This article is sponsored by Logistics Property Company.
To meet the demand of e-commerce growth since the onset of the covid-19 pandemic, tenants are increasingly looking for spaces that will reduce delivery time to the customer. Having the right asset in the right location could yield significant cost savings on transportation, and mapping travel routes could mean that a repurpose is more desirable than a new build, as well as lowering carbon emissions.
CEO James Martell discusses ‘last-hour’ spaces the firm wants to occupy and how the specialist developer Logistics Property Company, LLC (LPC) is managing its tenant and environmental risks in a booming sector.
LPC doesn’t use the term ‘last mile.’ Why is that?
The trouble we have with the concept of ‘last mile’ is trying to geographically define where that is. Where is that last mile? We like to think of it as ‘last hour.’ Products start at a manufacturer and need to end up in the consumer’s hands. Getting that product to the last touch – the handoff to the consumer – is the goal of the e-commerce market and that is usually within a last-hour radius of the consumer.
The critical issue for e-commerce delivery systems is defining a geographic area that has a population that they equate to a certain number of deliveries or boxes. They need to navigate traffic issues and natural boundaries associated with last-hour delivery, and it’s not always as clear-cut as one might think. To take an extreme example, if you have a logistics facility on a major street, you sometimes can’t get to the other side of the street or even a block away without driving miles around due to natural barriers or the way roads are set up. So, your last-hour location may be a block away, but you have to traverse miles to get there because you have natural boundaries or traffic issues you have to avoid.
It’s not a black-and-white discussion. It takes monitoring transportation and the speed at which you can deliver a product from a location that’s most efficient. Sometimes, most efficient does not mean closest. It may not be a last hour, it may be a block; but we still have to think it all through.
How do you meet increased e-commerce demands when both land prices and consumer demand have exploded in and around cities?
Certainly, the volume of deliveries has increased dramatically. It’s not just Amazon; it’s FedEx, it’s DHL and other delivery companies. There’s an e-commerce facility in Chicago that’s set up with a drive-through for Uber cars – the drivers open their doors up, the facility loads them up with packages, and away they go.
In e-commerce, everything starts with an algorithm that defines the population, and then you look at how transportation can best serve that population. In some instances, truckers and/or delivery drivers operate from 8pm to 1am to avoid peak hours. That both helps traffic in the local area and lets delivery drivers do two or three runs in the same amount of time it would take them to do one otherwise.
Since that’s what many of our customers do, as a developer, we are doing the same thing – we are defining populations, and then asking how we can serve those populations. Sometimes you might deliver 10,000 packages to a single residential complex in a month. Do the math; having a logistics facility right by a handful of those buildings would be very valuable and productive. We are trying to build one like that in downtown Chicago, at a location that sits between two major east-west routes off the Kennedy Expressway, with about a million people living within a very small radius.
Transportation is a huge cost for e-commerce. For every dollar spent, about 65 cents go to transportation. Rent is just 5 percent of costs. Even in areas where rent is high, the cost of transportation has risen along with rent. As a developer, giving companies a model that saves 10 percent on transportation is meaningful. Saving 10 percent on rent isn’t as meaningful.
Given the scarcity of space in major US markets, how do you decide whether to repurpose older buildings or build from scratch?
Volatility in real estate is related to land. You can generally build the base buildings for industrial for the same price – maybe a little extra for earthquake and hurricane safety. But the cost of the land can range from $3 to $4 per square foot, to even $100 per square foot. Some large plots of land in big cities may also have massive environmental issues, which will add to your redevelopment costs, your timeframe and zoning issues with the city.
Many places by LAX or the inner cities, for example, were old manufacturing centers. However, those locations are so valuable to our customers that rent isn’t a factor. They’ll pay whatever you can reasonably charge, because it will save them so much on their delivery and transportation costs.
To decide, you have to look at the utility of a building – can you adjust it to make current demand? Can you add in enough parking, ceiling clearance, etc? The cost differential for repurpose vs new build is hard to peg; it’s really a case-by-case basis. To build a new building is about $75 to $80 per square foot, but that doesn’t include tearing down the old structures, if necessary. Repurposing can cost more than that.
However, some of these buildings are so environmentally contaminated that companies will give them to you for a dollar. Some of them will even give you the money to clean them up, because they want them off their books. Another advantage of industrial, as a developer, is that the sector’s footprint is so big, there will always be someone who will take it – maybe a class C or class B tenant who doesn’t need the ceiling clearance that an e-commerce user does. Even if you can’t repurpose the building to the highest standards, it can still be very useful.
In your opinion, are there too many planning restrictions? Do governments and local authorities need to do more to incentivize developers and investors?
There have been all kinds of programs and incentives, a recent one being Opportunity Zones to bring developers into lower-income areas. However, the planning process does tend to be overbearing in most cases. Local governments expand their requirements to what they think adds value to their community. Some things are important, like storm water management and, of course, that needs to be structurally sound.
But now they’re going into a lot of areas that are unnecessary. The process by which they go about reviewing is sometimes also inconsistent, to the point that it comes down to the individual perspective of who’s reviewing it and their interpretation of the code. Reviewers are adding requirements based on their interpretations of the code versus what the code actually says. Cities are interpreting and/or adding to their codes, and few understand or know how to interpret some of the new ones.
There are generally good ordinances in place, but they should be black and white and should not be left open for interpretation.
To what degree will rents continue to rise as the economy reopens?
The driver of rents is demand exceeding supply. If there continues to be demand for key logistics locations as there has been over the last three to five years, and we can’t build them fast enough, so rents will go up. I’m expecting double-digit increases across major markets over the next two or three years, and in California up to 30 percent increases.
Increased rents are going to continue with the 10-year US Treasury rate getting closer to 2 percent. That will put some pressure on costs, but if demand continues, rents will go up. In California, for example, vacancy in the Inland Empire is less than 50bps.
Even if the general market slows, industrial is the darling everybody wants a piece of. Covid-19 by itself expanded e-commerce demand in the first quarter [of 2020], at a rate accelerated by 10 years. Generations of people who would never have used e-commerce, like me, were forced to use it, are now comfortable with it, and won’t go back.
I think we’ll see a lot more manufacturers bypassing the distribution and retail market and going direct to the consumer, since that drops their costs dramatically. All that means booming business for industrial real estate.
Given how fast industrial has been growing, what are the potential downside risks in the medium to long term and how can they be mitigated?
What helps mediate exposure to industrial is the large denominator. With five-year leases on average, a 1.5 billion-square-foot market like Chicago would have 300 million square feet rolling over every year. So, there’s an opportunity to deal with that large rollover annually to get exposure to a different kind of customer. We always see downturns as an opportunity to diversify and improve the quality of customers. That protects your downside. Based on what we see relative to all the drivers of industrial, I expect a solid three- to five-year run for the industrial market.
Our goal is to deliver the lowest cost of occupancy, not necessarily the lowest cost of rent, with lower operating costs by building a higher quality building and incentives. Having better long-term consistency in our revenue source and less rollover is better for us, even if the immediate return is lower. After all, the cost on re-leasing a building is expensive – advertising, commissions, vacancy costs. As our investors are long-term partners, we prefer to incentivize our customers to stay long-term by providing the lowest cost of occupancy so our rollover exposure is minimized.
ESG considerations for last-hour spaces
The logistics sector can and will take steps to reduce carbon emissions and do its part to fight climate change. Making buildings closer to last hour will make jobs attractive to local labor and help rejuvenate neighborhoods. Reducing transportation by being closer to the customer reduces emissions dramatically. Building charging stations at Class A, modern logistics facilities to charge electric vehicles on-site can also help.
When tearing down a building, Martell says that LPC recycles the materials they can. Powering buildings via thermal and solar energy will help long-term operating costs. While there is an upfront cost to getting LEED or LEED-equivalent certifications, it is a cost they absorb because they value it. “We make up for that by showing investors that we are delivering a lower carbon footprint and meeting our goals – we provide our investors with a thorough audit of our ESG activities that measures the actual results to a pro forma. That’s what makes us more competitive, as opposed to just cutting costs to meet the return expectations.”