Stacking Revenue
The warehouse real estate market is developing actively. However, not all projects announced by developers have been realized subsequently. What are the main difficulties in developing warehouse premises?
Firstly, specialists refer to the growth in construction costs, by 25–40% on average. “The main factors that influence pricing are the cost of land, connection to the power grid and cabling/piping infrastructure, and the cost of construction materials. Last year, the prices of all these spiked sharply” believes Michel Pascalis, general manager and partner of Mezhdunarodnoe Logisticheskoe Partnerstvo (International Logistics Partnership).
In Michel Pascalis’ view in the last few years the cost of land has almost doubled, while connection to the power grid has become 30–40% more expensive and the cost of building materials has risen by 20–40%.
The cost also rises due to the lack of qualified construction firms that forces developers to compete with each other allowing main contractors to dictate their own financial terms.
As usual, specialists note the lack of transparency of the land market and the difficulties with changing designated land from one category to another. “Changes in land legislation were supposed to simplify the procedure for changing the status of land, but have only served to confuse the situation. Moreover, the new Town Planning Code introduced the decree on developing the territorial planning project. This is a real financial burden considering the large surfaces of sites on which construction is currently underway. It is also worth noting that the organizations responsible for conducting this work are close to the government bodies and consequently there is no discussion about the quality of the work or compliance with precise completion deadlines. The intention of this order was to replace the permit but in reality it is just another headache”, says Ivan Potekhin, general director of the company Espro-menedzhment. The company’s project in Istra was supposed to be inaugurated a year ago. Obstacles interfered related to changing the status of the plot of land. “And this is despite the fact that we were included in the regional program for developing industrial and logistics parks. Another example is our project in Moscow. For several years we have been trying to rent a plot of land adjacent to ours that is currently occupied by a tip. However, the dump remains. If Russian bureaucrats aren’t offered an incentive, three years is no delay whatsoever to them,” asserts Mr. Potekhin. On average, up to 15% of a project’s budget goes on “gifts”.
The development of regional projects is also being held back. The dynamic expansion of Moscow developers who announced the creation of nationwide warehouse chains has failed to take off. The reasons are the same. Additionally, experts note that the cost of construction in the regions can be even higher though expenses for acquiring land may be the same, since transport costs for materials and labor from Moscow oblast are higher. Meanwhile, each region has its own rules and procedures for obtaining permits, and if a mutual understanding with the local government is not reached, achieving anything will prove difficult. “Not having the same rules of the game means our business has an element of unpredictability, which represents an additional risk when it comes to realizing large-scale projects. It is noteworthy that not only permit procedures may change but also the people on whom particular decisions depend can change entirely. Construction may be underway for a year in which time the whole civil servant apparatus may be fully replaced” says Michel Pascalis.
Another difficulty concerns the transport infrastructure. “The centers we build are considerably large. The concentration of a large volume of warehouse premises in one location requires changes to the road infrastructure, because cargo traffic flows rise considerably. Beforehand, nobody thought about this and the construction budget did not contemplate this significant expense”, adds Mr. Pascalis.
Lower returns
Currently, developers recognize that rent rate growth does not compensate for the rising construction costs. As a result, project returns have been declining recently. Specialists agree that 15% is currently the maximum rate of return.
“Many developers with no experience in realizing warehouse projects decided to enter this segment in the hope of obtaining high profit. They were not aware of the specifics of warehouse development and announced large warehouse projects that would be able to satisfy the excess demand. Although these announcements did not always come to fruition, they achieved one objective, which was to generate a discussion on lowering rent rates. Potential tenants who believed realtors’ forecasts tried to negotiate for lower rates. These discussions shake the warehouse real estate market and can have a negative influence on the warehouse development business as a whole” believes Ivan Potekhin.
Another tendency is worthy of mention. It is a given that large warehouse buildings are erected with a view to a future investment sale. However, recently specialists are observing that there is reduced activity in terms of investment deals. And it is not due to the fact that western investors are not prepared to buy – for them the Russian market is becoming more and more attractive because the political and economic risks are noticeably lower. Developers themselves delay selling because they are waiting for capitalization rates to decline on account of the intensifying competitive war between investors for quality products – currently they are 12–13% on average. A lower capitalization rate will provide the developer with higher profit. “The main concern is that the market could see developers emerge who build and rent out warehouses at lower rent rates in the hope of making up for lost profit on account of a future investment sale at lower capitalization rates. Current return levels may be low but under more beneficial investment conditions at a later date, they will be compensated. This is not the best way of developing the warehouse real estate market” believes Alexei Novikov, managing director of Parkadge Group.
What return?
As already noted, rent rates have recently risen. “In the warehouse development business return rates are relatively low. This is why in the last few months we have seen rising rent rates” believes Ruslan Suvorov, head of the warehouse and industrial real estate division with Praedium.
Nonetheless, specialists believe that it is too early to speak of a serious decline in the return offered by warehousing development. “The main factor that influences the rate of return is competition. Those who are currently renting out warehouses are not experiencing a serious competitive war, so we cannot talk of a serious reduction in rates of return. It will only happen when the war for tenants begins. Then it will be a question of not just quantity but also quality. Prices will have to be lowered, and consequently, profitability,” clarifies Alexei Novikov.
“Warehouse real estate remains a profitable business. There is a deficit of warehouse premises; although the market situation is changing. Even until recently the proportion of vacant premises was a tenth of a percent, although this indicator is rising now. We can see that the market is gradually developing and in several years will be saturated with universal warehouses. I say universal warehouses in particular, because currently there is no trend to build specialized warehouse complexes, for example cold stores, which are currently only being built at the orders of specific customers,” notes Igor Egorov, consultant of warehousing and industrial real estate with Jones Lang LaSalle.
“In Leningradskaya oblast, the Shushari district contains almost 80–85% of all of St Petersburg’s warehousing business. As a result, in two-three years, once the project’s of MLP and RosEvroDevelopment as well as several other developers are released and a large amount of space comes online, competition will intensify. Then owners who in the early stages inflated rent rates to increase their profitability levels, could lose tenants – a war will begin for every dollar. A difference of just a few dollars per square meter is a considerable argument in a competitor’s favor,” says Maxim Shakirov, director of the industrial and warehouse property department with Colliers International.
In fact, precisely for this reason the scheme for selling warehouse properties has started to change. For example, previously a broker would have a minimum price level that the owner would ask for but would be able to rent out the space for more. Now, investors who participate in property development establish a maximum – end-rate per 1 square meter, above which it is forbidden to charge rent.
We should also note that investors can also be made to pay for developers’ mistakes, which if avoided would increase the project’s level of return. “The profitability of warehouse projects depends on several factors, most important of which is a correct concept for the complex and the professionalism of its participants. Practice shows that if the right building materials are chosen and the construction process is controlled, to prevent thefts from the construction site, it is possible to save 15–20% of the budget. This allows the developer to sell the property at market rates, but at a higher profit,” observes Maxim Shakirov.
The experience of western countries where there is an oversaturation of warehouse space (for example Poland, Hungary, etc.,) shows that one of the main factors that help to retain tenants is a well-designed and thought-out infrastructure and professional management. “Here, a lot depends on how the building is designed, whether there is a sufficient number of parking spaces, if there is a cleaning service, waster removal service, shower rooms, canteens – all of this contributes to a better performance of warehouse logistics operations” adds Mr. Shakirov.
Already now end users are talking of the difficulties in managing warehouse properties and in particular with reference to the lack of qualified specialists. Additionally, this problem is intensifying due to the large concentration of warehouse space in a single location – which is currently a frequent phenomenon. In the US, a number of projects for creating technology parks and large warehouse complexes were sold precisely due to the lack of infrastructure. The opposite situation arose: a quality product was built but there was no one to work there.
Recent trends show that it is unlikely for rent rates to stabilize in 2007–2008. They will rise mostly due to the lack of vacant premises and rising costs. Another issue is whether at this stage rent rates growth may decelerate. Where stabilization is concerned, it will only happen once the level of supply approaches the level of demand.