Industrial production in December 2013 was the highest since 2007, and the sector is expected in coming months to years to be in the best shape since the 2007-2009 recession.
Manufacturing companies need warehouses, factories, and distribution facilities for their products, and this spike in production benefits companies that lease that space.
In 2009, BMW (NASDAQOTH:BAMXF) began leasing two distribution facilities in the U.S. from Prologis (NYSE:PLD) to allow for faster distribution. The automaker plans to continue to increase capacity in new locations, aggressively seeking more production in the U.S. and China.
BMW's sales were up 17% in May from one year prior. The company is seeking new factory and distribution facility locations to support these increases and to satisfy customers with faster delivery.
The company's behavior is indicative of the market.
Prologis is the largest provider of industrial real estate. Now, Brookfield Asset Management (NYSE:BAM), a real-estate investor in other types of commercial property, is taking steps to capture the lucrative potential of the sector.
Leading the pack
Prologis purchases real estate, bids to companies seeking warehouses, factories and distribution facilities, and then builds to suit. The customer leases the property for industrial use.
Prologis is well diversified with over 4,500 customers across the globe and 570 million square feet under its control. Its customers include Amazon.com, FedEx, and Home Depot. In 2013, the company earned nearly $343 million in net income.
Let me in!
Brookfield Asset Management, in its quest to attain profit in the sector, recently acquired a number of industrial property companies across the globe and hired Jay Cornforth as head of the operation last fall.
The new hire is key for Brookfield. Cornforth was the president of the east region of the U.S. for Prologis for 10 years before taking his new position. Cornforth will be instrumental in Brookfield's move into the sector.
Investment in land and equipment will ramp up as the fiscal uncertainty of the past years fades and investors and business operators become more comfortable making capital expenditures. There are two key reasons why Prologis' revenue will grow and Brookfield wants a piece of the action.
Increased occupancy and increased rents
In 2010, the U.S. vacancy rate for industrial-related real estate was nearly 11%, but tit had fallen to 7.7% as of the first quarter of this year. The rental rates per square foot that leasers pay to Prologis and Brookfield have risen 3.8% in the same period, from about $5.20 per square foot to $5.40.
For 1 million square feet, the occupancy and rental rates from 2010 would earn leasing companies $4.6 million. The current rates of 7.7% and $5.40 per square foot offers nearly $5 million. The combined effect is comparable to a price increase of 7%.
The vacancy rate is forecast to level off at 7% in 2017 in the U.S., including an addition of 380 million square feet of factory expansion. The rental rate is expected to reach $7.16 per square foot.
At an average rental rate of $6.62 per square foot between 2014 and 2017 for the 380 million square feet of new factories, there is over $2.5 billion at stake solely for the rental of new space, excluding development fees.
The real estate market is fragmented
Industrial real estate is unconsolidated and global, and the ownership of properties is dispersed. Therefore, properties are susceptible to regional economic changes and may be more easily acquired.
Real-estate companies may seek to diversify across nations to hedge risk. Although industrial property sales are increasing in the U.S., they remain stagnant in Europe and Asia, indicating that opportunity likely will arise in the future.
Easily acquirable and diversifiable, these properties present an attractive opportunity for investors such as Prologis and Brookfield.
Profitability vs. revenue
Brookfield's current industrial portfolio of 58 million square feet of occupied space and 68 million square feet of developable land seems to pale in comparison to Prologis' 600 million square feet of occupied space and land in development. Brookfield, though, is seeking high profitability -- 12%-15% total return, according to The Wall Street Journal -- and not volume.
While industrial real-estate companies may embrace increased manufacturing by purchasing and developing land more quickly, Brookfield will only make deals if the expected rate of return is within its stringent performance requirements.
Prologis is rapidly expanding as customers like BMW continue to grow and seek more space. In the final days of May, Prologis signed a total of 1 million square feet of build-to-suit agreements with companies in China and Mexico. It also added over 2 million square feet in the Americas in the first quarter and plans to add 3.2 million square feet near Tokyo.
Future looking good, but not certain
The coming years of industry, and therefore industrial real estate, look promising.
Prologis is continually expanding its sole business of industrial real estate to aggressively add revenue. The strategy will work well in the years of manufacturing growth, but it will cost Prologis when the market retracts.
Brookfield is being conservative as it enters the sector, and its hunger for high profitability will benefit it in the long run. When the market slows, Brookfield may break even when competitors are incurring losses.