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Economy Clobbers Industrial

With the Consumer Confidence Index at a 60-year low, development and acquisitions are down for the count.

It's a happy coincidence that the industrial development timeline is among the shortest cycles in commercial real estate because nobody expected the economy to get this bad this fast.

“With that sharp fall-off in demand and great limitation on debt capital for new development, the supply pipeline in industrial is falling off almost overnight,” says Al Pontius, managing director of Marcus & Millichap's national office and industrial properties group.

That ability to halt development is evident in Duke Realty Corp.'s pipeline. The Indianapolis-based industrial developer and owner, which ranked No. 5 in NREI's Top Industrial Developer survey with 19.8 million sq. ft. last year rose to the No. 4 slot this year with just 16 million sq. ft.

Seeing the economy beginning to falter, “We just pretty much shut the spigot off at the end of 2007,” says Denny Oklak, chairman & CEO of Duke.

Signs of the collapsed U.S. economy can also be readily found in the leading financial indicators for the industrial sector. For instance, the Consumer Price Index showed its largest year-over-year decline at 1.3% at the end of May since April 1950. At 95.8% of its 2002 average, overall industrial output in May was 13.4% below its level in 2008. Meanwhile gross domestic product contracted 5.5% in the first quarter, though forecasters expect positive growth by year-end.

Money cash, no carry

As a result of little debt and uncertainty over the health of the industrial investment market, would-be buyers haven't jumped into the market. In fact, the dollar amount of transactions fell roughly 50% in the first half of the year from volumes recorded in the prior six-month period, and 70% from the same period a year ago, according to Marcus & Millichap.

“That is a direct correlation to the gap in expectations between buyers and sellers in the broad marketplace,” explains Pontius. “There's a growing recognition of where the trading range is, and consequently we will see a pick-up in transactional activity in the second half of 2009.”

Still, not all industrial markets are feeling the same pain. In the port market of Houston, for example, the soft demand for energy has put near-term downward pressure on rents and vacancies as demand for oil-related products for refineries and rigs retreats declines. In the long term the outlook is much brighter. The projected widening of the Panama Canal and future demand for oil should eventually revive the Texas market.

In contrast, in Atlanta many local businesses have succumbed to the soft economy. The economic distress translated into negative net absorption of almost 2 million sq. ft. in the fourth quarter of 2008. And the jobless rate in the capital city of the South stood at 9.6% in June compared with the national rate of 9.4%.

When tenants struggle

With so little demand, development of new projects has fallen off precipitously. Completions shrank from 165 million sq. ft. in 2008 to 65 million sq. ft. this year.

Despite the swift move to halt new development, however, the effort was not enough to prevent vacancy rates from rising, or rents from falling. Effective rents are forecast to take a haircut of 6.6% in 2009 while vacancies are expected to increase 170 basis points to 12.5%, according to Marcus & Millichap.

With mounting job losses and tenants struggling to stay in business, the pain has been felt for owners across all industrial sectors including manufacturing, distribution and warehousing. As of early July, nearly $2.2 billion of industrial properties in the U.S. were potentially troubled or distressed, reports Marcus & Millichap.

Deciding which tenant deserves a break on rent and which tenant is a lost cause has put an extra-added burden on industrial landlords. “It really depends on what the tenant is willing to do,” explains Oklak. “We may be willing to reduce rent temporarily in exchange for a longer lease term or lease extension.”

However, the tough conditions aren't likely to abate anytime soon. “This year has been the worst I've ever seen our tenants struggle,” says Oklak. “I don't think we'll see the bottom of rents in industrial until probably early next year.”

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