Mexico’s Industrial Real Estate Market – Outlook 2011
The Market turned the corner; buyers will keep the upper hand
Mexico’s Industrial and Distribution Real Estate Market performance indicators provide an excellent and early benchmark for Mexico’s level of economic activity. Weather leased or owned, the execution of contracts for industrial and distribution buildings occurs well in advance of the creation of jobs and production of goods.
Mexico’s Industrial and Distribution Real Estate Market (from now on…The Market) ranks amongst the best in the world. Its high quality and cost competitive facilities provide a significant advantage to Mexico’s ability to attract Foreign Direct Investment.
After three years of dislocation and deteriorating performance, The Market touched bottom in 2009 and finally, yet slightly, turned the corner in 2010.
Also, in spite of the great recession, The Market has managed to improve the physical design and quality of developments and buildings as well as its financial and capital structures.
Most variables are aligning to make The Market’s 2011 a better year than 2010. But there are also some serious threats ahead.
In this article, we will review The Market’s performance in 2010 and discuss its exciting dynamics and trends for 2011.
THE MARKET IN 2010
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 2010, The Market accounted for 608 million square feet of roofed space (56.5 million Mt2). This is an increase of 1.3% and 2% over 2009 and 2008 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. Mexico’s GDP growth rate went from a terrible -6.5% in 2009 to a more reasonable, yet insufficient, +4.8% in 2010.
Employment followed suit and most of the jobs lost in 2009 were recovered in 2010. Nevertheless, there were no new, additional jobs to satisfy the growing economically active population (about 800,000 new job seekers per year), so the unemployment rate went up by 1.2% during 2010.
Propelled by a remarkable recovery in the auto industry, Mexican exports went back to pre-recession levels occupying available manufacturing and logistics space in The Market in 2010.
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 a 17th month in a row in December, 2010 rising to the highest level in seven months.
There was a significant recovery for much of the U.S. manufacturing sector in 2010, centered on strength in autos, metals, food, machinery, computers and electronics, all of which kept busy the supply chains in The Market in Mexico.
In fact, as shown in Exhibit #1, except for Ciudad Juarez and Reynosa, the major cities of The Market had important increases in gross absorption of industrial and distribution space.
And at the same time, as Exhibit #2 illustrates, they were able to lower their vacancy rates.
Mexico City metro area achieved the largest gross absorption at 8.3 million ft2 based on the strength of growing logistics space. Many domestic companies in the area are relocating to more efficient facilities in order to reduce costs. This sub-market was also able to reduce its vacancy rate by half a point.
Monterrey, the second largest city in The Market with over 74 million ft2 of inventory, managed to reverse its 2006-2009 downslide in gross absorption with 4.2 million ft2. The increase of 80% over 2009 came mostly from expansion of existing facilities and small and mid-size suppliers moving in to service OEM’s in the area.
The Guadalajara sub-market was also a gainer with 1.6 million ft2 of gross absorption, of which over 20% was high-end engineering and “back office” space.
The belligerence on the streets continues to significantly affect the Juarez sub-market, which had its worst performance of the past seven years at only 2.2 million ft2 of absorption and a towering vacancy of 14.7%. In 2010, Juarez was the only sub-market with negative absorption.
Reynosa, managed to post a reasonable 1.4 million ft2 of absorption and unchanged vacancy; while Tijuana, which has been able to contain street violence, had its best year since 2004 with 2.8 million ft2 of new contracts and an important reduction in vacancy of over two percentage points.
In spite of the slight general recovery in The Market, vacancy 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 the “deathly” combination 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.
Unless there is a booming year in The Market like it happened in 2000 and 2007, healthy vacancy levels are not likely to return to the sub-markets before 2013.
A BUYER’S MARKET 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 had already bottomed in 2009 and changed very little in 2010.
But there was a growing tendency to offer extra perks such as “free rent for a few months” to sweeten the deals.
The lack of new development and the general recession, continue to pressure the price of construction at the expense of general contractors’ margins that are also being hurt by increases in the cost of materials.
As far as land is concerned, prices have decreased. Demand for industrial and distribution sites continued to dwindle in 2010. In addition, some overstocked developers have put land holdings in the market, further dropping land values.
Price trends in The Market for 2010 are shown in Exhibit #3.
Many built-out, older properties that have been unoccupied in The Market for over two years exhibit bargain price tags.
Exhibit #4, sourced from the Colliers’ MexicoNOW “Knowledge Reports”, summarizes and details the size of the sub-markets and the market price ranges for leases, construction and land.
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 in understanding The Market:
Cap Rate = Annual Net Operating Income a Asset Value
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” or commercial value of a property.
Exhibit #5 illustrates the cap rates for industrial properties in Mexico and the U.S. for the past nine 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.
But during the recession, cap rates started to increase during 2008 and more sharply during 2009, but this was due mainly because property values decreased, reflecting a reduction in the denominator of the formula.
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. This reduction is also reflecting additional pressure on the lease rates.
THE MARKET’S PORTFOLIOS
The Market in Mexico 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 financial yields than U.S. similar investments, with just a marginal additional.
Exhibit #6 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.
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 in 2009-2010.
As of January 2011, at the top of investment portfolios in The Market, with 28 million Ft2 of properties are CPA of the Washington State Investment Board, followed by Prudential Real Estate Investors with 19.7 million Ft2. Prologis, the world’s largest provider of distribution facilities is at 18.6 million Ft2 and GE Capital’s Intramerica at 16 million Ft2 round up the top four portfolio holders in The Market, which is largely dominated by foreign capital.
The Market’s financial position is being strengthened as a result of increased availability of traditional credit and new financial structures introduced by new government regulations.
Old-timers lending to The Market’s developers such as GE Capital and JPMorgan Chase have new company in the likes of the Government’s Bancomext and other private banks rooted in Mexico.
After a credit drought in 2009, funding was more readily available in The Market in 2010. But understandably so, after the financial crisis, credit is more selective, slower and qualitatively tighter (more bureaucratic).
In the past, Mexican pension funds have not been allowed to be used for real estate investing, but a relatively recent banking regulatory change has opened a new market segment that industrial developers are taking advantage of to raise venture capital.
Such is the case of Prudential Real Estate convincing qualified investors to outflow about $US293 million into a fund created to invest in industrial real estate throughout Mexico and U.S. industrial real estate developer AMB Property Corporation’s similar fund, which raised US$262 million through the sale of equity-linked structured notes.
Their closed-end publicly traded funds are looking to invest the capital by developing industrial sites or by acquiring industrial portfolios or individual properties that will be leased to Mexican and multinational corporations.
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 undoubtedly receive a boost of liquidity, paving the way for a smooth sail during the recovery and beyond.
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THE ELEPHANT IN THE ROOM
But, as we all know, the mushrooming violence in Mexico is a very serious threat to The Market’s wellbeing.
According to JPMorgan-Mexico, organized crime side effects and bad publicity abroad will probably cost Mexico about US$4 Billion in 2004.
Some projects that chose to locate elsewhere than Mexico recently, such as the Electrolux’s and Whirlpool’s appliance projects, specifically addressed the violence in Mexico as an important part of their analysis and final decision.
In interviews with a sample of developers, real estate brokers and state development offices in late December, 2010, MEXICONOW learned of over 20 industrial investment projects originally planned to locate in Mexico that were cancelled or put on hold indefinitely, specifically because of the insecurity and violence spreading throughout the country.
THE MARKET’S 2011 OUTLOOK
US economy is expected to grow around 3.5 to 4 percent range in the year 2011 compared to just under 3 percent growth recorded in the year 2010. The economy will derive more 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 2011 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 Market.
At the end of 2010, industrial developers and real estate brokers in The Market indicated that they expected a reasonable flow of new prospects to continue through 2011, particularly in the aerospace and automotive sectors. But again, everyone warned about the significant potential setback in The Market that violence in Mexico poses.
For 2011, we can reasonably expect the following conditions in The Market:
Developers will continue to focus on marketing their existing properties. They will, for the most part, stay away from building speculative space and new industrial parks. But some speculative activity will emerge in Mexico City and Guadalajara. Although new construction will consist mostly of build-to-suit projects.
The total size of The Market will likely grow by 1.5% or about 10 million square feet in new construction.
Expect gross absorption in most major sub-markets to increase about 5% to 10 % from 2010 levels.
Negative absorption will disappear altogether from The Market, even in Ciudad Juarez. The Market’s vacancy rates will probably drop at least one percentage point across the board, except in Mexico City, where a half percentage point is more likely. The rest of the mid-size and smaller markets will likely improve their vacancy rates by at least one to two percentage points.
Asking rents will not have further declines, and as demand starts to stabilize they will increase slightly during 2011, albeit slowly. Buyers will continue to have the upper hand in The Market, but the pressure on prices will gradually diminish along with vacancy rates beyond 2011.
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 under the10% mark.
The signs for moderate improvement in The Market in 2011 are pretty widespread and are real, offering tenants, developers, investors and lenders attractive business opportunities.
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: email@example.com