by Stephen M. Coyle
Illustration by James Yang

A revolution is occurring in warehouse/distribution, perhaps more than in any other real estate asset class. For years, warehouses have been considered the least complicated property type. But the warehouse has recently evolved into an integral link in the supply chain, adopting many of the new technologies available to businesses. Companies now view and employ warehousing in new and innovative ways, and, as technology continues to develop, firms recognize that effective warehousing can position them for faster growth.

Steady Equilibrium
After vacancies exceeded 10 percent in 1991-92, the warehouse/ distribution market posted a strong recovery during 1993-97. Since then, vacancies have been somewhat flat at approximately 7.5 percent. While most consider this equilibrium, vacancies have leveled off because of healthy demand, strong capital flows, short construction periods, and a booming economy.

Real estate markets frequently dip below their equilibrium vacancy rates. For example, while no one would suggest that San Francisco, Boston, or Washington office market equilibrium rates are 5 percent or less, each has dipped below this threshold. One assumes that this occurred because demand exceeded supply - correct, but this is an oversimplification.

It takes significantly longer to build a class A office tower than a new warehouse/distribution building in these cities. Additionally, the capital necessary for a new office building is substantially greater than for a more modest warehouse/distribution building. Certainly, more potential construction lenders exist for warehouse construction than downtown office towers. The warehouse/distribution building represents a significantly smaller real estate bet for lenders, so construction capital flows faster to smaller warehouse/distribution projects than capital intensive office buildings.

The combination of demand, supply, and capital flows determines the level of vacancy rates. While warehouse/distribution vacancy rates seldom dip below their equilibrium vacancy point for extended periods of time, they also exhibit less volatility on the high side. Warehouse/distribution vacancy rates for the 60 largest U.S. markets have ranged between 6 percent and 10 percent for the past 17 years. The U.S. office market has ranged from 6 percent to 19 percent over the same time period.

The warehouse/distribution market has settled into a 7.5 percent equilibrium rate because of strong demand, a healthy economy, strong capital flows, and plenty of supply. Unlike other property types, warehouse/distribution is experiencing demand and supply levels that meet or exceed those of the late 1980s.

Demand Drivers
Warehouse/distribution demand has been boosted by a confluence of events: the longest economic boom in U.S. history, record homeownership levels, labor force participation of more than 67 percent, a strong U.S. dollar, a sudden expansion in high-paying office jobs, and more than two years of double-digit retail sales. While many of these forces are interconnected, the net effect is increased consumption and shipment of goods, which drives demand for warehouse space.

Growth in GDP, which covers all sectors of the economy, is good for warehousing (see the graph at the top of page 56). This is important because manufacturing and retailing are not the sole demand drivers for warehouse/distribution space. Growth in business services, for example, creates both a direct and an indirect need for warehouse/distribution space. As a company’s growth accelerates, it needs more office supplies. Additionally, as output rises, so do wages and corporate profits.

Real GDP growth has been phenomenal over the past several years. The correlation between GDP growth and warehouse/distribution demand is extremely close - a remarkable 98.7 percent from 1979 through the second quarter of 2000. However, GDP growth has recently escalated beyond the pace set by warehouse/distribution demand. Accordingly, one must ask whether there is pent-up demand, or if GDP growth is somehow not contributing to demand as much as before.

Supply Response
While all the demand-side drivers have created record warehouse/distribution demand, there also has been a supply response unequaled since the late 1980s. Rents often did not justify construction during 1996-97, but as they continued to increase through the late 1990s, pricing for new, modern warehouse buildings increased. Developers began building in anticipation of continued rent increases and healthy investor demand.

The emerging REIT market also provided substantial capital for development. Unlike previous cycles in which warehouse/distribution developers were thinly financed and their chief asset was land held for generations, warehouse developers now had shareholders and a need to increase FFO growth. So, these former developers did what they knew best; they built buildings.

Fortunately for them, demand was surprisingly strong. GDP growth rose to unprecedented levels, and logistics and shipping costs fell to record low levels (see bottom right graph on this page). With inventories falling, the net result was more goods in motion more often. Strong demand combined with strong supply to create a market in equilibrium.

Rents continued to rise during the late 1990s. REITs built new projects based on substantial preleasing and guaranteed takeouts via institutional owners. The 1990s also saw the emergence of large merchant builders who, unlike the previous warehouse developers, did not have a "build and hold" philosophy. The merchant builders, such as Industrial Developments International (IDI), had substantial balance sheets, enabling them to develop throughout the cycle. Additionally, a number of insurance companies increased their exposure to warehouse/distribution properties through development.

After the addition of more than 171 million square feet and net absorption of 160 million square feet in 1998, construction eased during 1999. Fewer than 153 million square feet was completed and net absorption was nearly matched to new supply. In 2000, 154 million square feet was completed.

Supply continues to ease, as many questioned how long the economic expansion would continue and investors tightened underwriting criteria in anticipation of a slowing economy. Investors believe that current economic conditions are unlikely to last, and are, therefore, tightening underwriting criteria.

Why Capital Likes It
Many institutional investors favor warehouse/distribution investments because they provide below-average volatility and fairly stable cash flows over long periods of time. Further, real estate, in general, and warehouse/distribution, in particular, can diversify portfolios.

So, why are so many investors underweighted in warehouse/distribution investments? These investments are typically much smaller than office, retail, and apartment investments. According to the first quarter 2000 NCREIF (National Council of Real Investment Fiduciaries) data, the average value of a warehouse/distribution property was approximately $18 million, the smallest of the four major property types. The average apartment investment had a value of $23 million, retail averaged $42 million, and office $46 million. Because many institutional investors’ (especially pension funds) investment minimums are $20 million to $25 million, many warehouse properties fail to meet these thresholds. Many have had to limit their investments to portfolios of warehouse/distribution properties. As a result, these portfolios often trade at a premium relative to the underlying assets.

Another limiting factor has been foreign investors’ lack of interest. While many have begun to consider other property types, generally office buildings, the list seldom includes warehouse/distribution. Instead, they have shown increasing interest in in-fill apartments and high street retail projects.

Investors have tended to overweight their portfolios in office investments, a sector in which it was easiest to do deals because of size considerations, the clearer future takeouts, and the highest investment returns. However, some of office’s advantages may soon fade. While office returns continue to exceed other property types, the gap has been slowly closing. According to NCREIF, office total returns were 12.8 percent as of the second quarter of 2000. Warehouse and apartment returns were 12 percent and 11.4 percent, respectively. While continuing to outperform the others, office returns have fallen significantly from their late 1998 peak.

We believe warehouse/distribution and apartment investments will likely capture increased capital flows. On a risk-adjusted basis, office looks significantly less attractive. Apartment and warehouse/distribution returns have exhibited the lowest volatility, with office returns’ volatility almost 60 percent higher. With current total returns of approximately 12 percent, warehouse/distribution appears most attractive on a risk-adjusted basis.

Investment interest in warehouse/ distribution properties will gradually increase, especially as funds and investors become increasingly risk-averse. How-ever, because of the size of warehouse/distribution investments and foreign capital’s preference for higher-profile projects, it is unlikely to approach that of other major property types.

What the Future Holds
While the office market witnessed the sharpest increase in rents and occupancies, it is the warehouse/distribution market that proved it could build alongside record growth and still not get into trouble. In most markets, supply met demand and there were modest rent increases. Property markets rarely exhibit this level of discipline.

While warehouse/distribution markets typically react quickly to a drop in demand, it still takes approximately eight months to complete a project. If a recession occurs, vacancy rates could rise slightly over the next year or two. However, we believe the most likely scenario is a continued slowing in the U.S. economy, and that warehouse/distribution supply will gradually react to this economic slowdown. Indeed, new starts have been slowing since late 1998. We project this will continue over the next two and a half years.

Over the longer term, demand should begin to recover as the echo boom wave of U.S. households and workers enter adulthood and the labor force. They will establish households and boost their consumption of goods, which will increase the flow of goods through warehouse/distribution space.

Net absorption nationally should average approximately 125 million square feet annually during 2002-05. The 141 million square feet currently under construction represents less than 2.1 percent of total inventory. While new warehouse/distribution supply may outstrip demand over the next two years, vacancies should rise modestly to near 7.7 percent by 2001. Property & Portfolio Research, a Boston-based firm that provides real estate research and portfolio strategy services to institutions, projects that by 2005, vacancies will recover to roughly 7 percent.

Warehouse rents increased 3.3 percent during 2000, while values increased just 2 percent. As demand growth slows and vacancies rise slightly in 2001, values and rents should level off. During 2002-05, as vacancies fall alongside recovering demand, values should begin posting slow, but positive, growth. Total returns should average 9.7 percent over the forecast (see graph above). While yields will provide the bulk of the return, the remainder will come from modest growth in values. Rents are unlikely to post substantial growth, as they are at or near the level supporting replacement costs in many markets.

Warehouse/distribution should perform quite well. While office returns will likely exceed warehouse/distribution returns this year and next, warehouse/distribution should provide the highest average returns over the next five years. The property type’s ability to react quickly to changing markets and its low vacancy rates relative to history should help spur strong returns throughout the forecast.

The Impact of Technology

Technology is rapidly changing how companies operate. While many pundits claimed that just-in-time inventorying would eliminate or reduce the need for warehouse/distribution space, it has instead increased demand. Just-in-time has shortened the time goods sit in warehouses, and it also has generated more movement of goods and raw materials throughout the supply chain.

Years ago, most raw materials and intermediate goods were brought to a site and assembled into the finished product. Today, products are increasingly partially assembled at a variety of locations. Inventories are held for shorter periods of time and are kept moving through the supply chain. While overall inventories are growing, the level of shipments (and hence the speed at which inventories are moving), is increasing at a faster rate (see graph below).

By increasing inventory turns, financing costs are lower, and the ability to better match inventories to customers’ changing tastes is improved. By using highly automated supply chains, wholesalers and retailers also can stock more.

This highly automated supply chain is dependent on computers, bar coders, communication devices, and database management. By carefully tracking which goods sell, manufacturers can shift their production accordingly. Likewise, since manufacturers increasingly outsource more of the manufacturing process, they can more quickly change their production schedule. And, retailers that actively manage inventories can better stock items that sell well and hold goods for as little time as possible.

Through automated logistics systems, the warehouse/distribution facility has become a major input into the supply chain. While the initial capital needed to automate one’s supply chain is very large, the benefits can be exponential. Automated supply chains typically allow distributors to reduce the number of facilities they own. Trucks equipped with on-board computers and voice/data communication systems see more service time, and, therefore, increased efficiency. For example, Wal-Mart installed satellite communications, global positioning systems (GPSs), and bar coding systems in its fleet of more than 3,500 trucks.

By increasing inventory turns and reducing out-of-stocks, Wal-Mart increased sales of Purina Dog Chow by 23 percent. This was achieved by lowering prices through logistics technology and increasing in-stock merchandise by a whopping 2 percent (from 97 percent to 99 percent). Similarly, Federated Department stores has reportedly reduced its distribution costs by $100 million annually through the use of logistics technology.

For major retailers, wholesalers, and distributors of goods, logistics technology translates into the ability to substantially change the way they use warehouse/distribution space. By using automated pick and pack systems, wire-guided forklifts, and superflat floors, some distributors can increase the cubic square footage that they use as well as the footprint of the building. Since users typically pay very little extra rent for higher ceiling heights, users of logistics technology often prefer to go vertical to decrease costs. The table on this page compares a typical 1990 big box distribution building with one that uses current technology.

Today, a big box distribution building would be equipped with satellite communications, scanners that read bar codes, wire-guided forklifts, Talkman terminals, and other state-of-the-art logistics technology. The distribution center would be substantially larger, taller, and more sophisticated.

Potential tenants for these centers include major retailers, manufacturers, third-party logistics firms, and e-commerce fulfillment centers. For the vast majority of tenants, however, modern big box distribution facilities are of little or no use. Cabot Industrial Trust estimates that this space accounts for less than 20 percent of tenant demand.

While the prices of logistics technology have fallen substantially, the initial capital outlay for such systems remains high. Therefore, most small to medium-size retailers, distributors, and wholesalers do not have the capital for such systems. In addition to the cost of computers, GPS devices, and communications equipment, forklifts must be replaced, racking systems must be scrapped, and the truck fleet may have to be altered.

For a small to medium-size warehouse tenant, ceiling heights above 24 feet are typically a negative, not a positive. Traditional forklifts cannot access higher than 32 feet. Further, in most climates, tenants must heat (and sometimes cool) space at great expense. And, while large distributors can utilize cross docking to speed the flow of goods, small to medium-size users have neither the technology nor the flow of goods to support cross docking. Finally, big box distribution space typically cannot be subdivided for most medium-size users.

Does this mean that big box distribution space is bad? Absolutely not. In fact, we believe it will continue to grow as a percentage of the overall industrial inventory. Ten years ago, there were just a handful of distribution facilities of more than 350,000 square feet. Today, there are hundreds, and more are being built and occupied every day. The cost of logistics technology continues to fall, and, as Wal-Mart has proven, bigger and technologically more savvy often mean cheaper. In today’s world, cheaper is better; lower prices increase the flow of goods and a stronger flow of goods translates into a better ability to negotiate even lower prices and, subsequently, sell more.

Rents in big box distribution space have reportedly been fairly flat, growing at less than 5 percent annually. However, this is a fairly new product type for which there is still limited demand. As more and more distributors consolidate operations and purchase logistics technologies, demand will increase.

Implications for Owners
Large national distributors, wholesalers, and retailers will increasingly focus on regional and super-regional hubs. While some distribution centers will need to remain very close to the urban population centers, many will prefer locations that can access an area within a day’s trucking drive (roughly 500 miles). Traditional distribution hubs (such as Chicago; Atlanta; San Francisco’s East Bay; Riverside, California; Dallas; and northern New Jersey) will experience significant demand. Other regional hubs will emerge. Markets such as Indianapolis; Memphis, Tennessee; and Reno, Nevada will see rapid demand and supply growth. Distribution users typically require an ample supply of cheap space (land availability), excellent highway access, a moderate-quality labor force, and easy access to an airport.

However, many developers are overstating the role of air shipment in today’s distribution world. While some markets, such as Memphis and Miami, are heavily dependent on air shipments, the vast majority of goods are shipped by truck. In fact, according to the U.S. Department of Transportation and the U.S. Commerce Department, less than one percent of all goods travel by air. According to ENO Transportation, the trucking industry accounts for 81.2 percent of the nation’s freight bill (vs. less than 73 percent in 1980). Thus, the impact of highways and the trucking industry cannot be overemphasized. (Study the Highway Transportation Bill, passed early last year; it will have major implications for where new warehouse hubs emerge.)

The best distribution locations will have access to both highways and airfreight terminals. The most expensive goods travel by air, while bulk and commodity goods will still be trucked. By carefully locating one’s distribution hubs near highways and airfreight hubs, a distributor can ship both orders out of one location.

As major distributors, retailers, and wholesalers continue to consolidate their operations into regional hubs, relationships will become increasingly important. Real estate owners will become part of the distribution decision. Certainly, ProLogis was a leader here, working both as a landlord and as a logistics provider/consultant. While many other owners may be less actively involved in providing logistics support, the ability to satisfy a tenant’s multiple requirements should increase, and, in fact, is already occurring. Cabot Industrial reports that 30 percent of its tenants are in multiple locations, compared to 20 percent in 1998. AMB Realty’s deal with Webvan to provide all of Webvan’s new warehouses is another example of the relationships forming between landlords and major retailers/wholesalers/distributors.

While this technology does not impact most small to medium-size warehouse/distribution tenants, it will impact the property owners. Traditionally, small to medium-size users were the "mom and pop" warehouse tenants. They often lacked credit, but paid higher rents and were more likely to grow over time. Landlords mixed these low-credit, locally driven tenants with larger, national tenants. The advantages of the larger, national tenants were that they had credit and could better weather an economic downturn. However, large, national tenants typically negotiated better rental rates and saw less rental rate growth. As a result, much of the development in the 1980s placed a small warehouse building next to a big box distribution building (at the time, 120,000 to 200,000 square feet). In doing so, developers mixed credit and noncredit tenants in one location. However, as national tenants consolidate their operations into a handful of regional and super-regional distribution centers, landlords will have fewer opportunities to combine high-rent, low-credit, locally driven tenants with better credit, lower rent, national tenants.

Impact of E-commerce
The growth in e-commerce has temporarily increased the demand for warehouse space, likely affecting warehouse more than retail space. While e-commerce firms capture less than 1 percent of nonauto retail sales, they have been actively taking down huge amounts of warehouse/distribution space. The e-commerce tenants’ largest impact will likely be on office space. However, the next largest impact will be on warehouse/distribution.

Many have said that e-commerce would boost demand for warehouse space. However, the concept of e-commerce is to move goods faster from the warehouse to the consumer, and e-commerce itself should not create increased need for warehouse/distribution space unless people purchase more because of lower prices. However, where the goods are stored changes significantly with e-commerce. E-retailers typically promise fast shipping, and need space near airfreight hubs and/or U.S. Postal Service hubs.

Most e-commerce firms do not own or lease space. Instead, many employ "fulfillment companies" that manage inventories, order processing, delivery, and customer service. Clearly, as the dot-com shakeout continues, some of these centers are at risk. Similarly, e-commerce firms are likely to re-lease some space in the market. Webvan’s recently announced merger with HomeGrocer should result in space being returned to a number of markets. Both of these e-grocers are building or have recently built facilities in Seattle, southern California, and Atlanta. The market that is most exposed to the shakeout in the dot-com world is probably Memphis.

Because Federal Express, UPS, and the U.S. Postal Service have major facilities in Memphis, a large number of dot-coms have located there. However, e-commerce is far from the only driver in Memphis. In fact, it is still one of the secondary drivers of warehouse demand. In other markets, which have superior highway access and are less impacted by overnight airfreight carriers, the dependence on dot-com demand is even lower.

E-commerce will present new challenges for warehouse/distribution space. The business model that most e-retailers employ is questionable, and many will go out of business. Some landlords will be stuck with vacant buildings and a temporary slowdown in demand. However, the benefits of regional and super-regional distribution are not limited to the e-retailers. In fact, it was the traditional retailers, starting with Sears & Roebuck’s bar coding and continuing with Wal-Mart’s Efficient Consumer Response, that created sophisticated logistics technologies and hub-based distribution. Increasingly, large tenants will take advantage of these technologies, whether they be e-retailers, retailers, wholesalers, distributors, or third-party logistics firms. The big box is here to stay. Unfortunately, the e-retailers’ expensive racking systems may not be. Therefore, landlords must carefully choose their tenants.

What’s Next
The overall outlook remains strong for the warehouse/distribution market. However, it faces a number of new and unique challenges going forward. Development is likely to remain heavy, as sophisticated capital markets have changed the nature of warehouse development. Public companies and heavily financed merchant builders may lengthen the overbuilding cycle. Despite this, warehouse development should remain fairly well balanced over the next several years because of low current vacancies and strong, pent-up demand.

Once upon a time, many thought that technology and warehouse/distribution were mutually exclusive concepts. Today, owners need to consider technology’s impact on the use of warehouse/distribution space. While the majority of tenants will not adopt this technology, the biggest, brightest, and wealthiest will. As large, national tenants consolidate to regional facilities, there will be impacts on real estate owners. Perhaps we will need to reassess the credit risk associated with warehouse buildings. Is it better to get high rents with a local tenant or obtain flat rents with a national tenant? How do you combine the two, when their locations differ? These are just a few of the questions that will challenge warehouse/distribution owners in the years ahead.

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