While the giddy investment market in the warehouse/distribution sector is backed by falling vacancies and rising rents, one wildcard clouds the short-term outlook: A potential slowdown in import-export growth could weaken demand for space just as the development pipeline begins to heat up.

For now, real estate fundamentals are giving investors reason to smile. Boston-based Property Portfolio & Research (PP&R) predicts that the national industrial vacancy will dip to 9.4% by the end of 2005, down from 10.1% a year ago.

Vacancies are expected to stabilize around 8.5% next year and into mid-2007, says Hans Nordby, research strategist with PP&R. “That isn't bad at all, though if you look at leading indicators, such as the growth of total imports and exports, that's slowing,” he says.

According to the Port Import-Export Reporting Service (PIERS), a commercial database that tracks waterborne shipping, import growth will rise 6.4% in 2006, up marginally from 6.1% this year, because interest rates and energy costs may put pressure on consumer spending. Export growth is expected to slow, dropping from 8.6% in 2005 to 5.5% in 2006, primarily because of the appreciation of the dollar against the yen and euro.

In response to lower vacancies, industrial rents are gradually climbing. Data researcher Reis pegs the average effective rent at the end of this year at $4.34 per sq. ft., up 1.4% over 2004.

Absorption expected to slow

Absorption of industrial space nationally will total 127 million sq. ft. this year, predicts Nordby of PP&R, but only total about 106 million sq. ft. in 2006, as demand growth from importers and exporters slows. “Those who extrapolate absorption from 2005 numbers into 2006 will be disappointed,” he emphasizes.

If absorption does continue to slow, and spec development continues at a fair pace, there's some risk that overbuilding could begin to hurt fundamentals during 2006. PP&R's recent numbers point to accelerating development in 2005: In May, there were about 16 million sq. ft. entering the “under way” phase. By August, that total had risen to 25 million sq. ft.

“High levels of liquidity in the market, combined with high asset sale prices and low cap rates, encourage development,” says Nordby. “It isn't here yet, but it's a real danger to the forecast.”

Not everyone thinks so. “Development responds to demand efficiently in the industrial market, and that's not going to change,” says Paul Fisher, president of CenterPoint Properties Trust, a Chicago-based REIT.

High energy prices ought to encourage further industrial consolidation in hub markets next year, Fisher says, as logistics companies pursue a strategy of long hauls by rail, then short hauls from hub markets by truck.

Local market conditions may prove an effective constraint on industrial development. In the San Fernando Valley north of Los Angeles, the industrial vacancy rate is 2%, says Mike Tingus, a broker with Lee & Associates. “You couldn't build industrial product fast enough to keep up with the demand, but the problem is finding land that isn't being used for something else. That's the case in almost all of southern California.”

Another wildcard for industrial development in 2006 will be the so-called “Katrina effect.” Next year, steel, concrete, and a host of other building materials will be flowing to the Gulf Coast, potentially causing shortages of those materials elsewhere and extending construction schedules. Besides that, there might also be a shortage of construction workers, particularly in the South, as that labor pool pursues lucrative reconstruction work.

“In Florida and Texas, there will be problems getting labor,” says Nordby. “There will be less excess supply risk in those parts of the country, and investors with assets in those regions may get an upward surprise in rent growth.”

Hungry investors

According to Real Capital Analytics, some $23.8 billion in industrial properties traded hands in the first nine months of 2005, an 83% increase over the same period last year. Industry pros don't expect this insatiable appetite to abate anytime soon.

Major institutional investors may rethink their industrial strategy in 2006, however, says Doug Poutasse, chief investment strategist with Boston-based AEW Capital Management. “For a core investor unable or unwilling to invest in development, or unwilling to step outside the United States, the answer would be to underweight next year because of the quantity of non-supply-constrained markets trading above replacement cost.”

The only markets Poutasse considers supply constrained, and thus worthy of acquisitions at above replacement cost, are the Los Angeles basin, northern New Jersey and parts of southeast Florida.

INDUSTRIAL RENTS GRADUALLY CLIMB

Though they are below levels reached in 2000, average effective rents are expected to rise moderately in the next few years.

Year	Effective rent	% change (over previous year)
2000	$4.50	4.2
2001	$4.38	-2.7
2002	$4.32	-1.4
2003	$4.26	-1.4
2004	$4.28	0.5
2005*	$4.34	1.4
2006*	$4.44	2.3
2007*	$4.57	2.9
2008*	$4.72	3.3
2009*	$4.87	3.2
Projected*
Source: Reis