In a Market Transformed, What's Next for Industrial?
The business infrastructure of Kansas City has changed in important ways over the past decade, but few sectors rival the kind of growth we’ve experienced as a national center for logistics, warehousing and distribution. Redefined as a marketplace for bulk industrial space, Kansas City now factors prominently in discussions about where companies nationwide need to be located to reach their customers. Assessing the prospects for future growth, nearly a score of brokers, developers and owners gathered at the Plaza offices of Polsinelli, PC, on Nov. 9 for Ingram’s 2018 Commercial Real Estate Industry Outlook Assembly. With Dan Jensen of Kessinger/Hunter & Co. and Zach Hubbard of Block Real Estate Services as co-chairs, they engaged in a spirited two-hour discussion of where the sector goes from here, and what’s at stake for tenants, landlords and investors. The bottom line for businesses seeking warehousing and industrial space is that Kansas City is currently a strong tenant’s market. Rents are stable, incentives are driving the cost of new construction down and making it competitive with older facilities, and there’s room for additional growth in the sector overall.
THE CENTER OF IT ALL | Figures from the 2017 Census update reflect the benefits of trying to reach a large part of the nation’s population from Kansas City’s Central location.
Status of the Game
Just about a decade ago, the Kansas City region witnessed the birth of an industrial real-estate boom, and from an unexpected direction. That’s when Kessinger/Hunter delivered a 602,000-square-foot building, considered enormous at that time by market standards. On top of that, it was built on a purely speculative basis: With no buyer committed before construction. If the explosive growth in that sector over the following decade can be likened to a baseball game, what inning would we be in?
That’s how co-chairman Dan Jensen of Kessinger/Hunter & Co. in tandem with Block Real Estate Services’ Zach Hubbard, teed up the assembly discussion. It prompted a general agreement that we’re in the latter third of the game—but with the definite prospects of going into extra innings.
Jensen’s thesis didn’t get much of an argument; most of those around the table ventured guesses in the seventh or eighth innings, including Joe Orscheln of CBRE. “I think we’re really right around the eighth inning,” he said. Recently returned from an industry conference in Atlanta, he said, “they’re saying we probably have 24 to 30 months of run time. I’m hoping the e-commerce trend will get the industrial guys in Kansas City through the downturn,” whenever it comes.
Joe Downs of the St. Louis-based Opus Group generally concurred, saying that “demand in all our markets continues to be encouraging.”
Cushman & Wakefield’s Joe Accurso was perhaps the most optimistic of the lot, figuring a sixth-inning status, with caveats. “The downside,” he said, “is record land prices and scarcity of sites. We’re in the sixth, but there’s a lot of room to run.”
Bouying his optimism, and that of others at the table, is the volume in the current pipeline. But more than that, should an economic pullback show up in 2020 or 2021, several brokers see the newfound strength of this region’s industrial market as a buffer against the kinds of forces that could hurt the office and retail sides of commercial real estate.
“I don’t think (industrial) is going to be immune to a slowdown; we might even see it this year a bit,” Accurso said. “But I think it’s going to be healthy and I don’t think we’ll slow down much relative to other sectors.”
JLL’s Kevin Wilkerson felt the same. “I think this next cycle, we’ll come through this better than any other sector,” he said. “We’re starting to see office warehouse product pop up, and that’s usually a sign were approaching the end,” which qualifies for sixth or seventh-inning status, he said.
Wagner Logistics’ John Wagner, also figuring things in the sixth or seventh inning, pointed to the big lead his team has built up in 2017 and 2018. “We’ve grown over 20 percent last year and look for another 20 percent in ’18,” he said. “A strong pipeline doesn’t mean that you’ll get that business, of course, but it does show there are opportunities.”
Paul Licausi of LS Commercial Real Estate sees the market here divided in two key sectors—the mega warehouses, where he thinks things are on the back side of the cycle, and the smaller segments. “I think there’s more growth and stability in the smaller market,” particularly with buildings in the 25,000 to 50,000-square-foot range. Beyond that, he’s anticipating regulatory gridlock from Washington, thanks to this months’ split decisions that divided control of Congress. “The question is whether we have pullback in terms of guys pumping the brakes,” on that end, he said.
Mark Long sees a considerable amount of growth potential in the market, making him a sixth or seventh-inning adherent. “Things could potentially slow down—they’ll keep going as long as demand allows for that—but I looked at the largest deals done over past few years, and if you take the 62 largest, that accounts for 16 million square feet. That’s about 250,000 square feet on average.”
Those generally involved companies operating in e-commerce and automotive sectors, as well as the food-processing industry. While auto and housing-related enterprises could see a pullback, he thinks the e-commerce and food sub-sectors will continue to absorb a lot of the new space coming onto the industrial scene.
Kessinger/Hunter’s Pat McGannon was also among the more optimistic. “I think there’s still room for growth,” he said. “The GDP number is too good for this to stop in a year.”
Colliers International’s Ed Elder said that irrespective of the inning, the bulk warehouse movement has lost a bit of momentum. “Having said that, we’ve all experienced a flurry, and the last 90 days, we’ve been very busy again,” he said. One distinguishing characteristic has been that activity is in the build-to-suit space, rather than the large spec structures.
For those on the development side, Elder said, market signals warrant caution on the larger facilities. “But this is a tenant’s market,” he said. For anyone seeking space in a site with 200,000 to 500,000 square feet, Elder said, “it’s a good time to be the kicking tires.”
Bucky Brooks, of Copaken Brooks, had a different take on where the game stands. From his perspective, we’re playing a
whole new ball game, based on the growth in industrial in this market over the past five years, in particular. “In many ways, I really feel like we have a long and exciting game going on, one that’s going to extend way past my career,” he said. And the driver for that: e-commerce.
A Repositioned Market
By injecting 32 million square feet of space into the industrial market in the past few years, Dan Jensen suggested, Kansas City has repositioned itself in national conversations about where companies should locate large-scale distribution facilities.
And it’s more than talk. Amazon.com, now with three large distribution centers in the metro area, has put more than 3,000 people to work and is rapidly climbing the charts among the largest private-sector employers in the region.
Earlier this year, J.C. Penney closed a massive 2-million-square-foot distribution center in Wisconsin, choosing instead to relocate that work to its Lenexa center roughly half that size. This summer, CVS opened a distribution center of more than 800,000 square feet in the Northland.
Like Musician’s Friend, Bushnell Outdoor Products (now Vista Outdoor’s Bushnell Division), Coleman and others, have discovered the advantages of shipping product out of Kansas City—or with many, after sending it here by rail.
“I like to say Kansas City has gone from secondary market to a small primary distribution point,” Dan Jensen said. “It used to be that if you wanted big box, you went to Chicago or Dallas, because for one, there simply was none here, and second, those larger cities had a greater population base for labor. Given where we are now, he asked, has Kansas City earned a newfound respect on the national brokerage scene?
“Everything in the Midwest, Kansas City is in on every deal,” said Joe Accurso.
Pat McGannon marveled that he gets calls from prospective clients “and they say their consultants are telling them that we need to be in Lenexa, Kansas. We never used to hear that.”
Kevin Wilkerson and Accurso both agreed that we’re a secondary market—albeit a large one—and Mark Long ad-ressed factors that are changing that. With BNSF Railway’s investment in the massive intermodal center in Johnson County, the growth trend is going to continue, he said. “People are going to bring product via rail through Kansas City, and that will help us as it relates to other regional second-tier markets. Look at what’s been done the past 10 years; I figure our market has grown by 15 percent. Ten years ago, we were smaller than St. Louis; today, we’re much bigger than St Louis.” And compared to all other cities, with the exception of Indianapolis, he said, Kansas City has seen more growth.
The old adage in distribution, said John Wagner, was that if you were trying to find a site for a single distribution facility, you took a map, folded it twice, and looked for the intersecting lines from the creases. That would be your spot. One problem with that: The spot might not be near a labor pool of sufficient depth. Kansas City’s bigger challenge, he suggested, is that “all the people are still on the coasts.”
That’s what drives growth in a market Kansas City would love to overtake—Indianapolis. “They are closer to the east coast,” said Joe Accurso, “and they are always going to have more 400,000 and 500,000 square-foot deals. If we have one floating around, they have four, and that’s just the way it is. But that’s the only one with our population that is consistently ahead of us.”
Orscheln, citing the industrial conference he’d attended, said Kansas City was being mentioned frequently—something that hadn’t happened in the past. “In construction starts, for 2016, we were actually among the top five largest,” he said, and 2017, showed 7 million square feet of new starts, plus 6 to 6 million) this year.”
The city is well-represented, said Charles Renner of Husch Blackwell, with state, county and municipal jurisdictions. “Public-sector partners have started to appreciate the economic value of transactions like this,” he said. “That was not the case five to seven years ago.”
After the Recession
The growth in big-box construction began at an unexpected time: In 2008, the nation was in the throes of the Great Recession. And that came just a few years after construction of the Kansas Speedway and the Sprint Center campus had wicked up construction labor and changed the cost structures for construction, noted Hunt Midwest’s Mike Bell. But industrial development is still dealing with lingering headaches from those two eras today, he said.
“When the recession hit, 20,000 construction laborers left he market; that seems like a long time ago, but we’re feeling the impact today,” Bell said. “The level of activity today may not be what we saw in 2000, when there was a lot of major construction. But even though we’re all busy, from construction standpoint, there are fewer employees for all these. The market is tapped.”
Chafing from the lessons of recession-era layoffs, contractors cautious about over-hiring in this relative boom have created a demand for labor that is driving up rates. “They don’t have the resources to build what we all need to be built,” Bell said. The effect of that? Hunt Midwest has opened new facilities of roughly 200,000 square feet in three succeeding years, and even though the building shells have been almost identical, each year has brought an increase of $2 a square foot for construction costs. Rents, however, have not risen proportionally, in part because of the addition of so much space in the market.
The other impact has been on construction materials. “Before Sprint was built, masonry costs were $7.50 a square foot,” Bell recalled. “After that, it was jacked up from $7.50 to the teens, and it never went back down.”
Kevin Wilkerson pointed out that the costs of building out a facility are not in the $100 range per square foot, up 25 percent from where they were just three years ago, when people considered $80 excessive. “It’s crazy,” he said.
Zach Hubbard wondered whether, given those costs and the new fiscal reality of rising interest rates, certain types of buildings might be getting priced out. Perhaps, said Dan Jensen, what we’re seeing is that the market is realigning in ways that will allow only deeper institutional pockets.
The Cost of Incentives
The conversation turned to an inside-baseball examination of cap rates and rent growth, leading Ed Elder to ask about the impact of public-sector incentives on the market. Those can drive down costs of a new project to compete with existing structures, “but that tax abatement will burn off,” he said. “We haven’t gotten there yet, but look what have incentives done to our market here and the underwriting. I think the threat we’ve already seen is to the modern Class B-plus buildings that don’t have abatements.”
Dan Jensen confessed to “drinking at that well for a long time,” with use of incentives in deals he’s orchestrated. “But are we creating a Columbus (Ohio)-type situation where everything gets abatements and can’t compete with new for re-tenanting? Have we gone too far? Where my bread is buttered, I think 50 percent (tax abatement) is a strong number, but communities that are giving 100 percent are going too far.”
“Is it going to affect market? Absolutely,” said Mark Fountain. “It’s yet to be seen how it’s going to, but it is going to make Class B stuff less valuable. And eventually, it’s going to make second-generation Class A less valuable. The well is going to run dry.”
Kevin Wilkerson related conversations his office had with JLL’s capital-markets group, where flat rents comparable to those of 2014 were an issue. “We’re seeing a reset when the tax abatement burns off,” he said. “It’s not dollar for dollar, but it’s a significant decline.”
That’s pressuring landlords to hold the line on rent increases and at times, pare back or offer other incentives to keep tenants from exploring their options. “I’ve seen cases,” said Ed Elder, where one has a significant investment, but at negotiation, just drop the rate to whatever it takes so they don’t take that step into the market. They know that if they went to market, it’s jump-ball. I think you’ll see more of that.”
The game, said Paul Licausi, has been created, and the consequences to come are “inevitable.” “It’s going to affect the front-end underwriting,” he said, as well as the timing of decisions on when to build. “The problem is the second guy in; he’s going to be facing the music.” Given the costs of tenant investment to make a building operational, he said, the bigger issue isn’t with the “plain Jane distribution guy. The automation guys have the bigger problem.” Thus, negotiations will come down to how much pain each side can tolerate in the absence of a tax abatement. “Who the hell knew how this was going to function, but this is the reality,” Licausi said.
One reason why the local abatement policies are a concern, brokers said, was the potential to put this market at a disadvantage compared to others.
“We’ve done 3 million square feet in Dallas, and abatements were not even an issue,” said Mike Bell. “Having a state line here causes part of it. Three or four years ago, Kansas was getting all of the growth; on the Missouri side, they’re trying to figure out how to keep them here.”
Charles Renner, who’s law practice is heavily tied to work with public-private partnerships and municipal incentives, said he didn’t think there would be a major shift coming soon in the way cities and counties approached incentives. Without a public-sector commitment to more funding for “education and infrastructure and the things that help push the economy forward, I don’t see that shift,” he said.
Riverside, noted Mark Fountain, doesn’t offer abatements, “and we’re building all the same big buildings,” he said. The lack of incentives means “we’ve lost a deal or two, but the bottom line on that is location still matters. We’re leasing them as fast as we can build them.”
And that goes for more than just access to highways and other transportation routes—it includes locations with access to labor.
A Shift In Focus
Some at the table suggested, the focus on explosive growth in big-box distribution facilities in Kansas City, both on the local and national levels had obscured what’s happening on the broader market.
“The guys who built industrial and held it are making a lot of money now,” said Mark Long of Newmark Grubb Zimmer. “But it seems like we’re only talking about big-box stuff, and nobody talks about what’s happening elsewhere. In a market of 280 million square feet, big-box accounts for about 45 million, he said, or roughly one-fifth. “We spend our time talking about 20 percent, and I think the other 80 per-cent is very active right now.”
Within those smaller spaces, the region is poised for significant growth, a number of brokers said. That’s particularly true of those in distribution who represent the so-called “last mile” of delivery, where large warehouse space isn’t needed because freight is being re-directed and moving, not sitting idle.
“That Class C space works well for last-mile,” said John Wagner. “They’re not stocking anything—what they need is the geography. There’s a reason why UPS located its facility in the West Bottoms. They can have a delivery truck in any neighborhood in Kansas City in 30 to 40 minutes. A central location for that sort of thing is very positive.”
The challenge, said Mark Fountain, “is to figure out what the last-mile guys need. The food guys already have.” Because the interior of the metro area is largely developed, that could mean tearing down more structures to clear the way for new spaces, which itself rewrites the calculus on affordability, he noted. But the push for creative uses of existing structures is significant, Fountain said. “We see it with product we have, where guys are scrambling to find where they can get in and out of the city real quick.”
As the session wrapped up, Kessinger/Hunter’s Jerry Fogel applied what might have been the most reassuring assessment of where the Kansas City industrial market stands today.
“We recently spent three days squiring around an out-of-town developer and showing them possibilities to come here and speculate on big-box buildings, and they turned around and left and said ‘See you,’ they’re not going to do it,” Fogel said.
“They regarded our market as almost impenetrable because of the aggressiveness of our brokerage community. It wasted a lot of time, but it validated the quality of this market, and there’s some reassurance in that, you know, maybe we are doing things right.”