Industrial property business basks in the glow of a virtuous cycle

The industrial property sector is partying like it's...well...2005.

The market—which lumps together manufacturing, warehouse and distribution center, transportation, and logistics facilities—is experiencing one of its strongest cycles in years. Warehouse rents are rising, with the average rental rate up 4.4 percent from a year ago, according to JLL, a real estate and logistics company. CBRE Inc., a huge developer, pegs the year-on-year gain at about 3.1 percent. In the southern California market, home to the country's largest seaport complex, rents are up nearly three times that, driven by huge demand for port-centric property as well as the need for more cross-dock space to handle the transloading of goods from 20- or 40-foot marine containers to 53-foot boxes moved inland via truck or rail intermodal.

Vacancy rates nationwide in the third quarter dropped to 7.2 percent, the lowest level in six years, according to JLL data. Vacancies in red-hot markets like the Lehigh Valley in central Pennsylvania have dipped below that, hitting levels not seen for a decade or more, according to Jake Terkanian, vice president of the global industrial services group at CBRE. Nationwide availability, which tracks current vacancies and space that will become available in the next six months, reached their lowest levels in the quarter since the first quarter of 2008, according to CBRE.

Nationwide net absorption, broadly defined as the amount of occupied space less the amount of space vacated, hit 143.8 million square feet through the first nine months, up 28.5 percent from a year ago, JLL said. Vacancy rates could fall to as low as 6.9 percent in the seasonally strong fourth quarter, when demand for space picks up before the holidays, JLL said. By year's end, net absorption will reach, at minimum, 185 million square feet, up nearly 10 percent from a year ago, JLL said.

The anecdotes add fuel to the story. In the Lehigh Valley, there are no more 500,000-square-foot "big box" distribution centers on the market, according to Terkanian, who oversees the region for CBRE. In Bethlehem, Pa., Zulily, a fast-growing e-tailer, leased out all the space of an 800,000-square-foot distribution center, which was built as a speculative development, about six months before construction was finished. Out west, Los Angeles has a 1.9-percent industrial vacancy rate, according to Newmark Grubb Knight Frank, a real estate services firm. About 2.5 million square feet is under construction there.

California's "Inland Empire," where industrial rents are significantly cheaper than in and around the Los Angeles basin, has been on a multiyear roll as the DC conduit between imports off-loaded at the Ports of Los Angeles and Long Beach and consumer markets across the west. Ironically, third-quarter vacancy rates have ticked up to 5 percent from 4.8 percent in the prior quarter and 4.6 percent in the year ago period, according to Newmark data. That could be because of a minor oversupply condition due to the 12 million square feet under construction there.

Low interest rates, sharply declining oil prices, and a generally better economy have created a "potent cocktail" for industrial demand, according to Jim Clewlow, chief investment officer of Centerpoint Properties, which specializes in developing transportation and logistics projects. Should oil prices stabilize at current levels or fall further, that could trigger demand for more distribution centers, Clewlow said. That's because higher oil prices generally encourage producers, distributors, and retailers to consolidate their DC networks in an effort to reduce shipping costs and conserve fuel.

The industrial segment is demand-driven, and tenant demand is demonstrating consistent strength. Space needs were up by 23.9 million square feet compared to the winter of 2013, and on par with summer 2014 levels, JLL said. In addition, 45 percent of the demand is for space under 500,000 square feet, a reflection of broad-based strength and the bullishness of smaller distributors, the firm said.

A VIRTUOUS CYCLE
When the real estate market turned down sharply starting in 2007, industrial construction nationwide virtually ceased. It stayed frozen for about 18 months. From 2010 to 2013, deliveries of new projects plumbed a 50-year low, according to JLL data.

However, as e-commerce growth and low interest rates began fueling economic activity, developers got busy and once-dormant markets started perking up. They've continued to gain momentum. Total construction in the third quarter of 2014 rose 16.5 percent from the prior quarter and 54.2 percent from a year ago, according to JLL. In Atlanta, construction reached 12.4 million square feet by quarter's end, up 104 percent from the end of the prior quarter, the firm said.

Still, there is plenty of catching up to do. New completions at the end of 2014 will only match 2003 levels, says Dain Fedora, JLL's research manager, Americas industrial. Projected new completions hitting the market next year will only return the sector to 2005 levels, he adds. The supply that went online in the third quarter, while being the strongest quarter to date, is still at levels below the long-term average, adds CBRE.

The market, being what it is, will eventually seek its level. Supply will continue to increase, eventually bringing it into equilibrium with demand. But that may not happen until well into 2016. "We still need that product," Terkanian says. Landlords, meanwhile—who three or four years ago were handing out incentives left and right to entice prospective tenants and keep existing ones—are now in the catbird's seat. "In 24 months, the pendulum has completely swung," Terkanian says.

Bigger markets like Los Angeles, Dallas, Chicago, and New Jersey/central Pennsylvania may find themselves with a supply overhang, according to Tim Feemster, managing principal of Foremost Quality Logistics, a consulting company. However, tenant demand should remain sufficiently strong to keep net absorption levels growing, Feemster adds.

Activity in 2015 will be influenced by how the holiday season pans out, Feemster says. Busy cash registers combined with a continued uptick in the overall economy will embolden developers to increase their capital investments, he reckons.

In this environment, it is hardly a surprise to see rental rates increase. And that is unlikely to faze producers, distributors, and retailers willing to pay a premium to be near transportation nodes and dense population centers. According to JLL, logistics costs—transportation, inventory, and labor—account for about 80 percent of a user's operating budget. Real estate, by contrast, comprises just about 5 percent. Higher rents are "a drop in the bucket" for companies keen on being where their customers are, Fedora says.