As the U.S. economy continues to shed jobs — 1.2 million in the first 10 months of this year — consumer spending is contracting and demand for industrial space is slipping. The national industrial vacancy rate hit 8.5% in the third quarter, up from 7.6% a year earlier, reports Grubb & Ellis.

But look more closely under the hood and a study of contrasts emerges. Pockets of the industrial Midwest are experiencing double-digit vacancies. In Detroit, the vacancy rate has ballooned to 13.4%. At the other extreme is Los Angeles, where the vacancy rate is 2.3%. Southern California benefits from strong trade activity with Asia. It's also a supply-constrained market.

The national vacancy rate has risen four consecutive quarters, says Robert Bach, chief economist at Grubb & Ellis. “By the end of 2009, we should see a vacancy rate of 9.5% or 10%.” Following 9/11, vacancy peaked at 10.1%. “This downturn shouldn't be worse than what occurred in the last down cycle,” he says.

With financial markets virtually frozen, sales activity has slumped. Investors who can still buy should stick with the safest properties, says Tom Mullahey, a principal with AEW Capital Management. “Prices are most likely to remain firm for best-in-class properties in primary markets.”

Spotty success

At a time when fewer goods are moving through ports and along highways, all segments of the industrial market are suffering. Warehouse distribution properties posted a vacancy rate of 9.3% in the third quarter, reports Grubb & Ellis, compared with 11.4% for R&D-flex buildings.

General industrial properties, which house factories and are less prone to excesses of speculative building because many manufacturers require customized construction, posted a healthier 6.6% vacancy rate in the third quarter.

However, the Institute for Supply Management reports that its index of manufacturing activity in October dipped to 38.9, the lowest reading since 1982. Any score below 50 indicates that the manufacturing sector is shrinking.

Trends in port cities remain mixed. While metro Seattle posted a healthy vacancy rate of 6.4% due largely to incoming Asian goods, properties near secondary ports face harsher conditions. In Norfolk, Va., vacancies hit 9.8%.

“Developers moved into the port areas to take advantage of the growth of global trade,” says Jim Dieter, executive managing director of CB Richard Ellis. “Now trade is slowing, and the smaller markets are facing challenging times.”

Silver lining?

A decline in construction activity could help offset the impact of weakening demand. Some 65 million sq. ft. of space will be completed this year, down from 76 million sq. ft. in 2007, reports Reis.

With new supply limited, average effective rents rose to $4.80 per sq. ft. in the third quarter compared with $4.70 a year ago. In 2009, effective rents are projected to rise to $4.87. “Rent growth has slowed, but not stopped altogether,” says Sam Chandan, chief economist of Reis.

Speculative building has nearly stopped. AMB Property Corp. began more than $400 million worth of speculative construction in the U.S. in 2008. But the San Francisco REIT will not start any such projects anytime soon. “Our clients do not expect to see much sales growth,” says Eugene Reilly, AMB's president of the Americas. “Much of the development that we see is designed to help companies operate more efficiently and lower costs.”

AMB is building a 657,000 sq. ft. warehouse for Home Depot in Tracy, Calif., 60 miles east of the port of Oakland. It will replace smaller, less efficient facilities.

Because of sinking share prices, publicly traded REITs like AMB could face problems financing any expansion. Shares of industrial REITs dropped 67.31% during the first 10 months of 2008. In November, AMB's share price was $14.75, down from more than $60 in June.

Price declines visible

Through September 2008, industrial property sales totaled $18.4 billion, down 54% from 2007, reports Real Capital Analytics. Property sales were especially weak in the third quarter, totaling $4.8 billion, down 67% from the year before.

The average sales price nationally for properties that traded in the third quarter was $69 per sq. ft., down 13% over the prior year. Capitalization rates — initial yields based on the purchase price — rose to 6.8%, up 22 basis points from last year. Worried about defaults, investors sought properties with multiple tenants.

Cap rates for warehouses in secondary markets reached a record low of 7% in 2007, but now exceed 8%. Cap rates in primary markets dipped below 6.5% early in 2008, but now stand above 6.6%.

Prices will remain soft until credit markets loosen, says Dan Fasulo, managing director of RCA. “The lenders are only providing financing for top-quality properties in the primary markets. Lower-quality assets are sitting on the shelf.”