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The National Association of Industrial and Office Parks is reporting an increase in demand for industrial space in the U.S. as the global economy continues to improve and officials believe the country will see as much as 425 million square feet of absorption by the end of next year. A lack of industrial development and an abandonment of the “just in time” supply-chain model is driving interest into the sector whereas not too long ago yield in real rents could not justify the cost of construction. That’s why some experts argue that there will be a return of interest in older Class-B buildings that offer the same utility without the amenities of Class-A properties. For more on this continue reading the following article from National Real Estate Investor

Over the past year we have seen continued improvement in economic activity across the world, creating increased demand for industrial space in the U.S. The National Association of Industrial and Office Parks (NAIOP) projects that, following a solid 100 million sq. ft. of absorption in 2012, the US will experience approximately 425 million sq. ft. of positive absorption between 2012 and 2014.

This projection of increasing demand reflects a combination of expected continued economic growth and positive fundamentals driving the U.S. industrial sector. Lower gas and electric costs in the U.S. compared to developing economies is leading to manufacturing being “on-shored.” An uptick in e-commerce is increasing the amount of goods stored in warehouses as opposed to bricks-and-mortar retail stores. The recent devastating Japanese tsunami and Thai floods highlighted the dangers of thinly stretched supply chains – entire plants had to be shut down because of inadequate inventory of a small, single out-sourced part. As a result, there appears to be some reduced adherence to strict “just in time” supply chain management, where companies keep only enough inventory on hand to meet immediate needs.

According to CBRE[1], due to increased demand, the national availability rate for industrial real estate in the US declined to13.1 percent in the third quarter of 2012. CBRE projects availability to fall to 12.2 percent by year-end 2013 and 11.3 percent by year-end 2014, as net absorption continues to outpace new development. This poses the question – why isn’t there more new development to satisfy this increasing demand?

A recent industry report[2]that analyzes industrial construction trends suggests this restricted supply stems primarily from a lack of recovery in real rents to levels that would provide the required returns to justify development. However, to fully explain the lack of industrial development it is important to examine how industry dynamics have created a disparity between the type of buildings supplied and what the “average” industrial tenant demands.

Most industrial real estate developers tend to build class-A buildings with 32 ft. to 36 ft. clear-height, cross-docked loading and state-of-the-art fire suppression sprinklers and lighting. While these are aesthetically pleasing and functionally efficient, their premium building costs require premium rents to justify their development. However, tenants that actually need the “bells and whistles” associated with class-A buildings may only be a small portion of total tenant demand.

According to a recent white paper[3]that examines the availability rates of industrial properties, it appears the majority of industrial tenants may be generally content with older class-B buildings. These buildings may have less overall functionality than class-A buildings, but are priced for the industrial “utility” they deliver. The high tenant retention rates experienced by these buildings  – especially if they are single tenant occupied – is evidence that their level of functionality (industrial tenant “utility”) meets tenant demands.  

The paper also examined the common belief that industrial real estate is particularly susceptible to obsolescence – that, due to outdated design, buildings lose their functionality for industrial tenants. In contradiction to this belief, the author discovered that older industrial buildings generally boast higher occupancy rates than newer buildings. Specifically by decade of construction, buildings built in the 1950s had higher rates of occupancy than those built in the 60s, and so on, with this trend continuing to buildings built in 2000 and beyond. These statistics seem to refute the common misperception of diminished utility and desirability of older class-B industrial buildings.

Overall, the aforementioned factors impacting the supply and demand dynamic create a compelling case for the attractiveness of class-B industrial buildings among a variety of constituencies. Class-B industrial property owners and operators benefit from low tenant rollover because of the buildings’ infill locations and sufficient functionality. Tenants benefit from low rentals rates, while investors can expect stable and predictable cash flows and lower volatility. With somewhat less functionality than their class-A counterparts but sufficient utility for their occupants, it can be argued that class-B buildings deliver better “bang for the buck” for tenants. In short, today and for the foreseeable future, class-B properties will continue to provide an important supply component in meeting the demand for industrial space as the new industrial revolution gains momentum.

Benjamin S. Butcher is, CEO of STAG Industrial (NYSE: STAG).

Footnotes:

[1]CBRE: Decline in Availability of U.S. Industrial Space to Continue in 2013, December 6, 2012

[1]CBRE Econometric Advisors: “Industrial Construction: Will It Ever Fully Recover?” By Jared Sullivan, December 10, 2012

[1]CBRE Econometric Advisors: “Why Does the Industrial Availability Rate Trend Upwards?” By Jared Sullivan, June 11, 2012