The more things change, the more they stay the same.
More than 150 years after the old French proverb was coined, industrial real estate professionals in Texas who have a penchant for philosophy may well be seeing its application play out in real time.
While the industrial market has cooled from 2021 and early 2022, when insatiable demand drove record rent growth, there are still enough positive fundamentals within the space to counteract the likes of inflation, interest rate hikes and geopolitical uncertainty during an election year. Against that backdrop, owners and brokers are frequently reminded of how fortunate they are to be doing business in the Lone Star State.
Muchos Gracias
Job and population growth are the Letterman guests who need no introduction, as they have always driven expansion and value creation in Texas across all sects of commercial real estate.
But as powerful as those drivers are, they’ve been there all along. In recent years, as disruption in debt markets has slowed industrial supply growth and inflation has put pressure on tenants’ costs of occupancy, other macro-level forces have also emerged to buoy the market. Specifically, the impacts of a growing concentration of manufacturing operations in Mexico have been especially beneficial to the state’s industrial demand and absorption.
“The onshoring of manufacturing is real and is driving growth in our market simply because we’re on Mexico’s front doorstep,” says Conrad Madsen, SIOR, co-founder and partner at Dallas-based brokerage firm Paladin Partners. “The movement of manufacturing operations from China to Mexico is massively in the works, so all of those finished and raw goods that are going to Texas border towns are coming to [Dallas-Fort Worth] distribution centers and on to their final customers.”
“The biggest winner in the reconfiguration of global supply chains over the past couple years has been Mexico,” adds Charlie Meyer, president of Houston-based developer Lovett Industrial. “The industrial market in Mexico is as tight as it’s ever been historically, and the United States is now importing more goods from Mexico than China. Texas led the country in absorption of industrial space in 2023, and a lot of that activity stemmed from manufacturing growth in Mexico and the increase in imports into Texas.”
Madsen points out that — like e-commerce — the onshoring of manufacturing operations represents a growth
factor that was very much in its infancy during the last market downturn in 2009. Yet those trends have exploded over the last decade, all while Texas has continued to organically attract jobs and people from other states.
“Those factors should keep the industrial sector healthy despite the concerns of overbuilding that occurred until [interest rates began to rise] a couple years ago,” he concludes.
In exploring the exodus from China and into Mexico, a 2023 Forbes article cited a range of factors: China’s tendency to steal and pirate intellectual property, social pushback on the domestic front against the country’s notorious labor practices and the potential for conflict with U.S. protectorate Taiwan. The article astutely noted that “breaking up [with China] is hard to do,” and conceded that Mexico has some issues of its own, but generally assumed an optimistic tone that the shift was legitimate.
CBRE has also explored the subject. A late 2023 report from the Dallas-based real estate giant found that the total volume of trade between Mexico and Texas was valued at $285.6 billion in 2022, up from $231.4 billion in 2021, before tapering to $252.6 billion year-to-date in November 2023. The report also states that the annualized trade between Texas and the country that once ruled it exceeds the value and volume of the United States’ entire trade with the United Kingdom, Spain and Brazil combined.
Cliff Booth, founder and CEO of Westmount Realty Capital, believes that the basic fundamentals that underlie industrial real estate in the United States — and Texas — are powerful enough to keep one group particularly entranced: foreign investors.
More than a dozen foreign countries are represented within the Dallas-based development and investment firm’s slate of investors. Booth says that while these capital sources do have geopolitical concerns about what’s happening stateside, basic financial prudence has them committed to U.S. markets — regardless of what happens this November.
“The larger story that we continually hear from foreign investors is that no matter what happens with the [presidential] election, it’s only four years, and America still has the demographics, growth, legal structure and economy that have held up in this interest rate environment and in the aftermath of COVID,” he says. “They simply can’t get the same returns anywhere else due to our demographics and growth.”
Booth agrees that even within that framework of preferring U.S. markets and assets, Texas holds a special place — but concedes that it hasn’t always been that way.
“We used to go to New York and talk to capital sources, and there was always somebody in the room or on the investment committee who got burned on a deal in Texas,” he recalls. “Now, everybody wants to do deals here. There is some short-term nervousness, but long-term, there’s nowhere else in the world that’s a more attractive place to invest.”
Structural Integrity
Drilling down even further to the realm of industrial assets in Texas, Booth identifies other macro-level factors that have helped position the sector favorably in the eyes of investors. They hinge on fundamental usage patterns and traditional debt structures, each of which has been responsible for distress in other asset classes.
“Industrial isn’t impaired operationally like office is, and you can’t lever up and borrow as much with industrial as you can with multifamily,” he explains. “With multifamily, there’s a lot more structure in the financing — preferred equity, mezzanine debt, agency debt — that has created stress [for that asset class]. There’s none of that in industrial.”
“While there is some distress in industrial in submarkets where too much product was delivered at the same time, nobody is panicking,” Booth adds. “And since a lot of these properties are backed by well-capitalized institutional groups, we really haven’t seen much distress selling.”
Meyer says that overall, his company feels better about where the debt markets stand today than at any point in the past 18 months, even if the Federal Reserve is taking its time in making good on its promises of rate cuts. The relative simplicity of financing industrial projects — at least at a certain size (see ‘Slimming Down’ section ahead) — has played into that sentiment, as have the sector’s doggedly strong fundamentals.
“We’re active in 15 markets, and the most robust lending pool is for projects in Texas compared to outside of the state,” Meyer says. “Texas seems to have a deeper pool of lenders that lend within the state, and a lot of the projects we’re doing outside of Texas are [being financed] with Texas-based lenders. Market dynamics in Texas are among the strongest in the country, which helps projects get financed here.”
Slimming Down
The 10-year story of industrial growth in DFW is beyond remarkable, and natural barriers to entry have sharpened in the aftermath.
Interest rates on hefty construction loans notwithstanding, there simply aren’t many infill sites left in the metroplex that can support the seven-figure facilities that became the poster children for industrial projects in the e-commerce era. As a result, the average sizes of both new buildings and deal requirements are both trending smaller. But that should not be viewed as a sign of the market softening, rather just recalibrating.
“In terms of where the capital markets are, lenders and investors are looking at smaller deals today,” says Bill Baumgardner, executive vice president of development at the Dallas office of Kansas City-based developer VanTrust Real Estate. “It’s easier for investment committees to support the purchase of two 500,000-square-foot buildings, or four 250,000-square-foot buildings, than a 1 million-square-foot building, because doing so lowers their risk profile.”
In Baumgardner’s estimation, there are about a dozen 1 million-square-foot industrial buildings in DFW that are currently vacant — down from 15 or 16 in late 2023. While many of these projects are receiving interest, until more leases on them are closed, lenders will be very reluctant to green-light projects of that size, he says.
Madsen identifies another reason why industrial developers that are targeting large-scale speculative projects are at a disadvantage in this market: They’re competing with build-to-suit deals. Landowners with sites that can support these massive, seven-figure facilities can be scarce to begin with. When developers approach these landowners, they may already be deep in negotiations with build-to-suit users who tend to have longer timelines for delivery for occupancy.
Madsen also says that the move toward smaller buildings supports the current nuances of tenant demand and how these users are thinking about their real estate situations.
“There’s a challenge right now in terms of smaller tenants being able to afford their spaces,” he explains. “Costs of doing business have gone up, and interest rates are only a small part of that. There are a lot of smaller users that signed deals in 2018 and 2019 that are now coming up for renewal, and their rates have gone up 40 or 50 percent. So a lot of these tenants are choosing to stay put rather than expand.”
Baumgardner echoes the notion that shrinking profit margins are partially responsible for tenants putting off expansion plans.
“In times like these, the CFO rules the roost. If the CFO says the company can’t expand with three 1 million-square-foot facilities because of where interest rates are and because the company needs to protect its capital, the company has to find a smaller facility,” he explains. “So that’s where some of these tenant decisions are stemming from.”
This trend represents a shift from the COVID era, when e-commerce and distribution users routinely took down more space than they needed in expectation of near-term expansion.
“Tenant demand has stabilized; for a couple years we had insatiable demand, but they’ve all looked at their situations and figured out how to right-size and make smaller facilities work,” says Baumgardner.
Office Conversion Potential
All sources interviewed for this story agree that there is some potential in DFW for older Class B office buildings to be converted into industrial facilities. In terms of preliminary steps, the biggest key is to find candidates in submarkets where industrial rents are high enough to cover the costs of rezoning, demolition and other redevelopment expenses.
Although the City of Houston has no zoning, which should theoretically simplify some of these office-to-industrial plays, Meyer says his firm hasn’t seen much opportunity yet in its hometown.
“The rents aren’t high enough in Houston to justify those plays right now, but the day is coming when they’ll make sense,” he explains. “But there are infill submarkets in Dallas where rents are twice as high as in Houston, and conversions are justified on those deals.”
Lovett Industrial has thus committed to such a project in the metroplex. Addison Innovation Center will transform the former 12-acre site of an office and call center complex on the northern outskirts of Dallas into a two-building, 242,000-square-foot industrial facility. Lovett is scraping the existing building in order to redevelop it into a 140,698-square-foot warehouse and also constructing a 101,364-square-foot warehouse from the ground-up on the site’s old parking lot. JLL recently arranged floating-rate construction financing for the project through First United Bank & Trust Co.
Baumgardner says that VanTrust has seen five or six such deals materialize in DFW since it became apparent that some office buildings had passed the point of saving. He cites the Las Colinas district in Irving as an area that is especially rife with office-to-industrial conversion potential.
“In Las Colinas, there are a lot of one- and two-story buildings there that had call centers and are now 30-year-old product, and there’s just really no way to make that product attractive [to users],” he says. “Las Colinas is part of the Great Southwest submarket near the airport, and that market has rents that can support these projects. The vacancy rate is probably about 3 percent; tenants want to be there and can’t find space, so doing a conversion in that area will likely get you the rents you need.”
As such, Orlando-based developer Foundry Commercial recently purchased 287,000-square-foot office building located at 4000 Horizon Way in Irving with plans to convert the property into an industrial facility. Foundry Commercial plans to reposition the property, which was built on 24.2 acres in 1999, into a three-building complex that totals roughly 337,000 square feet.
— This article originally appeared in the April 2024 issue of Texas Real Estate Business magazine.