US INDUSTRIAL MARKET - Another Solid Performance

The US industrial property market posted another slate of good numbers in Q2. Despite economic indicators that have been sporadic at best, the industrial property market has been consistently strong. Net absorption has been positive in every quarter dating back to 2010. New deliveries have been running very close to total net absorption, which has kept the risk of overbuilding very low and vacancy in steady decline. A substantial percentage of new construction has been in build-to-suit transactions, which has given builders the confidence to get more aggressive in terms of speculative development. Of the 97.4 million square feet currently under construction in the six most active markets, 41% of that space was preleased. That’s good news for developers, but also good for occupiers, as that means there is also a steady supply of new spec space that allows expanding companies to be more nimble in executing plans for growth. 

In the country’s hottest markets, large blocks of spec space are being leased during construction or within just a few months of completion. With net absorption as strong as it has been, the construction pipeline for distribution product should continue to flow at least at current levels for the next several quarters. New deliveries for both speculative and build-to-suit projects for Q2 hit 53.2 million square feet in 381 buildings. That followed a nearly 60.8-million-square foot gain in inventory in Q1. The US industrial property topped 21.73 billion square feet in Q2, and another 224.8 million square feet was still under construction by the end of the period. However, construction is concentrated in just a handful of major markets including Dallas, Houston, Atlanta Philadelphia, Chicago and Southern California’s Inland Empire. Last quarter we reported that a disproportionate amount of market activity was concentrated in big deals by big tenants in big buildings. That hasn’t changed. In fact, the warehouse sector accounted for just under 90% of the 74.4 million square feet of net absorption recorded in Q2. Most of that was in large distribution deals. The top three lease signings for the quarter were all over 1 million square feet each, and over 40% of the net absorption through the first half of the year was posted in just 10 markets.

It’s not usual for the bigger distribution hubs to report multiple transactions over 1 million square feet in the same quarter. Large 3PL operators and online retailers like Amazon currently have the biggest appetite for space. Although, electric car manufacturer, Tesla Motors, also signed a lease in Q2 for over 1 million square feet in the Oakland/East Bay market.

The national vacancy rate for warehouse and flex space combined has been falling steadily, and that trend continued in Q2, as the amount of vacant space declined by another 10 basis points to finish the quarter at 5.9%. In the past four quarters, the vacancy rate has fallen by 50 basis points, but several major market areas have reached critically low levels, including Los Angeles and Long Island, New York, both of which are experiencing critically low vacancy and almost no new construction. Finding quality product there is problematic at best, as the aging inventory in those markets is becoming functionally obsolete. Relief is not in sight in those markets, either, as older industrial product is being repurposed for mixed use residential, retail and office projects, which means the base inventory of industrial product is shrinking despite rising demand.

Vacancy declines have average asking lease rates moving higher in the majority of US markets. The national average asking rate has moved up in every quarter dating back to 2011. In Q2, rents moved up another $.10 to $5.93 per square foot. Markets with the most construction are seeing more rapid rent growth as tenants continue to pay a premium for first generation space that offers higher ceiling clearance and state-of-the-art fire suppression capabilities.

The owner/user market remains seriously out of balance. Demand from users to buy their own facilities is running much higher than supply. Competitive bidding and price points that exceed asking prices are commonplace these days. In most markets, prices have risen to levels beyond the previous market peak. Business owners who’ve had it with paying higher and higher rents are opting to buy so they can control occupancy cost with fixed rate loans in the 4% range, some fully amortized over 25 years at up to 90% loan-to-value. We have our central bankers to thank for the opportunity. The Fed’s low interest rate policy has kept the yield on 10 Year US Treasuries (the index used for setting rates for most commercial property loans) at record lows for the last six years. Without that stimulus, this niche market would not be getting near the attention that it is, and prices would be far below current levels. But, the Fed remains reluctant to move rates higher due to a long list of economic indicators that are still cause for concern. So, users can probably count on low rates to persist for the time being, and that means that prices are likely to keep moving higher, too. Even so, the temptation to lock in occupancy cost for decades is compelling.

Investors, both institutional and private, have lots of money to spend, but too few places to put it. As we point out every quarter, cap rates are compressed and there is no clear indication of a change in that trend. Though, for those who follow markets closely, the chatter is sounding more cautious and experts in all real estate disciplines are more inclined to sound the alarm about a potential market correction. Lenders are tightening up on underwriting for riskier deals and institutions are closely scrutinizing tenant credit. Some experts think this market is getting long in the tooth, but that sentiment doesn’t seem to have dampened demand to any significant degree.

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