After three years of surging demand, the industrial sector is expected to encounter some turbulence in 2007. The national vacancy rate, which registered 8.8% in the third quarter of 2006, is forecast to climb to 9.4% by the end of 2007, according to Boston-based Property Portfolio & Research (PPR).

The trouble can be traced to a cooling economy. At a time when sales ofsingle-family homes are slowing, the growth rate in the gross domestic product (GDP) slipped to 1.6% in the third quarter, down from 2.6% in the second quarter, reports the Department of Commerce.

Now many experts expect the slow growth to continue in 2007. With retail sales and construction sluggish, fewer trucks may be pulling up to some warehouses. “We are not expecting a recession, but demand for new industrial properties is going to fall,” says Hans Norby, director of U.S. market forecasting for PPR.

In response to a slowing economy, the volume of new development is moderating. New deliveries of completed space will drop from 153 million sq. ft. in 2006 to 144 million sq. ft. in 2007, according to PPR, and demand is dropping even faster than supply. PPR predicts demand for new space will drop from 144 million sq. ft. in 2006 to 102 million sq. ft. in 2007.

Hot and cold markets

The hardest hit areas should be in the Midwest, where markets are among the softest in the country. With the auto industry and other manufacturers slowing, vacancy rates are projected to rise from 8.8% to 10% in Indianapolis, while rates in Chicago are expected to rise from 10.5% to more than 12%. “There is way too much supply coming down the pike in Chicago,” says Norby of PPR.

The picture across the country is not uniform. Thanks to booming imports from Asia and Europe, demand for warehouses is strong on both coasts, and vacancy rates should stay in the single digits. But even hot regions are bound to cool. One of the strongest markets has been the Inland Empire, the area east of Los Angeles where many companies have moved to escape the high price of coastal real estate.

Of the 131.9 million sq. ft. of industrial properties currently under construction nationally, 23.8 million sq. ft. is located in the Inland Empire, according to CoStar Group, a real estate researcher in Bethesda, Md. But demand should slow as the vacancy rate in the Inland Empire climbs from 5.2% this year to 6.4% in 2007, according to PPR.

To be sure, a few strong markets should remain healthy. Vacancy rates in Los Angeles should hold steady at below 4%, says Edward Indvik, chairman of Lee & Associates, a commercial real estate broker in Los Angeles. Thanks to the city's tough zoning laws, scant new construction is on the horizon. Meanwhile, the economy appears strong, with a variety of industries driving growth. “The biotechnology business is very strong, and construction is healthy throughout Southern California,” says Indvik.

Choosy buyers

While national vacancy rates may soften, investors show few signs of losing their appetite to buy quality properties. Average capitalization rates, or initial yields based on the purchase price, have dropped sharply from 9.5% in 2003 to 7.1% in the third quarter of 2006, according to New York-based real estate research firm Real Capital Analytics. In 2007, bidding is likely to remain intense in strong markets, adds Leonard Sahling, first vice president of ProLogis, a Denver-based industrial REIT.

Much of the highest bidding is for large, Class-A developments in major markets. Because such state-of-the-art structures can provide steady income, they are particularly desirable for institutional investors. Pension funds, for example, tend to bid on either large properties or groups of many smaller properties. “It is not worth an institution's time to buy a small $5 million property,” says Dan Fasulo, director of Market Analysis for Real Capital Analytics.

A bifurcated market has emerged. While Class-A warehouses command higher and higher prices, many lesser-quality properties have been left out of the spotlight. Older properties in smaller cities are not attracting heated bidding wars. According to Real Capital Analytics, cap rates for the cheapest 10% of properties began rising in the second quarter of 2006 and kept climbing in the third quarter, hitting about 9%. The weakness is particularly noticeable in overbuilt markets, such as Atlanta, where average cap rates have climbed around 50 basis points in the past year to 7.5%.

Sahling of ProLogis acknowledges that a two-tier market is taking shape. “We are seeing some cap rates between 4.25% and 5% in California,” says Sahling. “That is unheard of. But institutions are not bidding ferociously for Class-B products.”