NET ABSORPTION COOLS - RENTS KEEP MOVING HIGHER

After putting in another strong performance to finish the year, the industrial market took a bit of a breather in Q1, but kept moving in the same direction. Supplies of quality space are declining across the country and rents keep moving higher. Construction activity is robust, but concentrated in a handful of major distribution hubs. Supply in more mature markets is running thin as industrial land is being repurposed to higher uses despite dangerously low vacancy and strong demand from expanding businesses. The post-election surge of optimism continues, but cooled noticeably after the failed attempt to repeal and replace the controversial Affordable Care Act. All things considered, the industrial market kept its momentum and should continue on current trend lines for the rest of 2017. The Fed made another move on interest rates during Q1, the second adjustment in just three months, after inching closer to hitting its targets for inflation and employment. Markets took the move without the global economic hiccup its initial rate hike caused back in December of 2015. This time around, the Fed’s moves seem to have come as welcome news, as industrial business owners and commercial real estate investors see the tightening of monetary policy as a sign of a strengthening economy.

The recent rate hikes did push mortgage rates higher, but not by enough of a margin to dampen the enthusiasm for acquiring industrial properties. Demand from owner/users and third-party investors has pushed prices to record levels, and supply continues to run at a fraction of current demand. Lenders are underwriting deals with closer scrutiny, but there are enough highly qualified buyers out willing to be under the microscope.

Caution has its place, especially so many years into the market up cycle. At this point, no one knows how much further rates will need to rise to initiate the cap rate decompression so many experts have been talking about.

For the time being, owner/user buyers, are still lining up to pay record prices, but even though owners can reap windfall profits by selling, the tax consequences of cashing out are significant and exchanging is seen by many as just kicking the tax can down the road. Still, buyers remain aggressive, especially user buyers who can take advantage of SBA financing at 90% of a property’s value. They like the idea of keeping occupancy costs fl at for up to 25 years with fixed rate mortgages that are still in low 5% range despite the recent increase.

In Q1, net absorption was positive, but tepid compared to the last several quarters. Rent growth was strong and vacancy held steady as new deliveries stayed in relative balance with leasing action. GDP growth for 2016 came in at a disappointing 1.6%, and the preliminary estimate for Q1 growth is under 1%, which doesn’t seem to sync up with current market sentiment and metrics. Fourth quarter earnings season brought generally good news from corporate America. Profits were up and so were revenues, which indicates that there is still room for industrial sector growth. In the past several reporting periods, much of the growth was in profitability caused more by cost-cutting than top line revenue gains. So, the increase in top line revenue was welcome news.

Vacancy was unchanged in Q1, but has been in steady decline in almost every primary and secondary market for the past few years. The shortage of quality space offered for lease has forced tenants to renew in place, relocate to inefficient space or pay the premium for first generation space. Rent growth is being driven by the increased efficiency offered in new projects where the latest in materials handling technology can help tenants think more three dimensionally. Owners of new space are demanding longer terms and stronger credit on top of higher rents.

Developers in low-vacancy markets are unable to find land suitable for ground-up development, and repurposing properties to multifamily and mixed-use retail/office projects is often the only way to make projects pencil out. Land is getting more expensive to acquire, projects are taking longer to get entitled and buildings are getting more expensive to construct, which is keeping significant amounts of spec building concentrated in major land-rich markets like Dallas/Fort Worth, Atlanta, Phoenix, Philadelphia, Chicago and Southern California’s Inland Empire.

Net absorption cooled off in Q1 but remained firmly in positive territory with a total gain in occupied space of 57.8 million square feet after posting a total gain of 80 million square feet in the final period of 2016. The e-commerce sector, big shippers and 3PL operators are still the market makers, taking down space in enormous chunks. Until recently, is was just the major distribution hubs getting most of the action, but the push for “Last Mile” locations to speed up shipping time has given secondary and tertiary markets a big boost. Amazon.com continues its massive expansion by leasing multiple fulfillment centers each quarter, some over 1 million square feet. Walmart is expanding in a similar fashion as part of its long term strategy to take the battle to Amazon. E-commerce is here to stay the need for state-of-the-art distribution space will be ongoing for years to come.


New deliveries for both speculative and build-to-suit projects for Q1 reached 63.3 million square feet in 517 buildings, nearly equaling Q4’s totals. That brought total US industrial property inventory past the 22 billion-square-foot mark. As the quarter ended, another 268 million square feet was still in the construction pipeline. Development activity is focused primarily in distribution hubs like Dallas, Chicago, Philadelphia and Atlanta where land is still available at prices that allow projects to pencil at today’s rents. That is not the case in mature markets like Los Angeles where what little land remains is too expensive for conventional industrial development. Infill markets like LA are losing industrial inventory to repurposing to other product types that make more economic sense.

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