For Industrial CRE, Secondary Cities Are Rising

Posted on June 25, 2014

With the strengthening U.S. economy helping to ease trepidation over the direction of commercial real estate fundamentals, industrial investors are in the market for the outsized returns that can come from increased risk and alternative investments. And for many investors in 2014, secondary markets seem to offer the ideal mix of slightly elevated risk and more attractive returns combined with many of the demand drivers that fuel investment in the primary markets.

The case for secondary markets begins in the nation’s prime distribution hubs. In Los Angeles, Chicago, New Jersey and other top-tier industrial cities, the supply of large, modern warehouse space is simply too scarce to meet demand. (In Los Angeles, the overall vacancy rate was a meager 4.5 percent in the first quarter, down 70 basis points from a year earlier.)

Investor demand has pushed up prices in these prime markets to formidable levels, particularly for the buildings that meet tenant requirements for today’s evolved distribution strategies and material handling processes. Capitalization rates, or expected first-year returns on the purchase of an asset, averaged more than 5  percent during the first quarter in Los Angeles, New Jersey, Miami, Seattle, Chicago and other major markets.

The scarcity of space in primary markets has spurred some investors to diverge from acquisitions into the development side of the business, providing equity for build-to-suit and even speculative projects in the nation’s largest industrial hubs. Some 40 of the 50 industrial markets tracked by JLL had speculative construction underway in the first quarter this year, with more than 25 percent of the nation’s 70 million sq. ft. of speculative development concentrated in Southern California.

On the user front, demand has spilled into strategically located secondary cities to create blistering market conditions in California’s Inland Empire, Dallas and the Philadelphia/Harrisburg area. Investors have an opportunity to tap into that displaced demand, and prospects are especially good in places like Phoenix and Indianapolis, which offer land ready for new construction.

Secondary markets such as Columbus, Ohio; Kansas City, Mo.; and California’s Central Valley now constitute auxiliary hubs to gateway centers. These growing distribution points are within a one- or two-day drive from the population centers that tenants serve, and have developed sites to accommodate the construction of large projects that would be difficult to erect in built-out primary markets. JLL researchers are projecting class-A rent gains in these key secondary markets as more users opt out of primary markets to take advantage of the greater selection of space options available in auxiliary distribution clusters.

“Tenants are aggressively competing for industrial and distribution space in a limited supply pool. They all demand the same thing: modern space, a robust logistics infrastructure and in proximity to population centers. Investors and developers alike will continue seeking opportunities in markets that have solid intermodal infrastructures in place,” explained Craig Meyer, JLL’s President of Industrial Brokerage.

Investors must calculate mounting risks in choosing a secondary market and in deciding the size segment for new construction. Only 15 percent of the spec product being built in Southern California was pre-leased at the end of the first quarter, for example, and concern is growing that the Inland Empire could soon overbuild in the 500,000- to 699,999-sq.-ft. segment, relative to existing user demand. Similar risks of overbuilding in various size segments are rising in Dallas/Fort Worth and, to a lesser extent, in Chicago.

Cleary, there are good reasons for the higher risk levels associated with investing outside primary markets. But while the imbalance between supply and demand lingers, the attractive returns available just outside the nation’s primary distribution corridors will make secondary markets a primary destination for investor capital.