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Duke Realty CEO Jim Connor: Cap Rates on High Quality Logistics Assets Have Been Compressing

The CEO of the publicly-traded industrial REIT discusses the outlook for industrial facilities, Duke’s balance sheet and dealing with natural disasters.

In today’s market, with ever-increasing e-commerce sales driving consumer spending, industrial REITs provide as much certainty and upside as is possible within commercial real estate amid the economic uncertainty and accompanying recession initiated by the global COVID-19 pandemic.

NREI invited Jim Connor, chairman and CEO of Duke Realty, one of the nation’s top publicly- traded industrial REITs, to discuss growing demand for industrial space and his company’s current and future strategic plans to meet retailer needs. Duke Realty, which owns and manages 518 modern warehouse and distribution facilities totaling 156 million sq. ft., is focused on 20 gateway and tier-one coastal markets nationwide.

This Q&A has been edited for length, style and clarity.

NREI: What are the biggest challenges your company is currently facing and what strategies are you implementing to meet these challenges?

jim-connorJim Connor: Obviously, the global pandemic has been a big shock to the world and the real estate industry in 2020. We’ve now gone through a significant six-month stress test. However, Duke Realty remains in exceptional shape. Our strategy has been to return to the fundamentals. We have improved our balance sheet and leverage, raised the occupancy in our portfolio and our development pipeline. All of this has enabled us to reinstate our earning guidance for the full year 2020, which we had reduced in April at the onset of the global pandemic.

NREI: E-commerce retailers and 3PLs are aggressively expanding—particularly Amazon.  How is this impacting user demand for space at your facilities?

Jim Connor: According to recent U.S. Department of Commerce data, e-commerce sales soared a record 44.4 percent in the second quarter of 2020—more than $1 in every $5 spent came from online orders during the April-June period. This activity is directly impacting demand for space. We estimate that close to one-third of our leasing and development activity is e-commerce related. That can be in the form of direct to consumer e-commerce companies or retail and consumer products companies expanding supply chain networks to meet the ever-increasing demand of online shoppers. In keeping up with anticipated e-commerce growth, we project demand to reach approximately 400 million square feet of space through 2022.

NREI: Your company has more than $800 million in new projects in the development pipeline.  Where are these projects located and why, how much space do they involve and how much of it will be delivered this year; and how much is speculative, build-to-suits and pre-leased?

Jim Connor: These projects are located all over the United States. We are always actively developing in the top 20 U.S. logistics markets. The highest priority has and will continue to be in the high-barrier, coastal tier-one markets like South Florida, New Jersey, Southern and Northern California and Seattle. More than 80 percent of our land bank for development going forward is in these markets.

NREI: There is currently more than 111 million square feet of new space underway. Do you think developers are overbuilding?  Why or why not?

Jim Connor: This level of construction is not significantly above recent U.S. historical demand levels. All developers stopped new speculative construction at the start of the pandemic. This has enabled demand to catch up. We anticipate that industrial markets will remain very much in balance with vacancies below five percent for the remainder of 2020 and well into 2021.

NREI: What types of tenant uses are currently driving the most new demand for space?

Jim Connor: We are seeing that e-commerce giants are impacting approximately 25 percent of the market activity. These are companies like Walmart, Target and Amazon. Also, big-box home improvement retailers such as Home Depot and Lowe’s seem to be very active right now. The major consumer products companies, 3PLs, furniture and food and beverage suppliers are also active nationwide. Currently, these big players seem to be taking an offensive position, which is driving much of our leasing activity.

NREI: I noticed in reviewing your company’s report to investors that there is considerable capital available after dividends are paid. Are you planning to use that capital to access funding for new projects, and if so what and where?

Jim Connor: We have in excess of $175 million of free cash flow annually. This is our cheapest form of capital and we plan to redeploy all of it back into our business to grow our portfolio through acquisitions and new development.

NREI: Are you expanding into new markets?  If so, where are these locations?

Jim Connor: We operate in the top 20 U.S. logistics markets, and I don’t see us actively looking to expand beyond that today. We will continue to focus on the coastal tier-one markets, while keeping an eye on infill opportunities. In fact, we have a number of infill redevelopment projects (underway or completed), including in the Chicago O’Hare area, San Francisco/East Bay, Seattle, Southern California, Atlanta airport area, Northern New Jersey and South Florida.

NREI: What types of new industrial tenants are entering the market that may become significant users of space?

Jim Connor: We have seen expanded purchase categories with grocery and furniture channels notably experiencing a spike in adoption. The e-grocery sector is expected to grow from about three percent of sales today to as high as 25 percent by 2025. So, we anticipate an expanded need for freezer/cooler and food-grade facilities in the future.

NREI: What types of uses do you predict will drive most of the demand for industrial space in the coming years and where will they be located?

Jim Connor: Our primary focus is on logistics space, and the growth we expect to see in U.S. markets will generally follow population growth. Our space is there to serve U.S. consumers and, as such, any markets where you see growth will create opportunities for Duke Realty.

NREI: You have a number of infill, redevelopment projects underway. Are these last mile facilities? What was the thinking around targeting these locations?

Jim Connor: We have been a prolific infill developer or redeveloper over the years. At last count, we had done over $2 billion in infill redevelopment. Many of the facilities are, in fact, last mile facilities for clients like Amazon, UPS and FedEx. The interesting thing about last mile facilities is they are much larger than people think. Many people envision smaller, older buildings close to the central business district. In fact, most last mile facilities are new 150,000- to 400,000-square-foot buildings that are built or redeveloped specifically for our last mile clients. The sites include substantial parking for drivers and delivery vans and are located closer to population areas rather than in central business districts.

NREI: What type of returns is your company targeting for new acquisitions and developments and within what timeframe?

Jim Connor: The value creation margins on our overall development pipeline are more than 30 percent, and we are targeting to maintain that margin. Given where there are market vacancies and where we anticipate demand trends, we should be able to maintain those margins.

NREI: Investment in the industrial sector is doing better than other commercial real estate sectors, and due to economic uncertainty, some experts are suggesting investment in REITs over private investment firms or one-off deals.  Is your company benefiting from the uncertainty in the marketplace, are you seeing an increase in investment in Duke Realty stock?

Jim Connor: Clearly, we are benefiting in some areas from the increased interest in the logistics sector. Our share price has performed very well, and our dispositions pipeline is seeing record low cap rates for the projects we choose to sell. Unfortunately, it has made acquisitions much more competitive. For example, we’ve seen cap rates compress by 25 basis points since the start of 2020 as a result of all the demand for quality logistics properties.

NREI: With more manufacturing companies near-shoring in Mexico, rather than China or Southeast Asia, what type opportunities do you think this will create for industrial investors on this side of the border?

Jim Connor: The continued trend of “on-shoring” or “near-shoring” will require more high-quality industrial space across United States. “Safety stock” is also a new term we’re hearing from major retailers, e-commerce companies, consumer products companies and distributors. These companies feel the need to have more critical or core material inventory on hand to avoid future supply-chain disruptions—said differently, the “just in time” models are under much greater scrutiny today. The shift has been to more of a “just in case” strategy. These are two new trends that we think will drive increased demand for high-quality logistics space nationwide for the next five years.

NREI: Duke Realty has properties on the West Coast, in Texas and in the Southeast. Are any of Duke Realty’s assets threatened by fires, hurricanes or flooding from tropical storms that are occurring in these regions? If so, can you describe the situation and any steps your team has taken to try to prevent or minimize damage?

Jim Connor: When you own and operate a portfolio of 155 million square feet around the country it seems like there’s always some threat we’re dealing with somewhere. We have local teams on the ground in every market we operate in to help our clients deal with any type of disaster or disruption. That’s one of the great advantages Duke Realty offers its clients. Duke Realty has been tested and proven—having been in business for almost 50 years, and with a portfolio of our size, we’ve dealt with virtually every kind of disruption you can think of. We have protocols in place to prepare for and recover from wildfires, tornados and hurricanes. I’m also particularly proud of how well our teams continue to help our clients during this pandemic. We have been a resource in helping our clients apply for government aid, institute safe workplace guidelines, and return to work practices.

NREI: Is there anything else you want to say?

Jim Connor: Despite the challenges created by this pandemic, Duke Realty remains in a position of strength. Our leasing prospects and project pipeline are very robust, and we are optimistic about continued new development starts. We develop and own the highest quality assets and have one of the most geographically diversified portfolios with high credit quality tenants. We are well positioned for future growth through development and select acquisitions.

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