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Rental Escalation Phase II

August 8, 2017

I will start by saying that I’m probably in trouble. After a couple years with over 3M sf of net positive absorption, I figured it would cool off to something in the low 2M sf absorption in 2017. However, after a first quarter with 600k sf absorption (I was feeling pretty good), we hit 1.1M sf in the second quarter, and it feels strong for the balance of the year. We’re probably headed for 3M again. Oh well, better to miss on the low side than the high side.

 

I do, however, believe the general market has softened some. There are more vacancies in the 25 -50k sf range at this time than we have had over the last couple of years, but the big deals just keep cranking. Leading the charge is Amazon with 100k sf in NW Portland, 300k sf in Hillsboro, 800k sf (2M sf with mezzanines) in Troutdale, and semi-announced 1M sf each in both Salem and North Portland Rivergate. Not all of these have hit this data yet, but Amazon and other large third party logistics companies (3PL’s) can push an annual absorption number up in a heartbeat. Other than Amazon soon owning and operating every warehouse in the US, it’s not really a bad deal.

 

We have net positive absorption (more companies moving into space than moving out of it) just about across the board, with Portland-wide warehouse vacancy (ignoring flex space) dropping down to 3.2%. You can see the data here: Industrial Abstract / Vacancy. Some markets saw positive absorption, but their vacancy went up. This can be attributed to new buildings coming on line with vacant space. In all fairness, though, it could also be our database company doing some clean-up.

 

Building sales have slowed, mostly because there isn’t any product, but also because prices are continuing to get pushed up. This is in part due to the “doobie effect.” In Oregon, you can only grow marijuana in less than 20k sf, so folks are paying “HIGH” prices for small buildings that are either well-fenced or in quiet neighborhoods. I’m not a proponent of this, but they appear to make for great neighbors as they have very little activity and try to be as low-profile as possible. Now, these small buildings are easily trading at more than $150/sf. If your mortgage is 2/3’s of the purchase price, that leaves you paying $1.00/sf/month in net rent. This is not economical for our normal Portland-legitimate businesses, which brings us to Rental Escalation Phase II.

 

While we are absorbing around 3M sf per year, we also have around 3M sf under construction, and for the many that aren’t relocating, they’re adding office, utility capacity, etc. Everyone seems to need a contractor. As all of you that hire people understand so well, it is very hard to find qualified employees in this part of the business cycle, when the demand for what they do has probably doubled in the last 5 years. For contractors, the demand has probably increased ten-fold in the same timeframe. Add that to increasing cost of materials and soft costs and you have a problem.

 

Legitimate developers who build during good and bad times, those that contractors want to treat well, are getting astronomical construction bids. One developer shared that their estimate to build a 30-40k sf building last year was $66/sf. Their last bid was $102/sf. Not a 5% increase, but 50%. The developer had to walk from a $0.65 shell rate deal.

 

Other large, legitimate contractors are saying that their favorite subs are just not responding to RFP’s or throwing out numbers that are double what they should be because they don’t have time to bid it and really don’t want the work anyway. In 2007, contractors just kept hiring and growing, lost money on the work they did with the crummiest last-hired employee, and then got toasted by being unable to downsize fast enough when the next (great) recession hit. This time, they have gotten as big as they want to be by just hiring people that can actually do the work and making margin on the work they do perform.

 

What does this mean? If you want to build, it is VERY expensive. In addition to construction costs, soft costs have also skyrocketed. Because cities require twice as much info and twice as much time from architects than before, system development costs (SDC’s) keep ratcheting up, cities saddle new construction with ever-increasing fees, and any land that that still remains usually has known/hidden issues with it. A couple examples: Currently on the market would include a 14k sf warm, dark shell (freeze protection heat, no lights or office) priced at $160/sf and a 50k sf warm dark shell priced at $135/sf.

 

We are running out of industrial land, which means the price should be going through the roof. However, there has actually been very little increase in land prices because while building values have increased greatly, all the price increase has been sucked up by the construction, soft cost, and SDC components of the development process. Land priced at $5-$6/sf a few years ago has only increased by $1-$2/sf.

 

Three years previous, I said that lease rates needed to increase from $0.35/sf to $0.50/sf to justify new construction for spaces less than 50k sf. We did see that increase and developers have been building in that size range for the last year or so. But those days will soon be over with the aforementioned construction cost increase. I’m waiting for the dust to settle (no pun intended), but I’m afraid it is going to take a $0.60/sf shell rate on a space less than 50k sf before developers will be able to re-engage in constructing this size range. What we need is Rental Escalation Phase II, but I don’t know if the local companies can afford this. It seems like they are kind of sputtering out at the $0.50 mark.

Fortunately, though, the move from retail bricks-and-mortar shops to the internet continues. Demand for industrial space remains strong. Today, I’m just glad I don’t do retail, after watching them enjoy about three decades of 3% population growth (and the shopping that comes with it) in the State of Oregon. Who knows what’s next as Amazon takes over the supply chain business. Maybe I’ll need to finish my career off by putting millennial makers in vacated warehouses that have been converted for app code writers. Time doesn’t stand still, nor do rents, as we enter Rental Escalation Phase II.

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