The Strength Of Industrial Real Estate

Improving Fundamentals And Reliable Returns — Especially For Well-Located Big Boxes — Lure Institutional Capital Back to Industrial Market
While the economy is volatile and leasing is healthy but not exactly stellar, investment sales of warehouse properties continued to strengthen in the third quarter, with a number of large transactions underscoring the growing demand for this historically safe and reliable sector of commercial real estate.Trading activity increased across the board in the third quarter, with investors particularly interested in large industrial portfolios in solid markets and a shrinking supply of vacant mega-big-box warehouses in the nation’s key distribution portals, according to Hans Nordby, managing director of Property and Portfolio Research, CoStar’s analytics and forecasting division.

Unlike the top-flight office and apartment markets where prices for core properties have been bid up dramatically over the last couple of years, investors haven’t “backed up the truck” and loaded up on warehouse assets. The industrial sector, however, is the next stop on the investment capital train, said Nordby, who co-presented CoStar’s Third-Quarter 2011 Industrial Outlook and Review with senior real estate economist Shaw Lupton.

Four of the five markets with the largest year-to-date investment sales totals are among the country’s largest distribution hubs, led by Chicago with $2 billion in sales; the San Francisco Bay Area and Los Angeles, each $1.6 billion; Atlanta, $1.3 billion and the nation’s hottest distribution leasing market, Southern California’s Inland Empire, with $1.1 billion in sales.

Ripples from heightened retail and wholesale sales that started 18 months ago, combined with a near freeze in the construction of new warehouses, is resulting in a very rapid turnaround in occupancy rates in super-big boxes of 500,000 square feet or more — and investors are taking notice, Nordby said.

Granted, not all metros are sharing equally in this sharpening appetite for distribution buildings. Rustbelt markets with the highest exposure to manufacturing and the U.S. auto industry are still seeing weak overall sales, including Western Michigan, Cleveland, Cincinnati, Milwaukee and Detroit. 

The strength of industrial real estate is reflected in its comparative lack of distress. Distressed sales, which barely rose above 20% of total warehouse transactions during the worst of the down market, have fallen to about 15%, where they’re likely to stay for at least the next year to 18 months. That compares to 35%-40% distress among hotels, Nordby said.

Despite unspectacular internal rates of return, returns on less flashy warehouse investments are relatively predictable, just the ticket for life insurance companies and other institutional investors who are seeking respite from the rising prices for the best office and apartment assets.

“Slow and steady wins the race. Dull is good,” the PPR managing director said.

Some of the top trades of the third quarter illustrate the draw of investors toward big boxes, well-performing portfolios and smaller properties in solid markets.

    • In the coveted Washington, D.C. market, Washington Real Estate Investment Trust (NYSE: WRIT) sold 40 buildings totaling 2.06 million square feet for $235.8 million to AREA Property Partners and Adler Realty Services in a deal that closed late last summer.
    • ProLogis (NYSE: PLD), in its continuing portfolio realignment following the merger with AMB Property (NYSE: AMB) sold 13 buildings in functional markets in Utah, Texas, California, Ohio, Georgia, Arizona and Indiana totaling 2.8 million square feet for $118 million to Clarion Partners . The 91% occupied portfolio sold at a healthy capitalization rate of about 7%. ProLogis, encouraged by the investor reception, is now said to be marketing a second portfolio that could fetch up to $250 million.
  • The quarter also saw triple-net transactions such as the sale of the 1 million-square-foot PetSmart Distribution Center in Ottawa, IL, by Inland Western Real Estate Trust to American Realty Capital Trust for $48.6 million. In Orange County, the 415,000-square-foot warehouse at 17871 Von Karman in Irvine sold to Menlo Equities for $47 million.

Steady leasing fundamentals should continue to fuel investor confidence for the next couple of years, especially in national hubs such as the Inland Empire, Dallas, Atlanta and Indianapolis.

“We think the intermodal demand story — of goods coming in through major sea ports and traveling inland via rail — will continue to be an important demand driver into the future,” Lupton said.

The third quarter was the sixth straight quarter of positive warehouse absorption at 29 million square feet, for a total of about 80 million square feet year to date. The top five markets of Inland Empire, Dallas-Fort Worth, Detroit, Chicago and Atlanta accounted for half of that total. More than three-quarters of the 210 warehouse markets tracked by CoStar have seen positive absorption in 2011.

Space under construction, restricted mostly to large build to suit projects, is a mere one-tenth of 1% of total inventory, compared to 1.5% during the boom years. Developers, however, are cautiously starting to make moves in certain tightening markets such as the Inland Empire, where occupancy in the largest buildings now hovers at around 97%.

“If I’m a tenant needing more than 500,000 square feet in the Inland Empire, I’m either going to build my own building or move to Phoenix, where occupancy in the largest buildings is only 82%,” Lupton noted.

Demand is also starting to pick up for smaller-bay buildings serving local markets in Seattle and other West Coast and Sunbelt metros where the housing market is finally starting to recover.

The national warehouse vacancy rate has now dropped about 70 basis points from its 2009 peak of about 10.4%, with about 1,300 of the 1,900 industrial submarkets tracked by CoStar seeing vacancy declines. The narrowing spread between falling availability and vacancy rates is a sign that quoted rents may soon see renewed growth, Lupton said. (credit, r,drummer, co-star)

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