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First Industrial Realty Trust, Inc.

Corporations that have not considered their property holdings as a primary component ofthe supply chain configuration may not fully realize maximum real estate efficiency,flexibility and profitability.

In today’s globally competitive world, operating efficiency is the primary focus of the corporate cost-minimization/profit-maximization equation. Many manufactured goods are becoming commodities as new substitutes emerge. Further, increases in speed and reliability in transportation, domestically and especially globally, allow for freer geographic distribution of manufacturing and warehouse facilities. Since the Industrial Revolution, supply chain management has become increasingly prominent in corporate thinking. While companies no longer strive for the vertical integration used by monopolies such as Carnegie Steel, maximizing efficiency is still a growing concern. In fact, practitioners and academics write about a day in the not-so-distant future when competition among companies is decided not by the quality of their products or by their prices alone, but by the relative efficiency and effectiveness of each company’s supply chain.

Supply Chain Trends

In their book on supply chain management [1], Ram Ganeshan and Terry P. Harrison note that there are four general decision areas regarding supply chain management:

• Production – what to produce, in which plants, allocation of suppliers to plants, plants to distribution and warehouse facilities and those facilities to end customers.
• Location – includes size, number and location of production; stocking and sourcing points, which once determined, dictate all possible flow paths of goods to end customers.
• Inventory – how much inventory of raw, intermediate and finished goods to keep either stored or in-between locations.
• Transportation – mode(s) of transportation used between nodes of the supply chain.

These decisions have a significant impact on a company’s utilization of real estate. The production decision determines the types of real estate necessary, ranging from R&D facilities to manufacturing and assembly plants (for a detailed definition and description of the primary types of industrial real estate, refer to Guide to Classifying Industrial Property by Johannson L. Yap and Rene M. Circ.) The inventory and location decisions primarily influence the size of individual facilities. Transportation decisions influence the physical characteristics of the buildings themselves (interior/exterior docks, drive-in doors, rail, etc.)

Simply put, real estate plays an integral role in every company’s supply chain. Thus, it is surprising that most definitions of supply chain do not refer to real estate at all. The Institute for Supply Management, the largest and oldest supply management association in the world, founded in 1915, defines supply management as, “the identification, acquisition, access, positioning and management of resources that an organization needs or potentially needs in the attainment of its strategic objectives.”

This and other frequently used definitions accurately capture the general supply chain trends revolving around outsourcing and applied technology. Outsourcing relates to all aspects of a company’s activities. The two most common forms of outsourcing are collaborative manufacturing, third-party logistics (3PL) and warehousing. Applied technology, such as inventory management software and radio frequency identification devices, is essentially the facilitator of other trends.

The modern form of collaborative manufacturing started to emerge in the 1970s as companies began moving away from a vertically integrated operation, in which a manufacturer owned all (or at least several) levels of production, from raw materials to final assembly. The first collaborative models outsourced component production, but kept final production and assembly in-house. During the 1990s, this trend was accelerated by the introduction of new technologies, such as the Internet, into production, logistics and sales. As a result, manufacturing has shifted from a build-to-plan to build-to-configure and build-to-order manufacturing. Dell Corporation is frequently cited as a successful case study of a buildto- order manufacturer. The most recent element of collaborative manufacturing has been the outsourcing of all stages of production. In 2005, Boeing outsourced its aircraft assembly plants in Kansas and Oklahoma to Toronto-based Onex Corporation, in order to focus on R&D and design.

Outsourcing of packaging, distribution and warehousing is even more common, especially in the manufacturing sector. According to Armstrong & Associates, 80 percent of Fortune 500 companies outsource at least one logistics function to a 3PL. The benefits of outsourcing are twofold. First, the cost of inventory can reach 40 percent of the value of the goods stored. Thus, relying on the expertise offered by 3PLs and the technologies they have implemented can reduce the amount of inventory needed and thus cut costs. Second, the original equipment manufacturer avoids large investments in nonproductive assets such as warehouses, trucks, containers, etc. The trend of outsourcing to 3PLs has been accelerating in the past four to five years, and according to the International Warehouse Logistics Association, it reached $78 billion in 2004 compared to $6 billion in 1991, and is expected to grow 15 to 20 percent a year.

There is one more form of outsourcing – outsourcing of corporate real estate, which is generally underutilized and often overlooked. To bring real estate to the forefront of supply chain management thought, particularly industrial real estate, we use the definition offered by Ganeshan and Harrison, who define supply chain as:

“…a network of facilities and distribution options that perform the functions of procurement of materials, transformation of these materials into intermediate and finished products, and the distribution of these finished products to customers. Supply chains exist in both service and manufacturing organizations, although the complexity of the chain may vary greatly from industry to industry and firm to firm.”

Industrial real estate plays an integral role in the overall economy. It is the place where ideas are tested, products are created and raw, intermediate and finished goods are stored. Although it is rare for an R&D facility, a manufacturing or assembly plant or a warehouse – the basic physical components of a company’s supply chain – to appear on the cover of a popular business publication, decisions regarding these facilities are critical to a company’s competitiveness. Users of these facilities have understood their importance however, as 65 percent of all industrial space is owned by corporate users (as estimated by First Industrial). This high percentage, the highest among all corporate asset classes, translates to between a $700 and $900 billion investment in passive assets by corporations.

Corporate Real Estate Ownership

The historical reason for ownership of industrial real estate was lack of alternatives. In addition to the users, there are three primary owners of industrial real estate: real estate investment trusts (REIT), pension funds and private investors/developers. While private investors have been active in the market much longer, REITs and pension funds did not play a role until relatively recently. Although they were created by the REIT Act of 1960, REITs did not experience significant growth until the early 1990s. During that time period, many REITs went public, which gave them the necessary capital to expand their portfolios. Meanwhile, though pension funds have been in existence longer, they did not start to invest in real estate until the late 1970s, with the first major investment undertaken by the California Public Employees’ Retirement System in 1983. Despite the relatively recent entrance by these new investors, some industrial building subtypes remain unattractive. This investor unwillingness is clearly demonstrated by the difference in user ownership, which is significantly higher for manufacturing buildings than warehouse distribution properties. Today, for most industrial subtypes, the primary reason for user ownership is control. Control of the asset rises in importance proportionately to the additional investment made by the user to the asset to make it operational.

However, tying up capital in real estate can have adverse implications for the company’s performance. For many companies, especially higher growth companies, there is a positive arbitrage between the expected return on core business investments and real estate returns. Further, real estate ownership requires management’s human resources, which similarly to financial resources, can be used more productively in the core business.

Outsourcing of Industrial Real Estate – Real Estate Solutions

Once the questions of production, location, inventory and transportation have been answered, a company is likely to be left with two supply chains – the one it currently operates and a more optimal one. In most cases, supply chain reconfiguration creates new space needs and renders other facilities superfluous, thus creating a new set of decisions: new versus existing inventory and lease versus own.

The decision between building a new build-to-suit facility, moving into a new facility that was built speculatively or moving into second- generation space is usually determined by two factors: configuration of space and market conditions. Companies that require space build-out and configuration above market standard are usually left with no alternative to building their own facility, while companies with commodity-like space needs have more options subject to market conditions. Industrial real estate market conditions over the past few years (2002-2004), and over the next one to two years will be ideal for undertaking supply chain reconfigurations. The high availability rates offer a variety of space alternatives, and weak rental rates allow companies to lock in low occupancy costs for extended lease terms.

The lease versus own decision is a capital allocation decision that affects a company’s balance sheet and return on invested capital. Figure 2 describes the steps involved in analyzing a lease scenario versus owning the same facility. The input variables address the current market and book values of the property, the residual value, the corporate tax rate and a proposed triple net lease. The result of this model is an internal rate of return (IRR) at which the corporation is indifferent between owning and leasing the asset. More explicitly, if the corporation is able to reinvest the sale proceeds at a rate of return higher than the resulting IRR, a positive arbitrage exists between the two scenarios. Taking advantage of this arbitrage increases return on invested capital, has a positive impact on corporate balance sheet, can be accretive to earnings per share and offers a source of capital beyond the bank and the capital markets. This analysis makes a strong case for leasing versus owning for a large percentage of corporate industrial real estate user-owners. The lease versus own decision extends beyond just analyzing new locations identified by the new supply chain; this process is equally applicable to buildings currently owned by corporate users.

The solution that is most applicable to disposition of real estate, but which is often underutilized, is a sale-leaseback, which can resolve both operational and financial issues. Today, the most common usage of the sale-leaseback structure is in the triple net lease arena, where a company signs a long-term triple net lease and thus converts the pricing of the building from pure real estate pricing to credit-based, debt-like pricing. However, this real estate solution is equally applicable to corporate expansion, contraction and surplus real estate. In all cases it provides capital, while improving pricing of the disposed real estate. Unlike in the triple net lease case, a partial sale-leaseback, whether short- or longterm, facilitates more efficient space usage by enabling a reduction in the amount of space utilized, while a short-term leaseback, whether partial or full, improves the pricing of surplus real estate versus selling a vacant building.

The process of supply chain reconfiguration, especially when complete relocation is undertaken, can be eased by using the company’s real estate as part of the solution. During a realignment, timing the disposition of a current facility with taking possession of a new facility can be costly. Teaming up with a national real estate solutions provider that owns, develops, buys, sells and leases property can help maximize the value of current real estate, minimize cost, speed implementation and result in a much smoother transition. A short-term sale-leaseback offers a corporation the ability to monetize its current real estate, while giving it time to build/lease new space and wind down operations at a current location. If a corporation chooses to lease new real estate, the same solutions provider can build and own a new facility, while signing a mutually beneficial long-term triple net lease to make the building marketable to a greater pool of potential investors. However, if a corporation wants to continue owning real estate, a fee development financed by the proceeds from the sale of a property can efficiently accommodate a corporate need. A sale-leaseback can be utilized even when a relocation does not involve building a new facility. Similar to the surplus real estate example, a short-term sale-leaseback can improve pricing and simplify the relocation process.

As corporations strive to maximize operating efficiency and profitability, real estate can play an important role in reaching corporate goals. Collaborative manufacturing has enabled companies to further streamline their operations and has allowed them to free up capital resources for reallocation into higher yielding investments such as product development and brand management. Until now, real estate has not always been viewed as an outsourcing opportunity, despite the emergence of national, diversified real estate operators, such as REITs. Outsourcing real estate, whether for supply chain reconfiguration or as a source of capital, has positive implications for a company’s balance sheet, return on investment and operating flexibility. As these new investors have matured and more creative real estate solutions such as saleleasebacks, operating/capital lease structures and credit-based valuation of real estate have emerged, the environment is ideal for companies to embark on a new wave of profitability driven by real estate outsourcing.

1 An Introduction to Supply Chain Management. Penn State University; http://silmaril.smeal.psu.edu/misc/supply_chain_intro.html