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Overbuilding Not a Concern in Most U.S. Warehouse Markets

Construction Booms In Dallas, Houston and Inland Empire Matched By Strong Demand for Warehouse Space
May 7, 2014
Developers are usually eager to break ground when the cost associated with acquiring land and building new warehouse space falls below the cost of profitably purchasing existing income-producing properties.

However, warehouse developers have been uncommonly restrained during the sustained recovery of 16 consecutive quarters of positive demand growth. Even as rising absorption of warehouse/ distribution space has resulted in rising rents in a widening array of U.S. markets, modest supply pipelines and rising land and development costs have continued to hamper new supply from catching up to demand, according to Prologis, Inc. (NYSE: PLD), the world's largest warehouse developer and owner.

As a result, warehouse/distribution tenants are increasingly willing to lease available space to lock in current rates in anticipation of further rate increases, given the shrinking amount of new supply, according to a recent Prologis research report.

The top 210 U.S. markets absorbed a net 41.9 million square feet of industrial space in what turned out to be a very strong first quarter, according to CoStar’s recent State of the U.S. Industrial Market First-Quarter 2014 Review and Forecast.

Dallas, Columbus, OH; Atlanta, Chicago and Houston led growth in both demand and new supply in the quarter, with Southern California’s Inland Empire and Pennsylvania’s Lehigh Valley among the leaders in new construction, according to CoStar Director of Industrial Research Rene Circ, who was joined in the first quarter presentation by Senior Real Estate Economist Shaw Lupton and Real Estate Economist Donald Hall.

Warehouse construction continues to accelerate into the second quarter. For example, Cherry Hill, NJ-based supply chain company NFI on May 1 unveiled its 1 million-square-foot distribution center in Kutztown, PA in Lehigh Valley. The massive distribution center, completed in 10 months despite 68 inches of snow that fell during construction, will serve as the distribution center for 40% of the global volume of beverage company Ocean Spray.

While construction is booming in a handful of prime industrial markets, it’s slower than one would expect overall - only about half of the levels of the last peak, Circ said.

Prologis Chairman and CEO Hamid R. Moghadam goes even further, saying the meager amount of new construction delivered in the face of growing demand -- a trend he believes is likely to continue into 2015 -- is unprecedented in his 31 years in the business.

"There have never been periods where we have under-built the demand in the U.S., anywhere near these levels that we experienced last year, and this coming year, and next year," Moghadam said.

As a result, warehouse vacancies are compressing and rents are escalating rapidly. U.S. absorption is running more than double the pace of new completions, pushing occupancies above pre-crisis levels, a trend expected to continue at a more modest pace into next year, Prologis said.

"We see no general signs of overbuilding, although speculative starts in Dallas are getting ahead of demand," Moghadam said. "There is also a fair amount of new construction in the Inland Empire and Houston, but we are not concerned about those markets as absorption is more than keeping pace with new supply."

The tame level of supply has resulted in a very low U.S. vacancy rate of 7.8%, down another 15 basis point from the fourth quarter, and an even lower 7.4% in the top 54 markets, down 20 points from the 2006-07 market peak, CoStar analysts said.

Demand and restricted supply drove up asking rents to $4.84 per square foot in the first three months, up slightly from the previous quarter and 2.8% higher than first-quarter 2013. In top 54 markets, rents rose by an even stronger 3.8% year over year.

With rents reaching their long-term annual growth rate of 1.3% and another year to 18 months of declining vacancies, demand should outpace supply well into 2015, Circ said.

“There’s still some aversion to building, and lot of developers are testing with a building here and there. The market is going to get tighter and the interest will remain high,” Circ said.

Meanwhile, developers are getting less risk-averse. Of the nearly 100 million square feet under construction nationally, about 60% is being built on speculation, a far cry from a year ago, Lupton said.

The Inland Empire’s 14.2 million square feet under construction was followed closely by 13.9 million square feet in Dallas, followed by a distant Houston, Chicago and Atlanta at around 4 million square feet each. Sizes and profiles of the new buildings vary widely. For example, completed buildings averaged 340,000 square feet in Dallas-Fort Worth. Down state in Houston, the average completed building was only 52,000 square feet.

"New construction is heating up. Despite this wave of new supply, current construction levels still fall short of demand, so we expect vacancy to continue to tighten in most markets, albeit at a slower rate," said Kevin Thorpe, chief economist with Cassidy Turley, in the company's May 2014 U.S. macro forecast.

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