Mexico’s Industrial Real Estate Market 2010 Outlook
Cautiously Optimistic Mexico’s industrial and distribution real estate market couldn’t be happier to have closed the books for 2009 at long last.
The 2009 performance indicators for the industrial real estate market were down significantly from previous years’ levels, including the 2001 recession. The combination of global economic woes, plummeting manufacturing activity in the U.S. and tight credit conditions sent market absorption and vacancy rates to one of their worst levels ever.
For example, overall industrial space vacancy rates in most major cities in Mexico are in double digit territory at the close of 2009, a far cry from the average of 5% recorded in 2005. And while no one expects the industrial real estate market to reach that healthy level anytime soon, there are indications that 2010 will be a better year.
In this article, we will review the relative results for 2009 of Mexico’s industrial and distribution real estate market (from now on “The Market”) and the trends and conditions that can be expected for the near future.
The Market’s Background The Market’s performance indicators provide an excellent and early benchmark for the activity level of Mexico’s manufactured goods export oriented industry.
Weather foreign or domestic, leased or owned, the execution of contracts that activate industrial and distribution buildings occurs well in advance of the creation of jobs, allocation of investment funds or actual exports of goods.
For our discussion, The Market includes: 1) Leased and owned facilities in cities with dollar denominated leases and buy/sell transactions; 2) Properties occupied, or previously occupied by subsidiaries of a foreign corporation, whether they are Class A, B or C buildings; and 3) Class A industrial space in major metro areas leased or owned by Mexican companies.
The Market includes all land and facilities zoned and used for manufacturing, 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.
The Market currently boasts stateof- the-art facilities throughout Mexico.
Actually, The Market in Mexico ranks amongst the best in the world, its quality and cost competitive facilities are an asset to Mexico’s ability to attract Foreign Direct Investment (FDI).
The Market’s roots can be traced to regional domestic industrial real estate developers that started in northern Mexico in the 60’s under the umbrella of the Maquiladora industry.
The strict construction requirements and the need for low labor cost of global manufacturing and logistics companies made The Market grow in sophistication and geographical reach. Also, in the last decade or so, modern construction and high quality facilities started to become the standard for industrial and distribution domestic firms.
The Market in 2009 At the close of 2009, The Market accounted for approximately 586 million square feet of roofed space. This is an increase of less than 0.7% since December 2008, and a lower showing than the 4.1% growth experienced during the previous year.
Please note 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.
Exhibit #1 shows The Market’s preliminary tally of gross absorption for the top locations in Mexico in million square feet for 2009 along the historical data for the years 2004-2008. Notice that, except for Reynosa, the main sub-markets suffered important losses, particularly Monterrey, Juarez and Mexico City.
The Market is tightly related to manufacturing activity in the U.S. and to global growth in Gross Domestic Product.
Mexico’s export oriented companies are actually a vital part of global manufacturing supply chains for the automotive, electronics, appliance, aeronautical and medical industries.
When the data for gross absorption are combined with the raising vacancy rates shown in Exhibit #2, the tough and evident news is that net absorption figures are very low and near negative territory. For example, Juarez gained 3.1 million square feet in gross absorption, but its vacancy rate worsened by 4.6 percentage points, which in a 57 million square feet size market represents about 2.6 million square feet of negative absorption. The result is a net absorption gain of only 500,000 square feet.
And although there is no comprehensive data for The Market to accurately and timely track underutilized space and space for sub-lease, it is estimated that these two factors would further deteriorate the performance of the sub- markets in Mexico in 2009.
Let’s turn to the pricing landscape of The Market shown in Exhibit #3. The graph shows that the general trend of asking prices to lease facilities whether “A” or “C” type is down. Reports from The Market indicate that industrial developers have closed transactions for “A” type buildings with discounts ranging from 5% to 12% from the previous year’s price levels.
In The Market’s demand and supply dynamics asking rent prices follow occupancies. Rising occupancy rates pull asking prices up, or, as is the case at present, lower occupancy rates drive prices down.
The Market is evidently a “Buyers Market”. Developers report that most customers will take every opportunity to negotiate longer and harder in hopes of achieving better and more flexible terms in their leases. They want lower prices, shorter terms, more tenant improvement allowances and more lenient financial and guarantee conditions.
Competition among general contractors and building materials suppliers has also lowered construction costs. The same situation goes as far as land transaction prices are concerned. But the latter have not been a factor because new developments have been extremely limited.
The Market’s Developers Foreign and domestic industrial developers in Mexico are focused on reducing the risk variables in their businesses. Most are following one or a combination of the strategies outlined below.
Before thinking on new developments, industrial property promoters need to reduce their empty buildings inventory. Because of the large overall supply, those who offer the most competitive lease terms are getting ahead of the game. Some developers are willing to be more patient and are waiting for The Market’s conditions to turn around. But often times, the opportunity cost of nonexistent income and the holding costs of an empty property make them join the ranks of the former.
The deployment of idle, non productive land is another way industrial developers are reducing risk. Many large players accumulated land reserves which under current market conditions might stay inactive under the sun for much longer than originally planned for. Most land overstocked developers are looking for new business schemes whereby they can generate returns from their land banks. So they are more willing to enter into development arrangements investing assets along their partners and customers or pursuing fee development management opportunities.
Another strategy to reduce risk during the “credit crunch” crisis is to deleverage the balance sheet. Some developers are raising additional equity or selling a part of their income producing properties in order to reduce their debt exposure. Some developers have even managed to renegotiate their loan and commercial debt structures obtaining extended terms and more favorable interest rates.
The Market’s Cap Rates An important tool to measure the financial dynamics of real estate properties and markets is the Capitalization Rate or simply the “cap rate”. It is a very simple but important formula that helps in understanding The Market:
Annual Net Operating Income is the rental income of a property less owners’ expenses, and the asset value is best defined as the “Market value” of a property.
Look closely at Exhibit #4 which illustrates the cap rates for industrial properties in Mexico and the U.S. for the past seven years. Notice how cap rates declined in Mexico during 2002-2007 from 14% all the way down to 9%, but they started to increase during 2008 and more sharply during 2009.
By looking at our previous graph of asking rents for type “A” facilities and noticing that rental prices are actually decreasing, meaning that the properties’ net operating incomes are decreasing, one may ask: If this is the case, and since the numerator in the formula is decreasing, wouldn’t cap rates should be going the other way? The answer is, interestingly enough, found under the line of the formula, in the denominator. And yes, even though rents are on their way down, the asset values are also decreasing, but at a relatively faster pace than the rental income, effectively over riding the effect of the diminishing rents.
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.
Actually, many publicly traded industrial real estate funds are currently well undervalued.
Or is it that they were formerly well overvalued? In the cap rate graph, notice how cap rates in Mexico compressed faster than in the U.S. during the 2002-2007 period, meaning that international investors were developing a better feeling (less risk) for keeping their money in The Market. Some of that good feeling dissipated in 2009 because the gap between U.S. and Mexico cap rates actually widened.
The Market’s Investors The Market in Mexico has attracted the attention of foreign financial investors since the 80’s. First lending institutions and later equity investors realized that Mexico’s dollar denominated, corporate guaranteed industrial and distribution properties offered more attractive financial yields with just a marginal additional risk compared to U.S. similar investments.
Exhibit #5 shows 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. Foreign investors have also aggressively undertaken direct development initiatives.
From 2004 to 2008 there was significant activity of income producing property acquisitions, purchase & lease-back transactions, mergers and consolidation. As a result of the global financial and economic crisis, these activities diminished considerably.
As of January 2010, at the top of investment portfolios in The Market, with 27 million square feet of properties are CPA of the Washington State Investment Board, closely followed by Prudential Real Estate Investors. Prologis, the world’s largest provider of distribution facilities and GE Capital’s Intramerica round up the top four portfolio holders in The Market.
The Market’s 2010 Outlook It is unlikely that the negative trend in The Market will continue through 2010. Rather, many industry leaders sustain a cautiously optimistic attitude into the start of the first year of the second decade of the twenty first century.
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We know that The Market’s performance is highly dependent on the level of manufacturing and GDP in the U.S. Consider the following macroeconomic conditions.
U.S. manufacturing activity jumped in December 2009, signaling growth in the sector for a fifth consecutive month, reported the Arizona-based Institute for Supply Management. Its index of U.S. manufacturing rose to 55.9 from 53.6 in November 2009, which is the highest level since April 2006 when the index climbed to 56.
Levels higher than 50 signal manufacturing growth, while readings below 50 indicate contraction. This is the latest sign of resiliency, recovery and strength in the manufacturing industry in the U.S., but there are still some industries mired in the downturn.
Of the 18 manufacturing divisions reporting, seven posted contraction — including categories such as wood products, plastics and rubber, and chemical products. Sectors reporting growth included apparel, computer and electronic products, furniture, transportation equipment and paper products.
Mexico’s has recently been particularly competitive in the logistics, aerospace and contract manufacturing sectors. At the bottom line, Mexico, with all of its shortcomings, is North America’s low cost manufacturing platform.
According to many analysts, U.S. GDP is unequivocally set to post at least modest gains in 2010 and post higher than 4% growth for the period of 2011-2014.
In Mexico, positive signs are emerging as well as employment and production in the maquiladora plants and the auto industry has turned the corner. Most plants are reporting an increase in production orders.
In late December 2009, industrial developers and real estate brokers in The Market indicated that for the last few months of 2009 contract closings and the flow of prospects had definitely improved from earlier in the year.
For 2010, we can reasonably expect the following conditions in The Market:
Developers will continue to focus on marketing existing properties and will stay away from building speculative space and new industrial parks. New starts will consist mostly of build-to-suit projects. The total size of The Market will likely grow by 1% or about 6 million square feet in new construction.
Expect gross absorption in most major sub-markets to increase at least 25 % from 2009 levels.
Negative absorption will definitely recede to more normal levels and net absorption will turn into more positive territory throughout The Market. Vacancy rates will drop 2 to 3.5 percentage points in the most overbuilt and battered sub-markets (Monterrey, Juarez, Tijuana and Reynosa) and from 1 to 2 percentage points in Mexico City and Guadalajara. The rest of the mid-size and smaller markets will likely improve their vacancy rates by at least two percentage points.
Asking rents will not have further declines, and as demand starts to stabilize they will increase slightly during 2010, albeit slowly.
As global real estate markets stabilize and regain the favor of investors, The Market’s cap rates will experience a slight drop from 10.5% to 10%.
Industrial developers will be very attentive and ready for a stronger rebound in The Market in late 2010 and into 2011. With a construction cycle of only 6 months from contract execution and ground breaking to actual building occupancy, industrial developers can react very quickly to changes in The Market.