We had the opportunity to sit down with Melinda McLaughlin, Vice President and Head of U.S Research at ProLogis, for an in-depth look at the state of industrial real estate, and how advancement in logistics technology is changing the game across industries and existing Real Estate Supply.
Melinda McLaughlin is a Vice President at Prologis and heads U.S. Research. In this function, she is responsible for the development and communication of Prologis Research insights and outlook on the U.S. logistics real estate market and economy. She joined the company in March 2015. Prior to joining Prologis, she was a Vice President at Rosen Consulting Group, a boutique firm that provides economic, housing and commercial real estate strategic consulting services.
Melinda holds a Bachelor of Science in Economics from the Wharton School at the University of Pennsylvania with a concentration in Real Estate.
Prologis Logistics Real Estate Research – https://www.prologis.com/logistics-industry-research
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Melinda McLaughlin – When we look at the overall cost structure, real estate is about 5% of total supply chain costs and transportation is about 50%. So if you can make a dent in those other components of the cost structure with a real estate decision, you would do that.
Adam Hooper – Hey, Tyler.
Tyler Stewart – Hey, Adam, how are you today?
Adam Hooper – Tyler, I’m pretty good.
Tyler Stewart – Yeah? You’re looking good.
Adam Hooper – Thank you I feel good.
Tyler Stewart – Yeah, yeah. Big old smile on your face today, and why is that?
Adam Hooper – Well, we had an opportunity to talk with someone about industrial space.
Tyler Stewart – It’s our first podcast doing a deep dive on industrial and it was a good one for sure.
Adam Hooper – It was, who do we have on?
Tyler Stewart – We had Melinda McLaughlin, Head of US Research at Prologis.
Adam Hooper – It was exciting to do a deep dive on basic fundamental supply and demand of industrial. We haven’t done that yet. We’ve done it on a lot of the other asset classes. But she commented on kind of how it looked post recession, how its developed since then, talk a lot about kind of supply and demand in terms of what those changing uses and drivers are for each side of that equation. Very interesting from that perspective.
Tyler Stewart – What a great resource, Prologis is a global company. They’re tracking data and research all across the world. We focus today on the US of course, and we talked a lot about innovation and disruption within the industry and how industrials adapt in robotics, how it’s adapting to creating a better employee experience, one at the properties and we’re now finding out that industry properties are developing to have great views of the city.
Adam Hooper – Yeah, I didn’t expect that either. To me a couple other stats I found really interesting and listeners, you’ll get there, how concentrated the industrial space market is across just six markets in the US. Surprisingly high percentage of industrial space there. Also, we talked about kind of different factors that go into logistics and supply chain and staggeringly high transportation costs. We talked about some of the innovations there that might be coming down the line, but you’ll have to listen to the listen to full episode to get into that.
Tyler Stewart – I love your question you gave to Melinda, what are we going to see first autonomous trucking, or drones?
Adam Hooper – Yep, she’s on the record.
Tyler Stewart – She’s on the record, but you have to wait to hear that answer a little bit later in the interview.
Adam Hooper – Okay, well, I think that’s enough of us talking, listeners out there, as always, we appreciate reviews and ratings. Every good rating and review gets our show in front of more listeners and allows us to bring more great content to you also. Please go rate, review wherever you listen to podcast, if you have any questions, comments, send us a note to firstname.lastname@example.org. With that, let’s get to it. Melinda, thank you so much for joining us today, we’re excited to dig in on the industrial market and pick your brain about what’s going on in the industrial space. Thanks for coming on the show.
Melinda McLaughlin – Absolutely excited to be here.
Adam Hooper – Great, well, why don’t you take us a little bit back. Tell us a little bit about maybe your background and how you got into real estate and then maybe a little bit about Prologis and kind of what you’re doing there today?
Melinda McLaughlin – Absolutely. I came into real estate kind of by accident, I was an econ major at a business school and just searching out different areas of potential concentration. I tackled corporate finance, but it felt really broad and I really wanted to dig in and happen to take an international housing finance course. One of the real estate courses, and it just struck me not only how, like tangible and real real estate feels, I know it’s in the name, but how much of an impact it can have on the wealth of the nations and the ability of households to climb the ladder and improve their condition. I just really latched on in college and kind of took it from there. After college, I really wanted to move to the West Coast. I grew up in Colorado, so I was looking for somewhere that was a big city, but closed outdoor activities and San Francisco fit the bill. And there was a consulting company hiring and I just really liked the sound of that. One of the things I liked best about college is you have a challenge or problem and you dig in, do the research, find the data, come up with this thesis and really test it. Consulting was a great place to kind of continue that work and continue to learn and get a lot of exposure. I was there for a while and digging into a lot of different property types, a lot of different geographic areas. But when you’re a consultant, you don’t really get to see things through, you kind of issue your recommendation, and then hope it ends well. I really wanted to go somewhere
Melinda McLaughlin – where I could see something through to the end, and really how does it impact the business and just happened to find Prologis, and it was the right time for industrial real estate. I joined it 2015, and it’s been a really incredible set of years since then. Today, I’m part of a global team, really focused on understanding logistics, real estate, the supply chain, what’s happening the market, the industry is going through some fundamental shifts, and we’re just trying to understand it and get that information out there.
Adam Hooper – Maybe you can tell us so from consultant to Head of US Research at Prologis, what’s different about that? You mentioned that in the practicing world, you kind of get to see those things through to where those insights lead and from actual implementation perspective? How do those roles change? What are a couple of differences that you get to see in your position now in the practice side versus the consultant side?
Melinda McLaughlin – I’ll go back to when they were when I was talking to my boss, the Global Head of Research about the position. Inside of Prologis, you’re one of two things most people in our business do not have. One is access to a vertically integrated platform where I can reach out and something strange is going on with the Dallas data, and I can call our market officer in Dallas, be like, “Can you help me understand this?” These people are experts in their local areas, and that goes through number of vertical integration. Our development team, something’s happening with steel costs, I can reach out to them and be like, “What does this actually mean on a per square foot basis?” One was the people in the vertically integrated platform, it really adds a lot of real life day to day experience to the data and the numbers that we’re trying to explore for insights. And then the second thing was more data than anywhere else in the industry. Just the nature of logistics real estate and the scale of the Prologis platform, you get a lot thousands of leasing transactions, and sale information and just resources that nobody else has in terms of gathering data, processing it, searching it for patterns. So those two things really attracted me to this position.
Adam Hooper – It’s one of the things that I’m curious in a couple of points there of one of the things that we’re doing in our businesses, is incorporating a lot more data, Our asset class in general has access to a lot more data than it has historically. I’m curious to get your thoughts on, how do you separate or where does the break from just pure data, insights from pure data and data alone, versus still that human component of it, right? If you’re talking to that guy in Dallas, and he’s seeing something weird going on with construction costs or material costs, how do you split that purely data driven insight versus a human component? Or how do you weight those two different factors?
Melinda McLaughlin – Anybody who’s in this side of the business always has to weigh that, because there’s so much insight to be gathered just from someone’s experience. That said, when you’re in an industry that’s undergoing a fundamental transformation, this stuff happening today might not be the same as the patterns of the past. You really have to weigh both sides equally. When the data is telling you something, and it might be surprising, really dig into that to understand why. And then work with someone on the ground and be like, “Might this be part of what’s happening in the data? Might this be something new, should we dig into this more?” And start to maybe change their perspective because these are people who are interacting with customers day today, and perhaps they might not be seeing that because they’re used to the normal cadence of business, but if it’s something new, we absolutely want them to start integrating that into those relationships and looking for patterns themselves. It’s a balance. Then sometimes there’s just a quirk in the data and they’re like, “I’m sorry, that can’t possibly be.” And you go back and find it’s because of some absurd data issue, which those things happen. So it’s a balance. I think, really playing off the two sides though, is where you get to the best final result.
Adam Hooper – Maybe using data to identify those anomalies are the kind of trust that verify, right?
Melinda McLaughlin – Exactly.
Adam Hooper – It can support either researching further on certain issues, or maybe challenging some of those common held assumptions that maybe there’s something different going on or reveal that maybe there’s something that, again, is walking the data maybe.
Melinda McLaughlin – Exactly. It’s something very exciting about this time in our industry that we are getting this data that can verify assumptions that have been long held, and they can challenge some assumptions and I think that’s part of the job of being in research and being on the data side of this business is making sure we don’t take long held assumptions for granted, but that we use all the resources at our disposal.
Adam Hooper – Great. Well, we’re excited to talk about industrial today, we’ve had a lot of investor interest in the asset class, haven’t really done a super deep dive on the asset class. We’re excited to dig in here. Why don’t you take us a high level, supply demand we’ve talked about for other asset classes multifamily retail, but at its most fundamental level, what are you seeing as kind of the main supply demand drivers in the industrial space as opposed to, well, I guess maybe we can talk about retail, right? Since we’ve talked about ecommerce and that kind of tying in, but what are you seeing just very base level supply demand in the industrial space?
Melinda McLaughlin – The supply and demand balance is, I would say more in line today than it’s been through this cycle, but you really need to understand what’s been unique about this cycle. Post global financial crisis we saw starts in our space. New construction dropped to the lowest level since we have statistics tracking this. It’s one of those property types, I think that had a historic really reputation for being fairly easy to build. To see a number of developers really just vanish from the space, and very, very little new modern product get built in those first years post recession, really led to a dearth of new supply. And so what we saw was for a very long time, a very slow ramp up. Some of it was the composition of developers really changed. A lot of your local regional, your mom and pop shops that maybe had a plot of land that they wanted to monetize, they really just vanished. And what we saw was, institutional players make up a greater and greater component of the product that was under construction. Those institutional players tended to have a more conservative approach to risk, I think, particularly given what happened in 2008 and 2009. We saw a very slow ramp up. At the same time that we were seeing rising structural barriers to new supply. In most markets, land that can accommodate, I would say a modern building is becoming harder and harder to find. There are two factors with that. One is buildings are changing, they’re getting bigger, the clear heights are getting higher, so the ceiling.
Melinda McLaughlin – And there are lower coverage ratios, so less building per acre of land. That all has to do with the way those large high throughput facilities operate. You need more parking, you need more trailer storage and turnaround space and just more modern building specs in order to accommodate things like automation. To find that kind of a plot of land harder and harder, and you have to go further and further from city center. Additionally, I would say that the municipal response to logistics real estate development has become a little bit more stringent. There are a few factors behind that. But we have seen in our business, even some municipalities that in the past had been relatively friendly to logistics, real estate development, really take a more scrutinizing look at these projects, really dig into the environmental impact, charge higher fees, and it’s made entitlement harder and lengthen that entitlement timeline. There are a lot of rising structural factors that are really chipping away at that reputation of logistics real estate as being easy to build. That’s on the supply side, what we’ve seen is a very slow ramp up but given the returns and rank growth that we haven’t had in our sector, in 2018, I would say the supply and demand balance is finally more in line. And that’s after nearly 10 years of demand outpacing new supply. So on the demand side, we’ve also undergone a structural shift, and this has to do with the way our customers use their space. And you’ve already touched on ecommerce, I always say ecommerce was really the catalyst
Melinda McLaughlin – for a much larger shift in the way customers view their supply chains. It’s really going, supply chain as a necessary evil. We need it, it’s a line item we can’t get rid of, to a source of competitive advantage. And so, with ecommerce, you have changing consumer expectations. I think Amazon is the obvious example. They keep raising the bar, and the rest of the industry needs to follow along. But it’s not just ecommerce, and it’s not just retail, what we’ve seen extends even to the business space, it’s just really about changing expectations. In order to deliver quickly, reliably and offer a lot of choice. We’ve seen customers really invest in their supply chains and their distribution networks in order to get close to the end consumer. And so that’s consumers, but it’s also businesses. And that shift has led logistics real estate demand to really outperform what we would expect based on pure economic growth. So we’ve been in this pattern of two to 3% GDP growth, fairly slow and steady. But logistics real estate demand has been above 250 million square feet for several consecutive years, which is something in the past you saw more in a three to 4% GDP growth environment. The outperformance, some of its ecommerce but really, it’s about a much broader group of customers building out their distribution networks. We, in the Prologis research group also do a survey every month of our customers. It’s called the Industrial Business Indicator or IBI really tracking just two simple things. One, how is activity changing in the warehouse?
Melinda McLaughlin – We ask is your warehouse busier or less busy than the month before? And then we asked about the utilization of space. If you look at your entire footprint, how much of the space are you using, we’re really trying to get to is how is the velocity of the flow of goods changing. And that can be an early leading indicator of economic trends as well. But also any shadow space that might be out there. So when businesses expand or contract, is there excess space that might portend a shift in demand? And what we’ve been seeing lately is really still strong, healthy growth. Anything above 50 indicates growth, we’ve been hovering around 60 for most of 2018 that basically leads us to expect to continue to healthy demand this year. It’s been a very long strong expansion for logistics, real estate and supply is just now catching up.
Adam Hooper – That’s really, really good info there. I want to kind of pick apart maybe a little bit more granular on both the kind of nature of usage and also the nature of the supply side. Industrial, I think a lot of what you’re referring to is more the kind of big kind of distribution logistics warehouses. Have you seen, in measure how far down the market you guys track, but 10, 15 years ago, industrial started you’d get a small flex space, right? You’d have 2000 to 5000 square foot suites, and then that tenant as their business grows it move up to maybe 10 15,000 square feet. That’s more kind of more, I guess, local, regional kind of producer manufacturing type space. Versus now, again, the shift from more maybe smaller industrial park type space, we’re seeing more of this demand and more of this activity for those big distribution centers. Can you talk me a little bit about from the usage area, kind of how that tenant profile or how that niche of the usage has shifted from the more I guess local, regional manufacturing type uses to more of this kind of a broad logistics distribution type model?
Melinda McLaughlin – Well, I think there’s still a lot of users along the entire spectrum. And I think that’s something that’s really important to understand. Consumption represents about 70% of our GDP. All of those goods that we consume have to flow through warehouses and a lot can be made in the US too. There’s an entire spectrum of logistics real estate users. What we’ve seen, I think that’s new and different during this cycle is one, what you spoke, what you referenced before, which are demand for high throughput, very large distribution centers, and that’s really about achieving efficiency through scale. A lot of times they’ll incorporate automation, things like that. We’ve definitely seen more demand in that type of space during the cycle than we have in cycles past. Part of it is we didn’t offer buildings that had those capabilities before. So it’s a circular pattern but we build larger spaces. I think more customers realize they can use them to optimize their supply chains. But at the same time, we’ve seen a real resurgence and demand for smaller spaces closer into urban centers. That’s does I think stem from both sides, the small kind of dynamic small business user. Absolutely, I would say, especially in the past few years, has been part of that demand. As this economic expansion has continued we definitely saw a lot of users in that space start to increase our activity. But also some of your mega players, the same ones releasing those very large distribution facilities are building out their distribution networks trying to get the right good
Melinda McLaughlin – in the right place at the right time, so you can get them to consumers faster. That could be Amazon or Home Depot or Target or a number of very large players or also competing in that space for small urban infill logistics real estate spaces.
Adam Hooper – Then from the supply side how has that, I guess we’ll talk a little bit later on, kind repositioning and infill. But how is that supply side change here? You mentioned the kind of more local smaller developers, they get industrial used to be a metal building or if you’re a fancy in a local market, it’s a concrete tilt building. How has that dynamic changed? Are you seeing more of those local or regional developers get back into the game? Have you seen construction costs kind of keep those people out of the game? Or what is the supply side looking like these days?
Melinda McLaughlin – On the margin, there might be a few more but it’s still dominated by institutional players and you hit on one of the big reasons why, which is replacement costs have been spiking. You have volatility and components. But what I would say is maybe the biggest force behind it is labor costs and the difficulties of even finding construction labor to build these buildings. It’s become incredibly competitive. So it is really tough for players without scale to compete for contractors for subcontractors, and the labor underneath.
Adam Hooper – And obviously, I think you mentioned you said there’s about 250 million square feet of demand annually, was that right?
Melinda McLaughlin – That’s been about average, maybe even a little higher. But that’s our expectation for this year, too.
Adam Hooper – Two questions following that, and I’m sorry, I’m just kind of nerding out on stats here. But that 250 million, I guess, where do you see that split across the I don’t know if square footage profile is right, but kind of maybe tenant usage profile? And then what is the supply looking like, I guess for pipeline to meet that 250 million? Meaning there’d be more, if you said, if there was more space available, it would be soaked up right now.
Melinda McLaughlin – I think that’s definitely been the pattern. Now what we see at this point in the cycle is there is a bit of a difference, a bit of a widening of outcomes based on your location and it definitely ties with some of the building characteristics that I talked about. Those larger more modern spaces definitely had an early recovery relative to the rest of logistics real estate. That coupled with just pure development finance is basically pushed and incentivized all development to be in larger product. Put the most building up that you can. We continue to see that today, that supply is concentrated in larger facilities. And its really concentrated in a handful of markets. When we look at the total pipeline of space under construction today, more than half of it is located in just six markets. And it’s because they’re popular markets for large products, they serve both large consumer populations and function as kind of a trade or distribution hub. And so we’ve seen a lot of dynamic demand there. That said in some places we have seen supply get a little ahead of it, particularly in the very large spaces. So what the market is delivering is a particular type of modern product, and we’ve seen a lot of healthy demand for that thus far. But what we see I think, at this stage of the cycle is perhaps more customers trying to build out their networks closer into consumers where we’re not really building that much at all. And it has to do with there’s no land there what there is, is extremely expensive. And there’s a lot of competition
Melinda McLaughlin – from other commercial real estate uses.
Adam Hooper – Now, I think you said 50%, more than 50% of the spaces in just six markets?
Tyler Stewart – Yes.
Adam Hooper – What six are those? Is that going to continue or are those markets getting saturated? You said some markets are maybe getting a little bit saturated and you’re going to see some more kind of secondary markets getting some of this new activity.
Melinda McLaughlin – I’ll start with the six markets and frankly, they’ve been on our radar for a while. So Dallas, Houston, Chicago, Atlanta, Pennsylvania and the Inland Empire. Fairly spread out but these are markets where if you go far enough from the city center, you can still secure some land and put up a larger product. We would expect this to continue. In some of these markets we have seen Demand keep up and vacancy rates hold steady. In some others particularly in the sub markets along the outskirts, we’ve seen vacancy rates tick up. What’s encouraging slightly is, as vacancy rates tick up, we do see the level of development start to come down. So the market is responding to conditions. But it does happen slowly and because demand for this type of products can be choppy, you can have you users come in in a bunch and take down five or six million square foot spaces or you can have a law where you don’t see much leasing in that space for a while. It’s also just tough to predict when that market will return to equilibrium. But really, it’s concentrated six markets and even within those markets it’s highly concentrated in specific sub markets further from city centers. As you get closer in, the vacancy rate goes down, the rent growth goes up and the fundamentals get a lot more attractive and it really speaks to the value of being closer into that end consumer.
Adam Hooper – I would imagine the construction complexity of spinning up a new development, a new warehouse to accommodate some of that demand would allow that balance to track, I guess be more nimble in response to those demand changes versus something like multifamily or office property that’s going to take just a lot longer to develop, just by its nature of complexity, right? Maybe do you think that would explain some of that more, I guess, nimble reaction to those demand changes?
Tyler Stewart – Part of it is just the speed at which you can put up a building, but as we’ve seen, buildings get bigger and frankly, I don’t think the complexity, it’s tough to compare logistics to an office building and complexity. Obviously, putting up a skyscraper will always be a lot more complex.
Melinda McLaughlin – Sure.
Adam Hooper – But for our property type relative to itself, let’s say buildings are becoming more complex and we see more investments in things like the floor load capacity and how flat the floors are. And that’s really about future proofing and making sure that your building can accommodate robotics and automation and some of the changes that might be coming. We’re seeing a lot more attention to wellness features because labor is become so difficult to secure. A lot of customers are talking about the lighting is their natural light?
Melinda McLaughlin – What are the amenities around the building? Do you have transportation links? We’re starting to see scrutinization of the physical environment and really a lot of ranking and differentiation that maybe we didn’t see as much before. In the development environment to be on the cutting edge, you absolutely have to keep up with what’s the latest. Clear height, column spacing, floor. Like I said, floor fatness, materials, and then some of the infrastructure around it. Wi-Fi, utility connections, all those things are becoming more important as the customer, the way the customer uses, the building is becoming more sophisticated.
Adam Hooper – That’s fascinating. Floor flatness is not something that I would have ever thought would be a factor that’s going to cause functional obsolescence, right? If you’ve got something that is either finely tuned machinery or robotics where you need to have high tolerance over those processes, I can imagine that that would be preventative for a lot of the older product out there that would drive again, a lot of this kind of new demand, just from the ability for that tenant to actually use the space.
Melinda McLaughlin – Exactly. Purely from a design feature standpoint, we’ve seen construction costs increase substantially up to 50% in some cases.
Adam Hooper – Wow! Due to some of those factors that you’re trying to get a tighter tolerance around or just kind of general supply market of a construction supply market?
Melinda McLaughlin – So I think just–
Adam Hooper – Both, everything.
Melinda McLaughlin – That specifically is an example where we looked at a building built in the Inland Empire in 2007 and compared it to one built today and just sub segmenting out the changes in building design features led to a substantial increase in replacement costs.
Adam Hooper – Are a lot of these factors I would imagine it would be difficult to completely change out the slab of a folder warehouse, right? I mean, a lot of these factors does that prohibit retrofits? Or does that push you towards new development? Or how does that dynamic work?
Melinda McLaughlin – I haven’t talked a lot with our development team about retrofits, but I would imagine so. Some of the floor flatness and load really comes to a type of netting that you put in before you even pour the concrete. So I would imagine to kind of go back and redo that or… Be a substantial effort. Now, maybe there’s other techniques you could use, which I’m not familiar with, but the way that we’re looking at floors today, making them seamless, making them have a higher floor load capacity. It really does add to the the overall cost of the building.
Adam Hooper – Fascinating. It sounds like a lot of these demand drivers from the tenant and the usage side. You mentioned this current demand you’re seeing is maybe what we would typically expect in a higher GDP growth area or market. What are some of the drivers from the demand side? Is it largely tied to the greater economic health? Are there other factors that you guys look at that maybe listeners, investors that are looking to get into this asset class that are some markers out there or leading indicators that you see from a kind of predictive demand perspective that would indicate kind of the health of where the market is going?
Melinda McLaughlin – We definitely have regressed a lot of different economic indicators on demand and the best one remains our IBI customer survey when we look at the next six to 12 months of demand. The current run rate, according to the IBI is around 225 to 250 million square feet. Rhat’s when you’re thinking about just kind of the short term stage of the cycle. We really look to the IBI but you can also triangulate, really it all comes down to consumption. What’s happening with consumer incomes? What’s happening with their confidence? What’s happening with employment? All of that amounts to more money to spend on goods that ultimately need to flow through a warehouse. I really look at that. And really, it’s a play on consumption and overall economic activity. That said, one reason why industrial demand has outperformed in this cycle is due to the structural trends. To focus only on the economic cycle alone, I think would be a miss. In the US, the structural trends really have to do with the way consumption is happening. Again, ecommerce is part of that. But it’s really about these rising service level expectations. When you think about where you need to store, high velocity goods, it’s really about getting close to the end consumer, but you can go a bit further out for your goods that are less bought. Like always try to think of an example. I’m going to want my diapers super close to me. Not my diapers, my daughter’s diapers. Something I’m going to need immediately, every day, like clockwork close in. Maybe sports equipment is going to be a bit further out.
Melinda McLaughlin – I’m still going to want it fairly quickly but it’s less bought, or less frequently bought. And then something like patio furniture, maybe it’s very space intensive, and you’re really only likely to buy it once every few years might be further out. I’m in the Bay Area so I always think of it like the immediate Bay Area, so Oakland versus Tracy, which is close in Central Valley versus maybe Reno. And you think about the time and distance and cost of getting that good to you and it absolutely aligns with the frequency of your buying patterns. That shift, it’s easy to focus on ecommerce and I think we all understand that example. But we saw it a few years back, even with auto parts distribution where this old, I think we all remember when you would take your car to the mechanic or the dealership and they’d be, “Oh, it’s going to be three or four weeks to get that part in.” That’s no longer acceptable to consumers, our expectations have just fundamentally changed. We saw a lot of auto companies really come in and build out their parts distribution networks, so they can offer a higher service level as well. It’s something that again, ecommerce is the catalyst, I think, it absolutely opened everyone’s eyes to what’s possible. And then once you realize what’s possible, you don’t want to settle for anything less.
Adam Hooper – Again I think that is interesting how it’s just getting kind of shifted the whole way that the space is used, right? That’s got some pretty big shift. I guess again, not to harp on the ecommerce thing, and I guess it’s just kind of our industry in general. You were pretty far into this recovery. You were like you said, we’re almost 10 years in, you’re still seeing a lot of really good demand from the tenant side. Are you guys seeing anything that would indicate a reversal of that? Similar to how we talked about technology or industry or just technology in general? In almost every company today is a technology company, right? The reliance on technology is so pervasive that we don’t see anything that’s like, the.com crash or whatever, just because technology is so critical to business operations. Are you seeing that similar shift or that similar reliance on whether it be smaller industrial parks or this bigger logistics distribution centers? Are you seeing anything structurally that would indicate a big correction in those trends or is that just the way our economy runs and the way that we expect goods later this afternoon or tomorrow, and if I don’t get it by tomorrow, I’m pretty upset that I have to pay 12 bucks to get it on Friday. Is that just a secular shift in how we view and how we’ll use industrial space?
Melinda McLaughlin – First yes, it isn’t absolutely a secular shift, its structural. There’s ultimately going to be the constraint of time, which is it just will always take time to get a good from one place to another. Again, physically, the closer in you can get, the less risk you stand of not meeting that service level expectation. I see it is really competing for revenue, you got to get closer in and you really have to think about how you store manage and deliver your inventory. But also from a cost optimization and risk management perspective, we see that push to get closer and to have a more decentralized approach to your distribution network, offering a competitive advantage to large players on those fronts as well. When you think about it ecommerce of old and we’ll stick with that example, was really centrally clustered. You have very large facilities in Kansas. And the expectations were lower back then you could take a week or so to get your goods to consumers along the coast, today that just would not fly. And there was actually a really good study out of Morton that looked at Amazon’s distribution network in 2006, and 2016 and their transportation costs. Back in 2006, I think they had six or nine distribution centers, again, very centrally located, and they were paying roughly two to $5 per package to ship. Fast forward to 2016. Obviously, they are leveraging economies of density and scale. And now with 90 distribution facilities, and their cost per package went down to like 80 cents to $1.50.
Melinda McLaughlin – A 70% decline by building out that distribution network. Now, obviously, there are costs associated with that, but they were able to recoup those savings by really optimizing the trips, for the cost per package and the number of trips and the distance traveled So especially as we see continued shortage in trucking labor, transportation costs, still very much a fossil fuel based industry and that can be volatile and introduce risk in your cost structure. We see customers really looking to their logistics real estate decisions to help with that risk management with that cost optimization and ultimately adding or offering a higher service level. When we look at the overall cost structure, real estate is about 5% of total supply chain costs. And transportation is about 50%. If you can make a dent in those other components of the cost structure with a real estate decision you would do that.
Adam Hooper – That’s pretty impactful. We want to talk a little bit about some disruptors and kind of what you’re seeing in that space, but Prologis being a global company, what are you seeing out there? And talk of tariffs and some of these different kind of trade issues going on. Have you guys seen any impact from the operation side? Or what do you see in kind of, I guess, globally, that again, 15, 20 years ago, industrial space wasn’t really a global thing. It didn’t really have too much global impact there. But how has that changed? And what are you seeing now from I guess, a more, not US macro, but just more of a global perspective, given where you guys said.
Melinda McLaughlin – Absolutely. First as a company, we really try to focus on the consumption end of supply chains. Even though we have a presence in China, it’s very much focused on where people live, work, consume their goods, and less around where the manufacturing centers are. That said, we’re keeping an eye on all of these areas that could potentially be impacted by Tariffs and Trade tensions. So far, we’ve seen surprisingly little impact. So I think it really speaks to what’s been driving the expansion during this part of the cycle. I’ll focus on the US first, really building out your distribution network to get close to end consumers. You’re not going to unwind all that work, if your country of origin changes, or if the cost of goods increases somewhat. You really are very, as a customer, you’re very focused on where people live, work and that doesn’t change very quickly. By having a focus on the consumption, and you can be, I would say there’s a degree of stability inherent in it. That said, we do have some key trade gateways in the US. And what might be surprising to some people is that they continue to be our out performers. Now, the Port of LA Long Beach 40%, roughly, of our imports come through the Port of LA Long Beach, but there’s also a population of 25 million people who live in Southern California. The customers who are there and I will say as soon as this issue kind of arrived, we had our local teams kind of go out, start conversations with customers, make sure that their sensors were up
Melinda McLaughlin – as far as tracking any changes in demand or a change in trends in the way customers are using space. What we found was most customers are there to distribute to Southern California or I would say, the greater Southwest, and not just as a way point between the Port of LA Long Beach and the rest of the United States. So there might be some who benefit from that proximity to the port, but I would say the majority of customers in Southern California are there because of the Southern California population and the spending that happens there. Now, if we take that and then go globally, one thing we saw, we are also in Mexico. And one thing we saw along the border in Mexico, when the NAFTA renegotiation was happening is that developers pulled back from the border. So we actually saw less supply come online, but demand kept pace. And so it really speaks to these supply chain driven leasing decisions. They’re often years in the making, and they don’t turn on a dime, and they’re looking at a much larger structural pattern, rather than I would say the volatility that we’ve gotten used to day to day in these trade policies, they’re looking at that long term relationship in the way. The two economies, let’s say, in this case, the US and Mexico the way their relationship has been going for some time. And so what we saw was actually an improvement in market conditions along the border because we had less supply and steady demand. We saw something similar in the UK when the Brexit vote happened, where the development community got a lot more conservative
Melinda McLaughlin – but customers continued to expand. Again, they were looking at the UK as a major consumer market. They need to build out their distribution capabilities there and be there no matter what. Its mission critical, its structural, it’s absolutely a service level they need to provide. So when you have supply take a dip down and then demand remained strong. Obviously, market conditions remained very healthy. So we continue to watch for signs. And certainly the big risk at the end of the day is that Tariffs and Trade volatility ultimately seep into business confidence and kick off, I would say a larger slowdown in which case, we’re going to be affected alongside everybody else.
Adam Hooper – It sounds like those decisions, again, kind of supply chain and mission critical decisions that were already on the path to execution, those still continued through. Have you seen anything that would indicate from here going forward, that some of those decisions might be rethought or some of that supply, you’re going out where those decisions are maybe being made a little bit differently, are going to impact that demand going forward? Or do you think that’s going to kind of remain where it’s been in more of a strong trajectory?
Melinda McLaughlin – I would say the only thing we’re watching on the margin is potentially more domestic risk management in the supply chain. I would say customers who have a Southern California presence in a way we waited to the west are looking to balance that with an expansion in the east. Building an increased risk management. Some of that is trade and tariffs volatility but there are a number of other factors that can really disrupt the supply chain. Strikes at the port, for example. There are a lot of customers who are really looking with the more scrutinizing eye toward where is the risk in my supply chain? And how do I put buffers up so that I make sure my customers ultimately get what they need?
Adam Hooper – Got it. Okay, well, let’s switch over to some disruptors, which we talked a lot about on the show, I was kind of looking forward. How are some of the new technology advancements and usage things going to disrupt kind of the traditional notion of this and we’ve talked about some of that with automation and kind of this last mile thing, which we’ll talk about kind of repositioning infill after this, but what are some of the major disruptors that you’re seeing in the industrial market that will either, Let’s focus on the supply side. What are some disruptors that you’re seeing from the supply side? And then maybe we can touch on demand after that.
Melinda McLaughlin – At the end of the day there isn’t that much disruption on the supply side. A building still needs to go up and pretty much the typical fashion, I think there are a few startups out there who are trying to do prefab, but really, I would say the old construction methods– I think that there are some players who are trying to approach it and think differently, but we haven’t seen anything yet that’s really disrupted the supply side. It’s fairly traditional, it’s concrete and steel and labor. And those items can be more and more costly and I would say, especially the labor component. We don’t see a ton of disruption on the supply side it’s really the demand side where we’re focused and where we see a lot more potential
Adam Hooper – And so on that demand side, automation. I think it’s a lot of talk, last mile and kind of delivery patterns. What are some of the bigger disruptors that you’re seeing on the demand side?
Melinda McLaughlin – Right now, I think it’s one of those very exciting times where there’s a lot right on the cusp of potentially having an impact. The entire supply chain, looking at it, really optimizing your data, tracking what’s happening with goods through the entire supply chain. We’re seeing absolutely automation but also Internet of Things, really building out a building and trucks and items with sensors so you can do better predictive analytics and really look to optimize your supply chain. It’s very much in the early stages, and what we see is a lot of experimentation. And so we see that even some of the more sophisticated potential disruptors like autonomous trucking, there are customers who are looking at particular routes to test out this technology. And I think it’s a really exciting time to be at a place like Prologis because we absolutely are looking to partner with customers in innovation and making sure that we adjust the built environment to accommodate these. We have a venture group here within the company. And recently we launched a facility in the East Bay called Prologis Labs where we can test out a lot of these new technologies. Testing out better sensors and autonomous forklifts and robotics and really give a space for customers of all sizes to come in and see how this technology works and what they might be able to implement in their own facilities.
Adam Hooper – Was that Prologis’s taking technologies being developed by third parties and seeing how that affects your space? Or just Prologis themselves actually trying to kind of create and push on these boundaries with disruption with this technology internally or both?
Melinda McLaughlin – It’s partnering with third parties. We’re really looking for companies where that’s their expertise. Our expertise is in logistics real estate, what we wanted to do is provide a space where it can be implemented. It’s not going to affect anybody’s business in the day today, because it’s an experimentation facility. I recently went and visited and one thing they had were lots of pallets of water, water is some of the heaviest and still cheapest, but more difficult pallets to kind of move around. Getting in there with an autonomous forklift or a robotics system and trying to see how it works. And so we can partner with some of our major customers. But we also have medium sized to small customers come in and they’re able to see how it works without necessarily investing a lot themselves.
Adam Hooper – You commented earlier, transportation is about 50% of supply chain costs. Have you guys seen or I guess we’ve all seen. But are we actually going to have autonomous trucking and transportation? Is that actually going to happen? And if so, I’ll make you a crystal ball here. When do we think that might start to become something we actually see in the wild?
Melinda McLaughlin – There’s obviously a really compelling value proposition. But the barriers, technological and then regulatory, are really, really steep. On one hand, I think it can be very exciting to see this experimentation. And it’s all happening in the areas you would expect. Those long haul trucking routes in places with not a lot of weather. In Texas and Arizona that’s where you see this experimentation happening, because they don’t have the same type of challenges. When you think about the way this is developing, I think we have a lot of time to really adjust to any implications, because I think we’re still solving some really basic technological issues. And then you have to get over the regulatory hurdles and all the potential challenges with implementing this technology. Let’s say you have to go through the Sierras up here. I think it’ll be something that is compelling enough that we will continue to see investment in development. But I think we’re going to have a lot of time to adjust. So crystal ball wise. It’s just really difficult to say. I think most experts don’t expect anything really commercializable. I don’t know if that’s a word, but really commercially viable in the next 10 years.
Adam Hooper – Okay, so we’re going to put you on the record though. We got to get your answer. Are we going to see Amazon making drone delivery or Tesla making autonomous trucks first, which gets to market quicker?
Melinda McLaughlin – Oh, gosh. I think the challenge is drone deliveries actually less. When I think about the actual physical and technological barriers. Now whether or not that’s a good business model we’ll see.
Adam Hooper – Right, okay. All right, you’re on record. I guess again on that thought, that line ecommerce, I don’t know what the actual status today but it’s a pretty minimal amount of total retail sales is still ecommerce transactions. How much more room does that have to grow in terms of what that means with industrial space, right? I mean, the goods have to get from either a port to a consumer or from manufacturing to consumer. How much more room does that have to disrupt kind of the industrial usage? If that grows from a 12, 13% roughly now or somewhere in that range? If that grows to 20 or 30 40% how does that impact the industrial space?
Melinda McLaughlin – My group has done a study on the way ecommerce use of logistics real estate is different than pure brick and mortar use. And what we found is that ecommerce users are a much more intense user of logistics real estate and for all the reasons that make total sense. First of all, they store all their inventory in the warehouse, there are no retail store shelves to store inventory on. Second, they often have to offer a much broader product variety. Your typical Walmart will have about 150,000 items, I think. Walmart.com obviously offers millions. So much product variety, deeper inventory levels, because the the patterns of buying can be a lot more volatile through ecommerce. And then many facilities also accommodate space for returns or reverse logistics. And that multiplier is about three times as much logistics space. If you sell $1 of goods through brick and mortar you use a third the amount of space as if you would have sold it online. What we see and what we’ve been expecting to see is that ratio to come down. What we’ve actually seen is that ratios remained in very stable. And that has to do with the pace at which ecommerce players continue to expand their distribution networks. It’s really keeping pace with the double digit growth in sales. And so as we look forward most experts in this space, I don’t claim to be a retail expert. But most experts expect double digit growth to continue. Now as the base gets bigger, obviously, the pace of growth will eventually slow. But there are a lot of segments of ecommerce
Melinda McLaughlin – that continue to have a fairly low penetration rate. We see a lot of investment there and a lot of potential. Now, what I think we’re ultimately moving toward is a much more seamless buying experience where it becomes truly omni channel and you probably meet somewhere in the middle in terms of productivity of your logistics real estate space. You still will need more inventory storage to accommodate your online sales channel, but it’ll only ultimately, I think move further, it’ll come down from 3X. As ecommerce players get more efficient, they get better data, they get better at predictive analytics. But they also potentially leverage some of that in store buying as well. We see it now where a lot of pure play online retailers are opening retail shops. And there’s a lot of cross pollination there. I do think it’ll obviously be a continued tail into industrial logistics real estate demand. But will the stabilization of ecommerce growth ultimately impact demand? I don’t think so. It’s really comes down to consumption and the ultimate need to offer higher service levels which that can apply to distributing to a retail store network as well.
Adam Hooper – I guess kind of going down that line, we’ll kind of close the conversation, with a little talk on repositioning and infill development. I forget how many, it was a couple years ago now that was at Sam’s Club. was shutting down some of their warehouses to be more kind of last mile development or distribution centers for Walmart products. What are you guys seeing in terms of how to solve that last mile component? And, we’ve even heard people talking about are we going to redevelop malls, regional malls to distribution centers, right? Because they’re close at population, Amazon buying Whole Foods, is that really an attempt to get to that kind of last mile situation? So can you talk a little bit about that and what you guys are seeing on that kind of infill development repositioning side?
Melinda McLaughlin – Sure. Net-net big, long term picture, we do see the need for customers to get closer in to be more urban, to be closer to end consumers. But we’ve already spoken about the challenges of developing in that space. What that’s really led to is developers have got to be creative. When you talk about repurposing infill space. There’s obviously a land shortage and costs can be very high. What we’ve seen is rents have also increased a lot. We are starting to see the dynamic shift, especially in some of your most attractive infill markets where it does make sense to go in and redevelop these properties in order to offer a last mile or a last touch property. Now, there are a couple things I think we need to consider. And it’s really just being smart about location strategy. You can’t just plop a logistics real estate facility in the middle of let’s say, a residential network and expect it to work for something like last mile delivery. While it might benefit from close proximity to the population, you still have to consider the transportation access, the fact you’re going to have to get big trucks. It really requires a lot of thoughtfulness as well. But what we see is increasing interest, there are a lot of examples of innovation. I’m in a company that’s really trying to push that front. Two key projects, one in the Bronx where we took an old ABC Carpet warehouse, it was already kind of multi-story, they had different access points based on the slope. And we went in and redeveloped it and made it a modern facility with all the infrastructure really needed
Melinda McLaughlin – to do a last mile distribution operation. And it has direct highway access. And now jet.com is in there doing last mile delivery. Also, on the other side of the country in Seattle, we developed the first multi story warehouse. And that’s increasingly being looked at for that last mile delivery as well because it’s incredibly close into a population that is very challenging to get to. And as we see congestion increase, especially in some of these fast growing cities like Seattle, the importance of being close and just gets higher and higher. It’s definitely an exciting place to be I think it still is incredibly challenging. Again to get that land, to get it in title or the building, you’re going to reposition, to get it entitled to get everything through the municipality. You really have to think about being a partner with the cities and with the local community. It’s not just about being creative with the building design, but really thinking about all the parties that will be impacted, because it’s just a lot more challenging and there are a lot more vested interests when you start to do urban.
Adam Hooper – Like you said, even the kind of economic and social impacts of a pretty dramatic change in use. Right, if you’re talking about again, a retail center, being redeveloped into an industrial distribution facility that has a pretty big impact on the kind of fabric of that neighborhood, right? Have you guys done much study in terms of what the economic or social impact of those repositioning strategies are?
Melinda McLaughlin – Well, not specifically for retail, and I’ll give you one I’d say fairly intuitive reason why. When you think about these defunct malls, and I think that’s the one that gets the most attention. There a couple, two, I would say major challenges. First is if this was a place that didn’t generate enough retail demand to sustain its population, when you think about the demographics of last mile, it might not be the most attractive demand environment for a last touch distribution operation. But secondly, malls are fundamentally designed to keep people in, and logistics is really a throughput operation. And so you really have to think does this space ultimately work for what we’re trying to do? I find it interesting and there certainly are some examples where this has happened and this is viable and we’re certainly tracking the success of the mall redevelopment properties. But we focus a little bit more on trying to take older logistics properties and make them more modern facilities, make them more appropriate for what’s happening today in the level of sophistication. Now, the benefits for employees of that, obviously, the location. But secondly we’ve touched on labor a couple times. And when you talk about an urban location, you’re all of a sudden accessing a much deeper labor pool. And that can really help with some of the risk around finding and keeping labor because you not only have more people, but you have transportation access, you have amenities. And then to sit to the city and the local community, what we are hearing more and more
Melinda McLaughlin – is based on the development of cities and how competitive it is for land and for property here, that they’re underserved in terms of logistics, real estate infrastructure, that you have a lot of people here and they have the same high expectations as anywhere else, but not enough local logistics real estate distribution facilities to really fulfill that need. And so when you talk about just locating facilities around the outskirts, all of a sudden you’re generating a lot more traffic, you’re introducing a lot more risk into your delivery operation. We’re starting to see some municipalities particularly in urban locations become more receptive to this type of use. It’s really about making sure that their populations have the infrastructure they need to live their lives.
Adam Hooper – Interesting. The multistory warehouse is absolutely fascinating, right? We’ve seen certainly some multi storey self storage facilities, in more urban locations. It sounds like you’re taking that actually to traditional warehouse space now building multi storey warehouse spaces.
Melinda McLaughlin – Exactly. The facility in Seattle which I’ve toured is really phenomenal. Not only does it have all the same specs that you would need to run a very sophisticated logistics real estate operations so heavy floor load capacity, high clear heights. Really strategic truck access and a lot of dock doors and it’s very well designed to facilitate the flow of goods. But on the third floor you have incredible views of the city.
Adam Hooper – Not something you’d expect from an industrial space.
Melinda McLaughlin – Exactly. We do see some interest from customers who are looking at it as kind of a maker/office space as well. And that really I think is exciting and there’s a new project we’re doing in London that kind of has a similar vibe where it has all the building design features you would need to do a last mile operation or kind of light manufacturing that make a space, But also amenities, I think there’s the gym there, there’s a rooftop lounge. Really, again, thinking about not just the customer but the customers employees and how they’re using the space and how you might create value there.
Adam Hooper – Not just the old kind of down and dirty for concrete walls, industrial space, and maybe a couple small offices actually trying to look at it as there are real people that work there too and and how do you make that a nice environment for them?
Melinda McLaughlin – Urban infill will never be the least expensive space for some of our customers. You need to make sure it’s valuable to them.
Adam Hooper – Fantastic. Well, this has been a really, really interesting conversation. Is there anything that we haven’t touched on that you think we should be talking about? Or investors that are looking at this asset class? New anything that we haven’t touched on that maybe some indicators or factors that they can be kind of keeping an eye on in the market out there?
Melinda McLaughlin – No, I think we hit on it. We’ve seen a structural transformation in the supply environment and the demand environment, it’s really provide a lot of tailwinds. And frankly, I think it’s hard to overstate how behind the market is and adjusting to this. Supply chain trends don’t happen on a dime. We will continue to see these factors influence leasing decisions for years to come. Really understanding the role logistics, real estate plays, how customers are changing their use of the space and then how developers are trying to respond to those changes are really important. So my main message is it’s more about the structural than the cyclical, although we certainly keep an eye on both.
Adam Hooper – Perfect. And then in terms of the research that you are doing, that the industrial business indicator, do you guys make that publicly available?
Melinda McLaughlin – We do. We write a paper on the US market and market conditions and obviously the IBI results every quarter. You can find it on the research section of Prologis.com.
Adam Hooper – Perfect, and we’ll have a link to that in the show notes here. For all listeners out there, if you want to dig into the data, you can click that link and, Melinda, really appreciate your time today. This was fascinating I’m glad we were able to have a deep dive on industrial, got a little bit nerdy there, but I think it should be a pretty good overview for listeners out there. Thank you so much for coming on today.
Melinda McLaughlin – Thank you for having me, I love nerding out.
Adam Hooper – Good, well listeners out there as always, we appreciate the reviews and comments and ratings. So wherever you listen to this, please let us know what you think about the show. With that we’ll catch on the next one.