Rising construction and land costs have not stemmed a growing wave of industrial development. Industrial space under construction rose for a ninth consecutive quarter to 109.7 million sq. ft. in the first quarter of 2006 — just 10% below the all-time peak recorded in the fourth quarter of 2000, according to Grubb & Ellis.

“This is another very strong year in terms of what we have in the pipeline,” says Whitfield Hamilton, a regional partner at Sacramento, Calif.-based Panattoni Development. The company expects to build 18 million sq. ft. in 2006, slightly less than last year, and up from the 16 million sq. ft. the firm developed in 2004.

That activity helped lift Panattoni to the No. 2 ranking in NREI's Top 25 Industrial Developers survey. The amount of space the firm completed in 2005 or had under construction as of Dec. 31, 2005 totaled 20.6 million sq. ft. “Across the country, we are in 22 markets, and in most of those markets we have significant industrial starts underway,” Hamilton says.

For example, Panattoni recently completed its first project in the new 750-acre Lakeview Commerce Center in Edwardsville, Ill. The 605,000 sq. ft. distribution facility for Spectrum Brands Inc. was completed earlier this spring.

Demand for space

What's driving the building binge? Rising occupancies and rents, an ample supply of capital for development and investment in improved distribution networks are the key. The industrial vacancy dipped a miniscule 10 basis points to 8% at the end of the first quarter — making it the eighth consecutive quarter vacancies have declined, according to Grubb & Ellis.

Higher oil costs are driving demand for space as companies look for greater efficiency in distribution networks. “All of these companies are very much thinking about their supply chains and their costs to warehouse and deliver the product,” says Bill Hankowsky, chairman, CEO and president of Malvern, Pa.-based Liberty Property Trust.

Liberty has 13 buildings under construction totaling about 2.7 million sq. ft. in markets such as Virginia Beach, Chicago and Houston. That volume is up slightly from the 2.5 million sq. ft. underway a year ago, and Hankowsky expects construction activity to increase in 2007 due to growing build-to-suit activity. Liberty ranks No. 14 on this year's list of top developers with 3.3 million sq. ft. of industrial space built or under construction at the end of 2005.

Part of Liberty's development strategy is providing a fresh supply of expansion space in markets where the firm already has a strong presence. “If we're 100% leased, we're sort of out of business,” Hankowsky says. “So, we always want to have some product on the shelf, so to speak, to respond to market demand.” For example, Liberty is building a 750,000 sq. ft. spec warehouse in Pennsylvania's Lehigh Valley, where the firm's current 11.5 million sq. ft. industrial portfolio is 98% occupied.

Rising building costs

The strong demand for investment real estate is continuing to fuel new development, as well as keep pressure on cap rates. “There is still an incredible river of capital that is coming into industrial real estate,” Hamilton explains. In 2005, approximately $24.2 billion worth of industrial properties traded hands at an average cap rate of 7.5%. That momentum carried into the first quarter of 2006 with $7.9 billion in transactions at a cap rate of 7.2%, according to Real Capital Analytics.

Yet, justifying development in the current environment of rising building costs and rising interest rates is a challenge. Competition for land is driving prices higher, while overwhelming global demand for building materials is escalating construction costs.

The cost of construction materials has increased 10% to 15% in the past year, while land prices have risen 5% to 10%. “There has been a huge run-up in construction costs, and frankly rents have not caught up with the true cost of building buildings,” Hamilton says. That has created a situation where developers have relied on the low cap-rate environment, or increases in building valuation, to make up for the difference in higher construction costs.

The average asking rental rate for warehouse/distribution space has increased 5.6% over the past year, ending the first quarter at $4.56 per sq. ft. per year triple net, according to Grubb & Ellis. The R&D/flex market experienced a year-over-year gain of 4.5% to end the first quarter at $9.53.

Many industry experts believe rents will have to take a much bigger jump in order to justify new construction in light of higher building costs. Hamilton predicts that “tenants in some markets are going to see significant increases.”