Industrial Fundamentals Improve at a Restrained Pace
Reis data for the fourth quarter of 2013 indicate that the U.S. warehouse/distribution and flex/R&D markets remain stuck in slow recovery mode with slim occupancy gains. However, continued trimming of concession packages implies that space market improvements, although sluggish, are providing property owners sufficient negotiating power to gradually increase revenue through rent hikes, at least for the most desirable buildings in choice markets. This fact, combined with relatively strong economic data from the last months of 2013, signals an accelerated pace of recovery for industrial properties in 2014.
Vacancy Declines Marginally, Rents Tick Up
The warehouse and distribution market registered a slight increase in occupancy during the fourth quarter as the national vacancy rate fell 10 basis points to 11.6%. This reduction is on par with the past two quarters, bringing the total decline in vacancy for 2013 to 50 basis points. The national vacancy rate is now 260 basis points below the cyclical high of 14.2% recorded in the third quarter of 2010.
Downward vacancy movement was minimal due to a decline in demand and an increase in new supply. Net absorption dropped to its lowest quarterly level in almost two years. Occupied stock increased 13.8 million square feet during the period, which is 13.1% less than the total observed in the third quarter and 51.2% less than the fourth quarter of 2012. The decline in absorption is surprising given that new construction, which helps boost absorption when it comes online pre-leased, was at its highest level since one year ago. Over 10.6 million square feet of ware-house/distribution space was completed in the final quarter of the year, compared to 8.8 million square feet in the third quarter. This brings total new supply for 2013 to 34.7 million square feet, up 50.4% from 2012.
Asking and effective rents grew 0.4% and 0.5%, respectively, during the fourth quarter. This compares with increases of 0.6% and 0.5%, respectively, in the previous quarter. Market conditions remain sufficiently stable to allow owners to reduce the value of concession packages necessary to lure and retain tenants. However, demand is not yet robust enough to reduce these packages in any meaningful fashion.
High Quality Space Continues to Drive Demand
So why is rent increasing while overall demand remains comparatively soft and completions are rising? These mixed market signals are attributable to the disparity between the performance of large, high quality space and small, lower quality properties, a trend that we have noted in previous quarters.
The market for high quality space in many of the larger metros is already quite tight, which when coupled with a dearth of new construction, limits a market’s absorption capacity. In markets in which the most desirable properties are already occupied, leasing activity can be constrained as space-users shun less competitive or obsolescent facilities. As a result, net absorption is only strong enough to push the vacancy rate down by 10 basis points. At the same time, developers are capitalizing on the tight market for high quality properties by introducing new product that satisfies the evolving requirements, which differs across markets, of local space users. A combination of rising rents in existing, sought-after warehouse/distribution buildings and the higher than average rents charged for newly constructed space has maintained rent growth despite slowing overall demand.
Heightened demand for “big box” properties is reflected in the year’s metro-level results. Annual rent growth for the nation in 2013 was 1.6%, with 18 (out of a total of 47) individual metros recording rent growth above that level. This group was dominated by metros with high concentrations of big box warehouse/distribution space. Among these were San Bernardino/Riverside (+4.3%), Houston (+4.3%), Atlanta (+2.9%), Chicago (+2.9%) and Los Angeles (+2.7%). At the opposite end of the spectrum were smaller metros without significant inventories of large, high quality properties. These metros included Richmond (-0.9%), Raleigh-Durham (-0.2%), San Jose (+0.0%), Suburban Maryland (+0.1%) and San Diego (+0.2%).
The Investment Landscape
Warehouse and distribution properties remain a popular target for investment by both domestic and international investors in search of stable performance. Norway’s Norges Bank formed a $1 billion joint venture with industrial REIT Prologis late in 2013 with the objective of acquiring 12.8 million square feet of industrial space in nine markets across the country. Investors from Canada and South Korea have also been particularly active in acquiring US industrial assets.
With the market for high quality space so tight, institutional investors have become particularly interested in development as a way to capitalize on the industrial market’s recovery. For example, CalSTRS, in a venture with Panattoni Construction, is building a 1.4 million square foot warehouse south of Dallas. By choosing to invest in development instead of existing properties, investors are able to offer more functional space to e-commerce and logistics firms, the users who are projected to be a dominant source of demand over the next several years.
Flex and R&D
The vacancy rate in the flex/R&D market declined by 10 basis points to 13.6% in the last three months of the year, on par with the third quarter. The pace of vacancy compression was static despite a more modest rate of net absorption for flex/R&D space. Occupied stock increased 1.6 million square feet in the fourth quarter, down 33.9% from the prior period and 52.1% from one year ago. Construction was also down from last quarter, as 382,000 square feet of space opened its doors, 26.7% below the third quarter. Asking and effective rents grew 0.2% and 0.3%, respectively, in line with last quarter’s growth. On an annual basis, asking and effective rents grew 0.7% and 0.8%, led by Houston (effective rent growth of +2.6%), San Francisco (+1.8%) and Phoenix (+1.7%).
Although fundamentals continue to improve, the gains in occupancy and rents remain minimal. Moreover, the flex/R&D subtype does not boast the underlying drivers of demand that make the warehouse/distribution segment comparatively attractive in the near– to mid-term despite recent softness in demand. Flex/R&D properties continue to be handicapped by especially constrained employment growth among small– and mid-sized firms.