By Jane Cotroneo and Tara Innes

Soft domestic property fundamentals and skyrocketing property valuations have industrial REITs looking at the global landscape for development opportunities to expand their portfolios. Growing global trade is also transforming the needs of U.S.-based industrial users who are redesigning their distribution networks to achieve the best supply chain strategy.

The U.S. economic recovery has quickly translated into growing demand for warehouse space. New tenant demand previously supported almost exclusively by home building and consumer products is now broad based across industries as industrial tenants increase their utilization needs. However, while demand has improved, industrial markets across the U.S. are still struggling with excessive supply. Current development has been fueled, despite space availabilities, by tenants’ redesign needs and also by a strong demand from real estate investors.

Not surprisingly, the best performing industrial markets in the U.S. are those with ports supporting global trade, namely Los Angeles, New Jersey and Florida. Los Angeles ranks number one with vacancy at 5.4 percent as of the first quarter 2005, compared to the national average at 10.9 percent, according to Torto Wheaton Research (TWR).

U.S. industrial product at in-fill locations near airports and ports is especially prized as industrial users redesign their networks and compete for areas in locations with scarce land for new development. Even older buildings are desirable in these constrained markets given their valuable location and in many cases older buildings are torn down for redevelopment.

Yet in most U.S. markets vacancy rates are lingering near recent historical highs and there is a lack of rental pricing power for landlords. Nevertheless, developers are cashing in on companies’ needs to redesign their distribution networks, providing build-to-suit developments and even speculative projects in desirable locations.

Despite weak U.S. market conditions, intense demand for real estate investment and low interest rates have escalated property valuations. Money is flowing more freely into real estate from a variety of capital sources including pension funds, structured finance real estate products, retail and foreign investors. The high property valuations have further encouraged development, exacerbating the supply imbalance and slowing the industrial sector recovery. However, rising construction costs for steel, cement, petroleum and land have lowered developers’ more recent returns. Competing demand for raw materials from the residential sector as well as global demand from China’s boom and the rebuilding effort in Iraq have escalated the costs of raw materials from 20 percent to 40 percent higher.

Overseas Attraction

Fitch expects more rated REITs across select sectors to explore non-U.S. expansion in the coming year. U.S. REIT management teams, confronted with high acquisition prices have preferred development, but narrowing returns on domestic development and low net operating income yields on domestic assets have further prompted them to explore opportunities abroad. Europe is attracting real estate investment especially for industrial REITs as European unification has stimulated growth and brought about a need for a Pan- European distribution. Supply chains in Europe are being reconfigured to accommodate the unification, and leasing in many markets has outperformed those in the U.S.

In Poland and the Czech Republic, industrial markets are benefiting from growth in manufacturing as companies are migrating facilities to these countries offering lower tax and wage costs. Real GDP in 2004 grew by 5.3 percent in Poland and by 4.0 percent in the Czech Republic supported by robust export growth. While some European markets such as Germany have suffered with weak economic growth, opportunities for real estate investment still exist as corporations seek sale-leasebacks to bolster their returns and remove low yielding real estate from their balance sheets.

Top U.S. Trading Partners in 2004
($ in billions)
Country	Exports	Imports	Total Trade*	Trade
Canada	$ 190.2	$ 255.9	$ 446.1	19.5%
Mexico	110.8	155.8	266.6	11.6%
China	34.7	196.7	231.4	10.1%
Japan	54.4	129.6	184.0	8.0%
Germany	31.4	77.2	108.6	4.7%
United Kingdom	36.0	46.4	82.4	3.6%
South Korea	26.3	46.2	72.5	3.2%
Taiwan	21.7	34.6	56.3	2.5%
France	21.2	31.8	53.1	2.3%
Malaysia	10.9	28.2	39.1	1.7%
*Trade in goods only. Source: Foreign Trade Division, U.S. Census Bureau

Fitch Rated Industrial REITs
	Ticker	Fitch Rating	Market Cap (in mil $)*	Int'l
AMB Property Corporation	AMB	BBB+	$ 3,564.4	Y
CenterPoint Properties Trust	CNT	BBB	$ 2,085.9	N
Duke Realty Corporation	DRE	BBB+	$ 4,803.8	N
EastGroup Properties	EGP	BBB-	$ 845.8	N
First Industrial Realty Trust	FR	BBB	$ 1,916.4	N
Liberty Property Trust	LRY	BBB	$ 3,582.6	Y
ProLogis	PLD	BBB+	$ 7,705.4	Y
PS Business Parks	PSB	BBB	$ 1,188.3	N
*Source: SNL Data as of May 16, 2005 *Some companies listed also own office properties.

U.S. industrial REITs have also benefited from inefficiencies in the European real estate capital markets where there is a significantly less developed marketplace for commercial mortgage-backed securities and collateralized debt obligations than in the U.S. This inefficiency which serves to limit competition creates opportunities for U.S. REITs to acquire attractive assets. However, this is beginning to change as Europe is accelerating the development of these instruments.

In Asia, U.S.-based industrial REITs have favored Japan and have reported consistently stronger leasing than in the U.S. as they aim to develop and lease build-to-suit projects. While entering China may prove challenging, it too is luring investments as manufacturing is rapidly growing to support its growing middle class and its surging global trade. U.S. companies are looking for an experienced partner to gain a foothold into China’s industrial markets.

International Explorers

In particular, ProLogis (NYSE: PLD) and AMB Property Corporation (NYSE: AMB) have set their sights on the international horizon, citing growing global trade and opportunities in strategic industrial markets abroad.

ProLogis has industrial interests in 42 markets across North America, 26 markets in Europe and four markets in Japan and China. The company’s developed cross border experience, especially in Europe, gives it an advantageous position as a global investor. The diversification of its global operating platform helps mitigate the effects of soft U.S. market fundamentals. Beyond diversification, ProLogis’ strategy is to leverage its tenant relationships to serve customer needs in multiple markets, providing many of their largest customers with facilities on more than one continent.

AMB’s domestic strategy targets hub markets and gateway cities in the U.S. with access to major airports and seaports. AMB has applied this investment strategy to the international landscape. Globally, AMB has focused on Mexico and select markets across Europe and Asia. The strategy in Mexico has been to select locations near major freeways, labor pools and manufacturers. In Europe and Asia, AMB has targeted airport adjacent locations supporting the high growth air cargo industry.

Balancing the Risks

Fitch acknowledges the diversification benefits international expansion brings to industrial REITs, and the opportunity for them to leverage their established expertise into new playing fields, however entering foreign markets poses challenges and these opportunities come with additional risks.

The biggest challenge is the added complexity of entering a new country. It is necessary to acquire the political know how and to learn new, complex and continually evolving regulatory and tax rules. New entrants must also learn the local market’s property fundamentals. Partnering with local experts has become an effective tool to minimize some of the unknowns in entering new markets, and for larger companies, Fitch considers measured expansion with local expertise and/or experienced partners as an appropriate and acceptable risk.

However, partnering in joint ventures with local partners creates a riskier credit profile as it increases complexity and reduces control. Exit strategies and management decisions are encumbered by partners’ interest and often these off balance sheet ventures provide less transparency.

Foreign exchange volatility is another wildcard. REITs have adopted some strategies to help minimize currency risks including recycling capital by reinvesting and borrowing in local currency, establishing dollar-denominated leases overseas and protecting short-term fluctuations by currency hedging. The additional risks posed by currency exposure need to be considered when weighing the advantages of earnings abroad.

The supplemental cost of setting up operations in a country will need to be spread across a large number of assets to be economically attractive over the long term. Smaller industrial companies and those companies at the lower end of the credit spectrum are probably less suited to overseas expansion from a credit perspective because the upfront costs of establishing the operation may dilute earnings in the near term. ProLogis and AMB are actively engaged in acquiring and developing overseas properties and contributing them to investment property funds, a strategy comparable to that of domestic funds they have also established in the U.S.

Fund activities boost profitability for the REITs by generating asset management fees, acquisition fees and performance management fees in addition to the operating income normally available from property operations. These earnings generated at the fund level, whether property-level income, fees or gains, are encumbered by the governing arrangement between the REIT and its partners and are less accessible to unsecured lenders.

Fitch distinguishes between earnings generated by the core portfolio, wholly owned assets on the balance sheet and earnings generated by activities off balance sheet. The highest quality earnings in Fitch’s view are those earnings generated by wholly owned, stabilized, unencumbered assets. Fitch looks to these earnings as the primary source of funds to service debt and affect repayment.

International investing is viewed favorably by Fitch for its diversification and forward looking strategy. Industrial REITs are poised to benefit from the combination of successful overseas ventures and the slowly improving U.S. industrial sector.