The property and the pendulum

If current conditions in the U.S. industrial property market were a Bruce Springsteen song, they'd be called "Glory Days" after his 1984 classic hit. If the history of the market were a Springsteen song, it would be a lyric from his 2012 song "Wrecking Ball" that reads: "... And hard times come, and hard times go ..."

Few American industries have rebounded as resoundingly from the recent financial crisis and subsequent recession. From 2007 through 2010, capital dried up, demand plummeted, speculative development vanished, and deliveries headed toward 50-year lows. Millions of square feet sat vacant. The turnaround, when it commenced in 2011, was somewhat halting. But it picked up speed in 2012, coinciding with demand for large-scale buildings to support the burgeoning e-commerce trade, and the market has not looked back.

"Net absorption," which compares occupancy rates at the beginning and end of each reporting period—factoring in vacancies and new construction during the period—has been in positive territory for 20 consecutive quarters as of this writing. The nationwide occupancy rate, which ended last year at about 6.9 percent, could fall during 2015 to near 6 percent, which would be a multiyear low. JLL Inc. (formerly Jones Lang LaSalle), a real estate and logistics services firm, said that 15 of the top 50 U.S. markets it regularly surveys are already reporting vacancy rates below 6 percent.

Vacancy rates in California's Inland Empire, the vast warehousing and distribution center complex 120 miles east of Los Angeles, sit at 5.3 percent, compared with close to 20 percent at the worst of the downturn, according to JLL. The rate in the high-demand, capacity-constrained Southern California port area is hovering around 2 percent. Vacancies in Pennsylvania's Lehigh Valley, the gateway for goods moving into the Northeast and swaths of the Mid-Atlantic, are at 3 percent, an all-time low, according to CBRE Brokerage Services, a commercial brokerage firm. About 90 miles to the south in Carlisle, Pa., a regional node serving the Mid-Atlantic to the Carolinas, vacancy rates are at 5.8 percent, according to CBRE.

In 2014, the Eastern and Central Pennsylvania markets—which total 216 million square feet and where goods can reach 40 percent of the U.S. population in one day's truck trip—reported positive net absorption of 17 million square feet. Vincent Ranalli, a CBRE senior vice president based in Wayne, Pa., outside of Philadelphia, called it the strongest one-year absorption rate he's seen in his 10 years there.

Like all real estate, industrial property has its cycles. The two recessions of the past 15 years took their toll on the sector. But the current up cycle seems different from the others, experts said. For one thing, it is the first where e-commerce is playing a significant role in renting and leasing decisions. Foreign capital is also more visible; in April, a joint venture between the Norwegian sovereign wealth fund and San Francisco-based developer Prologis paid nearly $6 billion for the assets of Rosemont, Ill.-based KTR Capital Partners, which controls 322 U.S. properties with 60 million square feet. In December, Singapore's sovereign wealth fund paid $8.1 billion to buy Chicago-based developer Indcor Properties Inc., which had 117 million square feet under management.

Goosing the cycle is a change in the leasing behavior of "mom and pop"-type tenants. Until recently, many cautious smaller occupiers have taken on short-term extensions to maintain flexibility, according to Jack Rosenberg, national director, logistics and transportation, for Seattle-based Collier's International, which manages about 1.7 billion square feet worldwide. Now, emboldened by the brighter overall outlook, they are committing to longer-term leases, Rosenberg said.

To no one's surprise given the shift in fortunes, landlords' asking rents are on the rise. Rent increases are in the 3- to 5-percent range, though specific increases depend on the desirability of the property and the market. JLL, which regularly surveys conditions in its top 50 U.S. markets, said its data at the end of the first quarter showed that rents were rising in each market.

An industrial parcel that might have fetched $2.70 per square foot in 2010 (net of taxes and other expenses) can command around $3.95 today, according to estimates by Collier's. In markets like Southern California and the Dallas/Fort Worth "Metroplex," rents can run as high as $5 per square foot. "There is real rent growth, and it's as high as it's ever been," said Rosenberg.

Landlords are not only minting more coin; they're also making fewer concessions and are stingier with incentives than they've been in years. In the bad old days, it would be commonplace for landlords to concede six months to up to one year of free rent just to generate occupancy. Tenants could also get thousands of dollars worth of improvements as sweeteners. Today, tenants will be fortunate to win two months of free rent. And improvements that might have been equal to $10 a square foot several years ago have been reduced to $3 to $4 per square foot today. Craig Meyer, president of JLL's U.S. real estate business, said that incentives are down between 60 and 70 percent since the market has improved. In a growing number of cases, tenants are being asked to pick up the tab for specialized improvements to their space, according to Ranalli of CBRE.

Ranalli said most tenants that are doing well enough to make major investments in industrial space aren't balking at the higher rents or the loss in negotiating leverage. In particular, e-tailers experiencing rapid growth will pay up for a modern well-equipped building to support their fulfillment operations, he said. "Tenants have accepted this, so you pay the price to get the deal done," he said.

That doesn't mean tenants are jumping at the first property they see. A multiyear commitment, combined with the expense of leasing a 500,000 to 1 million-square-foot building that may cost between $50 million and $100 million to construct, is cause for tenant selectivity. Increasingly, cream-of-the-crop "Class A" buildings are being built with 36 feet of "clear ceiling" height, up from 32 feet, in order to accommodate e-commerce companies that want multistory mezzanines and higher picking modules, according to Ranalli. Top properties are also coming equipped with deeper truck courts for better vehicle maneuverability as well as more trailer positions and additional car parking to accommodate the influx of workers and equipment, he said.

Lease durations have also been lengthened as landlords look to lock in better contract terms. Ranalli said landlords increasingly insist on a minimum five-year commitment. At the depths of the recession, the best landlords could hope for were two- to three-year terms, he said. Ironically, longer lease durations may be a better deal for tenants occupying custom-designed properties if they are putting up stakes in markets with significant construction activity that might lead to oversupply, according to Jim Clewlow, chief investment officer of CenterPoint Properties, a firm that specializes in developing transportation and logistics projects.

The roster of industrial property executives is stocked with folks who've been in the business for decades and have seen their share of downdrafts. Another down cycle awaits, but it's unlikely to occur before late 2016 or 2017. Spec development, which has remained relatively subdued even as the overall market has strengthened, is starting to accelerate. The Inland Empire has 20 million square feet of property going up. About 8.4 million square feet are under construction in Eastern and Central Pennsylvania. The Pennsylvania properties are expected to be delivered by the end of this year or early next.

At some point, demand will reach a crescendo, developers will scramble like the dickens to loosen what's been a tight supply market, the U.S. economy may slow, and the flood of space will then put tenants back in the driver's seat. JLL's "property clock," which analyzes its 50 key markets at their various cycles, shows that markets like Dallas-Fort Worth, Atlanta, and California's Silicon Valley are peaking. However, those markets are in the early stages of the cycle. Until the clock runs out on those and other big markets, landlords will remain firmly behind the wheel.