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With Demand Increasing, Developers Warming Up to Spec Warehouse

CoStar Forecast Projects Supply Wave of U.S. Warehouse Through 2017 As Demand Lures Speculative Developers Back Into the Market
December 4, 2013
Speculative warehouse development is coming back into vogue across more markets as the remaining blocks of modern industrial space continue leasing up at an accelerating rate in the recovering economy - though not quite at the level of the Great Warehouse Boom years of the 1990s and early 2000s, before coming to a near standstill in late 2009 during the Great Recession.

Though total construction and delivery volumes for new industrial space have picked up only modestly over the last 18 months, the ratio of speculative development as a percentage of new inventory has finally returned to 2006-2008 levels. According to an analysis by CoStar's forecasting and analytics company, Property and Portfolio Research (PPR), developers and their investment backers are becoming increasingly confident in the future prospects for new spec warehouse and distribution space.

For example, nearly three-quarters of new supply in California's Inland Empire warehouse market is being built with no tenant in tow. High percentages of new warehouse construction in Chicago, Dallas-Fort Worth, Houston, Lehigh Valley, PA, and even Atlanta are also going vertical on a speculative basis.

In Chicago, strong absorption and occupancy and a shortage of top-tier industrial space is fueling a rapid increase in spec construction, said Scott Marshall, executive managing director for CBRE's Industrial Services, Americas, in presenting the company's 3Q 2013 U.S. Industrial Marketview. Of the 5.5 million square feet under construction in the market, almost half broke ground in the third quarter.

While interest rates and other concerns have kept a relative lid on construction in many markets, "we may see spot shortages of space developing in some of the healthiest markets, including Orange County, Los Angeles metro, Denver and Oakland," Marshall said.

"These trends are exemplified by the conversations we are having with many institutional owners, where they are singing the praises of rent growth for first time since pre-recession."

All told, about 62% of the 59 million square feet under construction in the country at the end of the third quarter is being built without signed tenants as optimistic developers take on more risk in response to rising occupancies, rents and tenant demand, according to CoStar data.

Moreover, as investors acquire leased-up, existing buildings at record-low capitalization rates in many markets, the value proposition is narrowing between building new warehouse space versus buying older warehouses, some of which lack dockside appeal for today's efficiency minded retail and distribution tenants.

"If an investor can either buy existing warehouse property at a 4.5% cap rate in the Inland Empire [CA], or build something new with a 200-basis-point spread on top of that, then development looks pretty good," observed Rene Circ, PPR director of industrial research, during a recent third-quarter industrial real estate market review and forecast.

Improved Economy, Fundamentals Push Demand

Underwriting criteria for financing spec warehouse development is easing after 13 consecutive quarters of positive industrial absorption nationally since 2010. Especially after 41 million square feet was absorbed in the third quarter of 2013, the second-strongest since the recession. The recent market performance has pushed tenant demand and investment capital beyond the nation’s largest distribution hubs and into secondary markets, including such long-dormant housing crunch markets as Las Vegas.

The U.S. warehouse vacancy rate has fallen to 8.3%, down 91 basis points from a year ago, and CoStar forecasts that vacancies will fall by another 50 or 60 basis points over the next five or six quarters. With developers still raising new warehouse walls at low levels compared to history, demand could ramp up quickly as U.S. rents finally approach their long-term 1.3% annual average.

In fact, demand is forecast to outstrip available new supply by late next year, with new construction fueled also by tenant preference for modern, efficient warehouse space, including the new 37-foot-clear heights compared to the standard 32 feet.

Recent industrial space development activity in Central Pennsylvania, Philadelphia and Texas markets illustrates the varying appetite for risk for building warehouse and distribution space without tenants in tow.

In Dallas/Fort Worth, one of the nation’s hottest development areas, large industrial developers such as Majestic Realty Co., Trammell Crow and Hillwood Properties are racing to complete their spec warehouse projects as quickly as possible to meet rising demand from local and regional suppliers such as Grocers Supply Co. as well as a growing list of large corporate tenants like Home Depot, L’Oreal and BMW seeking lower business and labor costs and affordable land in the Lone Star State.

At more than 1 million square feet, Majestic’s new project near Dallas/Fort Worth International Airport, Majestic Airport Center DFW, is the largest speculative warehouse under construction in the northern part of the state. Trammell Crow Co. and Prudential Real Estate Investors are building a 823,379-square-foot warehouse south of Interstate 20 in Dallas. In the AllianceTexas project, Hillwood is building Alliance Center North 2, a spec building of 1 million square feet, along with a separate 310,000-square-foot spec building.

In South New Jersey, on the other hand, spec warehouse building is just getting its groove back. Liberty Property Trust (NYSE: LBY) broke ground last month on a 200,000-square-foot warehouse along the Jersey Turnpike at 2277 Center Square Road, in Logan Township, NJ. It’s Liberty's first spec project in Gloucester County since 2009.

Sharp vacancy declines are helping drive spec demand the markets of Central Pennsylvania and Lehigh Valley, typical of smaller distribution markets where developers are waiting to lease up existing developments before starting new ones. For example, Liberty finally leased its 1.2 million-square-foot building in Lehigh Valley to, and promptly started another 800,000-square-foot spec building.

Other Lehigh Valley spec projects include 425,000 square feet of speculative warehouse space by Denver-based DCT Industrial in Palmer Township, PA. Verus Partners has entitlements for 2.5 million square feet of warehouse and light industrial space the Chrin Commerce Center.

However, plans by industrial developer Dermody Properties and investment management firm PCCP for a 1.3 million-square-foot industrial park on 107 acres acquired near Harrisburg, PA, show a more cautious approach.

Dermody and PCCP acquired the land on Ames Drive for LogistiCenter Carlisle with an already constructed building of 700,000 square feet. However, Dermody Properties plans to begin construction of the second 602,250-square-foot building "based upon the leasing progress of the existing building," the developers said.

"Today, the building site is available as a build-to-suit for a future customer," the venture said in a statement.

More Spec Ahead

According to the just-released Third-Quarter Jones Lang LaSalle Construction Outlook, in all, 40 of 48 top U.S. markets are building on a spec basis. As demand broadens, more than half of the new speculative construction involves building sizes that range between 100,000 and 499,999 square feet, according to JLL.

Developers, who haven’t forgotten the overbuilding that marked the last cycle’s peak, are building on spec at a much more measured pace, and tenants with requirements of 750,000 square feet or more -- particularly e-commerce companies which utilize more than 10% of total U.S. warehouse construction -- aren’t finding many options. Those companies, famously including, are commissioning built to suits.

However, warehouses have a very short development cycle and fear of overbuilding is never far below the surface for industrial real estate investors and analysts.

Even though tenant requirements are up from six months ago, a substantial burst of new inventory "may prove too much if developers become too aggressive and are not sensitive to where U.S. demand is concentrated," said Erin Patterson, research manager for Project and Development Services and Construction, author of the JLL construction outlook.

"In a sense, a calculated game of risk is being played, and local market intelligence is crucial to determine where expectations and realities are in-synch," Patterson said.

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