Industrial: In Search of Stability

For real estate investors seeking stability, warehouse space looks like a safe bet. The stalwart of the industrial sector, warehouse space is viewed as a smart defensive play because of its stable returns and short development timeline.

“Warehouse properties continue to hold strength because they appeal to a broad section of investors, including private local investors and institutions trying to fill up [investment] allocations,” says Ken Riggs, CEO of Chicago-based Real Estate Research Corp. (RERC).

In the bumpy market of 2002, investors who sought safety in the industrial sector were rewarded. Through November, industrial equity REITs posted a return of 21.47%, second only to retail REITs, which had a return of 23.61%, according to the National Association of Real Estate Investment Trusts (NAREIT).

Softness May Persist

However, while developers agree that the industrial sector will recover faster than other property types, they are not at all sure when the recovery will begin.

For now, industrial vacancies are continuing to rise. Nationwide, vacancies registered 11.4% in the third quarter of 2002 compared with 9.5% last year, according to Los Angeles-based CB Richard Ellis. “The question is, when do we think they're going to start turning the other direction?” asks Denny Oklak, co-COO of Indianapolis-based developer Duke Realty Corp. “My crystal ball isn't quite that good.”

Some industry executives are willing to call this the bottom, however. “We don't have any reason to believe there's going to be significant further deterioration in occupancies,” says Oklak. He adds that in Duke's portfolio, industrial vacancies peaked at the end of 2001 and remained flat through 2002.

And the severity of the downturn varies according to geography and property type. For instance, there is still excess capacity left over from the 1990s expansion of R&D space in tech-heavy markets, notes Riggs. Those properties will take a long time to fill.

On the other hand, major distribution hubs in New Jersey, Chicago and Dallas — vital to any major logistics program — have held up relatively well, notes Richard Gatto, executive vice president of Chicago-based developer The Alter Group. Chicago vacancies, for example, rose a mere half-percentage point between third-quarter 2001 and third-quarter 2002, from 9.7% to 10.2%, reports CB Richard Ellis.

Most markets have been spared the problems associated with overbuilding, in part because the industrial sector can react more quickly to market conditions than the office sector due to shorter construction timelines. Developers hit the brakes when they saw the economy stalling. Duke, like many other developers, has steered away from speculative projects without significant pre-leasing, according to Oklak, focusing instead on build-to-suit facilities.

That's a trend in several markets around the country, says Cynthia Jeter, director of research services in the Dallas office of Cushman & Wakefield. In Atlanta, for example, speculative construction as of the third quarter totaled only 2.5 million sq. ft., compared with 3.9 million sq. ft. of build-to-suit.

Meanwhile, total construction completions are dropping dramatically, Jeter says. Through September, 56.5 million sq. ft. of space had been delivered this year, compared with 88.5 million sq. ft. of space through the third quarter of 2001, a 36% drop, reports Cushman & Wakefield.

However, net absorption is expected to worsen. Bethesda, Md.-based CoStar Group Inc. reports a negative absorption of 57 million sq. ft. as of the second quarter of 2002, far worse than the negative 13 million sq. ft. measured in the second quarter of 2001.

According to Oklak of Duke, the biggest challenge across the industrial sector in 2003 will be finding tenants to fill the unoccupied space. “There just aren't tenants out there,” he declares.

Rental rates have shown equal volatility, especially in markets with high amounts of high-risk R&D space, such as Silicon Valley, Seattle and Boston. Overall rates per sq. ft. averaged $6.83 during the third quarter of 2002, down from $7.62 in the third quarter of 2001, reports Cushman & Wakefield.

Industry execs don't expect rents to start percolating in 2003. At best, rental rates will remain steady, and they could slide a bit further due to higher-than-normal concessions, Oklak warns.

And what if the economy doesn't begin to improve next year?

“We need to begin a recovery within the next 12 months for sure,” says Mike Tingus, senior vice president of the industrial properties group of Los Angeles-based real estate service provider Charles Dunn Co. “Otherwise the sector is just going to choke itself.”

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