Real estate development is risky. Cost overruns, construction delays, and permitting issues are only some of the problems that can cause a development project to flop. Another major issue is that tenant demand might not materialize, leaving the developer with a vacant building. Because of that, most developers prefer to lease up a significant portion of a project's available space before breaking ground.
However, sometimes taking a big risk can pay off. That has been the case for First Industrial (NYSE: FR), which is benefitting from starting speculative development projects to capture red-hot demand for warehouse space. Here's a closer look at its strategy.
Speculating that demand will remain robust
Most real estate investment trusts (REITs) tend to be conservative. Because of that, they either won't engage in any development projects or focus on less risky opportunities like fully leased build-to-suit projects. However, with demand for industrial real estate growing briskly, industrial REITs like First Industrial are increasingly starting speculative projects that don't have tenants lined up.
The company initially pressed pause on its speculative development program in early 2020 due to the initial uncertainty on the pandemic’s impact on the industrial real estate market. It relaunched its speculative development in the fourth quarter by starting the first phase of its First Park Miami development. It has since launched several other speculative development projects. At the end of the first quarter, it had five speculative projects under development, representing more than 2 million square feet of space and over $200 million of investment. The company also had one 100% leased build-to-suit project underway, representing more than 220,000 square feet and a $22.4 million investment.
The company started those speculative developments on the belief that it would secure tenants before it finished construction. Driving that view is the expectation that the industry will need a significant amount of warehouse space in the coming years to support the accelerated adoption of e-commerce.
The bet is beginning to pay off
First Industrial hadn't leased any of this space when it reported its first-quarter results in late April. While "building is great, '' quipped CEO Peter Baccile on the second-quarter conference call, "if you don't lease the buildings, that's not good." That's why the company was happy to report that those speculative bets are starting to pay dividends. First Industrial noted in its second-quarter report in late July that it had signed 1.2 million square feet of leases for speculative developments during the second quarter and early part of the third quarter. That secured tenants for a significant portion of its speculative projects.
That success gave the company the confidence to launch new speculative projects. It started four development projects comprising 2.7 million square feet of space and $266 million of total investment during the second quarter, including two fully-leased build-to-suit projects. That brought its total development program up to $500 million and 5 million square feet of space, 29% of which it leased by the time it reported its second-quarter results.
Meanwhile, First Industrial has three more projects lined up to start construction in the third quarter, totaling 692,000 square feet and $107.5 million square feet of total investment. It pre-leased 50% of the space on one of these projects. It has plenty of room to start additional developments, given its growing land bank. The company recently acquired a 95-acre site in Southern California where it could develop up to 1.4 million square feet of warehouse space. The REIT also bought out a joint venture partner to control the remaining 138 acres at a location in Phoenix where it could develop up to 2.2 million square feet of space.
Taking a calculated risk
While speculative developments are risky in real estate, First Industrial believes these bets would pay off. That's because demand for warehouse space is so strong that the company remains confident it can secure tenants for this space. With its leasing program making solid progress in recent months, the REIT is well on its way to cashing in on its speculative bets. Because of that, it could generate strong returns for its investors in the coming years.