Having hit the halfway point of 2021, it’s not only safe to say that the Chicago industrial real estate market is having a strong year, but it’s essentially a unanimous consensus. The flurry of press releases about new spec development starts continues to hit our inbox at a steady pace while quarterly reports back up the empirical evidence with hard data, detailing exactly how much demand there is for new Class A industrial across the metro region.
While the trend in industrial is a much-needed reprieve from the tough, ongoing news and reports in office space and retail, there are still many challenges facing industrial developers, contractors and brokers. However, the current moment is more than just a boom or a bull market, it’s truly a sea change in the way that we manufacture, warehouse and distribute goods across the country. And this evolution we’re witnessing is expected to continue for at least the next few years.
High construction costs and lead times requires careful capital deployment
The story about sky-high steel and lumber prices has affected the construction and real estate development industries across the country. And while the costs of some raw materials are starting to come back to earth, acquisition lead times are still a major problem for developers looking to piece together and finance a deal. The solution, at least in the short term, is to be careful about where new projects are being built, and to ensure that these new facilities will hit their numbers today and in the future.
Chicago-based Sterling Bay has become a household name in the region for its exponential growth and notable projects, such as the Lincoln Yards mega-development along the Chicago River. However, Sterling Bay has leaped into industrial at the right time and is competing for new opportunities just like every other major player in the region. And despite the tough competition, the steep costs of construction, and long lead times, the overall demand for new product means that there is still a lot of opportunity out there.
“There’s no question that it’s becoming increasingly competitive with capital interest in the space, the market getting tighter and it’s harder to to find deals, but the reality is that this is just indicative of the volume of tenant demand that’s out there,” says Mark Barbato, director of Sterling Bay’s industrial division. “So we’re leveraging those deep, long relationships that we have with the brokerage community to continue finding opportunities.”
And there’s possibly nowhere in the Chicago area where there’s more competition and higher costs than the O’Hare submarket, however, it’s also where the highest demand is. And while the sticker shock of new construction is tough to shake, the reality is that tenant businesses who need to be in the submarket will make it work. And so long as demand remains steady, there’s a safe presumption that rent rates will also follow the same curve.
“Steel [costs and lead times] are the biggest limiting factor for us right now, which makes it extremely difficult to respond as quickly as we would like to all of the demand that we’re seeing in the market,” Barbato says about the crucial construction material, where procurement timelines are backed up by roughly a year. “What we’re continuing to focus on is picking sites and submarkets that we really understand and believe in and the places where you’re seeing rents grow at a pace that’s keeping up with the rising costs of construction.”
In addition to O’Hare, Barbato says that there’s also a tremendous amount of opportunity to bring newer Class A industrial space within Chicago city limits. And while there’s a notorious barrier of entry to developing within Chicago proper, Sterling Bay’s experience with developing office buildings, hotels, and residential projects will come in handy when it’s time to meet with city council members and community stakeholders for new industrial projects.
The trickle down effects from policy changes have impacted logistics and real estate
While steel is the biggest hurdle for real estate developers, fuel and labor costs have the biggest impact on overall revenue and expenses for the operators and businesses leasing space in these new industrial facilities across the Chicago region. And to make things even more difficult, the transportation and logistics industry is still playing catch-up with some policy changes that have had a big impact on trucking since before the pandemic.
Ultimately, any major policy change or issues facing transportation and trucking will have an effect on industrial real estate, or the “Rule of 1.5” as Adam Roth, Executive Vice President and Director of Global Logistics for NAI Hiffman refers to it. The federal government mandates a sweeping change to the way that mileage is measured and tracked? Expect it to take a year and a half to finally have an impact on commercial real estate, because ultimately, “everything touches a truck,” Roth expresses.
“In January 2020, a new provision was passed by the federal government called the Drug and Alcohol Clearinghouse which states that if a driver fails a drug test, gets fired and then goes to a new trucking company, that infraction stays on the record,” Roth says, detailing one recent change to the trucking industry that has had a major impact. “So guess how many drivers since January 2020 have been suspended by the DAC? 70,000, which is equivalent to Schneider, J.B. Hunt, Werner, Swift, and U.S. Xpress all sitting their drivers.”
Removing tens of thousands of drivers from service reduces overall trucking capacity, thus leading to higher costs. Another policy change that Roth highlights is the congressionally mandated use of Electronic Logging Devices (ELDs) for measuring mileage and breaks, virtually erasing artificially underreported (or over-inflated) driving time. The implementation of ELDs meant that trucking companies could no longer falsify records or require drivers to continue past unsafe limits.
While both of these measures are much-needed and well-intentioned efforts to improve driver working conditions and safety, there is always going to be a financial impact anytime a sweeping change is made, Roth explains. Instituting limits to drive time and mandating the use of rest breaks means that drivers need more places to park, therefore requiring that newer facilities have more trailer parking. And it was a year and a half after this policy went into effect that facility operators and drivers started seeking more parking space.
So, how can industrial users cut down on transportation costs while also creating new opportunities for developers to build new space?
“There are two ways,” Roth suggests. “You get closer to intermodal, which Chicago is the capital rail in North America, and the other way is you reduce your length of haul by getting closer to population, or you add to your number of warehouses. And we’re seeing both of these happening in Chicago.”
There will continue to be a need for new development for the foreseeable future
The e-commerce boom has undoubtedly been one of the biggest drivers of demand for new industrial space across the Chicago metro area, as well as the rest of the nation, and this demand trend is likely to continue for the foreseeable future. But there’s also a need for additional warehouse and distribution space to help prevent the supply chain disruptions and product shortages that we’ve witnessed over the course of the pandemic from happening again.
There’s so much demand for industrial space at the moment, that this could potentially be a once in a generation boom that we’re witnessing. And because it is indicative of a broader evolution and change in the way that consumers purchase products and the way that these products reach their end destination, we’re still more or less at the beginning of this major transformative change.
“With the expansion of e-commerce, we’ve done extensive market research across the nation, and we see a billion square feet of new warehousing space needed in North America over the next 60 months,” says Dominic Carbonari, Executive Vice President with JLL. “But we’re about 20%, or a year, into that run right now, so we can say that we’ve still got 800 million square feet to go,” adds colleague Rob Wheeler, Senior Vice President at JLL.
Wheeler and Carbonari, who have both been in the industry for over 20 years each, express that Chicago-area industrial vacancy rates are at the lowest point they’ve seen in their careers. Demand has been steady from users, but a number of large-scale deals have represented huge absorption figures in the last year. And while e-commerce has had a major moment during the pandemic, orders and fulfillments from online retailers are only just over 20% of all global retail sales.
But distributors are wising up to the inefficiencies and costs related to the current supply chain shortages and tacking on additional space for storage and warehousing. Wheeler notes that for one deal he’s working in a different area of the country, the midstream requirement has increased by 20%, specifically to hold additional inventory. So overall square footage on new construction Class A space is likely to increase to meet these new thresholds.
And fortunately, the Chicago area’s geography and infrastructure will not only help the region catch-up to meet the needed demand for industrial space, but it’ll only further solidify the city’s reputation as a crucial transportation and distribution hub at a broader scale. This will continue despite the county and state’s ongoing (and infamous) financial troubles.
“With all of the mixed messages coming with the state and taxing issues, Chicago is still where all of the Class A railroads connect, there’s still population here, and there’s still demand for companies to be here and distribute from here and a need for the efficiencies based around it,” Carbonari says of the metro area’s massive population and need for additional industrial space.
“You can’t change the railroads, there’s water availability, and all of the logistical supply chain related infrastructure that’s here cannot be replicated,” Wheeler adds. “So despite some of the headwinds that you might have from a political climate, Chicago will continue to perform.”
This article also appears in the July 2021 issue of Chicago Industrial Properties