Rent increases can’t offset the challenges of rising costs
The recession many have predicted has not yet reared its ugly head, but that doesn’t mean SIORs are not facing significant challenges — particularly in the cost of new development. “One of the biggest things is the cost of materials — how everything has skyrocketed; that, and the supply chain,” says Arlon I. Brown, SIOR, senior advisor for SVN/Parsons Commercial Group, Boston. “Certain materials are hard to get. The second is permitting and linkage; these towns are taking forever. If they say three weeks, you get it on the 21st day — and time is money.”
Speaking of time, he continues, subcontractors who are poorly organized can also be an issue. “In most cases, for the subs we work with we are their biggest client, and so most times when we set a date they’ll be there, but there are some specialized people who say they’ll be there on a certain day, and they’re not,” he shares.
Landon Williams, SIOR, senior vice president of Capital Markets, Cushman & Wakefield, Memphis, Tenn., agrees. “The construction costs receiving the most attention over the recent past are labor and materials,” he says. “Certainly, real estate costs and the cost of capital are major considerations in terms of the whole development process.”
What about less traditional issues that have emerged recently? “Land, labor, and materials have been three of the major cost considerations as long as I’ve been in the business,” says Williams. “Over the last cycle, land values have generally increased, labor costs have increased due in large part to a shortage of labor, and material costs have increased due in large part to supply chain challenges.”
For the industrial and multi-family asset classes, he continues, the significant increase in rents, because of historically low vacancy, have allowed the development projects to work in the initial underwriting. “However, retail hasn’t seen the same amount of rent increase, and office has its own issues,” he notes. “Consequently, we haven’t seen as much development in either of those two asset classes because the underwriting is much more challenging based on the higher development costs and pro forma rents that don’t support those costs.”
Brown concurs. “These things have always been there, but they are just magnified now more than ever,” he states.
One recent change he has observed is the sophistication of some billing departments. “Before, you could get by with having just a plan,” he says. “Now, everything has to be stamped. They now want you to get an AIA architect put a stamp on it, and that puts costs up constantly.”
Melissa Alexander, SIOR, partner at Foundry Commercial in Nashville, Tenn., sees a number of hurdles facing new industrial development. “There’s a lot less bulk product (500,000 — 1 million sq. ft.) coming out of the ground,” she notes, due to underwriting challenges. “Where you could get 50% loan to value, now it’s 60%.” Accordingly, she says, “You will not see much (new construction).”
With a rise of 150 basis points in the past year, she continues, there is a requirement o “underwrite to a new return.” While construction costs have levelled off, they are still high, which only leaves higher rents to offset those changes.
Before, you could get by with having just a plan. Now, everything has to be stamped.
“Rents in our market are still increasing, but not at the level they were,” Alexander notes. “In the Nashville market, especially shallow bay, single load and probably rear load with shallower building depths (250,000 sq. ft. and below) there’s still a market; they were never overbuilt. Still, rents are not increasing like they were, and the activity level may be slowing slightly. Because we’re at 5.5 cap and not writing 6.5 to 7, the only lever to pull is the rent level — but no comps point to that; I’m not sure you can get $1 more in rent.”
CONTROLLING THESE COSTS
Brown offers a number of different strategies for controlling those costs. “The two biggest things are definitely dealing with people where you’re their largest client and dealing with them over a long period of time. It’s the personal contact that is so important,” he says. “Then, try to minimize that whole supply chain; if I know I’ll need a generator and it will take eight months, make sure eight months out you have it ordered. And, have a supplier you can count on — someone you know can produce the products for you.”
Engineering a project is another big issue, says Brown, noting it’s important to have sophisticated people on your team because issues can arise that you did not anticipate. “Always ask, ‘Do you have sewer?’” he advises. “You may need one or more pumping stations, so you need real pros who can deal with that, and who know the landscape really well. It seems like there’s always something biting you in the behind.”
WHAT'S AN SIOR TO DO?
As expert advisors, one of the key value-adds for SIORs is the ability to offer guidance to their clients in times like these. Alexander has some specific thoughts on what developers might consider. “One of the biggest strategies is to try and look for build to suits, or pre-lease before you go,” she says. “I see a lot of people with land positions that hold onto them and wait for tenants to come along; that’s the safest bet.”
There are still developers out there that will bring a building out of the ground, she continues, “And as an SIOR you really need to know the market — what the competitive set is, what the vacancy rate is. Inevitably rents will go up if you’re in a 2% vacancy market, but you also have to keep an eye on how healthy the sublease market is; that’s typically one of the lead indicators of tenant fallout. If you see some softening, you need to point to that.”
Again, for developer clients, she sees a lot of opportunity in land. “One of the great strategies is identifying sites — unique sites that may have been passed up or dropped — and get those tied up or under contract,” she says. “But give yourself enough time to see how the market will perform.” This approach takes longer, she concedes, “But you’re de-risking the project.”
SUNSHINE THROUGH THE CLOUDS?
Looking to the future, Williams sees some of these challenges lessening. “As development has clearly slowed down, the current labor market won’t be stretched as thin — which should stabilize labor costs,” he predicts. “Additionally, the supply chain wrinkles of the recent past seem to be ironed out, which should result in more stabilized or maybe even slightly reduced material costs. In fact, some industrial developers have told me some material costs are already down.”
The biggest challenge for development over the foreseeable future, he continues, will be the cost of capital. “It will either need to come down, or the rents will need to continue to rise substantially if the cost of capital stabilizes.” he says.
“I think we will have a lot less new space delivered in the market,” says Alexander. “What we will see are rents still increasing — as long as the sublease market remains healthy.”
Brown sees AI as a major issue; how it will affect CRE, he points out, is a big unknown. “Will [AI] be really positive, or will it make things more expensive because it says you need a door here, sprinklers there?” he poses. “Who knows how it’s going to affect [the market], but that’s going to be the biggest change in the future.”
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