Backed by Healthy Demand, Industrial Developers In Texas Can Pace New Projects

The current industrial development landscape in Texas is a true testament to the awesome power of demand — and of interest rate hikes.

From El Paso to Houston, industrial users of all sizes and across all industries continue to demand new or expanded spaces to accommodate their ever-growing warehousing, distribution and manufacturing needs. E-commerce, nearshoring, COVID-19 — name your impetus — they’ve all contributed to a feverish pace of industrial development and absorption in recent years.

According to fourth-quarter 2022 data from CBRE, Dallas-Fort Worth (DFW) saw an annual supply gain of about 36.1 million square feet in 2022 while posting positive net absorption of 36.5 million square feet. Third-party logistics users drove much of the new leasing activity, which contributed to a 4.6 percent vacancy rate at the end of the year. The market has now posted consecutive years of sub-5-percent vacancy. Fittingly, there remains more than 75 million square feet of product under construction throughout the metroplex.

In Houston, developers delivered approximately 18.8 million square feet of new industrial space in 2022, per CBRE. Yet the market posted more than 30 million square feet of positive absorption over the course of last year, and the industrial vacancy rate shrunk by 130 basis points to 3.8 percent. Some 33.5 million square feet of space is currently under construction to alleviate this tightening of the market.

In terms of tenant demand, these dynamics are nothing new, and they are starting to demonstrate some serious staying power — and not just in the state’s marquee markets.

“Over the last year there has been a tremendous amount of speculative industrial development in El Paso, and regardless of the cost of capital, whatever comes out of the ground seems to be leasing,” says Doug Derrick, managing broker at NAI El Paso. “Lease Rates have almost doubled during this time, and the average lease size is much bigger too. Demand certainly exceeds supply in this market, largely due to it being a gateway to Mexico, and we expect this to continue for the foreseeable future.”

But the barriers to supply growth, which have largely shifted from matters of global supply chain disruption to concerns over national economic volatility, continue to be as obstinate as they are diverse. For example, in El Paso, Derrick says that the biggest obstacle to adding much-needed supply does not involve interest rates or access to materials, but rather and availability.

But regardless the market, the element of time is always a concern. And until about a year ago, developers were generally incentivized to acquire land, secure permits and approvals and deliver new projects as quickly as possible to meet demand.

Now, however, some developers are seeing the upshot of taking their feet off the gas, even as robust requests for space keep vacancies low and rates of rent growth strong. Voluntarily slowing down new development in such an environment not only requires restrained discipline on the part of developers, but also unshakeable faith in long-term tenant demand.

“Around this time last year in DFW, we had more than 100 active developers in the market,” says Liam Logan, director of investments at Core5 Industrial Partners, an Atlanta-based developer that is active throughout Texas. “Today, there are about 15 that are still actively buying dirt and moving forward with speculative projects.”

“We have seen a thinning out, particularly among merchant builders, in the competition for dirt,” concurs Kent Newsom, executive vice president at Chicago-based Logistics Property Co. who oversees regional development in Texas. “But we’ve also had a lot of new developers enter the DFW market in recent years. Those that are backed by long-term, programmatic capital are winning the day, because as land prices come down, sellers are looking more carefully at who has the financials and track record to close.”

Even prior to the inflation-induced rate hikes, many developers opted to buy land with cash or equity rather than take on additional debt. Newsom believes this that approach will only become more commonplace until rate cuts are enacted at a meaningful pace and magnitude.

Why Time is Valuable

Like virtually everything else in the 2023 world of commercial development, investment, lending and leasing, these self-imposed slowdowns can largely be traced to interest rate movement.

The Federal Reserve’s eight interest rate hikes totaling 450 basis points over the past 12 months are bona fide gamechangers that are reining in general business activity as a means of lowering inflation. At the most basic level, the nation’s central bank wants to discourage commercial borrowing, or at least force businesses to delay and defer those decisions. Less money in circulation deflates the dollar and increases consumers’ purchasing power. All of those initiatives require time to come to fruition.

Within the more specific context of industrial development, the muted business activity takes different forms. Some developers, particularly those that target high-demand infill locations, have simply hit pause on acquisitions of new tracts. Others are walking away from land deals in which sellers are not motivated to sell in an environment wherein prices are slipping.

Some merchant developers are waiting to close on their land and construction loans until they better understand the Fed’s plans, as interest rate volatility complicates their ability to accurately underwrite exit cap rates for would-be buyers.

“Because interest rates are rising, exit cap rates are uncertain, and as investors and developers look at projects, it’s tough to green-light something when you don’t know what you can sell it for,” explains Sam Owen, managing director and partner at the Austin office of Stream Realty Partners. “So the math equation behind new development is somewhat broken; there’s too much uncertainty to be able to get projects approved right now.”

“We’ve seen a lot of capital go to the sidelines and cease to be aggressive on industrial deals, mainly because there’s uncertainty about values and what constitutes a good investment,” adds Chad Parrish, managing director at Houstonbased Alliance Industrial.

“We’ve also seen land fall out of contract in every market we’re in,” Parrish continues. “In a lot of cases, land sellers are still clinging to the prices and cap rates of the past and have been slow to adjust to the new market realities. There’s a finite number of landowners that are motivated at lower values, and that creates a pause in the market. In addition, bid-ask spreads between what developers can pay and what sellers are asking are very wide right now.”

Time has a way of providing land sellers, developers and long-term investors alike with the data and clarity that they need to feel more comfortable engaging in those deals.

“We had a few land positions that were under contract prior to rate hikes that we’ve since tried to put back in the box,” says Newsom, whose firm prefers to hold assets for the long haul rather than sell upon stabilization. “Some landowners are waiting it out, and some have more time to wait than others. But we are beginning to see some reality checks as land prices come down — it’s just that some landowners aren’t willing to accept that yet.”

But until enough time has lapsed, the market faces a logic-defying scenario. Developers generally want to be aggressive as possible when robust demand is keeping vacancy low and rent growth strong. The latter parts of that dynamic appear firmly entrenched in Texas, but the interest rate movement has been drastic enough to offset some of the positive momentum. And though it’s generally very risky to try to time any f inancial market, some developers are comfortable with finagling their timetables as a means of hedging against greater economic risk.

“In terms of land sales, it’s tough for all developers to pencil deals. We’re trying to give sellers the price they want, but also extending under-contract timelines to allow ourselves enough time to get through permitting and entitlements,” says Logan. “It’s a matter of trying to stretch the traditional 90- to 120-day window in which land buyers conduct their due diligence into 180 to 240 days.”

“It's taking longer to get through entitlements or permitting these days, so extending our due diligence timelines and closing upon receipt of necessary approvals helps in two ways,” Logan continues. “Specifically, that approach buys us a little more time to get through entitlements and to see if the debt markets calm.”

Core5’s latest project in Texas is a 1.8 million-square-foot development in Schertz, a northeastern suburb of San Antonio, that the firm is building in partnership with California-based MBK Industrial Properties. Construction began in late 2022, just before the Fed’s mid-December meeting, which delivered a 50-basis-point increase to the federal funds rate.

Todd Marchesani, partner at Dallas-based Box Investment Group, ascribes even greater legitimacy to the notion that having extra time to close on land and secure approvals is critically important in this market. In fact, in his view, being granted additional time to close on land might even be more valuable than successfully negotiating down the price. Of course, the bigger the site, the less financially feasible that approach becomes.

“At least for sites we target, which tend to be five- to 15-acre infill locations, the land component is such a small piece of the overall development budget that chasing a price reduction from the landowner doesn’t move the needle much,” says Marchesani. “We’d rather ask for time, which is an advantage when it comes to securing entitlements.”

“It’s nice to be able to close on your land with your building permits in hand so you can lock those costs into your budget and have more confidence in your underwriting when you approach debt and equity sources,” Marchesani continues. “To have the time to update your drawings, deal with feedback from municipalities, lock in your permits and construction financing — all while closing on your land — that eliminates risk in this environment.”

Box Investment Group’s latest project is M380 Business Park, a 156,090-square-foot development in Denton. The project will comprise four shallow-bay buildings that are designed for tenants with smaller requirements. The firm is also underway on Skyway Logistics Center, an 84,406-square-foot project in Irving.

Looking Ahead

Despite headwinds facing new development, there is still a healthy volume of new supply in the development pipeline. According to CBRE’s data, across the four largest markets in Texas, there was approximately 130 million square feet of space under construction. This should not be surprising, because with the exception of Austin (5.9 percent), each of the Big Four closed 2022 with a sub-4-percent vacancy rate.

Further, with DFW, Houston, Austin and San Antonio all clearly exhibiting the ability to absorb new supply as quickly as it’s delivered, developers can reasonably expect to see more healthy rent growth in the first half of 2023. But following the completion of those projects, the ensuing phase of the development cycle should bring a reduction in new deliveries.

The question of when that occurs will be a function of what moves the Fed makes. The uncertainty of it all underscores the crucial role that time plays in successfully executing these ventures.

“We’re optimistic about projects that are in progress or actually on the ground, because we know there will be a blip in supply at some point. That creates opportunities to push rents for a period of time,” explains Newsom. “We want to close on our land and get our approvals in the coming months and start construction at the end of the year, when things have presumably lightened up. If we can bring that product online 18 to 24 months from now, we think we’ll be hitting a sweet spot in the market.”

“There’s a lot of product planned out there now, but given the difficulty of getting debt and the difficulty that municipalities present, the market could become very tight in the near future,” concurs Owen. “Even with a healthy development pipeline, we could see this scenario come to fruition just because a lot of people are hitting pause and land values haven’t come down yet much.”

The development community agrees that a slowdown in supply growth is seemingly inevitable. However, that doesn’t mean they’re underwriting excessive rent growth in subsequent years for projects that are being green-lit today.

"Since COVID, we have seen doubledigit annual rent growth in shallow-bay industrial warehouse space. And while we believe strong rent growth will continue, we also expect it to moderate to 5 to 8 percent annually, which is still above historical norms,” says Marchesani. “That said, prudent underwriting would entail utilizing today’s rents on an un-trended basis for projects that won’t break ground and lease up until later this year.”

Generally speaking, industrial owners in Texas have been on the receiving end of record paces of rent growth in recent years. And all sources interviewed for this piece expressed unshakeable faith in the state’s blistering levels of job and population growth as indicators of long-term success.

Even so, the market contains cautionary tales of owners that successfully underwrote trended rents without taking into account the impacts that interest rate hikes could have on cap rates.

“As for developers acquired land at a high basis before interest rate hikes, deals that penciled then may not even come close to working in this environment,” says Logan. “We are seeing several sites fall out of contract or come back to market. We tend to underwrite conservatively, whether it’s with regard to lease-up timelines, achievable rental rates, exit caps rates and construction costs, to give ourselves enough breathing room in times like this when markets are not working in our favor.”

In Conclusion

Both merchant builders and developers that hold for the long term can find advantages in this market. Since the former plans for quick exits, those developers don’t require long-term fi nancing that is sensitive to all the interest rate movement of the past 12 months.

“With value-add development, the carry time frames are typically shorter, so we’re less likely to be locked into a long-term debt structure in which our interest rate is higher than the yield,” explains Parrish. “The construction fi nancing is capitalized into the project budget, so we’re not as sensitive to negative leverage in the short-term. However, the ultimate buyers are sensitive to negative leverage, so we monitor that metric as it impacts valuations on the exit.”

Negative leverage occurs when the all-in interest rate exceeds the cap rate at which the asset was purchased. Industrial developers that hold their properties for lengthier terms after stabilizing them are currently at greater risk of finding themselves in this scenario.

But the healthy tenant demand that is backed by levels of job and economic growth that continue to outpace national averages, even as the U.S. economy wobbles, means that investors buying at negative leverage can likely get into the black within a year or two. Even if they’re conservatively underwriting rent growth, the dip in supply that is clearly forming in the future should provide an added boost to cash fl ows. With a little luck, the strongest upticks in rent growth may coincide with the slashing of interest rates.

“Any investor with a longer-term business plan is probably in a better position than one who’s trying to time the market,” says Owen. “It’s hard to say what’s going to happen in the next 12 months, but we continue to see people moving and businesses expanding in Austin and throughout Texas, so this should be a more dynamic metro area in the next fi ve to 10 years. So if that’s your investment horizon, you’ve got more flexibility.”