Demand for U.S. warehouse space continued to putter along in the third quarter, with companies making fewer leasing decisions in the face of mixed economic signals that include lackluster job growth in manufacturing and other sectors impacting industrial real estate.
However, the lack of robust absorption in recent quarters hasn't stopped developers from dipping their toes back into the warehouse market to fill a heightened demand for big-box warehouse space, with about 47.1 million square feet of total warehouse projects under way in 86 markets, up 3% over last year.
The tepid market response went with an unexciting 17.4 million square feet of positive net absorption of warehouse space in the third quarter, a decline from the second quarter’s 25 million square feet -- which itself was revised downward by 10 million square feet -- and down from 36 million square feet at the same time a year ago, according to CoStar’s Third Quarter Industrial Review and Outlook, presented recently by Rene Circ, director of industrial research for CoStar's Property and Portfolio Research (PPR), and PPR Senior Economist Shaw Lupton.
The national vacancy rate for warehouses fell by a scant 10 basis points to 9.2% in the third quarter, but is down 70 bps from the same period last year, according to the CoStar presentation, which had to be rescheduled last week due to Hurricane Sandy.
To be sure, warehouse demand continued to grow in the quarter as it has for more than two years. Of the largest 210 U.S. markets, 115 posted positive absorption totaling 31.4 million square feet in the third quarter, compared with 95 markets that posted 14 million square feet of negative absorption. While fewer companies are moving into industrial buildings, more tenants are also staying put, a sign that the pace of companies that are consolidating or going bankrupt has slowed in recent quarters.
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Still, absorption has slowed in markets across the country this year, standing out particularly in some areas that have exhibited the strongest recovery previously, such as the Inland Empire region of Southern California.
Third-quarter performance "was just okay," said Circ. "This has been literally a very, very slow year. Net absorption is still positive, but we would like to see a lot stronger activity than what we are seeing."
Despite what seemed like strong absorption last year, particularly toward the end, shadow warehouse space has lingered in 2012, creating a slack in demand. The stubbornly wide spread between warehouse vacancy and availability rates has frustrated warehouse sector analysts. While vacancies have trended down into single digits, the amount of industrial space deemed available -- buildings being marketed by the landlord in anticipation that the tenant will leave -- remains above 13%.
"There has been a little bit of a disconnect between the [economic] drivers and what’s actually happening on the demand front for industrial real estate," Circ said.
The recovery to date has been strongest among larger, newer buildings. Demand for boxes of 100,000 square feet or larger built since 1990 has risen by more than 300 million square feet since the recession, while smaller buildings have experienced a demand decline of 300-350 million square feet. While overall absorption has been less than robust, "we can stop talking about recovery and start calling this an expansionary period because total absorption has reached pre-recession levels," Circ said.
The heightened availability rate has made it very difficult for landlords to raise rents, even though vacancy continues to drift down. The few metros that have benefited from the early stirring of rent growth are also among the most supply constrained. Investors have taken notice, with trades in the sub-5% vicinity in such as Miami and Los Angeles.
"The capital chasing the limited amount of transactions out there knows what’s going on, and it’s pricing in the rent growth," Circ said.
The Chicago, Columbus, OH, Dallas/Fort Worth. Edison, NJ and Nashville, TN markets posted the strongest absorption in the third quarter, while Los Angeles, New York, Pennsylvania’s Lehigh Valley, the Inland Empire of Southern California and Miami were the weakest performers.
Softening in the Southern California warehouse markets is linked to the slowing volume of goods passing through the ports of Long Beach and Los Angeles.
While construction of new warehouse supply remains fairly weak, there are signs that developers appear ready to cautiously return to the construction party. The U.S. totaled 12.8 million square feet of construction completions in 48 markets, slightly up over the second quarter and essentially flat from a year ago. About , up 3% over last year, however.
While the 47.1 million square feet of projects under way in 86 markets is a mere fraction of the 160 million square feet under construction in any given quarter during the warehouse and distribution building boom between 2005 to 2007, such numbers inevitably cause economists and analysts to fret about the prospect of overbuilding.
Several markets have already seen speculative construction, illustrating the confidence starting to return among developers, Lupton said.
"If there’s one thing keeping us up at night, it’s the swelling project pipeline in planning. We see a critical mass of demand for large blocks of space out there and that means the building stage of the cycle is fast approaching," Lupton said. "While as a percentage of total space it’s very muted, there’s a substantial amount of space just waiting to go up. The proposed square footage is growing and when that dam breaks, many of these markets could become flooded with new and highly competitive space."
Developers have been on the sidelines for an uncomfortably long time and are ready to come back, with construction capital finally starting to become available, Circ added.
Much of the activity so far has been projects on land owned by the developer and already on the balance sheet. However, developers are now starting to buy land and build new projects where they can bring value in such warehouse markets as Lehigh Valley, Circ said.
In part explaining its weak absorption numbers, the Inland Empire led the nation with 3.1 million square feet of completions in the quarter and 5.4 million square feet under construction. Unlike the rest of the country, the bulk of the Inland Empire projects are built on speculation.
Lehigh Valley, PA, Chicago, Atlanta and Harrisburg, PA, were the other top markets for deliveries in the third quarter, while Atlanta, Richmond, VA, Nashville and Dallas rounded out the markets with the highest amount of space under construction, all with more than 2.3 million square feet.
Vacancy declines mirrored net absorption, with Trenton in central New Jersey and Edison in northern New Jersey among the most improved.
With existing warehouse filling up and little new construction, "maybe we can finally start talking about rising rents," Circ said. Average asking net rents are up a slight 0.4% quarter over quarter and year over year at $4.66 per square feet.
Trenton, NJ saw an 8.6% quarterly bump in asking rents, with Indianapolis rent rising a surprising 2.8%. In all, 108 markets saw improvement in asking rents while 102 markets saw worsening rent conditions during the quarter.
With a baseline forecast that includes no recession and continued slow growth over the next year, CoStar expects demand to outpace supply through 2014 in the 210 largest markets. By the end of next year, developers won’t be able to hold back anymore and construction will cause supply to rise.
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