1st Quarter 2017 Hotline
by Joe A. Hollingsworth, Jr.
The so-called “Trump Revolution” that has one-half of America seemingly in despair and the other half in euphoria, from our industrial perspective, is a good thing. The full control by the Republicans of the White House, Senate, and House of Representatives means there will be accountability. For the half of America in despair, this total realignment of responsibility means Republicans have to prove their despair is totally baseless. For the half that are euphoric, Republicans will be required to produce substantial results. Additionally, as many of you know and many have been nice enough to help, my son (Trey) has joined the 115th Congress from the 9th Congressional District of Indiana (so it could be that I am a little biased).
In addition to the responsibility that comes with newly elected authority, a relatively small shift in increasing industrial needs will have a profound impact on existing space and resulting rents. It has been roughly estimated that the on-shoring of jobs from foreign countries back to America (but especially the south) could accelerate as much as 30%.
The roll back of the immense EPA overreach during the last 12 years that has given us costly energy code and drainage regulations will roll back the scheduled construction cost increases (that we have been anticipating) and could save as much as 14% of new construction cost on industrial facilities. This would go a long way to close the gap between existing rent rates and new construction rent rates. It will also increase speculative building by aggressive developers.
Corporate tax changes will have profound effects going forward. The punitive taxes that corporations have had to pay on worldwide income have been causing inversion; and, when adjusted, it will immediately
keep business at home. Taxes could also be bifurcated in so much as foreign income earned by US corporations could be taxed at higher rates
than domestic earned income thus shifting more business to America. Lower domestic taxation would present more opportunity for on-shoring,
but also enabling smaller companies to grow at faster rates allowing them to keep their money rather than having it taxed away.
The repatriation of up to 3 trillion dollars of US Corporate money positioned overseas to avoid US taxation will totally change the dynamics in America. This is the fuel America needs to accelerate the growth of operating businesses domestically. While there should be several things attached to the money coming home (in order to get the lower taxation) and if the strings are properly structured, it will be forced to be used domestically and will breed capital stacks and formation for years to come.
Whether its regulation, on-shoring, tax changes, or repatriation, these changes coupled together can produce a domestic GDP that is almost hard to fathom in this eight year old “restricted economy”. Our belief is that it could be at least 5 consecutive years of 4.5% GDP growth annually. These massive structural reforms will have long lasting effects with an economic run record that could be in excess of 12 years. Euphoria?…maybe, but I don’t think so…let’s enjoy the risk and the ride!
4th Quarter 2016 Hotline
After making the recent decision to keep interest rates down, Chairwoman Yellen cited an improving labor market specifically noting that labor force participation was improving off multi-decade lows. Her interpretation is that improving wages are drawing more Americans into searching for (and hopefully securing!) work.
Talking with many distributors and manufacturers across the southeast, this interpretation does not jive with the anecdotal evidence we hear. For many managers and owners, securing productive labor is their number one issue constraining them from taking advantage of market opportunities, but higher wages aren’t drawing in new workers off the sidelines.
The slight bounce of workforce participation rates off lows set in the 1970s is likely more a reflection of a higher proportion of graduating kids obtaining work. For illustration, if overall workforce participation is at 62% but each year, for the last few years, 85% of graduating students are getting into the workforce, then the workforce participation rate will creep up even without a single discouraged worker getting back into the labor force.
From what I hear from employers, this explanation is more likely for a few reasons. First, with today’s pace of rapid change, skills are decaying quickly while a worker is unemployed; employers might elect to hire a newly-minted graduate at an entry-level position over trying to retrain a worker into a mid-level position that might have antiquated skills. Second, to generate the need for mid-level managers and skilled employees, more dynamic economic growth is needed; you don’t need a supervisor until after you’ve hired several or many entry-level employees. There hasn’t been the growth necessary to reach the capacity constraint requiring new mid-level employees.
The concern for America – and many employers – is that this will result in longer bouts of unemployment for discouraged workers leading to further skills erosion, such that it’s not a question of wages that could draw them into the market but rather an unsolvable skills gap. Yellen’s optimistic view for workforce participation doesn’t reflect the significant challenge employers face today in attracting long-absent discouraged workers, something a skills gap might prevent at any wage price.
This extended so-called “recovery” has created many legacy problems that call out for a huge directional change in our country, not more of the same. Quite possibly, the government coddling and the P.C. Revolution might be exchanged for individual effort and initiative – the American way!
3rd Quarter 2016 Hotline
When one focuses all their time on developing products and delivering them to customers, it can be tempting to take government policy as an unchangeable impediment or enhancement to business. But, governments are competing for talent, investments and risk initiatives in a new global environment.
Stark reminders of this fact are events like Brexit, where thousands of corporate plans were scuttled immediately by a change in policy. For companies that located facilities in Britain to serve both the U.K. and European populations, that assumption of free flow of goods may no longer be valid. Similarly, the passing of ACA in the United States created sudden and continuing uncertainty that has curtailed hiring and investment by businesses facing a new, burdensome and ever-changing regulation.
More immediately relevant for the manufacturing and industrial businesses we serve is how government policies shape location decisions. Businesses are growingly attuned to the long-term affects of government policies have on their taxation, regulatory enforcement, and future workforces. This information is all available instantly on Google so these decisions are never in a vacuum.
Whether it be poor fiscal positions that might lead to massive tax increases in the future (e.g., Chicago) or underinvestment in education that could impair the ability to retain and attract top talent (e.g. Detroit), understanding the policy context is an important heuristic in any location decision. More and more, even a past history of erratic policy decisions at the state or local level can remove a particular location from consideration; with the size of investment in a particular location, businesses understand how costly a mistake can be. With all the economic uncertainty, decision-makers don’t want to layer on political uncertainty because in the end businesses hate variables.
Municipalities, states, and even countries need to understand they are competing for investments and talent and should understand the signals they are transmitting to business decision-makers. From success stories like Ireland and Singapore to horror stories like Russia or Brazil, the resulting differences in economic growth can be enormous, both in current years but also in decades to come as companies hesitate to make big investments in unstable regulatory or political environments.
Watershed moments like Brexit put the effect of policies on business decisions in the headlines, but more and more government living in their own protected bubble with an endless stream of highbrow overblown do-good causes affect the decisions of new risk and investments. The results of these decisions “play out” in our news every day, often locking entire populations into almost hopeless financial challenges largely beyond their control.
Often, the power of our vote is the only restraining tool available to allow hope, risk and individual success to thrive.
2nd Quarter 2016 Hotline
by Joe A. Hollingsworth, Jr.
Some of you may remember our 4th Quarter 2015 Hotline Market Watch article that discussed the new International Energy Conservation Code that is being mandated by EPA, and now the Environmental Protection Agency (EPA) is at work once again seizing property rights from owners of real property. Now the EPA through the Clean Water Act is trying to regulate not just “navigable waters” which used to be the proscribed limit of federal authority regarding water (and incidentally was given to the feds by the states to insure economic benefits by empowering the federal government to prevent practices that would restrict interstate commerce), but now are claiming authority on all tributaries to the navigable waters, including “waters” that are sometimes completely dry. The EPA has incrementally raised the bar for states to comply with the act. “Water quality” is the current focus of costly new regulations. With the new regulations intended to limit the effects of fertilizer runoff from agricultural operations, the job creating developers are being asked to help correct the perceived problem coming from farmers. What used to be simple detention ponds to slow the amount of water coming off of a site after a rain now turns into multi-layered water filtering through proprietary sand mixture that has to be from an “approved” source. These proprietary products without a fully developed competitive market are very expensive and also require large portions of the site be devoted to infiltration ponds that now prevent the site from being developed to the same extent they used to support.
Why is this a hot topic? The cost to install this filtering system and ongoing maintenance for it will be $1.46 PSF to $2.88 PSF above the cost of a detention pond (based on this size and type of construction). The states that are implementing these new standards are finding that companies searching for a new place to do business are becoming very savvy. They are beginning to ask, “What does your water quality regulation cost us?” This is in addition to the tremendous increase just implemented by states that adhere to the 2012 International Energy Conservation Code. The net result of these two requirements flowing from the EPA could be as much as 12%-23% of the total cost of the project.
States that have passed these rules are discouraging developers because of the increased costs to speculate on facilities, so there are fewer new facilities available in those highly regulated states that can attract new businesses. Therefore, prospective industrial clients go elsewhere to a state that is more practical. A country cannot put itself in a position to be uncompetitive in the world marketplace. To create a job and provide a family with a sense of pride should be the highest priority for state and local governments.
For our readers that have significant amounts of existing industrial space (as we have said on this page before), hold on! Some rents are jumping 18% to 26% upon a 3 to 5 year renewal. Scarcity, with limited speculation, is continuing to drive this market. The only part of the speculative market that is active is in million square feet multi-tenant facilities, and now they are having to incorporate the new higher cost due to intensified regulations. Also, general speculation on smaller facilities has become less cost-effective. So, think carefully before you sell an income producing property where the rents could jump substantially.
1st Quarter 2016 Hotline
Despite much ink being spilled about the Fed’s “liftoff” last month, the increase seems to be accompanied by little disruption in the financial markets. The market operation went smoothly in a single afternoon, and short-term rates have adjusted to their first increase in nearly a decade accordingly. At first glance, the real estate markets seem to be reacting with calm and a focus on 2016. Such equanimity is probably warranted, for there are several reasons the “liftoff” isn’t a huge paradigm shift.
First, the rate increase wasn’t much of a surprise. Fed Chairwoman Yellen invested much of the year signaling an increase was coming and imparting the gradual nature of the subsequent moves. While speculation as to whether it would be October, December, or January was a favorite sport for journalists, investors had long been factoring a commencement of rate increases into their forecasts and analyses; for at least a year, it was a matter of when, not if.
Second, as our previous article detailed, the “liftoff” would garner big headlines but ultimately be a tiny move towards normalization. Rates are far from “normal” ranges, and, while a small move begins a directional shift, the march back to that range will be very long.
Third, and perhaps most importantly, real estate tends to perform best in rising rate environment. Generally, rates are rising when the contextual macroeconomic environment is strong leading to improving property fundamentals. Reasonable inflation, declining unemployment, business expansion, and credit growth are all indicia of an
environment where interest rates would be rising and where occupancy and rental rates would be increasing. Such examples would include the mid-1990s or mid-2000s.
By no means is this a minimization of the first rate increase since 2006, but, with all the speculation about which meeting the change would occur, the larger picture might have been lost. There is a time for extraordinary measures, and there was always going to be a horizon at which they would no longer be needed. Last week’s “liftoff” may be the “shot heard ‘round the world,” but it’s probably just the start to a marathon not a revolution.
4th Quarter 2015 Hotline
In the midst of an energy revolution and where the cost of BTUs are dropping like a rock, the international committee for tree huggers has endorsed a code known as the International Energy Conservation Code. A copy of the map is at Energy Codes
Each of the states are being virtually forced by the federal government to update to this code. The problem with this code in the industrial sector is that the code is not designed to accommodate facilities that are not intended to be a comfortable 72 degrees. The code works fairly well, although it is very, very expensive for office and residential properties. However, in industrial properties, we have everything from an icehouse to a smelter with resulting temperatures in the facilities which are radically different. The IECC only recognizes differences in the application of its standards based on two criteria: 1) geographical climate based on arbitrary political subdivisions; and, 2) building use which is only differentiated into two simple subcategories of residential and commercial. There is no separate provision for industrial or warehousing.
Why does the above matter? The return on investment is virtually nil and in some cases a negative. When you over insulate a building designed to be a smelter, you now have to ventilate or air condition it; therefore, the net use of energy is far greater. We estimate the cost increases to over insulate concrete tilt-up due to the 2012 code alone being adopted will be 7% to 8% increase; and the costs of primarily metal structures will be 9% to 14%.
The smart states are slow to adopt the new energy code and resisting the federal government forcing this code forward. Pennsylvania and Michigan have code authorities that both rejected the 2012 IECC as too costly to justify the significant construction cost increases.
Most of the states have adopted it this past July. All previously issued building permits have a distinct cost advantage as they are presented to the market as a finished product. Regulation does have a cost. Over regulation has a tremendous cost. In this case, it’s not only money; but, it’s costing jobs.
We are just now seeing build-to-suit inquiries from sophisticated companies asking about current building codes and energy codes as they survey various states. Obviously, companies will leave some states for the “not so green” pastures where they can be more profitable.
So, the net result is builders will be more hesitant to speculate on new facilities in the states that have adopted the new code taking away one of the most important resources a community can have to attract new jobs. Existing buildings not required to update the energy code will enjoy an increase in rents over the next couple of years as replacement costs of new energy compliant structures push even higher.
3rd Quarter 2015 Hotline
Financial literature has become rife with rampant speculation as to when Federal Reserve “lift-off” will occur. “Lift-off” is now popular colloquial reference to the first increase in the Fed Funds rate. Each morsel of economic data or newsworthy event is framed in whether it moves the lift-off forward or backward. Is it June or September? Could it be early 2016?
I, like others, think there is some importance to the date of lift-off. The last tightening cycle started in June of 2004; the commencement of tightening will send a signal to markets about the strength of the recovery and the commitment of the Fed to price stability. No doubt the event and months thereafter will see significant volatility as investors globally readjust to the termination of easy-money paradigms.
However, while lift-off has no doubt been getting all the coverage, the larger question for real estate investors is the speed of the rate rise thereafter. Since 1954, the Fed Funds Rate has averaged 5.04%; today it stands at 0.25%. The lift-off everybody is discussing will only move it 0.50%, which is still just one-tenth of its long-term average. In fact, if the Fed raised the target rate every meeting starting in September, the long-term average wouldn’t be breached until the first meeting of 2018; if it were raised every other meeting, the target rate would not reach its long-term average until early 2020.
There are two powerful levers the Fed uses to exert some control over markets: the first is expectations and the second is the absolute level of rates. With all the focus on lift-off, everybody already expects the Fed will raise rates later this year or early next year; that calculation has been built into every model. Whether it happens in September 2015 or March 2016 should make little difference in the long-run; nobody seriously believes it won’t happen in the near term.
The economic growth, cap rates, and other important factors in our collective businesses aren’t that sensitive to whether the rate is 0.25% or 0.50%, but they are sensitive to whether rates are climbing by a steep two percentage points a year or a gradual half a percentage point a year. The former can send the economy backsliding as rates ascend faster than borrowers can absorb or create uncertainty about where the peak is; the other allows the economy to grow stronger into a more normalized environment with less fear about peak rates given how far into future it would occur.
All the attention is being focused on the moment of take off, but, as any pilot would tell you, it’s the rate of ascent that determines whether you clear the treeline.
2nd Quarter 2015 Hotline
While the Federal Reserve’s current forecast suggests rates will rise later this year, let’s take a moment to reflect on what we have lived through recently on interest rates to put things in perspective.
Interest rates in the developed markets collapsed to levels not seen in centuries. For example, earlier this year five-year German sovereign yields turned negative meaning investors were paying the German government for their use of investor money (assuming zero or positive inflation). The five-year French debt reached a yield of 0.13%, a level that hasn’t been seen since the 14th century. Perhaps even more incredible is the magnitude of this financial repression; over $4 trillion is now parked in developed market sovereign debt globally that bears negative yields.
Domestically, in all but one of the last 142 years – notably 1941 – prior to 2012 the ten-year US Treasury has averaged more than 2.0%; since 2012, it hasn’t once averaged above that threshold.
We have been blessed (from the real estate borrower’s perspective!) with incredibly low rates for a long time even though each month calls come forth trumpeting the huge rate increases around the corner. The low interest rates coupled with the negative-yielding money that needs to be placed is continuing to drive down cap rates. We have, indeed, experienced a unique time in history.
The US industrial real estate market is rapidly changing in what it is supplying. The majority of the country’s industrial space is smaller warehouses (under 200,000 square feet). However, in the last five quarters, 75% to 80% of the new industrial stock being developed are larger buildings (200,000 to 1M square feet).
Is the supply-side or demand-side driving this change?; Is this being driven by the larger developer having better access to credit than the developers that would develop the smaller warehouses, or is it being made necessary to build large facilities to spread the cost of the increased building costs over a larger number of square feet to keep the rental prices as competitive as possible (supply side)?; and Is e-commerce’s continued growth reshaping the occupancy needs of modern distributors (demand side)? All of this is going on when seemingly there is an ever-increasing demand by security-conscious companies to occupy single-tenant, smaller warehouses to minimize possible terrorist activities or mischief.
Additionally, with demand picking up, the ever-dwindling stock of existing smaller industrial space that is versatile and an even smaller base that is single-tenant, functional, and is evident. While most of the supply might have gone to larger boxes, the smaller warehouses – because the paucity of supply, the continued healing of the smaller businesses, and in spite of the higher construction costs – might see the bulk of the rental rate growth over the next few years. We see immediate rent growth for the small warehouse segment producing speculative building for the first time in this recession by 3rd quarter 2015.
1st Quarter 2015
by Joe A. Hollingsworth, Jr.
So, the government just announced that unemployment is at 5.6%. You have to ask yourself is that even relevant anymore? How many people do each of us know that have given up looking for work or have figured out a way to get government assistance or are underemployed? For the last four years, we have clearly been losing the job war in productivity as the below chart shows.
Why is this important to industrial real estate? Manufacturing and distribution clearly drive the need for more square footage, and over 200 major companies have had announcements of onshoring their manufacturing operations, thus creating a lot of highly productive jobs. The onshoring of manufacturing jobs clearly is a driver just like innovation, technology, and entrepreneurship are drivers; and, each of us have seen the benefits of those four drivers during America’s most prosperous times.
Our view is that America is getting its feet under itself, and this productivity decline is reversing its trend. The huge energy realignment in America is beckoning energy-dependent companies to onshore, and lower energy prices can fuel America’s GDP by at least one-half of a percentage point. Most importantly, the four drivers as mentioned above are finally being acknowledged once again as providing prosperity for the individual as well as the country.
As a company, we are seeing a much higher percentage of manufacturing inquiries, and these have not been small value-added products but instead have been new products or reconfigurations to greatly increase efficiency. The need for this more efficient production is driving companies to consider new build-to-suits instead of adapting old facilities to their current needs, and this is going on despite the higher prices for new construction. This is what productivity increases are based on, and they result in more worldwide market share, thus more high paying manufacturing jobs being created and moving the productivity growth charts.
While each of us get an overload of domestic and worldwide news which much of it is negative, it is good to keep in mind that the underpinning of America (the creation of good paying jobs) is beginning to come in to full bloom. The onshoring of jobs, innovation, technology, and entrepreneurship are at play again, and Adam Smith’s invisible hand of prosperity is beginning to be felt.
4th Quarter 2014 Hotline
Our last few articles have talked about the present and future “demand” side for industrial facilities in America such as the advantage that America is beginning to show in labor, productivity, and the onshoring of jobs as well as the resurgence of manufacturing in America.
Typically, this far into a national recovery the industrial construction sector should have been producing new product for the last couple of years; yet, we still are producing less than 55% of what we would in a normal recovery. So, instead of further addressing the “demand” side, I would like to address the supply side.
As a developer in an economic recovery, we always guide ourselves by the cost of replacement of existing industrial facilities. To proceed with new construction, we need to have a narrow gap between existing rents and the higher new construction rents. However, that gap is currently exceedingly wide; and, at the first sign of a “real” pick up in construction, commodities/component prices will have a significant jump resulting in a gap that will be even wider. However, this is just the beginning of a developer’s challenge.
The financial crisis weakened several key elements in the equation to build or not to build new speculative space. The higher credit requirements that are involved are very burdensome and lenders are loaning considerably less to fund a new project with more guaranties involved. While this was almost totally prohibitive two years ago, it is now easier but still yet a challenge. Most lenders got burned in the broad sector of real estate, so talking about “speculative” real estate in any category is a credit-approval hurdle. Therefore, only the strongest balance sheets can overcome this.
Then to the cost…Yes, you will have a sigh. When you actually look at steel, concrete, gravel, asphalt, and copper (that makes up the substantial cost of the facility) and all of these costs are surprisingly high for this point in the recovery, the sigh often becomes that of total disbelief! When you calculate the rate of return that you have on this much higher cost per square foot, it can be staggering. So, the motivation to overcome the cost differential will drive most developers to sit on their hands several more quarters, but the ones forging ahead on new product in selected areas are going to be rewarded.
We believe the scarcity issue of finding flexible facilities in the right locations is picking up an ever-increasing momentum. In certain areas, we have seen existing space being priced $0.40 to $0.65 PSF higher in just over the last 180 days where scarcity does exist. These bold moves are inspiring other investors in vacant properties to have bold pricing moves, also.
In our opinion, the key to success for the next year is to find where scarcity exists and building a highly flexible, single/multi-tenant facility now. A year from now, we will look back and see this as a sweet spot for construction; because, at that point, we will have a contagion of higher commodities/component pricing that will drive the cost per square foot up as much as 6.5% to 8.0% combined with higher long-term interest rates. These two points coupled together will drive a spiraling rental price per square foot up tremendously by the time normal recovery trends are in place and industrial demand completely returns.
In real estate, cash is always King Kong; but, timing and the scarcity issue maybe King Kong’s twin.
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