Tenants Are Starving For Shallow-Bay Warehouses. That's Too Bad

Massive warehouses were all the rage when Eastern Pennsylvania bulked up to accommodate the pandemic e-commerce boom.

As demand for those behemoths has cooled off, a different industrial sector has taken its place on tenants’ wishlists.

Businesses across the region are clamoring for shallow-bay warehouses and other small industrial buildings, but elevated construction, land and entitlement costs mean new builds aren’t penciling, even in the face of soaring rents.

“There’s definitely an opportunity there for real estate developers to satisfy the demand that exists for small bay,” KBC Advisors broker Brian McCurdy said. “We know that tenants are looking for it.”

They aren’t having an easy time finding it.

Cresa Managing Principal Eric Zahniser experienced the supply crunch firsthand as he worked to help a client find a 20K SF to 30K SF space in Lehigh Valley.

The company needed 22-foot clear heights and an advanced sprinkler system. Zahniser identified about 50 properties with those attributes, but 45 of them were bulk warehouse facilities. He found two properties that could accommodate units as small as 50K SF. Only one landlord would carve out 30K SF.

Zahniser said he doesn’t expect to see a new wave of small industrial projects entering Eastern Pennsylvania’s pipeline anytime soon.

“In order to get the returns they would need given the construction and development costs, they would have to charge a rent none of the tenants would be willing to pay,” he said.

McCurdy said KBC Advisors has seen some investor appetite in this sector, but so far these projects haven’t advanced beyond the conversation stage.

But shallow-bay warehouses, small properties of less than 50K SF and with layouts that minimize the distance between the interior and entrance/exit points, do present some advantages for investors.

They cater to a much more diverse array of users than the institutional firms that dominate bulk warehouses, according to a shallow-bay report published by CompStak and Faropoint this summer that includes warehouses up to 150K SF. That includes small businesses like light manufacturers, last-mile distributors and local contractors.

Shallow-bay projects also tend to be multitenant, which carries less risk for investors.

This smaller product type also tends to have shorter lease terms, which means owners can adjust rents based on market conditions more frequently, CompStak Senior Director of Real Estate Intelligence Alie Baumann said.

Shallow-bay rents in greater Philly have expanded dramatically in recent months.

The going rate for industrial spaces under 150K SF has grown almost 9% year-over-year in the region, according to CompStak. That is more than any of the nine markets analyzed in the firm’s July small-bay report. Atlanta, Chicago and Dallas-Fort Worth each came in at around 4%.

But shallow-bay properties in Philly don’t carry as much of a premium as they do elsewhere.

CompStak found that buildings in and around the city go for about 7% more than their heftier counterparts. That rate came out to 21% for the other nine markets analyzed.

Low supply is a major contributor to the rent premium in Philly, but the extra income per square foot investors can earn with a small-bay facility is generally not enough to make new speculative construction pencil.

That is partly because elevated land costs are even more of a factor for shallow-bay and other small industrial facilities, since they generally need to be closer to major population centers than bulk facilities, according to the CompStak report.

“Because we’re in an infill area, there’s not a ton of available land to begin with,” McCurdy said of greater Philly. “The pricing of the land definitely matters. … You’re going to need the rents to go up just as much.”

Building costs have been ballooning nationwide, and that pressure is even stronger in Philly, which Turner & Townsend identified as the fifth-most-expensive construction market in the nation this summer.

Those pressures are even more intense for small industrial projects, which cost more to build per square foot.

“A giant rectangle is a more favorable ratio of floor area to wall in terms of linear square footage,” Zahniser said. “With a smaller rectangle, there’s a higher amount of wall relative to the interior area.”

And the legal and entitlement costs investors face for smaller industrial projects are no lower than for a bulk warehouse, KBC broker Brad Boone said.

The industry has struggled to find ways to minimize these expenses, but Boone said there is one construction technique that could help lower construction costs.

Institutional investors prefer to build small industrial spaces with concrete panel walls, which are relatively expensive. But many of these structures could also be built with preengineered metal walls, which are slightly cheaper.

Penntex Construction usually aims to save 5% to 10% on the cost of shell construction by using metal walls instead of concrete, Senior Vice President of Preconstruction Mark Ginther said.

But things didn’t work out that way with a 40K SF industrial building he is planning in Lehigh Valley.

Ginther’s cost projections for the warehouse with 36-foot clear heights came out to $79 per SF, just 3.7% less than the conventional construction technique.

“This building had an odd shape which eroded some of those savings,” he said in a statement.

Those short-term savings are a moot point for institutional investors focused on future resales since the building with metal walls will trade at a lower yield, Boone said. That is because they are seen as less durable than their concrete counterparts.

A large spec construction wave of small industrial spaces may not be coming to greater Philly anytime soon, but several build-to-suit projects have popped up in recent years.

Boone highlighted East Capital Partners’ construction of a 48K SF Northeast Philly warehouse for Stateside Vodka, which utilized the metal wall technique. There was also a series of new metal-walled buildings built off Three Tun Road in Malvern, including one that houses a Rivian electric vehicle service center.

With little to no spec construction underway in Eastern Pennsylvania, shallow- and small-bay users that can’t afford new builds are getting by with the older stock available.

“Those tenants will make do with spaces that don’t necessarily completely meet their needs,” Boone said.