Market Watch

Cap Rate Validation

4th Quarter 2019

Market Watch
by Joe A. Hollingsworth, Jr.

As industrial developers, we live and die by interest rates.   While supply and demand affect the market tremendously, the interest rate on medium to long-term borrowings dramatically affect the outcome in rents.  Many of us have stood on the sideline and watched cap rates drop from 10% and 11% down to 5.5% to 6.5%.  Although we have been shocked (and in some cases utterly astounded) on how far they have dropped, the market has clearly been giving us signals that we all will sooner or later adopt.

The global financial challenge is evident where $13 trillion out of $33 trillion worth of bonds have negative yields which forces you to pay a fee to allow financial institutions or sovereign bonds to hold your money; it’s a paradigm quake.    I don’t think the market could send us a louder signal.  For the first time in hundreds of years, half of the world may soon be in negative yields.  Hypothetically, if there is a negative 1.5% financial yield, and you have a 5% cap rate on a real estate investment, the spread is still 6.5%.  Many of us are willing to invest in that long-term scenario.  The trick will always be matching your long-term rental structure with long-term maturities.

The naysayers of the world are always worrying about “the sky is failing” and will say negative interest rates in America would devastate the financial system, even though this has proven to be false elsewhere in the world.  Japan has experienced a deflationary period for the last two decades. Admittedly, it is unusual; and, it requires a paradigm shift in investment strategy.  However, it is workable.  I think the United States Federal Reserve is faced with the stark reality that if they don’t lower interest rates that America (with the world’s largest economy) won’t be able to continue to pull the world’s GDP along with it.  Clearly, China is a “debt bubble” waiting to pop, which we consider the greatest threat; and, behind that, the next largest threat to the world is the United States Federal Reserve not realizing they need to adjust rates rapidly.  A 0.5% adjustment in the interest rate could grow our exports by 4.5% (due to a lower exchange rate on the US dollar) making a huge difference in the manufacturing sector and our economy.  With manufacturing currently onshoring to America at a rapid rate, I would predict that with the interest rate move that manufacturing could be growing at double the rate that it has over the last couple of years.  Together, this will keep us from following into Japan’s deflationary cycle.

All that being said, maybe the 5.5% to 6.5% cap rates are defining our future for us; and, those that are locking in returns at that level could have captured “the goose that lays the golden eggs”.

Continued Excess Demand

3rd Quarter 2019

Market Watch
by Joe A. Hollingsworth, Jr.

Those of us that have been in the industrial development business for several decades have really never seen a time when excess demand is repeatedly outstripping supply. The below chart highlights how radical this is. Our opinion is that the industrial sector of the economy is progressing very well. There are repeated naysayers, such as the nightly news highlighting everything that could possibly go wrong. However, the solid proof is still an expanding GDP that leads us to more aggressive positions when speculating on industrial real estate. Even with the surge of speculative activity and more than doubling of the build-to-suits, the vacancy rate is at an all-time low. However, this chart also begs for bifurcation of the market. New Jersey, Dallas, California, and Central Pennsylvania were some of the top industrial markets last year, accounting for over 34% of the total US absorption. While these areas will continue to grow, we think they will grow at a much more moderate rate; because, even higher paying companies cannot fill the minimal job needs for distribution in these locations. It is our opinion that a great deal of that demand for space has already begun to shift to tertiary cities that are interstate-connected where they can expect cheaper land, less taxes, less regulation, a chance at a TIF, and can find employees. Also, while you may have differences in logistical costs from the big distribution hubs, being able to operate at all without labor is impractical. In fact, we are seeing more projects use existing available labor pools as the driving reason, even over geography, for their next plant location.

Source: CBRE Econometric Advisors, Q1 2019.

Also, the chart highlights and brings forth the question of how much speculative is enough in these high-velocity logistical areas. We believe these tertiary markets have already begun to see the onshoring of all the early movers with tariff exposure. Available buildings outside of those areas mentoioned above are seeing a much higher proportion of manufacturing and value-added company visits versus logistics. The industrial developers that are working either on build-to- suits or existing space in these tertiary markets are getting cap rates that make all the REITs jealous.

High-Tax State “Screaming”

2nd Quarter 2019

Market Watch
by Joe A. Hollingsworth, Jr.

What a nice time to be an industrial property developer, owner, or investor in the Midwest or the South! It almost feels like a warm, spring day when the sun pops out, and everything is beginning to bloom. Finally, all the low-tax state citizens that have been subsidizing the high-tax state citizens of the Northeast and California have gotten their “reprieve”. We are going to be hearing the constant whining from the Illinois, New Jersey, Connecticut, etc. states about how their citizens are being “stolen” by the low-tax states. However, in all reality, “the worm has turned”. For the first time in literally decades, SALT (state and local taxes) are not slanted toward subsidizing the citizens of the high-tax states through their federal income tax deductions. They are actually having to pay their fair share. Therefore, the statement that the citizens that have been “stolen” that Governor Cuomo constantly talks about is not accurate. In fact, Governor Cuomo’s citizens have been “stealing” from the citizens of low-tax states for decades through the subsidizing of taxes with us paying higher federal taxes to accommodate them paying lower federal taxes.

When higher income individuals move (generally influenced by their age), they are not bringing children for the local government to have to school. However, they do bring a sense of knowledge, work experience, consulting ability; and, probably most importantly, they bring capital and the willingness to invest it. In some cases, they become “angel investors”. Now, it is true that the people in the Midwest and the South have to educate them to not convert our areas to high-tax states. However, if we can get them over that hurdle, a lot of good things happen with our Northeast transplants. Where there is population, commerce follows. Therefore, industrial and distribution projects bloom!

Industrial real estate in most cases follows population migrations. From the invention of air conditioning in the South, the great migration of population began, now culminating in the South having such a vibrant and dynamic economy. Out of each recession, the South has gotten proportionately stronger compared to the other regions of the country. Therefore, this bodes well for real estate investment, both short-term and long-term in the Midwest (except Illinois) and the South. Cities like Nashville are becoming the new Philadelphia. In fact, one percent of the world’s cranes are currently in Nashville. Tertiary cities near the interstates in the South and Midwest are becoming hot growth areas; because, they still have labor, and they are attracting business to utilize that labor.

We are just now hitting the sweet spot. As I mentioned before, industrial cycles (compared to residential and commercial cycles) are much longer in length and much more stable. Population migration, lower regulation, and less taxation is a winning combination.

Enjoy the sunlight of the a spring day!

No, it wasn’t the “new normal.”

1st Quarter 2019

Market Watch
by Joe A. Hollingsworth, Jr.

In the Obama years, how many times did we all hear the words “get used to the new normal” – whether they were talking about Baby Boomers retiring, persistently high unemployment (if you included all the unemployment variations), lack of productivity increases, or the words “manufacturing jobs will never come back”?  Well, as it worked out, they had almost half of the country believing it by the end of 8 years. However, in the case of manufacturing jobs during the Obama years, overall employment grew faster than employment in the manufacturing sector; thus, causing the New York Times columnist and economist Paul Krugman on November 25, 2016 to say, “nothing policy can do will bring back those lost jobs. The service sector is the future of work, but nobody wants to hear it”.  We were destined to be a country of lower paying restaurant and retail outlet jobs which was the grand vision by the Obama administration. However, slightly more than the other half of the country decided they would take a gamble on Trump; and, with Trump’s policies (and expectation of those policies), things changed on manufacturing.

In the 22 months of Trump’s presidency, manufacturing employment grew by 3.1%, and non-farm employment grew by 2.6% which was just the inverse under Obama.  In fact, in the last 22 months of Obama compared with the first 22 months of Trump, more than 9 times the number of manufacturing jobs were being created under Trump – so much for Obama’s “new normal”.

Never have regulations been lifted, modified, or revised at such a rapid rate.  In fact, some estimates say as much as 3 times the rate of the Reagan years. However, that’s not the best of it.  We have finally got a tax code that makes sense for business, and thus industrial real estate. Whether it’s totally expensing off new building upfits or purchasing higher productivity equipment, this manufacturing resurgence is likely to continue at an extremely fast clip. Sure, we have a Federal Reserve that just went crazy with QT (quantitative tightening) and raising interest rates at the same time (December’s terrible decision) as well as the ever-evolving threat of higher tariffs. However, such variables are always present in a Democracy!

As Phil Graham constantly says, “Government can’t rescue the poor”. But, I believe higher paying manufacturing jobs stand a good chance.  After 50 years of the war on poverty, roughly 13% of Americans lived in poverty both at the start and the end of the 50 years. There is not enough federal money to make everyone rich; only individual initiative can accomplish this.

Less regulation and more individual initiative with less government dependency are greatly expanding the opportunities for an individual’s economic destiny, and it’s playing out in front of our eyes! Higher income jobs are being created; lower income jobs are being eliminated; and, in some cases, jobs are being replaced by robots or software.  Let the good times roll!

A Persistent Optimist

4th Quarter 2018 Hotline

Market Watch by Joe A. Hollingsworth, Jr.

As readers of the Market Watch articles know since September 2016, I have been a persistent optimist about what should happen to the manufacturing and distribution industrial space sector. I have covered: 1) the accelerating GDP; 2) the ever-increasing on-shoring of jobs; 3) the improving protective tariffs and equalizing trade; 4) relentless regulation relief; 5) low inflation and inflation not driving interest rates; 6) more jobs available and more people working than ever in America’s history; 7) reasonable energy costs; 8) more consistent business friendly courts, etc., etc.

With the knowledge that the longest expansion in America’s history would take us to September 2019, I am constantly asked what carries this expansion beyond that. While there are numerous answers and possibilities (some political and some not), I think it comes down to two broad points.

With a stroke of a pen and at the appropriate time when the economy needs a boost, President Trump can simply inflationadjust the capital gains tax rate. The  courts have approved that the government can change regulations to reflect the inflation indexing of capital gains. However, the President has the power to do such on his own by executive order to demand treasury issue a “definitional order”. This could be a powerful motivator that can be well-timed and used as a tool to  continue to prime the economy. This should be a significant decrease in the capital gains tax, thus prompting more velocity of real estate turns and more key investing which would literally free up billions of dollars for further investment. We have no crystal ball but, I think the 2nd quarter of 2020 would be a politically-potent and economically-viable time to unleash this mighty tiger, if not sooner.

In my opinion, it is not enough to just have 4% growth in the GDP; but, it also has to be coupled with productivity gains. There are so many new workers coming into the workforce that there is a time lag in the learning curve necessary for them to operate in an efficient manner. Within the next 6 months, we will start seeing  productivity gains from all the newer employees becoming “seasoned”. Seasoned employees will be using new and more efficient equipment bought under the new tax reform act (allowing 100% write off) producing a productivity miracle. While major expenditures are taking place for capital investment, these will all be productivity based and designed to be operated by less employees; thus, stretching our existing employee base further. This combination of 4% GDP growth and tax inspired capital expenditures will finally restore our natural historic productivity back to the American worker and our economy. This by itself can extend the  expansion an additional 3 to 4 years.

Barring any catastrophic political or global economic issues, we continue to stand by last quarter’s comments, “Build Baby Build”! These economic times will be part of the history we will be so proud of in a few years that is leading to the restoration of the American Dream and the fact that our kids will be better off than us. We are not only in for the longest economic expansion in American history but, we project it will go on several years longer than economist project. Now is not the time to dream small dreams!

Build Baby Build!

3rd Quarter 2018 Hotline

Market Watch by Joe A. Hollingsworth, Jr.

Well, officially, we are in the second longest economic expansion ever! And, as I said before, there is an awful lot of naysayers, and they cannot help but talk about it constantly. However, they are wrong!

The tax cut that Congress passed has motivated businesses of all sizes to reassess the opportunity of using the tax savings for capital expenditures that will dramatically increase productivity. This is happening from sandwich shops to major defense firms. CFOs are actively using the tax savings to dramatically increase productivity and profits. This is playing out in company valuations, share prices, capital expenditures, etc., thus benefitting everyone all the way down to the factory floor. Daily, we talk to management of any of the 124 companies that we lease to, and it seems like that is their opening line. They are excited about what they can achieve.

Onto the statistics…Last month, the Bureau of Economic Analysis revised its assessment for the 1st Quarter of 2018; the BEA now says that the GDP grew 2% annualized, down from the previous figure of 2.2%. A more accurate measure averages factors in statistics on incomes which shows growth at 2.80%. The difference between this is the BEA does a separate analysis by adding up all the different sources of wages, profits, and various forms of income. BEA calls this Gross Domestic Income. Using those numbers, it is closer to 3.7% annualized. Generally, forward-thinking economists average these two together, thus the 2.80%. This shows the GDP is accelerating for 1st quarter, and 2nd quarter 2018 should be north of 4.5% using the same average.

Okay, maybe you are still a naysayer……A few things that could happen on the upside such as the NATO Alliance fully funding their part of the military, North Korea continuing to calm down, and the WTO making China play by the rules – all of which will indirectly affect the stability of the global economy, that will result in better support for the US growth. But, here are a couple of big surprises that we predict are coming October of this year. These will totally turn the midterms toward conservatives and also assure the re-election of conservatives for the presidential cycle: 1) The NAFTA surprise! – a greatly improved NAFTA agreement that gives blue collar and union voters a direct impact and reason to support conservatives; and, 2) President Trump through an Executive Order will invoke a 2002 Supreme Court ruling that sets the stage for indexing capital gains for inflation like most IRS rates are. This in effect would lower taxation on capital gains which always provides significant economic growth.

Based on all the above, this will be by far the longest expansion in American history. Internally, our company is preparing for the ride! Therefore, industrial builders, build baby build!

 

A Couple of Thoughts for the Future

2nd Quarter 2018 Hotline

Market Watch by Joe A. Hollingsworth, Jr.

As it pertains to construction as an industry, for thousands of years, we have basically performed construction with materials that are largely from the earth such as clay, wood, iron ore, limestone, crude oil based materials, etc. Now, things are on the cusp of changing and changing very rapidly, and these will substantially affect industrial real estate. Composite materials are now becoming very common such as carbon fiber, plastics, and lab-produced finishes. Federal and state regulations have become so onerous and costly in the removal and processing of earth materials that it has forced many manufacturers to go to a more predictable and less costly methods to control outcomes by minimizing the use of earth materials. An elementary example is that we are now beginning to use concrete spoils or old concrete previously removed to crush it in lieu of gravel (that is often monopoly pricecontrolled), thus cutting the cost by half. However, a new concrete is now being developed with a bacteria in it that can last 200 years, and that bacteria can actually heal itself in case of a structural crack. Does it sound far-fetched? It’s already been proven and being tested!  Additionally, concrete as it is presently formulated is estimated to produce 4% of all greenhouse gases (GHG omissions), but this new bacteria concrete actually becomes a consumer of said gases.

Another dramatic advance in construction would be utilizing the advances in carbon nanotubes that directly affect the strength to weight ratio of structural materials, thus allowing for tremendous increases in flexibility and strength per pound. This would dramatically decrease the cost of construction once these materials are commercially produced (Image bar joists at roughly half the size).

Artificial intelligence and robot builders are already being coupled together in laboratory test and trials – much as robotic surgery has been used in hospitals. Imagine the advances in precision and predictable outcomes with up to three times the production per man hour and how that will affect construction timelines and better use the existing labor pool!

As it applies to real estate developers and builders, we have been virtually stagnant in construction processes for years. These radical changes are about to disrupt everything we have known in construction practices, similar to how the smartphones with all their applications did to replace the old flip phones.

 

The Fear of Asking for Rent Increases

1st Quarter 2018 Hotline

Market Watch by Joe A. Hollingsworth, Jr.

For the last decade, landlords have had those calls that will absolutely ruin a landlord’s day from tenants saying that they need a “downward rent adjustment” or “shortened term or to shrink their space”. We have become so accustomed to hearing those requests that we, as an industry, have gotten into a very defensive mindset. Day after day for over a decade, we have been scared to raise per square foot sales price or rent price thus leading to lengthened debt amortization schedules and constant pressure on costs to construct. As developers and landlords, we have re-looked at our cost structures so much in the last 10 years that we have rung every possible penny out of them; and, most of us have had to become very efficient in what we do, or we could not survive.

Finally, the game changed over a year ago, and some in the industry still have a fear of asking for rent increases.  We now have tremendous pricing power, both in sales and leasing. In my estimation, it is likely to be this way for the next decade. However, the biggest hurdle might still be ourselves. The mindset of what “we think” companies may be able to pay based on what they have said for the last decade is definitely a challenge for us to overcome. Finally after years of mediocre returns, it is time to be bold, assertive, and farsighted. Scarcity should be driving landlords’ demands for: 1) longer term leases; 2) stronger protective covenants; 3) parent company guarantees; and, 4) “take it or leave it” on “as is” space – all contributing to a much better outcome on build-to-suits, renewals, or new leases.

One thing that developers can be sure of is that costs are going to continue to go up with: 1) the international building codes forced on the states by the “DC” crowd; 2) the ridiculous EPA energy code that has been adopted in most states; 3) the prolonged drought of new industrial construction limiting capacity with so many suppliers; 4) the developing shortage of skilled labor to build facilities; and, 6) last but certainly not least, rising interest rates. All of these are contributing simultaneously to sizable cost increases to any type of industrial construction. There is simply nowhere to go with these cost increases, except pass them on. Therefore, let’s make “golden hay” while scarcity exists and demand is high.

 

 

Economic Cycle

4th Quarter 2017 Hotline

Market Watch by Joe A. Hollingsworth, Jr.

By now, you have read it over 50 times. You have heard it on TV over 30 times. Sometimes it just seems to be relentless…that the media has to drive home the point that we are in an economic cycle that should have already matured or is approaching the downturn. Economists, who try to do forecasting based on the past (which is like driving a car looking in the rear view mirror), cannot get it right. When they say they estimate something, it is more of a guesstimate. In fact, my weatherman does a much better job of being accurate. It’s obvious that the stock market doesn’t agree with the economists.

I, for one, am strongly convinced that at no point in time (that I can recall) in America’s economic history that: 1) The onshoring of jobs/business has become so massive; 2) The discussion of protective tariffs are realigning America’s national corporations to relook at investing in the United States instead of overseas; 3) Regulation after regulation in literally every department of the federal government is being lifted or revised. In fact, a recent statistic quoted in the Wall Street Journal said over 610 regulations have been substantially altered as of June 30th year-to-date; 4) Capital is fleeing from the potential controls of China; 5) Low inflation is justifying (to some extent) lower than normal interest rates; 6) Over 40 million people are receiving federal assistance in which a portion of those could be active participants in the workforce if the entitlements were lowered or drug tests were implemented; 7) The controls of federal government are more in conservative hands (not saying that they are good at it yet); and, 8) There is pent up demand that has built up over the previous 8 years. In fact, the list goes on and on.

I maintain that the next 12 years (whether Trump is re-elected or not) will be the “best 12 years of our economic lives”. Small business ownership and individual initiative can lift this country again easily, unleashing the ingenuity behind individuals and their thirst for personal success. Although, this is not limitless; it can certainly carry us for a decade.

As it pertains to industrial real estate, I believe that there is no better time to build; because, scarcity has taken hold of the market, driving rental prices up. Older space has taken a “grand ride”, also. Many might say, “Why not just buy existing space?” However, as we have experienced in the market, existing net leased properties are greatly overpriced. And, while I certainly don’t want to throw rocks at that business model, to have new highly-flexible space with life spans of 40 to 45 years is now beginning to command premiums. The real question is whether developers can force the market to longer term leases with firm escalators to justify new builds; we say yes!

As far as our company’s direction, we are buckled up, strapped in, and ready to experience what will be “the greatest ride of our economic lives”.

Blowing and Going

3rd Quarter 2017 Hotline

Market Watch by Joe A. Hollingsworth, Jr.

At the end of the first quarter in 2017, the US industrial market has really never been stronger. Specifically, only 5.4% of the nation’s industrial space was vacant; and, it turns out that this percentage is the lowest rate on record. Even though new construction slowed down at the end of 2016, there was almost 60 million square feet of new supply that was completed and absorbed in Q1 2017. This is a tremendous record.

Market rents for higher quality space are averaging above $6.00 PSF; and, as we have written before with the ridiculous new EPA enforced energy codes and drainage codes adopted by several states, they are affecting new construction prices dramatically. We predict that rents will average $6.40 PSF nationally by the end of the Q1 2018.

So, where is all the space demand coming from?: 1) The onshoring of companies is accelerating because of the current administration’s jawboning and trade policies; 2) the House of Representative’s proposed Border Adjustment Tax; 3) Monies needing to flee the “China bubble”; 4) the incremental increase of demand for products that are currently made in the US; and, 5) a burst of innovation in retailing and logistics.

A case in point on the President’s trade policy working is that out of 30 years of showing industrial property up to December 1st, 2016, we had only seen one Chinese company express any interest in the Southeast. However, since January 1st, we have had four specific serious Chinese interactions. These range from 90,000 SF up to 300,000 SF. Two of the Chines companies openly said that the reason they are moving is that they have been making the same product in China for over twenty years, and they read the “handwriting on the wall” and are now going to have their first American footprint. Some on the “left” would say this is coincidence. However, instead, this is real hard, tangible evidence that a seismic shift is occurring and increasing the pace of onshoring which is bringing high-paying manufacturing jobs back to America.

Another observation relating to the above list of reasons that space is being “taken down” at such a rapid rate is the supercharged innovation cycle that always follows an economic crash, slow recovery, or a period of overregulation (which in this case we have all three). The supercharged innovation that we are seeing is technology combined with a slight shortage of labor. Ingenuity is creating this cycle of supercharged innovation causing “reconfiguring” in ways we currently make products using new composite materials creating new products and the need for space.

I think the next twelve years are likely to be the best sustained period in our economic lives. Speed bumps will occur; however, this will be like the Reagan/Clinton years, only on steroids.

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