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Slowing Industrial Construction Eases Fears of Overbuilding

Despite recent analyst concerns that the U.S. industrial market is in danger of overbuilding this year, vacancy rates are falling and the volume of projects entering the development pipeline is tapering.

That’s according to two reports released March 26 by ProLogis (NYSE: PLD). The Denver-based distribution space provider publishes its U.S. Property Market Review and U.S. Construction Pipeline Reports twice yearly, covering the nation’s 30 largest markets.

The average industrial vacancy rate fell to 7.6% at the end of 2006 from 7.9% at midyear and 8.0% at the end of 2005. Asking rents, meanwhile, increased 1.7% during the fourth quarter and 7.6% over the full year.

Some analysts have expressed worries that speculative industrial development will flood cities that are already struggling with double-digit vacancy rates. Those include Chicago at 12% vacancy, Dallas at 10.2% and Atlanta at 10.9%. Indeed, most industrial construction is speculative, and growing more so. Speculative building accounted for 80% of total starts in the second half of the year compared with 73% in the second half of 2005, ProLogis found.

The volume of projects entering the construction pipeline appears to be slowing, however. New starts totaled 59 million sq. ft. in the latter half of 2006 compared with 81 million sq. ft. in the first half of the year. For the year, total new starts equaled 2.7% of existing inventory.

That suggests builders are aware of the overbuilding risk and are dialing back on new product, according to Leonard Sahling, ProLogis’ first vice president of research.

“The nation’s distribution property markets ended 2006 with the wind at their back,” Sahling writes in the U.S. Property Market Review. “Demand is growing briskly, developers and their financing sources are exercising discipline and restraint, and rents are ratcheting higher.”

While Chicago-based Grubb & Ellis doesn’t report project starts, its construction numbers seem to jibe with ProLogis’ assertion that developers are showing some constraint. Prior to the second quarter of 2006, the amount of industrial space under construction had increased each quarter since 2002, when it was at a low of about 50 million sq. ft. In each of the past three quarters, however, construction has leveled off at about 115 million sq. ft.

“That’s a hopeful sign,” says Bob Bach, national director of market research at Grubb & Ellis. “That’s a potential sign of discipline on the part of builders.”

Nationwide, vacancy held at approximately 7.7% in the third and fourth quarters last year. Bach calls that a healthy level that is unlikely to change much this year. “My sense is that supply and demand will be roughly in equilibrium,” he says. “But I don’t expect the overall market to tighten further.”

Property & Portfolio Research Inc. has noticed a tapering in warehouse construction and planning for new projects since about the middle of 2006, while activity among other commercial property types has been on the upswing. Josh Scoville, director of strategic research at Boston-based PPR, attributes the slowed industrial pipeline to a faster reaction to slowing economic indicators.

“Warehouse developers can react to changing economic conditions due to the short construction period for warehouse product,” he says. “It takes, on average, two years to build an office building, but you can deliver a warehouse in six months.”

Dangers of an overbuilt industrial market are definitely subsiding, Scoville says, and PPR is forecasting a 10% decline in warehouse completions in 2007. Construction won’t slow soon enough to stave off some softening, however. PPR expects the slowing economy to reduce demand for distribution space by 30% this year.

“So we still see a little up-tick coming in vacancy, from 8.7% at year-end 2006 to 9% at the end of 2007,” Scoville says. “That will slow rent growth this year from a little over 4% in 2006 to close to 3% in 2007.”

For a copy of ProLogis’ current or past reports, visit the "Proprietary Research" page of the ProLogis web site, at www.prologis.com.

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