
Knutson And again, that’s very much a local mentality. Whether it’s R&R or Hubbell or Anderson. Opus, on the other hand, their business model is they build it, they sell it. That’s what they do. There’s no angst about that. That’s what they do, whereas we tend to be long-term hold.
What prevents, or why wouldn’t somebody who was looking, instead of trying to buy something that’s existing, why not build it?
Pitts I think you’ll see those groups, additional groups start to come into this market. I just can’t predict the future and say that’s going to be in the next six months, 12 months, 18, 24. That I can’t predict the future on, but I think we will start to see more out-of-town developers coming to compete with the local guys.
Knutson I think historically one of the reasons you haven’t seen it is developers are typically averse to coming into a new market and buying land in the hopes of either doing a spec building or even more so to get an anchor tenant for their project. Opus, on the other hand, when they came into the market, they bought the Ankeny land. They had a risk tolerance, and to their credit, it’s becoming a successful project. In my mind, that’s why you have not seen a lot of national interest in Des Moines, because they just don’t want to bank land.
Pitts Rather than re-create that wheel every time, we were kind of listening to what Opus was telling us. It was a really good partnership and still is, but listening to kind of what they were saying, what they were looking for, and so next time they want to look at a site or somebody wants to look at a site, we have that playbook ready to go.