Demand Driven Industrial Real Estate Development

The case for developing speculative industrial buildings in today’s real estate market

Industrial real estate, has always been the life blood and infrastructure backbone of commerce in America, even more so today, with many technology driven changes in delivering goods. Industrial buildings, ranging in size typically from 20,000 to over one million square feet, provide manufacturing, warehousing and distribution facilities, housing businesses and keeping them functioning operationally. For example, whether its import or export, retail, e-commerce, food, assembly of parts, equipment or literally any number of users that rely on industrial buildings for their businesses to operate; industrial real estate is the key to the supply chain and logistics of commerce without question across the country.

In Southern California you have the number 1 & 2 shipping ports in the U.S. where 48% of all goods are imported or exported through Los Angeles and Long Beach harbors. Tied to these ports are a vast network of intermodal rail and highway transportation systems that connect across the country as well as regional, state and local delivery of these goods to warehouses and distribution centers everywhere. With over 23 million people living in this area of California, the economy is considered to be the 11th largest in the world if viewed separately as a region with other countries. Because of this stable and thriving business environment, growth for consumer goods, especially imports from Asia, has increased demand for industrial buildings of all sizes; the highest in the country. Southern California as a result is the number 1 industrial market in the nation and one of the most sought after markets in the world.

Acacia Real Estate Group has thrived in this competitive and challenging Southern California real estate environment successfully for over 20 years as a top Orange County based developer. Our main focus is not random selection but a proven set of criteria that we have measured against multiple real estate market cycles of development, that has withstood over time and remained major factors in contributing to the success Acacia has enjoyed with all of its development projects. Acacia operates under the philosophy of demand driven development. In essence, the ability to read and understand market trends and imbalances as well as perfecting the timing of, then executing those development projects as quickly as possible. The sites Acacia selects are primarily close to urban centers and are highly sought after by users, self-employed or small business operators and often investors because they offer great locations, direct access to transportation networks, a variety of housing and services nearby; which become important factors in a buyer’s or operator’s mind when making the decision to purchase an industrial building.

Over the last 10 years there has been an increasing need to upgrade aging and outdated buildings with high clear height ceilings to accommodate more efficient storage and racking technology. With the advancement in fire suppression systems, these much higher ceiling requirements by users, have become possible, as well as lowering their fire insurance premiums. During the Great Recession industrial building demand waned but organic growth and technology driven storage systems increased demand for new state of the art industrial buildings, which was not being addressed, because of the tepid economy as well as the lack of developer financing for new projects. In addition, unlike residential development, commercial developers and their lenders, were very disciplined in not over building for the market. As a result, industrial did not have much in the way of inventory going into the downturn. Vacancies never rose or came close to historical averages as in previous down cycles and demand for newer buildings subsequently continued as vacancy continued to fall. The larger size institutional industrial building requirements stepped up once the economy edged out of the recession, these larger buildings have been in huge demand ever since. The improved economy and changing dynamics of e-commerce has become a major impetuous in the growth and demand for these new Class A state of the art industrial buildings. Most of these buildings have been leased to major corporate tenants and few if any were sold directly to users in this product class. Institutional owners, control the vast number of buildings over 150,000 square feet in size.

At present while the institutional investment side of the industrial market, has been busy expanding and replacing their outdated buildings, users and tenants that need buildings under 100,000 square feet have been hard pressed to find or be able to source new Class A product in this size range across all markets. Typically, the buildings range in size from 25,000 to 90,000 square feet, but are more expensive to construct than larger buildings and difficult to find suitable parcels to build on which makes it extremely challenging in a built out industrial market for developers. Referred to as, “in-fill” sites, these parcels have become coveted by users and developers alike for their strategic locations. Often these sites were passed over during other real estate cycles for various reasons or may have antiquated or obsolete structures with excess land and over time become more valuable, due to their location, access to transportation corridors, customer base or pools of employees nearby. The growth of e-commerce has also put a premium value on in-fill sites due to their strategic locale; that can service the “last mile” of delivery to a customer. The process by which an on-line merchant or a third party logistic operator delivers from the warehouse to the purchaser their order, often within the same day or hours after placing it. As a result, most industrial sub-markets in Southern California have experienced tremendous competition from developers and users alike for these properties.

Historic low vacancies, non-existent supply of new product and increasing demand for all industrial buildings in general, has pushed up lease rates which in turn fuels even more users to find a building to purchase and avoid paying higher rents. If an operator can buy a building, they can “lock-in” their occupancy costs, build equity in the property and enjoy long term appreciation as well as many tax benefits associated with owning real estate. And the purchase of these buildings is also facilitated by SBA financing which only requires an owner occupied borrower to put a 10% down payment at very favorable rates. Even with this type of financing, often buyers will pay half down and finance the rest through their bank or in many cases will close all cash.

Paralleling this under supply of industrial demand, is a very challenging equity and debt environment for the development of buildings in these sizes and you can begin to understand the inefficiency that is impeding new development. While this demand continues for new buildings under 100,000 square feet, very few developers have been able to focus on these hard to acquire sites because of the reluctance to build one off speculative product and the fact that most traditional equity capital sources available today

prefer to invest in “for lease” projects that institutions like to purchase and own. Because the total project costs are smaller than the minimums institutional investors have established, they will not finance or invest in these types of projects. In general, it takes 18-22 months to plan and develop a project from start to finish in today’s development world; a relatively short investment cycle. Institutions like and understand this market but their job is to put out large chunks of investment dollars for at least 3-5 years. The building “for sale” business model is designed to build quickly and timely in a marketplace that has very little competition and huge demand.

More recently, due to current and new regulatory laws, the banks are cutting back or have no incentive to make construction loans because of the balance sheet requirements Federal regulations requirements. When they do make a construction loan, banks typically require a recourse provision which the borrow pledges all of his assets as a guarantee to pay back the loan, a financial commitment which hampers doing multiple projects for a developer without tremendous capital resources. The good news is there are debt funds that are filling the gap on construction lending albeit at much higher rates than conventional banks but will allow non-recourse and higher leverage ratios than banks are not able or unwilling to provide.  On the equity side, developers that pursue building speculative industrial buildings under 100,000 square feet, must seek out nontraditional sources of equity such as friends & family, country club money or JV partners that may already have seasoned investors in tow to fill in this capital raise for a specific development. This is often a very tedious and time consuming process in a world where expediency and timeliness are paramount to being competitive and successful in this marketplace.

Traditionally, Acacia has pursued these in-fill sites with Joint Venture partners and has recently completed and sold a 71,000 square foot class A building while under construction to a manufacture of high quality custom windows. The buyer’s business was booming and the owner had out grown its 50,000 square feet facility within the same city of Corona, California. The site fit Acacia’s criteria and in this case was located near two major transportation corridors and visible from the freeway. It had been the only remaining site in a 20 lot master planned business park which had been completed over 20 years prior. The site had been known to contain immense rock formations that required expensive blasting to make the site useable which was passed over by other developers looking for less intensive projects. In addition, a fire road that required permission from the adjacent property owner for grading, was just another added obstacle to many that needed to be solved in order for the project to make economic sense. But Acacia excels at taking on challenging in-fill site opportunities and in this case, fortunate timing and at a negotiated price that reflected the value and many costs involved in developing this site for a building from the seller. By all other standards, the project met all the criteria we look for in a site; eventually was constructed and ultimately exceeded the pro forma exit pricing objective by over 12%. Overall, investors received in excess of a 27% IRR over 24 months.

Currently, Acacia is finishing construction on a two building industrial project located in Ontario, California. It is well located on Interstate (10) Freeway just a quarter mile west of the Interstate (15) Freeway and near Ontario International Airport. The property is adjacent to the Etiwanda off ramp and has tremendous visibility. The development came with some hurdles including the configuration of the site that consisted of multiple parcels. Originally the business plan was to build one large building but the site plan lacked certain easements. But we saw the potential to develop a complimentary, two building design, consisting of a 33,000 and 75,000 square foot buildings. Subsequently, both buildings have been well received in the marketplace and will be completed summer 2017 and have been sold during the course of construction, similar to the Corona development. Projected returns to investors will again exceed pro forma projections and deliver mid to upper twenties IRR over a 24-month period.

While these examples validate our view of the industrial scene, similar results could apply almost in every industrial sub-market throughout Southern California if there were new buildings available for sale as well. Acacia continues to focus on these opportunities and believes that there are many favorable metrics that confirm this current wave of demand, that it will continue for the foreseeable future, even if a down turn or cyclical correction comes in the next several years. That there is still tremendous upside, from e-commerce and port activity, that can be accredited to larger market trends alone, to justify this scenario because of the aforementioned challenges. In essence, the company’s goal is to seek industrial sites for development using our successful method of sourcing opportunities and to capitalize on the imbalances in the marketplace.

To fulfill and execute this plan, Acacia is sponsoring a discretionary fund in order to act quickly when making site acquisition decisions which is essential in this fast moving real estate market. A discretionary pool of funds enables a developer to avoid the constraints in sourcing a JV partner for every new project he wants to pursue and the ensuing negotiations over fees, profit splits and control issues. The fund will raise capital with the intention of putting the capital to work immediately. Acacia believes that with a specialized market niche (development of industrial buildings for sale to users), strong track record of success (all previous investors received their capital back plus a return with an average annual IRR’s of 20%), a team of breadth (18-year relationship with contractor, top architectural and civil engineering firms) and experience (35 years in commercial real estate and 20 years in development) the company will be poised to take advantage of the imbalances in the marketplace and to continue developing successful projects for many years to come.