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U.S. Industrial Property Review: Sector outperforms other property types

Global Real Estate Monitor

It may not be considered the sexiest or most exciting property type, but industrial real estate’s stability and growth opportunities in 2010 put the sector head and shoulders above other types of commercial property.

“There was less overbuilding in the industrial sector and overall vacancy is below that of retail and office properties, so fundamentals are better and perhaps more appealing,” says Micheal Palmer, senior managing director with Studley’s Houston office. “When the economy truly picks up, industrial users are at the forefront of activity to meet demand and landlords may be able to increase rates at that time, likely in advance of office and retail owners.”

Wall Street analysts and industry professionals expect the industrial property sector to show marked improvement this year, driven by improvement in the manufacturing and import/export industries.

“Industrial is likely to be one of the first, if not the first commercial property type to bottom out and embark on a recovery,” says Ross Smotrich, REIT analyst with Barclays Capital, adding that occupier demand for industrial space is less dependent on job creation – which is a lagging economic indicator – compared with the office, retail and apartment markets.

Larry Harmsen, president of ProLogis’ U.S. and Canada business, says the industrial REIT is seeing some signs of stabilization and increased customer activity. “While industrial demand is still soft, occupancy declines are slowing and activity levels appear to be picking up,” he notes. “However, market rents are still lower than they were a year ago, and we’re seeing some signs of declining cap rates.”

Growing demand drivers

Smotrich notes that the drivers of demand for industrial space – production activity, freight shipments and global trade – have bottomed out and begun to grow again, at least tentatively. “This is reflected in the steady moderation of vacancy increases and negative absorption in recent quarters,” he says. “The trend line suggests that industrial vacancy could peak as early as mid-2010 and embark on a gradual, multi-year recovery cycle late this year or early 2011.”

There is a close historical correlation between industrial demand and economic activity. The ISM (Institute for Supply Management) index, which measures business activity for both manufacturing and non-manufacturing, is a key indicator of an expanding or contracting economy and is an especially relevant metric for the industrial sector. Since bottoming in November/December 2008, both the ISM manufacturing and non-manufacturing indices have increased, indicating an economic expansion.

In February, for example, the ISM index was 56.5 percent, and a reading over 56 percent is consistent with strong growth in manufacturing and growth in the economy of about 4.9 percent, according to the ISM.

“The February ISM index provides further evidence the recession is over and the increase in manufacturing activity during the first quarter is likely to be sustained at least at a moderate rate in 2010,” wrote Joe Liro, an economist for Stone & McCarthy Research.

In addition to the ISM index, global economic trends are key metrics to watch in order to forecast industrial demand. Because tenants that occupy industrial space are global, and the goods housed in the warehouses tend to be shipped globally, it’s important to keep an eye on global gross domestic product (GDP), not just U.S. GDP.

Historically, global GDP has grown faster than U.S. GDP, especially since the early part of this decade. In 2008, global GDP grew at 3 percent, outpacing the 0.4 percent U.S. GDP growth; global GDP turned negative in 2009, however, but is expected to fall less than U.S. GDP (–1.1 percent versus –2.7 percent).

Looking forward, the International Monetary Fund expects global GDP growth to exceed U.S. GDP growth by 150 to 200 basis points annually. This year, the IMF forecasts global GDP growth of 3.1 percent, versus 1.5 percent for the United States.

Global trade, which may have a more direct impact on industrial fundamentals than pure economic direction, has an interesting historical relationship to global GDP. When the economy is expanding, global trade growth exceeds global GDP growth; conversely, when the economy is contracting, global trade falls by a larger amount than global GDP.

In 2007, when global GDP was growing at a strong pace of 5.2 percent, global trade grew at 7.3 percent; in 2008, when global GDP started to slow but was still positive (3.0 percent), global trade started to fall faster (also growing 3.0 percent). In 2009, when global GDP is expected to fall 1.1 percent, global trade is expected to fall 11.9 percent.

While the IMF does not forecast global trade, one can expect that if the historical relationship holds going forward, global trade will exceed the mid-single-digit growth expectation for global GDP, according to Barclays.

In fact, analysts are anticipating a rebound in container traffic through U.S. ports during 2010.  After having contracted about 10 percent during 2009, U.S. container traffic is expected to grow about 6.5 percent in 2010 to 41 million TEUs. However, traffic is not expected to regain its 2007 peak until next year.

Noticeable green shoots

Green shoots of improving fundamentals in the industrial real estate sector are beginning to emerge. In Houston, for example, KDC has inked four new lease deals in the past couple of months including 40,600 square feet to Goodman Distribution Inc. and the Houston Chronicle at Ellington Trade Center. Goodman Distribution Inc. will occupy 25,300 square feet and the Houston Chronicle will take 15,300 square feet.

“We’ve got good activity at our properties in Houston and Austin,” says Randy Touchstone, executive vice president of Dallas-based KDC and director of the firm’s industrial program. “It feels like companies are looking up, and saying ‘let’s take advantage of the market and try to lock up these low costs to benefit our business.’ They’re making decisions and moving forward.”

Although the U.S. industrial real estate markets finished 2009 on a weak note, they showed a marked improvement compared with the previous three quarters, according to Ross Moore, executive vice president of research for Colliers International. 

During the fourth quarter, U.S. warehouse markets continued to lose tenants – but at a reduced rate – and supply continued to be constrained. Fourth quarter absorption was again negative, but showed significant improvement over previous quarters. Rents, however, fell again and continued an eight-quarter-long series of declines.

In 2009, industrial absorption was 160.7 million square feet, and the U.S. industrial warehouse vacancy rate increased by 18 basis points during the fourth quarter to register 10.92 percent, according to Colliers International’s most recent industrial report. This was the smallest quarterly increase since vacancies started rising two years ago, but it does represent a decade high number, up 307 basis points from the low point in the fourth quarter of 2007.

Of the 51 markets tracked across the country, 38 saw vacancies increase while 13 registered declines, according to Colliers International. “Primary markets’ infill sectors fared substantially better than non-infill markets in either primary or non-primary regions,” says Michael Frankel, managing partner, Rexford Industrial, a Los Angeles-based industrial property owner, pointing to Southern California as an example. Vacancy topped out at 3 percent to 5 percent, on average, across the infill markets of greater Los Angeles, while vacancy ranged from 9 percent in the Western Inland Empire to the mid-teens in the Eastern Inland Empire.

In fact, nationwide vacancy remained lowest in land-constrained Los Angeles County at 3.3 percent and was highest in economically depressed Detroit at 22 percent, according to Grubb & Ellis. Vacancy increased most sharply last year in San Diego, Las Vegas and Palm Beach County, Fla., all of which recorded gains of 400 to 500 basis points. Only the Oklahoma City industrial market saw vacancy tighten slightly in 2009. 

Scarce construction financing and weak rents have halted almost all speculative warehouse development. This was reflected in quarter-end construction activity, which registered just 15.4 million square feet, a substantial drop from the 153.5 million that was under construction at the end of the third quarter of 2007 and well below previous levels ever recorded, according to Colliers International.

Dallas-Fort Worth led all markets with 1.6 million square feet still to be completed. Five other markets each had more than 1 million square feet remaining in the pipeline: Philadelphia, California’s Inland Empire, Oklahoma City, Phoenix and Houston, according to Grubb & Ellis.

In the upcoming quarters, industrial construction is anticipated to go even lower and stay well below 10 million square feet per quarter for all of 2010 and quite possibly 2011, according to Colliers International.

“In my opinion, the biggest story for industrial is the supply side – we’ve never seen so little industrial construction,” Moore says, pointing out that occupier design-build business has halted.

“When demand returns, the vacancy rate will come down very quickly.”

Meanwhile, fourth quarter 2009 warehouse rents posted a modest decrease, falling 3 percent to $4.99 per square foot. With this latest decrease, U.S. warehouse rents are down 9.7 percent over the past year and 12.3 percent from the peak recorded in the fourth quarter of 2007. While some markets have seen rents remain steady, some metros have seen industrial lease rates fall by more than 25 percent in the last 12 months, Moore points out.

Moore forecasts a further increase in vacancy early this year, although at a much reduced rate, with vacancies reaching a plateau as early as the second quarter. With almost no construction coming onto the market and forecasts for continued economic growth over the next few quarters, occupancies should begin to rise by midyear and show firmer fundamentals by year-end, he says. Rental growth, however, is not likely during 2010, and many markets may have to wait until 2012 before rents start to rise.

“Industrial is clearly on the upswing,” Moore says. “If I had to pick one property type to invest in for the next five years, industrial is where I’d want to be.” 

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