Mexico’s Industrial Real Estate Market

Recovery gains momentum, demand splits geographically

Amid global economic doldrums, Mexico is positioned to take advantage of a few, yet strong, niches of growth. Led by a booming auto industry and strong support from other sectors such as aerospace, electronics and logistics, Mexico’s Industrial and Distribution Real Estate Market is in a recovery mood.

The analysis of Mexico’s Industrial and Distribution Real Estate Market (from now on…”THE MARKET”) is a very interesting tool that provides business people insights about regional development and the country’s macroeconomic pulse. THE MARKET’s performance indicators are an excellent and early benchmark for Mexico’s level of economic activity.

Whether leased or owned, the execution of contracts for industrial and distribution space occurs well in advance of the creation of jobs and production of goods. THE MARKET ranks amongst the best in the world. Its global-class and cost competitive facilities give a significant advantage to Mexico in its ability to attract Foreign Direct Investment (FDI).

After underperforming during the great recession, THE MARKET touched bottom in 2009. It managed to slightly turn the corner in 2010 and build a reasonable, although geographically unbalanced recovery in 2011. Also, in spite of the great recession, THE MARKET has improved the physical design and quality of developments and buildings as well as its financial and capital structures.

It looks like THE MARKET’s 2012 will be a better year than 2011, but there are some serious threats and competition ahead. In this article, we will review THE MARKET’s performance in 2011 and discuss its exciting dynamics and trends for 2012.

THE MARKET IN 2011

For our discussion, THE MARKET includes all leased and owned facilities zoned and used for manufacturing, assembly, logistics, high-tech activities and business process (“back office”) operations. Many of these facilities are in industrial parks and others are on “stand-alone” sites.

At the end of 2011, THE MARKET accounted for 619 million square feet of roofed space (57.5 million Mt2). This is an increase of 1.8% and 3.1% over 2010 and 2009, respectively. Please keep in mind that the total size of THE MARKET includes both occupied and vacant facilities, so THE MARKET will almost always experience some year-to-year growth, irrespectively of vacancy rates.

Mexico’s economic turnaround was very important in supporting THE MARKET in 2010-2011. Mexico’s real GDP growth rate went from a terrible -6.5% in 2009 to a more reasonable +5.1% in 2010, but growth decelerated in 2011 to about +3.9%.

Mexico’s industrial production and domestic retail sales reached all-time highs during 2011, when these three indexes were a tick above pre-recession levels. Employment followed suit and most of the jobs lost in 2009 were recovered in 2010-2011. But there were no new, additional jobs to satisfy the growing economically active population (about 800,000 new job seekers per year).

Official data indicate that unemployment in Mexico is about 5%, but a more realistic figure for unemployment is the official “unemployed and partially employed” datum of 15.9% of September 2011, up from 14.46% earlier in January.

Propelled by a remarkable recovery in the auto industry, which produced a record 2.5 million light-vehicles in 2011, mostly for foreign markets, Mexican exports went back to pre-recession levels occupying available manufacturing and logistics space in THE MARKET in 2011.

Mexican exports are highly correlated to manufacturing activity in the U.S. According to The Institute for Supply Management manufacturing activity in the U.S. expanded for the 28th consecutive month in November, 2011, but was short of its peak in February, 2011.

There was a significant recovery for much of the U.S. manufacturing sector in 2011, centered on strengths in autos, metals, food, machinery, computers and electronics, all of which kept busy the supply and logistics chains in THE MARKET in Mexico.

In fact, as shown in Exhibit #1, except for Ciudad Juarez and Tijuana, the major cities of THE MARKET had important increases in gross absorption of industrial and distribution space in 2011.


But most notable, as Exhibit #2 illustrates, vacancy rates decreased across the board in all major cities in Mexico.


Mexico City is booming: In 2011 it reached a gross absorption of 11.2 million ft.2 based on the strength of growing logistics demand for space. Many domestic and foreign companies in the region such as UPS, Oxxo, Genomma Lab and Office Depot are relocating to more efficient logistics facilities in order to reduce costs.

Because of the lack of substantial new construction, the Mexico City sub-market vacancy rate dropped to an unprecedented 6.7%. And actually, the top Class “A” facilities vacancy rate dipped to 3.5%, down from 8.5% just 12 months ago. Monterrey, the second largest city in THE MARKET with over 74 million ft.2 of inventory, continues to recover from its 2006-2009 downslide in gross absorption, posting a second consecutive year of growth with 4.9 million ft.2 in 2011.

Monterrey’s vacancy rate declined to 7.5% in 2011 from 9.8% in 2010, as developers continue to be cautious of building additional speculative buildings. The Apodaca sub-market continues to lead in Monterrey, but it is closely followed by Santa Catarina where new facilities have attracted the likes of Ryder and Galvaprime.

The Guadalajara sub-market gained 1.8 million ft.2 of gross absorption, including facilities for Flextronics, Siemens, Wal- Mart and Kuehne Nagel. Although the belligerence on the streets receded by more than 40% from 2010, it continues to significantly affect the Juarez sub-market, which had its worst performance of the past two decades at only 1.2 million ft.2 of absorption and one of the highest vacancies in Mexico at 14.5%.

There were less than a handful of new projects in Juarez in 2011 (RR Donnelly, 3M), but the companies that have been operating there for a few years had a strikingly high rate of renewals and relocations within the city during 2008-2011, taking advantage of very competitive lease terms.

Paradoxically, in spite of the security issue, Juarez today is possibly the most competitive city in Mexico for manufacturing and logistics costs. Long gone are the days of 10% workers’ monthly turnover and expensive leases. Workers’ productivity is at its highest level ever in Juarez as well as export value of goods. In spite of having practically gotten rid of homicides in the Tijuana sub-market, it largely resembles Juarez’s numbers. Tijuana was also severely affected by the still ailing California economy.

Reynosa managed to post a reasonable 1.7 million ft.2 of absorption and improved its vacancy by over a percentage point to 10.5% at the end of 2011. Steelcase, Corning and Sekai represented the largest transactions. In spite of the improvement in vacancy rates in THE MARKET, the overall vacancy rate of approximately 9% remains well above of what may be considered a “healthy vacancy” level of about 6%.

In retrospect, THE MARKET got into unwanted high vacancy rates as a result of aggressive construction of speculative space by developers during 2007-2008 and the concurrent start of the recession, which caused negative absorption or vacancy of space throughout THE MARKET, particularly in 2009. Unless there is a booming year in THE MARKET like 2000 and 2007 and a frank global economic recovery, healthy vacancy levels are not likely to return to the submarkets before 2015.

GEOGRAPHICAL DIVIDE

THE MARKET experienced a “geographical divide” of investor preferences between the border zone of Mexico and the south of the country. The big story of THE MARKET in 2011 unfolded in central Mexico. The “Bajio” region, which technically includes the states of Queretaro, Guanajuato and Michoacan, has built robust foundations for long-term growth.

Mexico’s auto industry is strong throughout all of the country’s geography, but the concentration of many automotive mega projects in one state has no precedent. The state of Guanajuato has a tradition for gold mining, but in the last few years, the gold rush in Guanajuato is about cars. It started in 2005 with a constant flow of investment by GM and its suppliers, estimated at about US$2.5 billion. Last year, this was followed by Volkswagen’s new US$800 million engine plant and Pirelli’s US$200 million tire facility.


In mid-2011, Mazda announced the construction of a US$500 million assembly plant in Salamanca in conjunction with Sumitomo. And to top it off, Honda launched another assembly plant project that plans to build 200k vehicles on an investment of US$800 million in the city of Celaya.

And as the suppliers start to flock to be near the facilities in the tradition of Japanese auto manufacturing, the impact on THE MARKET will be huge. The neighboring states will of course benefit as well from the auto industry rush in Guanajuato and in Mexico in general. But just in case, Queretaro is putting many chips behind the growth of the aerospace sector.

Bombardier’s renowned success and accelerated growth in the area has lured many suppliers to the region. Bombardier started with basic assembly of harnesses and in just five years has evolved to launch the assembly of the Learjet 85 fuselage.

The favorable conditions prompted Eurocopter to select Queretaro for the location of its US$500 million facility. The French-German subsidiary of EADS will build fuselages for several of its helicopter models. After its failed bid to establish a Chinese auto assembly plant in 2008, Michoacan is building on its strengths.

Logistics strengths that is. The port of Lazaro Cardenas, second in Mexico behind Manzanillo in maritime cargo handling, is preparing to become the number one choice for Asian sourced materials bound for Mexico and the U.S.

The Danish firm Maersk of APM Terminals will build a US$900 million container and storage handling terminal at Lazaro Cardenas to reduce logistics costs to the large importers of consumer goods, parts, autos, etc. from Asia to North America.

Following global trade routes and understanding the logistics needs of importers will prove invaluable for distribution real estate developers in Mexico. The port of Lazaro Cardenas will be a large leverage to the logistics corridor of imports from Asia and will have a significant impact on THE MARKET.


Exhibit #3 shows the size of the various sub-markets of THE MARKET in Mexico and Exhibit #4lists the main transactions by sub-market during 2011.

PRICE TRENDS

As a result of high levels of inventory throughout The Market, buyers continue to have the upper hand. Many tenants have taken advantage of the large industrial space offering and have either renegotiated their leases or relocated to less expensive, better facilities.

Lease prices for A, B and C type buildings bottomed in 2009, changed very little in 2010 and showed an uptick in 2011 as vacancies improved in THE MARKET. The lack of new development and the general recession pressured the price of construction in 2009-2010 at the expense of general contractors’ margins. But the recent devaluation of the peso and the general increase in construction materials have increased the price of construction in 2011.

In general, land prices continued to decrease in 2011, as demand is still weak and some overstocked developers have put land holdings in the market, further dropping land values. But some selected sub-markets with emerging activity in central Mexico are starting to show signs of land price revitalization.

Price trends in THE MARKET for 2001 to 2011 are shown inExhibit #5. Many older properties that have been unoccupied in THE MARKET for three or four years continue to exhibit bargain price tags. Old, increasingly obsolescent space needs a new purpose, especially if it is at an off location. Operations will continue to move to high-ceiling, efficient and well located facilities.

THE MARKET’S BASIC MATH

The Capitalization Rate or simply the “cap-rate” is an important tool to measure the financial dynamics of real estate properties and markets. It is a very simple but important formula that helps to better understand THE MARKET:

Cap Rate = Annual Net Operating Income
                                 Asset Value

Annual Net Operating Income is the rental income of a property less owners’ expenses, and the asset value is best de- fined as the “Market value” or commercial value of a property. Exhibit #6illustrates the cap-rates for industrial properties in Mexico and the U.S.


for the past ten years. Notice how cap-rates declined in Mexico during 2002-2007 from 14% all the way down to 9%, largely as the result of more competitive rents or smaller net operating income, which means a reduction of the numerator in the formula. During the recession, cap-rates started to increase during 2008 and more so during 2009. But this was due mainly because property values decreased, reflecting a reduction in the denominator of the formula.

This took effect in spite of the reduction in rents during the recession (lowering the numerator). So the decline in property values overrode the effect of lower rents in the cap rates both in Mexico and the U.S. In fact, all rental income producing properties around the world decreased in value as a result of the economic recession driving cap-rates upwardly in 2009. This is evidenced by the values in stock prices of the publicly traded industrial real estate funds which plummeted along with the global economic woes.

In 2010, property values recovered a bit over 2009, lowering cap rates in THE MARKET. And with the improvement of general conditions in THE MARKET and the growing confidence of investors, property values continued to recover in 2011, further lowering cap-rates in Mexico to almost 2007 levels. In conclusion, during the recession and the recovery phase of THE MARKET (2008-2013), the dominating trend in the cap-rate formula is and will be the denominator: Property values or commercial market value as perceived by investors.

LEVELED OFF

THE MARKET has attracted global leading financial investors since the 80’s. They realized that Mexico’s dollar denominated, corporate guaranteed industrial and distribution properties offered more attractive overall financial yields than U.S. similar investments.

Exhibit #7 shows a history of the main industrial and distribution property portfolios for the period 2004-2012. Notice how foreign investors have taken significant equity positions in THE MARKET by acquiring property from domestic industrial developers, with whom they have also built strategic operating alliances.


From 2004 to 2008 there was significant activity of income producing property acquisitions, purchase & lease-back transactions, mergers and consolidation. But since, activity just leveled off, mostly affected by the financial crisis and alternate investment options.

For example, Brazil is currently the hot spot in the Americas. Brazil is today what Mexico was 5-10 years ago. About US$3 billion FDI in real estate per year have gone to Brazil in the last four years. The country benefits from a fast growing middle class and a burgeoning manufacturing base.

All of the international operators that started in Mexico a few years ago have now turned their head south to Brazil. And Colombia and Peru are also showing great potential for attracting FDI in real estate. The big story in Mexico in 2011 in this subject matter was the merger of ProLogis and AMB, which catapulted the new firm to the top of the portfolio’s chart of THE MARKET in 2012 with total properties of 29.8 million Ft2.


ProLogis is closely followed by CPA of the Washington State Investment Board with 29 million Ft2. Next in size in THE MARKET is Prudential Real Estate Investors with 19.9 million Ft2. Finsa & Partners and GE Capital’s Intramerica round up the top five portfolio holders in THE MARKET, which is largely dominated by foreign capital.

SUBSTITUTING FOREIGN CAPITAL

The reduction of foreign credit by traditional lenders and the decrease of foreign capital inflows to THE MARKET are being replaced, at least partially, by domestic financial sources. The government’s export developing bank, Bancomext, and other private banks in Mexico have aggressively extended loans to compete with old-timers lenders such as GE Capital and JPMorgan Chase to THE MARKET’s developers.

After a credit drought in 2009, funding was more readily available in THE MARKET in the second half of 2010 and in 2011. But after the financial crisis, credit is more selective, slower and qualitatively tighter.

In the past, Mexican pension funds have not been allowed to be used for real estate investing, but banking regulatory changes in 2010 opened a new market segment that industrial developers are taking advantage of to raise venture capital. Today, Mexican pension funds and other investors may access THE MARKET through new financial investment tools such as Development Capital Certificates (CKDs).

In addition, fiscal legislation is in place for Real Estate Investment Funds (REIT’s), or “FIBRAS” as they are known in Mexico, to emerge in THE MARKET. The new financial tools are nothing but great news to THE MARKET, which will eventually receive a boost of needed liquidity to substitute for the lack of FDI real estate flow.

Furthermore, the new financial tools indicate that THE MARKET is maturing and is slowly opening its doors to the individual investor and small property owners. As it was experienced in the U.S. and Europe many years ago, the access of the general public and investors and independent owners to THE MARKET financial stream increases the wealth of the country and the quality of properties.

THE MARKET’S 2011 OUTLOOK

The U.S. economy is expected to grow around 2.5 to 3 percent range in 2012. The economy will derive most of its growth from revived consumer and business spending and manufacturing. According to the Bank of Mexico and most analysts, Mexico’s GDP growth for 2012 is forecast to be about 4%. The growth will be based on a continuing improvement of exports and a moderate improvement in consumption.

The strength of the U.S. cycle and the future performance of domestic demand remain keys to Mexico’s manufacturing and logistics outlook and the performance of THE MARKET. At the end of 2011, industrial developers and real estate brokers in THE MARKET expressed a cautiously optimistic outlook for 2012. They expect a reasonable flow of prospects and deals, but continuing to favor central Mexico.

Besides the global macroeconomic threats from Europe and the eastern countries’ unrest, Mexico has presidential elections in July 2012, which adds risk to the economic landscape. For 2012, we can reasonably expect the following conditions in THE MARKET: -As vacancy rates continue to recede in 2012, developers will cautiously restart building speculative/inventory space.

Monterrey, Mexico City, Chihuahua City, Queretaro, San Luis Potosi, Saltillo and the main cities in Guanajuato cannot continue to afford not having new, quality, ready-tooccupy facilities.

-The total size of THE MARKET will likely grow between 2% and 2.5%. About 12 to 15 million square feet of new construction will be needed to accommodate new OEM’s, suppliers and logistics operators and satisfy expansions of existing companies.

-Expect gross absorption in most major sub-markets to increase about 7% to 15 % from 2011 levels.

-THE MARKET’s vacancy rates will continue to drop across the board.

-As demand continues to grow and stabilize in 2012, prices will increase, albeit slowly. Even in good times, industrial rents do not move much. Buyers will continue to have the upper hand in The Market, but the pressure on prices will gradually diminish along with vacancy rates beyond 2012.

Type “B” facilities, which suffered most during the recession should expect the best improvements in price.

-As global real estate markets continue to stabilize and regain the favor of investors, property values will further improve and THE MARKET’s cap-rates will likely slide lower short of half a percentage point.

Even if global risk is higher and the economies of NAFTA-land are flat, and security continues to be an issue in Mexico, THE MARKET will perform better in 2012 than in 2011. The reasons are simple: Mexico continues to gain momentum as the low-cost manufacturing platform for the U.S. and the domestic market continues to grow.

In 2012 THE MARKET will offer attractive business opportunities for investors, developers and users alike.

Sergio L. Ornelas has 30 years of experience in international trade and direct foreign investment. He has business degrees from Babson College, Southern Methodist U. and Harvard; he was head of the State of Chihuahua Industrial Promotion Agency in 1980-5 and General Director for Intermex Industrial Parks through 2000. He is MEXICONOW’s editor.
He may be contacted at: editor@mexico-now.com