There has been much talk over the past 12 months about the return of speculative development, or more affectionately referred to as “Spec Building”.
We commonly break down commercial development into three basic categories; office, retail, and industrial. Each is unique in its own way, and has behaved differently as we have entered into the economic recovery cycle from the Great Recession of 2008 – 2010. Although many of us feel that we may have finally turned the corner and are looking toward improving overall commercial real estate market conditions, we still have quite a long road ahead of us, and certain categories are progressing better than others.
Let’s be honest, the Midwest commercial real estate sector got hammered during the Great Recession, with declining values and stagnant lease rates. All during this time, new construction costs have continued a steady increase, primarily related to increased costs of construction materials. For example, over the past 10 years (2004 – 2014), prices for all construction materials have increased 40%. This leads us to the basic conundrum. Since construction and development costs are the primary factor in determining lease rates for new speculative development, we find ourselves in a situation where these costs result in a required base rent range which is significantly higher than current market rents for existing and comparable space. This situation is relevant and prevalent in all three basic categories. When will it get better, you ask? Good question. Much of it depends on annual absorption rates and supply/demand. As occupancies increase and vacancies decrease, it is logical that lease rates should start to increase. The extent and velocity of this process is yet to be seen, particularly in the office and retail categories, where the markets are recovering, albeit very slowly.
The particularly interesting category to watch will be industrial, where demand and absorption rates are starting to pick up some pace, and certain sizes of industrial product are becoming increasingly difficult to find. In the past, a significant drop in vacancy and increased demand was usually the trigger for speculative industrial development, however, this has not yet occurred on a widespread basis. There are likely a couple good reasons. First and foremost, we have yet to see any tangible increases in industrial lease rates. This increase would start to close the gap between existing lease rates and lease rates for new development, and give developers (and financial institutions) the much needed fundamentals and confidence to support new speculative development.
Currently, lease rates for existing industrial space range from $1.50/SF - $3.00/SF NNN. Conversely, lease rates for new industrial spec buildings range from $3.50/SF - $6.00/SF NNN. Unfortunately, the few (and the brave) industrial developers who were gutsy enough to try to be the first horse out of the gate and build spec industrial buildings in the last year or so have found limited success in attracting tenants to lease their new buildings at the higher than market rates. As other developers watch this from the sidelines, most seem likely to sit on their plans and sit tight, and await the tangible signs of increasing lease rates, and closure to the gap.
At what pace all this occurs, and when we reach the tipping points, is anyone’s guess.