4 Factors to Consider Before Developing Industrial Real Estate

With the demand for industrial real estate expected to grow by over 1.2 billion square feet over the next five years, the oft-forgotten, humdrum real estate sector has now emerged to become of the best performing real estate asset classes over the past 20 years. With strong underlying fundamentals, strong rent growth, and dwindling vacancies, logistics real estate is considered a favorite amongst family offices and institutional investors. The capital markets have similarly been bullish on the long-term outlook for the industrial REITs as drops in valuations for industrial REITS have been far tamer in comparison to other commercial real estate asset classes.

Several factors attract sophisticated capital to the asset class, which include long term NNN-leases, lower Tenant Improvement Allowances on a per square foot basis, and the fact that industrial real estate has historically been less prone to oversupply. However, one of the problematic features of industrial real estate is that it is common to see obsolescence with older properties. Multifamily properties, for example, built in the 1970s and 1980s, can be repositioned to become a viable asset with the right value-add strategy in place. In contrast, the primary features that attract tenants to an industrial building have to do with the physical design and construction of the property. For example, it is common to see older warehouses having clear heights between 16 and 20 feet. Modern tenants, particularly logistics and e-commerce tenants, are seeking buildings with clear heights as high as 40 feet in some cases. As a result, leasing an older building is out of the question for a wide range of modern industrial tenants. Older buildings may also have issues regarding configuration, parking, or building construction. Unlike previous generations of warehouses, which can be summed up as ‘four walls and roof’ modern logistics facilities are becoming increasingly sophisticated in comparison to their predecessors. Through the adoption of energy-efficient lighting, advanced power systems, and specific docking configurations designed to enable high-throughput distribution, the contemporary logistics facility reflects the sophistication of modern logistics tenants operating in the fast-moving world of e-commerce.

Large scale development is taking place across several major metropolitan areas across the United States as landlords and investors alike seek to attract top tiers tenants that are willing to premium rental rates. While the development of industrial properties is relatively simple in comparison to office buildings or apartments, there are several unique considerations that developers and investors should consider before pursuing any particular project. Although the development of industrial assets itself is a highly nuanced endeavor that is well beyond the scope of this writing, this short article will serve as an introductory overview of the essential factors involved with investing in industrial development. In summary, this short article will explore four factors that should be considered before deciding to develop a logistics facility.

Entitlements & Zoning
Markets characterized by scarcity are starting to see industrial buildings inch closer towards non-industrial neighbors – namely retail and residential buildings. This will inevitably lead to conflicts related to truck traffic and pollution. Despite the insatiable consumer demand for one-day, and even same-day shipping, NIMBYism and local resistance can still stifle or stall new developments – especially if it involves amending or receiving exemptions to local zoning. In fact, most municipalities have some sort of restrictions on industrial uses. For logistics properties, the most common restrictions have to do with limitations on volume and restrictions on the hours in which trucks can operate. These restrictions tend to be localized in nature and can change from suburb to suburb.

Before choosing a site, here are a few important questions to consider:

“Is this site zoned for industrial real estate. If not, will I require an amendment or exemption to local zoning?

“If I do require an amendment or exemption to local zoning, what is the likelihood that I will receive this. How long will this take?

“How receptive are my potential neighbors towards the development of industrial property?”

“Will building on this site interfere with my neighbor’s right to enjoy their property?”

“If this development does interfere with neighbor’s right to enjoy their property, how severe is it, and how can this be remediated cost-effectively?”

Parking
Despite the shift towards automation and increased adoption of robotics, the parking ratio for logistics real estate continues to increase. Traditionally, two parking spots per one thousand square feet of industrial space was considered the standard. Newer industrial developments, however, are being designed with up to three spots per thousand square feet of industrial space. As parking requirements for office, retail and multifamily see declines, how is it such that the demand for parking continues to burgeon for industrial properties in the age of artificial intelligence and automation?

One possible explanation as to why this is occurring has to do with the fact firms are now able to process more orders per day than ever before. The speed at which these orders can reach the end-consumer is dependent on the number of vehicles that can be stored and loaded on-site. As expectations for same-day delivery continues to normalize, distribution centers will require larger fleets of delivery vehicles to deliver on-demand. As a result, parking has become a critical consideration for the end-users of industrial real estate and is arguably as important as proximity to major transportation routes and intermodal ports. With previous developments, developers focused on maximizing the square footage of the building with little regard for parking. However, property owners are now realizing that top tier tenants are turning down specific properties on the basis of insufficient parking.

In addition to being a hub for delivery vehicles, parking lots are also utilized for containers and portable storage units for auto parts. Recent trends in industrial leasing show that with buildings with additional acreage are not only leasing for a premium but are also leasing up faster given the dearth of adequate product that meets the demands of modern tenants. As previously mentioned, sites that were built between the 1960s and 1980s were focused on maximizing the amount of building space at the expense of parking. In addition to having parking problems, these properties also have lower clear heights, fewer loading docks, and may require certain sections to be torn down in order to create room for additional parking – a highly risky endeavor that rarely makes sense from an investment standpoint.

With regards to parking, here are a few questions to consider before moving ahead with development:

“What are the parking ratios for the competitive set in my submarket?”

“Where should parking be placed to ensure there are no ingress/egress issues in the near future?”

“What kind of tenants are looking to lease in this submarket? What are they looking for in terms of property?”

“How big are truck courts for the competitive set in my submarket?”

“How do industrial tenants in this area utilize parking? Is it mainly trailers trucks, or is it a combination of several different delivery vehicles?”

“How can I best configure the parking of this building to ensure that I have a competitive product that meets the demand of my ideal tenant?”

Proximity to Labor
Despite the highly digitized nature of the modern distribution center, labor is still a crucial factor that drives the success of the vast majority of industrial tenants. The success of several cities as logistics hubs, such as Orlando and Dallas-Fort Worth, can be attributed to the talented and rapidly growing labor pool that is readily available in those respective cities. Unlike previous generations, industrial jobs do not carry the same aura as it did during the heyday of American manufacturing. As a result, industrial tenants rely heavily on the local labor pool. Although industrial labor requires less training than manufacturing, firms strategically aim for leasing industrial space in densely populated in-fill locations to have access to a large workforce. This is especially important because having a qualified, large pool of labor is a significant competitive advantage from a business standpoint. As a result, firms are willing to pay more for space that is within reasonable proximity to the labor force.

Here are a few critical questions to consider when evaluating proximity to labor:

“Who are my tenants, and what kind of workforce are they looking for? Blue-collar or skilled?”

“Is the surrounding 5-mile radius a hotspot for the desired workforce that my tenants are looking for?”

“Where do my ideal tenants’ workforce live?”

“What is the average commute for these tenants in terms of length and distance. Depending on the city and state, this can vary drastically and will materially impact the decision whether to move forward with a project?”

“If my tenants require skilled labor, how far is the nearest university/college?”

Proximity to Customers
With the last mile constituting over 25% of the total cost associated with delivering an item to the consumer, large industrial tenants are willing to pay healthy premiums for infill industrial sites close to major populations to reduce their last-mile delivery costs. This has prompted some developers to undertake lengthy and complex projects that involve environmental remediation because infill locations in major metro regions have become such a scarce commodity, and the only available land leftover are brownfields. This sentiment is echoed by several experts who assert that the only remaining opportunity left is to redevelop on challenging sites, including those with environmental issues. In addition to the scarcity of infill sites, some of the already developed infill products feature obsolete properties. The lack of available infill sites has cued some developers to consider demolishing the existing structures and then subsequently redeveloping the sites from the ground up – a complex and capital-intensive endeavor. Similarly, many industrial developers are reaching out to mall owners to see if they would consider selling their malls. Several dead malls, especially in crossroads states like Ohio, have become hotspots for developers looking to capitalize on the mall-to-warehouse conversion. Despite the old adage of ‘location, location, location’, the costs associated with acquiring and redeveloping the perfect location into a viable industrial asset can be alarming and potentially derail an otherwise sound opportunity. Instead, it may be more reasonable to search for a site with ‘perfect price’ – a price that accounts for inherent risks involved with the development of the industrial real estate. As prime infill locations zoned for industrial real estate continue to disappear, investors and developers alike may be better off considering developing on reasonably priced greenfield sites located on the periphery of a major metropolitan area.

Here are several questions to ask when considering a site’s proximity to customers:

“How much has the population grown over the past two decades?”

“Why has it grown, and what are factors that will continue to draw people towards his market – both metro market and submarket?”

“Are there major employment drivers or developments taking place over the next five years that will continue to draw more potential customers and businesses to the area?”

“How business-friendly is the state and metro area?”

“If you were to draw a 300-mile radius around your property, how many people would you be able to reach?”

“What is the current median income and median home value?”

“What will the metro, city & submarket look in 20 years with regards to median income and median home values?”

“Has crime increased or decreased over the past ten years in this metropolitan area and specific submarket?”

“Who are the end-consumers of your prospective tenants? Where do they live, and how long would it take for your tenant to reach them?”

Conclusion:
In summary, before giving the green light to a particular project, Investors and developers alike should pay close attention to issues regarding entitlements, parking, proximity to labor, and proximity to customers. Given the exorbitant cost of last-mile delivery, sites that have easy access to a growing consumer base in a business-friendly jurisdiction will be well-positioned to outperform the benchmark. It is essential to analyze regional and domestic migration patterns to determine the presence and sustainability of the demand drivers that are drawing people to a particular metro region to make an informed decision as to whether a site makes sense from a demographic standpoint. In addition to considering the demographics of a specific site, it is also imperative to think about labor and how easy it would be for firms to recruit labor for their respective businesses. Industrial jobs do not carry the same clout as other industries, such as tech or healthcare. As a result, the labor force is highly localized in nature and can vary significantly depending on the municipality. Although investors and developers may not actively consider the implications of the labor force on their investment, modern industrial tenants are willing to pay a premium for space that has access to a reliable labor pool. From a physical standpoint, one of the overlooked aspects of an industrial site is the parking requirements. Although parking ratio seems to be trending downwards for several asset classes, the requirements for modern logistics facilities continue to increase. Modern industrial tenants, namely 3PL and e-commerce tenants, require large fleets of delivery vehicles to fulfill the same day and one-day delivery shipments. Parking requirements that may have sufficed a decade ago can no longer accommodate the increasingly complex high-throughput operations that take place in a modern logistics facility. Lastly, developers and investors should consider issues related to entitlements and zoning regarding industrial development. As the need for logistics facilities and warehouses spawn new industrial development, the line between business parks and residential communities is slowly starting to blur, spurring a host of new land use issues. Given the highly localized nature of land use regulation, developers need to have a solid rapport with the municipality and understand community concerns at a granular level.

As firms continue to adopt e-commerce in droves, the opportunity to build or invest in industrial real estate assets remains a compelling narrative despite the economic challenges posed by the COVID-19 pandemic. Although the industrial real estate has historically been immune to downturns in the economy, there are several challenges associated with investing or developing industrial properties that are unique to this particular asset class. As a highly nuanced, multidisciplinary endeavor that involves the orchestration of several different teams, the development of industrial real estate is riddled with challenges that can be easily overlooked by a novice investor accustomed to run-of-the-mill value-add or core-plus offerings. Similarly, it is easy for the entrepreneurial spirit to overlook several critical pieces that make up the puzzle of modern industrial development. The four particular factors discussed in this article are by no means an exhaustive overview of the development process, nor should it be considered as a definitive checklist for analyzing an offering or site. Rather, it should serve as a starting point for anybody looking to make informed decisions regarding industrial real estate development. Although real estate development is fraught with both covert and latent risk, the COVID-19 induced lockdown orders and prolonged work from home stretches have not only facilitated increased online shopping but have also radically reconfigured consumer behavior at a fundamental level. As the floodgates for e-commerce entrepreneurship slams wide open, the development of logistics facilities in the age of online shopping is the quintessential parallel to selling shovels during a gold rush.