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Battered Industrial Property Sector Poised to Resume Growth

Although Vacancies Remain Stubbornly High and Activity Is Hardly Stellar, Sales and Leasing of Warehouse and Flex Space Moving Into Positive Territory After Six Tough Quarters
February 3, 2010
The amount of empty warehouse, distribution and flex space hitting the market contracted again sharply in the fourth quarter, and CoStar analysts say industrial real estate appears poised to join office and some retail categories in returning to positive net absorption.

While stubbornly high, industrial vacancies are flattening. Leasing activity is starting to pick up nationally and, unlike previous downturns, the market is not plagued by an overhang of new supply. Sale prices also appear to have hit bottom as buyers and sellers begin to come to terms with losses inflicted by the recession and the bursting of the real estate bubble, according to the Year-End 2009 Industrial Review, the third and final installment of CoStar Group, Inc.'s "State of the Commercial Real Estate Industry" webinar series.

See related CoStar coverage: "In a Surprise, Office Market Posts Unexpectedly Good Results"

"Positive Outlook for Retail Real Estate Tempered by Ongoing Market Correction"

Jay Spivey, Senior Director of Research and Analytics for Bethesda, MD-based CoStar, was joined on a panel by noted commercial real estate analysts and commentators Norm Miller, Vice President of Analytics for CoStar; and Hans Nordby, Global Strategist for Property & Portfolio Research, (PPR) Inc., CoStar's forecasting and analytics subsidiary.

The market improvements are unfolding against a backdrop of an increase in general economic activity for the manufacturing and industrial sectors. Gross domestic product (GDP) grew a faster-than-expected 5.7% in the fourth quarter, eclipsing forecasts of 4%, in part due to the impact of government stimulus dollars and the need to replenish depleted inventories. Miller expects GDP growth of around 4% for the first two quarters of 2010. Boosts in industrial production and corporate profitability will eventually lead to jobs and renewed investment and expansion by companies, whetting the demand for space.

The latest survey of manufacturing by the Institute for Supply Management released Tuesday offered some timely good news for the manufacturing and logistics industries. The Purchasing Managers Index (PMI) jumped 3.5 points to 58.4 in January. Such high PMI numbers typically point to sustained and solid GDP growth. "This kind of confidence is a really good signal for the economy," Miller said.

One caveat, cautioned Nordby of PPR, is that inventories continue to fall. "If you're falling down a flight of stairs and your velocity decreases by the time you get to the bottom, you might not necessarily feel better," Nordby noted. "Inventories really haven't gotten better; they're just not falling as fast."

Retail sales, which drive part of the demand for end-users of warehouse and distribution facilities, appear to be picking up after bottoming late last year. But consumer confidence won't fully return until housing prices fully reach bottom across the country, and foreclosures and REOs are expected to peak around midyear, Miller said.

Despite signs of progress, the current recovery is clearly slow relative to those following past economic down cycles -- unsurprising given the depth of the most recent recession and financial crisis.

"If you look at the year-one and year-two GDP levels, we're not nearly where we were at the same time in past recoveries," Spivey said.

Jobs continue to lag and the U.S. could finally reach 2000's level of total employment later this year. However, industrial property, especially the automation-rich warehousing and distribution sector, isn't as exposed to job growth and loss, compared to, for example, more densely occupied office space. That said, temporary employment is rising across the board, and that should be followed by an increase in permanent jobs within a quarter or two.

In reviewing a grid ranking the short- and long-term economic prospects of major U.S. markets based on employment growth, the three panelists noted the prevalence of strong long-term job markets crowded with cities in Texas, Florida and Georgia. Houston, in particular, is leading the charge, with its growing population and energy sector and low business costs, Nordby said. Cities such as Detroit and Cleveland will likely continue to struggle due to weakness in the domestic auto and manufacturing industries.

Despite the visible signs of improving conditions in Texas and other sunbelt markets, the economy still faces a list of economic challenges. Distressed sales are increasing and will likely continue to tamp down rents, though industrial is faring better than other product types, Miller said. Credit remains tight even though banks are cautiously starting to lend again and many properties are saddled with very oppressive loan-to-value ratios. Fending off inflation and rising interest rates will be an increasingly difficult task for financial and monetary policy makers and regulators.

However, year-end metrics show that industrial fundamentals may be ticking upward, or at least, in the words of CoStar's analysts, becoming "less bad."

Leasing and Absorption

Although leasing activity was soft in 2009, it's down less than 20% from the previous year -- not a dramatic drop -- and has risen for three consecutive quarters, Spivey said. "Leasing is starting to pick up and it's relatively stable compared to sales activity. Deals are happening and renewals are occurring."

Industrial players will not so fondly remember last year and late 2008 mainly for the massive 200 million square feet of negative net absorption in warehouse, flex and other industrial space piled onto the market over the last five or six quarters. That compares to about 70 million square feet during the market downturn 10 years ago, which was accompanied by the collapse of tech and Internet commerce companies.

Only one major market, Houston, posted positive absorption at an anemic 1.8 million for 2009. Markets that saw huge increases in negative absorption included Chicago (-19.2 million SF), the San Francisco Bay Area (-11.6 million SF), South Florida (-11.4 million) and Los Angeles (-9.4 million).

But those numbers don't tell the whole story. The fourth quarter's 12 million of negative absorption is much lower than the minus-37 million square feet posted in the third quarter, negative-58 million square feet in the second quarter and -47 million in the first quarter. PPR forecasts that absorption will turn positive this quarter for the first time since third-quarter 2008 with a modest 13 million square feet. That should be followed by steady absorption growth, peaking at a projected 68 million square feet in mid-2012.

A look at fourth-quarter absorption numbers for various individual markets shows the upward trend. Although quite modest, seven markets saw positive absorption, led by Philadelphia at 3.9 million square feet. The other six markets all posted essentially flat absorption of 600,000 square feet or less, including Cincinnati, Houston, Cleveland, the Inland Empire in inland Southern California, and Los Angeles.

"But the tide does appear to be turning. The office and retail sectors saw positive absorption in fourth quarter and it appears industrial is headed in the same direction but with a little bit of a lag," Spivey said.


Just 0.5% of new supply was added to the national industrial inventory in 2009, far lower than the 1.7% in new supply added to the market on average over the last 50 years. Extremely low deliveries and construction starts will persist through 2010, with only Houston, Dallas/Ft. Worth, Inland Empire, CA and Philadelphia delivering any appreciable new space. Detroit, Cleveland, Los Angeles, South Florida and Chicago will see very little new development.

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Bottom line is, "Supply won't be an issue in industrial until late 2011 or 2012 at the earliest," Nordby said. "This level of construction doesn't even come anywhere close to making up for routine functional obsolescence and demolitions. In fact, we're modeling negative supply in many markets."


Companies shedding space drove the national vacancy rate to 10.3% in the fourth quarter, up from 7.5% at the market peak two years ago. Availability, which includes space that may not yet be vacant but is on the market, rose to 14.6%, up from just over 10% two years ago.

The widening gap between vacancy and availability rate bears some reason for caution, but "we believe we're at or near the peak on vacancy due to the lack of new supply and positive absorption" in supply constrained markets like Long Island and Los Angeles and past over-developed markets like Inland Empire and Dallas, Spivey said.

The upside is that vacancies and reduced rents are driving stepped up leasing activity in markets like San Francisco.

Investment Sales

Although overall industrial investment sales volume is down 54% from the 2007 peak, prices are finally adjusting to the lower LTVs and tighter underwriting that have driven overall industrial cap rates up from 6.7% in 2007 to 8.9% in fourth-quarter 2009. Most of that cap rate expansion occurred during 2008 and was fairly flat in 2009.

Industrial prices adjusted for inflation have plunged 33% since the market high of $90 per square foot in 2007, and have fallen past the historic average in 1995 of $63 per square foot. Fourteen of the top 20 industrial markets took double-digit losses in per-square-foot sales prices in 2009 compared with the previous year. CoStar's analysis of repeat industrial sales, meanwhile, found some price strengthening, with the trough reached late last year.

"It looks like we're close to equilibrium now in terms of the prices investors are willing to pay relative to the rent," Miller said. "Sales prices are very likely near bottom for non-distressed industrial property, but we will likely see a scattering of distressed sales occur at a discount to the mortgage balance. It will be important to distinguish the type of sale when analyzing average prices for industrial, as well as all property types."

Industrial owners appear to be somewhat more insulated from distress than holders of other property types, particularly apartments and office buildings. About 15% -16% of overall CRE sales are currently considered distressed, Nordby said. However, only about 8% of industrial sales are made under distress, the lowest among major property types.

REITs such as industrial giants ProLogis and AMB, along with institutional investors were net sellers of property in 2009, while opportunity funds and other private equity trying to take advantage of distressed assets were buying. Falling prices and narrowing bid-ask spreads are also luring owner-users and other private parties to jump in, Miller added.
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