Warehouse Market Sees Gains As Absorption Increases, Vacancies Improve


Despite Leasing Gains, Recovery Isn’t Yet Robust and Industrial Sales Continue to Lag
October 20, 2010

Add another commercial property type that is now on the path to recovery. The U.S. warehouse market joined the office market in clear recovery mode after logging another quarter of positive absorption and improving conditions as the national industrial vacancy rate edged down slightly for a second consecutive quarter.

Similar to its office market counterpart, the industrial real estate market is also seeing the pace of recovery vary quite a bit from market to market, according to CoStar Group’s Third Quarter 2010 Industrial Real Estate Review & Outlook.

Recovery is slower to take root in the sales market and probably won’t be as robust as some would like to see. But with so little new warehouse supply on the horizon, any growth in demand could quickly cause the rate of recovery to accelerate, CoStar Senior Director of Research and Analytics Jay Spivey said in a webinar presentation this week with Hans Nordby, Director of Advisory Services.

“We could be surprised at the level of recovery, given the low levels of supply we’ve seen,” Spivey said.

Seven of the previous eight quarters prior to second-quarter 2010 posted negative absorption. The market has bounced back since earlier this year, absorbing 10 million in the second quarter and 8 million square feet in the third quarter. While far from broad-based, “it’s official – we’re in recovery,” Spivey said.

Leasing activity remains steady. The amount of gross square footage leased quarterly has been a “picture of stability” through the downturn, even spiking to a decade high of 620 million square feet in 2009, one of the worst years for the economy on record. The Inland Empire, (positive 5.6 million square feet), Philadelphia (+5.1 million), Houston (4.6 million) and Phoenix (3.2 million) topped the list for net space absorbed, with Chicago and Cincinnati tied for fifth at 2 million.

While four of the top six markets reporting positive absorption are large distribution hubs, not all the major distribution regions are doing well. Some of the largest, Atlanta, the San Francisco Bay Area and Los Angeles, all posted negative absorption exceeding 5 million square feet in the quarter. New York, Dallas, Chicago and New Jersey also gave back significant space. Seven of the eight markets with the highest negative absorption have been hit hard by the housing and manufacturing busts.

The good news for the market, Spivey said, is that very few warehouse construction starts are on the books for the next couple of years. New supply will hit another all-time low in 2010 — so low that any significant growth in demand as the economy improves could cause a fairly dramatic decline in vacancy rates, quickly accelerating recovery in the warehouse sector.

A look at the percentage of submarkets with declining vacancies in the third quarter shows how fast industrial occupancy is poised to rise as a result of constrained supply. Submarkets vacancies are a leading indicator for the national warehouse market because they generally start to decline much sooner than the national rate.

Almost 55% of the nation’s industrial submarkets saw falling vacancy rates in the third quarter. During the last recession in the early 2000s, it took about 11 quarters to reach that level of submarket recovery, largely due to the huge amount of new space that hit the market early in the decade. With limited supply, declines in submarket vacancy have been much steeper in the current cycle.

Quoted rents have declined steadily for two years in the current downturn, about 11%, a larger drop than the last recession. With quarterly occupancies rising in about half the nation’s industrial markets, rent declines appear to be bottoming.

CoStar forecasts relatively mild absorption in the industrial sector through 2014, much lighter than the huge spikes in both absorption and supply that marked the last recovery. “Overall, we’re going to see improving fundamentals, declining vacancies and rising rental rates,” Spivey said.

Sales Market Recovery Lags

Like other property types, industrial sales transaction volume, measured as a percentage of the total market, remains far below historical averages, and well below the trough of the recession 10 years ago. Most markets are plagued by poor liquidity, though a few, including Raleigh-Durham, Richmond, VA, Washington, D.C., Inland Empire, Tampa/St. Petersburg and Charlotte, are seeing higher square footage sold as a percentage of their total market size. Buyers and sellers remain at odds on selling versus asking prices, though the number of properties withdrawn from the sales market by discouraged sellers is starting to level off.

The CoStar Repeat Sales Index, which measures the price differential between properties that have sold more than once, shows that industrial prices remain in decline, though larger investment-grade properties are seeing some price appreciation in the bifurcated market. Those investors returning to the market prefer the safety of those well-leased higher-end properties.

The largest industrial sales in the third quarter were portfolios, with three of the top four acquired by REITs, including the purchase of seven data center properties in Arizona, California and Virginia by Digital Realty Trust from Rockwood Capital for $725 million. Portfolios made up 40.6% of total sales volume in the third quarter.

While bullish on the recovery long term, industrial CRE brokerage executives sampled by CoStar are cautious about what they see as uncertain signals from the economy.

“The summer may have proved to be an inflection point in the industrial leasing market, but we are cautious about the mixed signals we are seeing in important leading indicators, and what they are telling us about the overall direction of the U.S. economy right now,” said Craig S Meyer, Jones Lang LaSalle managing director and head of industrial real estate for the Americas.

While there’s still significant activity in the big-box sector, manufacturing has lost some of its momentum as inventories have stopped growing as fast, Meyer said. Consumer confidence is being constantly tested and supply chains are expected to run leaner going forward. While imports and cargo volumes through gateway seaport and airport markets have improved, it’s uncertain whether these higher volumes are sustainable, Meyer said.

“We are expecting rents to continue to decline through 2011,” he said. “The worst of the declines may be over, and while there are pockets of organic growth now beginning to develop, demand has not firmed significantly enough throughout the entire industrial market to envision an overall or sustained uptick yet.”

“It will be a long process toward recovery, but the worst appears to be behind us,” said David Bercu, principal in the Chicago office of Colliers International.

“The first step was landlord capitulation on rental and sale prices, which started its rebound second-quarter 2010. Owners have acknowledged that prices have dropped approximately 30% since the peak of 2007 and met the market,” Bercu said.

Recent economic data indicates a slowdown in manufacturing and a reduction in inventories, however, which could have a direct impact on industrial real estate, Bercu said.

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