Infill Markets Running Short On Supply

The Lee Industrial Brief Q1 2015

The Market By the Numbers

Optimistic users, developers and investors continued the positive pace of 2014 in the first quarter of the new year. Net absorption, construction activity and cap rates all point to another year of solid growth and improving market metrics in primary and secondary markets across the US. However, concerns over declining vacancy are also becoming more prevalent, as some markets are reaching critically low levels of quality space for expanding businesses to grow into. The national vacancy rate for warehouse and flex space combined fell another 10 basis points in Q1, settling at 7.0%. Year-over-year, the vacancy rate has fallen by 100 basis points and several major market areas, including Los Angeles, have vacancy ranging as low as 3%.

New deliveries for both speculative and build-to-suit projects started the year on a strong note. Thirty-seven million square feet of space in 284 buildings were added to the total base inventory in the US of 21.5 billion square feet. Another 152 million square feet remained under construction in Q1, which is a clear indication that the building boom is showing no signs of abating. If anything, construction is not likely to keep pace with demand in expanding markets. That said, construction activity is concentrated in the biggest markets that still have readily available land for ground-up projects, including Atlanta, Dallas/Fort Worth, Chicago and Southern California’s Inland Empire. In more mature, infill markets like Los Angeles and New York, construction remains at a virtual standstill, and there is an increasing risk of an eroding industrial base due to the gentrification and repurposing of older properties to mixed-use projects that have residential, office and retail components.

Net absorption for the overall industrial market for Q1 hit 49.6 million square feet, giving the year another strong start. This followed a whopping gain of 86 million square feet in occupied space in Q4. Large distribution users continue to account for the bulk of the net gains, with flex activity contributing less than three million square feet of the Q1 total. Major leases signed in Q1 included a 522,000-square-foot lease to Solo Cup in the Inland Empire, the 401,000-square-foot lease for MI Windows & Doors in The Dallas/Fort Worth market. E-retailers are still making big moves, as well, including Amazon’s 1.1 million-square-foot fulfillment center in the Baltimore area Absorption in almost all markets around the country was positive in Q1, but some areas impacted by tight supply are seeing net growth moderate, as tenants must renew in place for lack of quality options in the market. When vacancy falls to low levels, a disproportionate amount of the available space is second and third generation space with elements of functional obsolescence.

Average asking lease rates for all industrial product rose another 1.3% to $5.63 per square foot in Q1 after a .5% gain in the previous quarter. Rents for newer distribution product are moving up even faster due to the higher clear height and fire suppression technology offered in new projects. However, in markets with lower vacancy, all industrial product is seeing rent growth, as some tenants are forced into less than desirable space to remain in their preferred submarkets.

Owner/user product remains in very short supply, which is slowing market activity, while users anxious to take advantage of SBA financing deals continue to hold out for the right property to acquire for their own use. This demand should continue to strengthen throughout the year, as the Federal Reserve is yet to make a move on raising interest rates. Investors are not faring much better than the users in terms of locating quality assets for acquisition. To the chagrin of buyers across the country, cap rates keep moving down, and until the cost of capital begins to head north, they will continue to move down. Even major institutional buyers are becoming more active in smaller market areas where they can achieve slightly higher yields than they can in primary metro markets.

Economic Drivers

The nation’s total output of goods and services showed significant improvement in 2014. GDP grew at an annual rate approaching 3%, but lower than anticipated due to a disappointing fourth quarter after back-to-back quarters in the 4% to 5% range that had everybody talking about better times ahead. Unfortunately, preliminary estimates for Q1 GDP growth are not optimistic. Another cold winter for most of the country is expected to negatively impact Q1 performance. Bad weather was blamed for a 2.1% decline in the first quarter of last year. With circumstances being so similar, poor Q1 performance will not come as much of a surprise. The Congressional Budget Office recently released its annual economic forecast, and it calls for GDP growth of 3% for the year.

The unemployment rate has been moving down for several years, and is now fluctuating in the mid-five percent range. The national unemployment rate through February remained at 5.5%, but tends to fluctuate by a tenth or two each month, as the impact of new jobs is balanced against the change in the number of unemployed workers rejoining or exiting the work force. Part-time positions remain a problem, and may be giving a false sense of improvement to the economy, as these jobs yield less spendable income to boost GDP. The Labor Participation Rate, which measures the number of people eligible to work compared to those who are gainfully employed, is stuck at 62.7%, lowest in four decades. This is partly due to retiring Baby Boomers, but more importantly, it is indicative of a lack of quality jobs at rates of pay that motivate more participation in the work force.

Job growth picked up the pace in 2014, which showed up in the net absorption gains for the year. Job creation ranged from 200,000 to 300,000 per month in 2014, topping out at 353,000 in November. Then 2015 got off to a strong start. January and February hit 275,000 and 295,000 in new job creation respectively, but March was another story altogether, adding a meager 126,000 jobs for the month. Nobody saw it coming, and nobody seems to know why it happened, but it is cause for concern, and it will put all eyes on April’s report and the preliminary GDP estimates for the quarter. However, the poor job numbers gave the stock markets a boost, as investor concerns over a near-term move by the Fed to raise rates were softened.

Wage growth is perhaps as much a concern as job growth. Since the last recession, real wage growth has been lackluster at best, with many of the jobs being created in the unskilled and semi-skilled categories. The increase in the number of part-time jobs is also a drag on wage growth. Without more disposable income, GDP growth will be negatively impacted, as consumer spending makes up roughly 70% of GDP. The slowdown in the energy sector is also affecting wage growth, as jobs in that sector tend to be higher paying and full time assignments. Layoffs in the field have become commonplace again, and it will certainly curtail job creation in the energy states. Fortunately, job gains in technology, professional services and the TAMI sector (technology, advertising, media and information) have been strong and are expected to remain so. While these sectors offer more of a benefit to the office market, any net gain in jobs and income help the economy at all levels.

While job and GDP growth are closely watched, more eyes may be on the Federal Reserve Bank than on any other market variable. Our central bank has taken unprecedented steps over the past six years to stimulate economic growth, so much so that more attention is on Fed action than on the actions of the marketplace itself. By holding interest rates to near zero for over five years, yields on investments of all kinds have been negatively affected. Savers have been punished, as yields on cash deposits fall well short what little inflation we have, and investors have been forced to take on more risk to get even a nominal yield on their capital.

The equities market has soared for the past five years as result, as it is offers a chance at a reasonable yield without giving up liquidity. Real estate borrowers have also benefited from Fed actions. Long term financing is still available at historically low rates. Low cost of capital has also contributed to cap rate compression in industrial markets around the country. Positive leverage is still a possibility, even with cap rates as low as 4% for prime properties in major markets. But, that is still double the yield of 10-Year Treasuries, which, in late April was just 1.9%. When treasury yields finally go up as the Fed moves interest rates higher, cap rate decompression to maintain that spread becomes a real possibility. Investors will have to focus on markets where rent growth is strongest to make up the difference. Exit cap rate estimates will have to go up, which will bring IRR’s down accordingly.

Thankfully, quantitative easing (QE) is finally behind us, so now it becomes a question of when the Fed makes a move on interest rates. While many believe that will occur in Q2, others think no rate hike will occur until GDP and core inflation become more predictable.

The global economy is another variable for our central bank to consider before bumping our interest rates. The European Central Bank announced an aggressive QE program just as we ended ours in the US. With growth either at zero or in negative territory in the Eurozone, it may not be a good time for our central bank to make things more difficult domestically. Several central banks in Europe even have moved core rates into negative territory in their attempt to avoid a potential deflationary cycle that would stall out the chances for economic growth in the region.

Changes in currency valuation are also impacting economic growth domestically. The US Dollar has moved to all-time highs against the Yen and the Euro. That means additional buying power when purchasing foreign goods and services with Dollars, but it also has a negative impact on US companies with revenues generated from customers paying in other currencies.

Oil prices remain in the $50 per barrel range after plummeting from $107 per barrel in June of 2014. Industry experts are all over the board in terms of predicting an end to the decline. Here again, the good news is also bad news. Lower energy prices have put tens of billions back in the pockets of US consumers, but they have also hurt job growth in energy states and reduced the level of exploration and extraction activities across the country. Excess supply is to blame, and that is due to increased productivity in the US and anemic worldwide economic growth, which has reduced demand for fossil fuel products. OPEC has thus far refused to cut production in response, which many believe is a strategic move to slow US production by pushing prices low enough to make US oil and gas extraction unprofitable. At the moment, that strategy seems to be working.

A Look Ahead

The US industrial market should remain strong through the end of 2015. Domestic GDP and job growth should be healthy enough to offset a sluggish global economy. The strong dollar and interest from foreign investors to invest in the US has re-established our status as the strongest and healthiest in the world. The dollar is still the world’s reserve currency and US Treasuries are still the safest investment alternative.

Low oil prices will be with us for the near-term and that will give consumers more buying power, lower costs for fuel intensive industrial users and stimulate job growth. This will increase consumer spending in the short term and stimulate additional job growth across the country. Energy dependent states will have a rougher time until prices stabilize at much higher levels. Expect more layoffs in high-paying energy job categories and a significant slowdown in domestic production until the price of oil makes sense to extract and refine again. Fortunately, gains in employment, even in the energy states, are broad-based enough to stay in positive territory overall. Vacancy rates will continue to decline and net absorption will remain at least at current levels. However, markets with the lowest vacancy will see absorption and leasing activity moderate due to lack of supply. Cap rates will remain compressed due to record high demand, but they could begin to move in the other direction once the Fed makes a move on interest rates. Higher interest rates means higher yields on alternative investments, which could hurt the equities market and pricier real estate markets in the short term. Development will continue in markets with large inventories of vacant land, and slow even further in infill markets as redevelopment of existing industrial sites to alternative uses will become more prevalent. Q2 may be when the Supreme Court announces its ruling on the challenge to health care subsidies offered through Healthecare.gov. If the plaintiffs in the case prevail, the viability of the entire program will be called into question.

Click the following link to download The Lee Industrial Brief Q1 2015

About the Author Michael Staskiewicz

Michael Staskiewicz, CCIM is the Managing Broker/ Senior Vice President of The Garibaldi Group and Founder of EffectiveWorkplace.com. Michael helps innovative, purpose-driven CEOs clarify the strategic plan for a world-class work environment, so they can attract the best talent and reduce voluntary turnover.

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