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Recovery in U.S. Warehouse Leasing Gaining Speed

CoStar's Positive Industrial Outlook Comes As Commerial Real Estate Market Learns of Possible Mega-Merger Between Two Largest Warehouse REITs
January 26, 2011
Warehouse leasing accelerated sharply in fourth-quarter 2010, helping to drive down vacancy rates amid record-low deliveries of new industrial commercial properties last year, according to CoStar's Year-End 2010 Industrial Review and Outlook.

"We saw good, stronger demand in the fourth quarter, given the historic low levels of warehouse supply," said CoStar Senior Director of Research and Analytics Jay Spivey. "That will eventually translate into higher rents. The story here is pretty good."

Spivey, along with Hans Nordby, director of advisory services for Washington, D.C.-based CoStar, and real estate economist Shaw Lupton presented the year-end warehouse report and forecast during a Wednesday webinar for CoStar clients.

The positive market outlook comes just as two global owners and developers of warehouse and distribution space may be close to merging. In breaking news first reported late Wednesday by The Wall Street Journal on its website, Denver-based ProLogis (NYSE: PLD) and San Francisco-based AMB Property (NYSE: AMB) confirmed that they are in active discussions over a "potential merger of equals" in which the two companies would combine in an all-stock, at-market transaction in what would be one of the largest combinations of publicly traded real-estate companies. These two global industrial property giants have a combined market capitalization of nearly $14 billion.

Denver-based ProLogis, which has been working to reduce debt, pulled off the largest sale of industrial property of 2010, trading a portfolio of 182 properties in 19 states to private-equity giant Blackstone Group for $1.01 billion.

“Anytime you have a merger of this magnitude, it will have an impact on the overall industrial marketplace, with the magnitude varying from market to market,” said Chris Macke, senior real estate strategist for CoStar. “The potential merger is a good sign for the industry in that REIT valuations are at levels that make mergers and acquisitions more cost effective.”

LEASING DEMAND INCREASES

The national industrial market logged 29 million square feet of positive net absorption in the fourth quarter, a noticeable spike upward from 11 million square feet and 10 million square feet in the third and second quarters, respectively.

The three months ending Dec. 31 was the third consecutive quarter of positive absorption since occupiers gave back 17 million square feet of negative absorption in first-quarter 2010, according to CoStar data. That was the last of six straight quarters of negative absorption dating back to early 2008.

The current recovery is all the more impressive given that the Great Recession left a total of 250 million square feet of negative absorption in its wake -- nearly four times the space vacated during the previous downturn. Early in the last decade, when massive overbuilding and the simultaneous collapse of early Internet commerce dot-coms contributed to a warehouse downturn, negative absorption totaled 65 million square feet.

The market is also recovering faster this time around. In the early 2000s, it took 2 ½ years to achieve the level of 29 million square feet in positive space absorption logged at the end of 2010. Moreover, the historically low amount of new supply delivered to the market will move the demand needle upward very quickly if the broader economic recovery continues on schedule, Spivey said.

As always, results will vary by individual market. Not all metros are benefiting equally from renewed demand, Nordby said. But some large markets, notably Southern California's Inland Empire, which led the nation with 10.7 million square feet absorbed in 2010, are clearly reaping the benefits of increases in retail sales, trade and port traffic.

In fact, other markets that recorded the strongest total absorption in 2010, such as Cincinnati, Philadelphia and Northern New Jersey, are all national distribution center hubs for retailers that benefited from the rebound in sales and consumer confidence last year, Nordby said. Markets oriented to ports, and metros with strong local fundamentals, also tended to see better demand last year over 2009. Examples include energy industry based markets in Texas like Houston and Dallas, which seemed almost immune to the national housing crash and recession.

In contrast, Detroit, hit hard by tough times in the auto industry, led the nation in total negative absorption at 3.7 million square feet in 2010. The runner up, Los Angeles, saw 3.3 million square feet of negative absorption due to continuing exposure to the housing and manufacturing downturn, Nordby said.

VACANCY RATE FALLS AGAIN

The improvement in the national vacancy rate generally mirrors the 2004-2007 post-recession period. The U.S. industrial vacancy rate fell for the third straight quarter to 10.1% at year-end 2010, down from 10.3% in the third quarter -- the largest quarterly decline since third-quarter 2006. Over 65% of the submarkets that CoStar tracks are seeing vacancy declines.

"Given the low supply, we can expect to see the vacancy rate recovery move quickly; the recovery is pretty broad based across the country," Spivey said.

In addition to recession-resistant Houston, markets with the tightest vacancies included space-constrained metros such as L.A., Long Island, NY, and Orange County, CA. Markets with the highest vacancies include oversupplied but growing metros like Atlanta, Chicago and Dallas/Fort Worth, "still suffering from a hangover from the construction supply party," Nordby said.

Giving the absence of new supply, rents should continue to move upward as they have since the beginning of 2010. The annual increase in warehouse rents will approach 8% by 2012-13 -- a seismic shift for the warehouse market, where rents typically rise and fall very slowly.

NO NEW SUPPLY EXPECTED SOON

A healthy infusion of new industrial space won't begin until 2013, CoStar forecasts. In the meantime, it's official: 2010 had the lowest amount of new industrial deliveries, measured as a percentage of total inventory, since at least 1960.

Only about 17 million square feet of warehouse space started construction in 2010, almost 90% below the 10-year annual average of about 136 million square feet of new starts, Spivey said.

The scant few new projects that got under way were mostly build-to-suit rather than speculative projects. One example is the 1.8 million-square-foot project being built for Skechers USA footwear in Moreno Valley's Highland Fairview Corporate Park in the Inland Empire market, Nordby said. Delivery of the massive distribution center is expected this spring.

"Almost nothing [speculative] is breaking ground now. Given that you need about a year's lead time in the industrial market, we're not going to see much built over the next year or so," Spivey said.

While a bust for developers, there's an upside for existing owners. With little new product expected in the pipeline for two years, demand for warehouses should continue to rise very quickly.

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