After three years of rising vacancy rates and plunging rents, industrial properties have begun showing modest signs of new life. With employment rising, manufacturers and retailers are expanding their distribution facilities. The national vacancy rate is projected to register 10% at the end of 2004, down 0.4% from a year ago, according to brokerage firm Marcus & Millichap.

“We turned the corner in the first half of 2004, and now we should see gradual improvement in vacancy and absorption in 2005,” predicts Alan Pontius, national director of Marcus & Millichap. Absorption is expected to top 80 million sq. ft. in 2004, up from 72 million in 2003.

Construction activity has slowed, but hasn't stopped. Marcus & Millichap projects that 67 million sq. ft. of industrial space will be completed in 2004, down from 88 million sq. ft. in 2003. Still, some companies are beginning speculative construction that could hurt fundamentals in 2005.

When it began work on a 667,000 sq. ft. distribution center in Columbus, Ohio, in June 2004, Duke Realty had no tenants. But recently McGraw-Hill agreed to take 500,000 sq. ft. Duke expects to sign more tenants before the project is completed this quarter. “The Columbus market is fairly strong and looks healthy,” says Bob Chapman, senior executive vice president of Duke Realty.

Developers say demand is improving throughout most of the country. Some rent increases are appearing in the strongest markets, including Southern California and Northern New Jersey. Rents should climb in the next 12 months, predicts Rick Imperiale, portfolio manager of Forward Uniplan Real Estate Fund, a mutual fund. Imperiale says that demand is improving, and costs have been skyrocketing for steel and concrete, big elements of warehouses. “As the cost of building new facilities goes up, owners will be able to raise rents on existing properties,” he says.

Though steel may be expensive, debt financing remains cheap with the 10-year Treasury yield hovering around 4.2% as of early December. Such favorable loan terms have enabled investors to load up on leverage and purchase properties at high prices. With bidding competitive, the average capitalization rate — yield on the initial price — of industrial properties reached 8.3% in the second quarter of 2004, down more than 60 basis points from a year ago, according to Marcus & Millichap.

Rates on prime properties have fallen even further, with top industrial real estate commanding cap rates of less than 7%. Marcus & Millichap is seeing bids with capitalization rates as low as 6.25% for a prime property in Tucson. The Arizona warehouse has an attractive location near the airport and a solid tenant with a 15-year lease. “Conservative investors want security, and there are a lot of people bidding for a limited supply of top-quality properties,” says Pontius of Marcus & Millichap.

Pontius expects cap rates to fall slightly in 2005. With the economy strengthening, rising interest rates will make borrowing more expensive. Still, prices of industrial properties should hold up.

For four years, the supply of new facilities has fallen, dropping from a peak of more than 150 million sq. ft. in 2000 to 67 million in 2003. Now that demand for space is growing again, absorption should climb. Says Pontius, “This is a time to be more bullish on the industrial sector.”

Executive Insights

Name: Michael W. Brennan

Title: President and CEO

Company: First Industrial Realty Trust

Headquarters: Chicago

Biggest Surprise of 2004:

“Normally, industrial absorption rises along with increases in corporate profitability. This year profits rose, but absorption was relatively slow. Instead of spending on new plants and equipment, companies have been increasing their cash balances or decreasing debt.”

Prediction for 2005:

“In the next 12 months, speculative building will remain low. Vacancy rates will keep coming down until they get below 10%. Once that happens, we will have a landlord's market and rental rates will increase sharply.”