Industrial Development, Leasing Trend Smaller Throughout Northeast Markets

by Taylor Williams

Sometimes smaller is better. 

“Sometimes” is of course the operative term in that controversial and wholly non-salacious statement. But in the context of industrial real estate, it’s becoming increasingly clear that at this point in the cycle, smaller buildings make more sense for developers to deliver as e-commerce and distribution users actively consolidate their footprints. 

“Most leases in New Jersey and Pennsylvania over the last 12 months were for less than 500,000 square feet, with 50,000 to 200,000 square feet being the ‘sweet spot,’ for leasing,” says Anthony Amadeo, executive vice president at New Jersey-based developer Woodmont Industrial Partners. “There is strong demand [for that product type], but other developers are now building it too, so we’re going to see some elevated competition in that space.”

This activity is occurring across the country in varying degrees. But in markets like New Jersey and Eastern Pennsylvania, where sites that can support large-scale developments are extremely scarce and entitlement and permitting processes tend to be long and arduous, the trend is perhaps even more pronounced. Yet those longstanding characteristics of the Garden State and Lehigh Valley industrial markets are only partial reasons as to why new developments and deals are effectively downsizing. 

The Obvious Cause

As with literally every commercial real estate decision or action over the past 18 months, interest rates play a part in shaping industrial development and leasing patterns.

Larger projects require greater quantities of land, materials and labor, necessitating higher amounts of financing for these inputs. More debt at higher rates hurts bottom lines no matter how you slice it. And despite coming down from the massive high of 2021 and early 2022, the industrial sector retains healthy fundamentals, and lenders are not shunning those deals. They’re merely shuffling and redirecting the flow of funds within them.  

“In addition to New Jersey simply not having large infill sites that can accommodate buildings of 750,000 square feet or more, the ‘sweet spot’ in the debt markets right now is about $20 million to $50 million,” says Clark Machemer, senior managing director at Crow Holdings. “That’s simply not enough [money] to build a 1 million-square-foot building.”

“That’s not to say that 1 million-square-foot buildings won’t get capitalized in submarkets where there is tenant demand and limited supply,” Machemer continues. “But overall, the pool of lenders is a lot thinner for
larger-size projects.”

Crow Holdings recently completed a 207,000-square-foot project in the Northern New Jersey community of Elmwood Park. The facility is a redevelopment of the former Marcal Paper Factory, which was destroyed by fire in early 2019. Following remediation of the site and securing of new permits and approvals, Crow was ready to start the redevelopment by summer 2022, just as the Federal Reserve’s campaign of interest rate hikes was taking off. 

Over the ensuing 12 to 18 months, speculation and uncertainty surrounding the nation’s monetary policy and war on inflation would cause values of many industrial development sites to crater and many new deals and projects to be put on hold. And although the industry is still eagerly awaiting the first of the Fed’s “promised” rate cuts for 2024, the target range for the federal funds rate has now held steady for nearly nine months. 

Late July 2023 was the last time the nation’s central bank raised rates — by 25 basis points — to their current level of 5.25 to 5.5 percent. At its latest meeting on March 20, the Fed signaled that a total of 75 basis points would ultimately be trimmed from the benchmark rate by year’s end. 

Better High Than Unknown

Sources say that although interest rates remain high relative to recent years, the fact that they have at least stabilized at their current range has helped the development and leasing markets regain and build momentum. 

“Today, because the federal funds rate has actually stayed at its current range for a period of time, the market is benefitting from consistency,” explains Tom Golarz, senior vice president at Colliers’ Philadelphia office. “When the Fed is raising interest rates with no clue how high or how long they’ll go, that really pumps the brakes on new development and leasing.”

David Greek, managing partner at New Jersey-based developer Greek Real Estate Partners, says his firm is erring on the side of caution when it comes to pricing in rate cuts for 2024 deals and opportunities. And while the company generally expects a “higher for longer” environment for the immediate future, that mindset still reflects new thinking. 

“There’s been a shift in focus from looking at the downside of continuing interest rate hikes, where we were a year ago, to more optimism today, knowing that rate hikes are generally over and cuts are coming,” explains Greek.

Being able to assign a known value to interest expense goes a long way in successfully underwriting a deal in this market. 

“Underwriting has stabilized; before you were trying to forecast what your interest rate would be, which was difficult,” says Machemer. “Once the interest rate stabilizes, it’s just another line item in your budget. And if [that expense] was more than before, it was factored into the land purchase.”

“There’s a little more consensus that the Fed will lower rates this year; it’s just a question of when,” adds Amadeo. “Groups are raising money on the sidelines and are eager to get back into the market. We’re getting calls from groups we’ve worked with in the past to discuss opportunities, whereas at this time last year, it was clear that people were waiting.”

In mid-2023, Woodmont delivered a 55,000-square-foot building in the Northern New Jersey community of Woodbridge. Amadeo says that the company was able to achieve a “high water mark” of more than $20 per square foot on rent with the eventual tenant. 

More Nuanced Causes

In a broader sense, the shifting preference to smaller deals and projects by lenders, investors and developers embodies a natural reaction to macroeconomic disruption: diversification. 

For some companies, it may all have started with Amazon’s widely publicized announcement that it was scaling back development of its poster-child mega-facilities. When the Seattle-based e-commerce giant makes a move, it almost always has major ripple effects  throughout the world of industrial development and leasing, but for all companies, on some level the move to go smaller stems from activity in the capital markets.

Last fall, Greek Real Estate delivered Langhorne Logistics Center, a 210,564-square-foot project located about 25 miles northeast of Philadelphia. The company noted at the time that there was relatively little competition in that submarket for buildings of that size — another competitive advantage and exploitation of a natural barrier to entry.

Since then, the firm has inked two new leases at other properties that illustrate the new “sweet spot” in leasing. These include a 197,000-square-foot deal with Fabuwood Cabinetry at Linden Logistics Center in Northern New Jersey and a 117,000-square-foot deal with Aramsco, a distributor of disaster recovery supplies, at the 3.2 million-square-foot Logan North development in Southern New Jersey. 

 Greek offers some plausible explanations behind why smaller buildings have seen more demand and healthier rent growth in recent months.

“The tenants that occupy those [smaller] spaces are usually not big credit companies — they skew more local than national or international,” he explains. “That makes those companies slightly less sensitive to international credit markets and interest rate movement and the impacts on debt service coverage because they might not even have access to those markets given their size.”

Greek concedes that the market could see some larger deals — 500,000 square feet or more — in the second half of the year. This is simply a factor of the basic economic need that e-commerce and distribution users have to invest in their supply chain networks.

Golarz notes that at least in Southern New Jersey, the framework to allow for greater proliferation of small deals and projects has long been in place. 

“While there has recently been a concentration of smaller-format deals between 200,000 to 500,000 square feet that have landed or are in the market, greater Philadelphia and Southern New Jersey have historically been smaller markets in terms of deal size,” he says. “That’s because very little bulk product has been delivered, so those 1 million-square-foot opportunities didn’t exist until recently in that area.”

Another semi-complex reason that large-scale deals have never been the norm in the region centers on the fact that many New Jersey industrial properties are backed by institutional capital. In addition to being less sensitive to macroeconomic fluctuations, those debt and equity providers behind the seven-figure projects prefer that they be occupied by a single user. 

“A lot of institutional developers don’t want to divide large-format buildings because they’re so unique in the marketplace, and they want to preserve those for the period in which they see demand for large-format spaces and users in the market,” explains Golarz. “That gives those owners an advantage in knowing that they’re one of the only options at that size.”

Not to mention, dealing with a single tenant and avoiding a demise of space is a cleaner, financially leaner way to operate — if you can get away with it. But many owners have no choice but to meet the market, which at present means providing smaller, turnkey spaces, regardless of whether they’re standalone or subdivided. 

Lastly, there is the reality that over the last two years, the market has moved on from a state of frenzied demand and explosive rent growth that simply wasn’t sustainable. Interest rate hikes have facilitated that comedown, and it’s not all bad. 

“In 2021, owners were saying, ‘maybe I don’t want to get a tenant and prelease the building because in six months, the rent will be up another 10 percent,’” reflects Machemer. “People were a little reluctant to do deals in that situation for fear of missing out on an upward-trending market. But when you hear that, there’s reason to be concerned about where the market is.”

“The rent growth in 2021-2022 really wasn’t sustainable,” concludes Golarz. “It was a period in which demand for space was so strong that occupiers were doing things that were contrary to how they normally obtain new space or even renew existing space. Demand was such that if you didn’t take that building, somebody else would. Today, we have some vacancy, and that allows tenants to grow within a market and to have some natural movement and for new tenants to enter and facilitate growth.”

Office: The Next Frontier?

All sources interviewed for this story agree that New Jersey and Eastern Pennsylvania possess opportunities to add new industrial supply through office conversions. 

Whereas media speculation about the fate of obsolete office buildings usually takes a residential bent, some real estate professionals see equally strong opportunities for these sites to function as distribution hubs. In some cases, it’s simply the location that makes this feasible; in others it’s the column spacing or parking allotments. 

But in either case, the opportunity is undeniably there. And earlier this year, when a joint venture between institutional investment firm Ares Management and New York City-based real estate giant RXR launched a $1 billion fund to target distressed office assets, the trend was further validated. In fact, for some companies, it was ongoing long before that. 

Last year, Woodmont received approvals to redevelop a 351,782-square-foot office building in the Northern New Jersey community of Somerset into a two-building, 426,000-square-foot industrial complex. The firm, in partnership with Denver-based EverWest Real Estate Investors, paid $42 million for the building and land in fall 2021, believing that the location was valuable enough to justify the conversion. 

“You really have to get creative when it comes to repurposing these older assets in terms of tearing down buildings, dealing with environmental issues and [working with] older product that doesn’t meet market needs anymore,” says Amadeo. “But the land is so valuable in those markets that if you have a willing seller and can get the site at a slight discount, you can make the numbers work.”

Woodmont undertook a less-intensive office-to-industrial project in The Meadowlands, executing a gut renovation of a 30,000-square-foot building as opposed to a total demolition and rebuild. Still, the capital outlay was extensive due to the addition of new dock doors and office space and repaving parking lots, as well as basic repositioning measures like upgrading lighting, interiors and utility systems.

Greek notes that, as critics of the office-to-residential discussion often point out, the majority of obsolete office buildings lack true conversion potential. But owners of those buildings that do check the boxes and are struggling to secure rent and occupancy would be wise to consider offers from industrial players.

“Most office product doesn’t make sense for industrial redevelopment, but some does —maybe 15 percent,” says Greek. “That’s an opportunity we’re watching closely due to the amount of distress and how well-located a lot of these buildings are for distribution uses.”

This article originally appeared in the March/April 2024 issue of Northeast Real Estate Business magazine.

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