iven the pace of change in business, seven years is a long time. It's long enough to have learned a few things, and now seems like the right time to take a look back at trends we observed and what we've learned since my colleagues and I started publishing our airport-area rental rate survey here in the spring of 2001.
If you are a regular reader of Air Cargo World, you know the year-end asking rental rates for office/warehouse space around the top air cargo airports in the United States. Along with the usual table showing 2007 data, this year we are also providing a graph showing the historical national average and an average of the averages over the seven-year period.
As for this year's survey, it should be no surprise, given the active economy, that the national average rental rate rose 4.6 percent to $6.65 per square foot this year from $6.36 last year. This continues the trend from the prior year's survey, when rates went up 3.6 percent from $6.14 to $6.36.
The national average now stands only eight cents per square foot from the high of $6.73 in 2001. An increase of about another 1 percent would do it.
As for the trends we've seen and lessons learned over the last seven years, here goes:
1. As the economy slowed down in 2001 and tenants pulled back, a significant overhang of bargain-priced sublease space developed in many markets with rates 20 to 50 percent below market, and it took 18 to 24 months for this space to be absorbed. The office market generally was more affected than the industrial market.
2. Most markets near airports had started to recover and some new development had gotten underway by 2004 to 2005.
3. Expenses - property taxes and insurance, common area maintenance, common area utilities, and building repairs - now commonly comprise 10 to 25 percent of total rent-related expenses. Tenant-specific utility costs have not been included in the survey because of the variation in tenant hours of operation.
4. As more properties have come under the ownership of institutional owners, leases have become more net-focused in recent years, meaning owners are passing more building-related expenses through to tenants than they once did. Landlords once absorbed the cost of items such as management fees and roof and parking lot repair costs. But these costs are now frequently paid initially by landlords only to be reimbursed later by tenants. The consequence is budgeting for total rental costs has become more difficult for tenants.
5. Landlords usually prefer to offer free rent - with the free months added to the end of the lease term - instead of simply discounting the face rate in the lease. This is mainly because properties are evaluated on a capitalization or cap rate basis by investors. The cap rate is the net income divided by the purchase price. If a hypothetical property has an overall net rental rate of $6.50 per square foot and an investor wants a 6.5 percent return, the investor would be willing to pay $100 per square foot for that property ($6.50/0.065). Discounting the $6.50 rental rate by 5 percent to $6.18 at the same cap rate would reduce the value from $100 per square foot to $95, and most investors would rather offer free rent and take the short term hit to cash flow rather than harm the value by discounting the face rate. Fortunately, most tenants agree with this approach because the free rent helps them offset moving costs.
6. Even as rates have fallen, stagnated, or grown very slowly, real estate values have increased dramatically as cap rates for quality properties have fallen from the 9 to 10 percent range in the early part of the decade to 5 to 6 percent today. Consider the impact on value for the hypothetical property described above that is leased at $6.50 per square foot. At a 9.5 percent cap rate this property a few years ago would have been valued at around $68 per square foot. At a 5.5 percent cap rate this same property today would now be worth around $118 per square foot. This drop in cap rates resulted from the bidding up of prices by both investors and owner-occupants who started fleeing the stock market starting around 2001-2002. Many say there are signs values now have peaked.
7. The overall cost to develop new buildings has gone up significantly because of increases in cost of building materials and a shortage of well-located developable sites. The time required to deliver these buildings has also increased in most locales because of tighter regulations on development.
8. For tenants there is almost always a tradeoff between getting space on their schedule, on their economic terms, or getting the build-out they want. The old saying is true: Give it to me fast. Give it to me cheap. Give it to me right. Pick two.
9. Tenants have more negotiating leverage when they have more choices, and they have more choices when they have more time.
10. Among the cities we survey, New York, San Francisco, Boston and Los Angeles are consistently the most expensive. These mature coastal cities have in common locations that offer multi-modal transportation options. Houston, Philadelphia, Newark, Miami, Seattle, and Oakland also offer similar alternatives to airport access, but generally at lower rental costs.
To these lessons learned from past surveys, I have to add a new item from a recent challenge faced by one of my clients.
Lesson 11 might be stated simply, in a dynamic business environment flexibility matters. My client is a very successful local transportation company owned by one of the most customer-focused people I have ever met. This company recently got a new account that required them to almost triple the size of their facility, and they continue to be given opportunities to grow because their existing customers give them a shot at larger and larger portions of the customer's distribution business.
Because of his success at gaining the confidence of customers, my client was looking for short-term, off-site warehouse space. One landlord who had a particular space vacant for several months said no thanks when we asked for flexibility on the length of the lease term. Another landlord said sure. Undoubtedly, my client will soon get a permanent commitment from his own customer, which will lead to a permanent commitment for the new space.
Which landlord do you suppose will get his business? Remember, lesson #11: in a dynamic business environment flexibility matters.
Ed Riggins is executive vice president in the Atlanta office of CRESA Partners, an international real estate advisory firm. He can be reached at eriggins@cresapartners.com
