Here’s how you overbuild an office and industrial market

Implications: The greater fool enters a market when investment interest rates elevate and negative leverage occurs. Or when income streams are interrupted by an inventory of new construction.

Analysis:

The office and industrial property market in the United States is a perfected market, meaning that investment property sales are usually conducted at auction with nationwide distribution. Capital currently exceeds available property as evidenced by up to six or seven offers per property on some or most occasions depending on the particulars of the property and short close periods. Buyer yields have halved over the past five years while rents have risen. The resulting prices are universally record highs and the transactions are keyed to projections of even higher rents.

The City of Chandler, a part of the Phoenix metro area, has grown to become a substantial residential and retail community. Like its neighbors in the South East part of the Phoenix metro area, employment was originally provided by Motorola and Intel and Hughes. Those jobs are still key to the area, but mostly the residents commute in to the employment centers which are located 15 to 30 miles to the west. Chandler is no longer a perimeter community, in fact it is close to residential build-out, as Gilbert, Queen Creek and portions of PinalCounty to the east are under development too. The state of growth of the communities has been stimulated by the residential sales and development maxim of “drive ‘til you qualify”. These some nine or ten communities plus many more on the west and north side of the Phoenix metro area are now concentrating on seeking employment for their residents in other than retail stores or homebuilding or government endeavors or the old standbys of copper, citrus, cattle, cotton and climate/tourism.

Chandler is typical of the other communities with its 9 square mile area set aside for office and industrial occupancy. The build-out if it follows the recent national trends will wind up with about ½ manufacturing and ½ warehousing in the industrial zones and financial and professional services in the office areas. Remember that close to 20 communities including Chandler have similarly sized areas. Know also that prospective tenants favor “real deals” and will choose the community with inventory in place over other competitive offers. Since the results over the last five years in the office and industrial markets have been good, developers have lost their fear of down markets. Decisions are being made with significant research in place to proceed with speculative construction. Rationales are advanced which speak of market segmentation and windows of opportunity. Some will be right and some will be wrong. The problem lies in the probability that there will be more wrongs than rights. Since every past market has resulted in a surplus of space leading to investment losses, the investment decision must anticipate macro-business accurately to realize the hoped for return. Since not one of these 20 or so communities has a supply constraint characteristic, the inevitable if history repeats is an over build which staggers. After all, commercial and industrial developers are just like home builders in that if you give them money, they will build. And we are giving them money as indicated by banking regulators currently issuing warnings to institutions regarding overexposure in the commercial/industrial loan portfolios.

When the bubble bursts, the good are sometimes dragged down by the poorly conceived. There is a double opportunity then of acquiring empty buildings at a significant discount to reproduction cost and/or completely renovated buildings at a similar discount to reproduction. Or you can develop commercial and industrial land from regulated institutions at a dime on the dollar in anticipation of a return within 5 years or as long as 10 years further out depending on the situation.