It could be said that most industrial buildings, unavoidably, have some degree of functional obsolescence. So, why should that be such a source of concern to industrial property owners? It really comes down to the degree to which use becomes limited.
Last week on the blog we spoke plainly about the possibility of an industrial market correction in Southern California. Property values have risen to more than double the previous peak of 2007 and one of the primary drivers of that price run-up, low mortgage rates, has shifted dramatically in recent months.
The SBA 504 rate, the most popular mortgage option for owner/user acquisitions, has more than doubled in 18 months and just moved above 5% last week. We think the double whammy of high prices and more expensive mortgage money may be enough to send the market in another direction soon.
With that possibility in mind, we are particularly concerned for those of our clients who own older properties with elements of functional obsolescence, as their properties are likely to see steeper value declines if a correction did occur.
That fact reminded us that we wrote on the topic a couple of years ago in a post that we believe is even more on target today than it was then. Here’s what we had to say:
The Perils of Functional Obsolescence
Industrial buildings with elements of functional obsolescence can create a variety of difficulties for their owners. In this post we take a critical look at this important aspect of ownership.
Before we do that, let’s define it in the simplest of terms. According to Investopedia, functional obsolescence is a reduction in the usefulness or desirability of an object (in our case, an industrial building) because of an outdated design feature, usually one that cannot be easily changed.
When applying this definition to the obsolescence of industrial buildings, we generally refer to things like ceiling height, parking ratio, column spacing, turning radius, loading doors, lot size, yard area, type of construction and other physical componentry. The combination of physical characteristics within the existing building inventory varies widely, and each property’s mix of size, age, shape, location, stand-alone or common wall configuration, creates its own degree of functional obsolescence depending who uses it.
Ceiling height is a good example, as it is critical to distributors, but not to most manufacturing or assembly operations. Companies like Amazon combine ceiling heights of more than 30’ with sophisticated racking systems to maximize their space utilization, while machining operations making precision parts for Boeing or Lockheed Martin, can probably function efficiently with 15’ foot ceilings. So, a 200,000 square foot, 24’ clear-height distribution building in the Inland Empire is functionally obsolete because the overwhelming majority of users looking in the area are bulk distribution users. A similar building located in Anaheim could be divided into smaller spaces and leased to local suppliers, last mile delivery operators or manufacturers who don’t require high-pile storage capability.
Thus, it could be said that most industrial buildings, unavoidably, have some degree of functional obsolescence depending on who uses them. So, why should that be such a source of concern to industrial property owners? It really comes down to the degree to which use becomes limited. A 70’s era building with 14’ ceiling height, no fire sprinkler system, ground-level loading and low parking ratio is a good example of extreme functional obsolescence. Unfortunately, there are too many buildings that fit that description, and the lack of new construction in this real estate up-cycle means that the problem of functional obsolescence worsens every day.
For obvious reasons, rents and sales prices for buildings with significant elements of functional obsolescence trail those of their more functional counterparts. They offer less “bang for the buck” and they attract a narrower band of industrial users. The market for the most functional buildings is wider and deeper, and that creates greater competition amongst potential occupants for each building that comes to the market. Greater demand facing limited supply keeps upward pressure on price.
In today’s market, less than 2% of the total inventory is available at any given time. That means that users have to compete fiercely for quality space and are even forced to pay a premium for functionally obsolete facilities just to have a roof over their heads. So, scarcity is benefiting all property owners through higher monthly rents and record-high sales prices, but more so for owners of functionally obsolete buildings with shortcomings that tend to be overlooked for lack of suitable alternatives.
The real problem for owners of obsolete facilities comes during a market correction and the initial stages of recovery. When a market enters a correction phase, the availability of highly functional buildings increases and lease rates and sales prices begin to decline. Owners of obsolete facilities, already facing a narrower user base, must lower prices in even larger increments to get their properties leased or sold before their more functional counterparts.
Currently, the industrial market remains in an up-cycle, but there are increasing concerns that the recovery is losing momentum for a variety of reasons including a spike in mortgage interest rates, sluggish economic growth and concerns over expanding asset bubbles, especially in the equities markets. None of us knows what the future holds, but history has a tendency to repeat itself, and to deny the inevitability of the real estate cycle is unwise. It is more a matter of when rather than if a correction will eventually occur.
For those owners of properties with significant elements of functional obsolescence, we recommend an immediate and thorough review of your strategy for those assets. If your plans call for a disposition in the next few years, it may be wise to sell sooner rather than later to take advantage of current demand and pricing dynamics. If your plans are to hold for the long term, look for creditworthy tenants from industries that tend to be less affected during economic downturns. Be willing to negotiate aggressively on price and terms to secure them as your tenants, as grappling with vacancy during a down cycle will be more difficult for you than for owners of more functional product.
Waiting for a clear sign that this market cycle has peaked before taking action is dangerous for all property owners, but especially so for owners of functionally obsolete buildings. Selling now virtually assures industrial property owners of a record-high price. Any other strategy is far less certain.