The nation's industrial real estate market is showing signs of a split personality. On one hand, according to CoStar Group, the first quarter's 10.7% vacancy rate is the highest since 1994. On the other, increasing demand for industrial product is pushing prices upward. In fact, over the past six months cap rates have dropped about 100 basis points and now range between 7.5% and 8.5%, industrial owners report.

“The vacancy rate has been rising since the fourth quarter of 2000,” says Robert Bach, national director of market analysis for Grubb & Ellis in Northbrook, Ill. “It won't rise much further, but I don't see real improvement until 2004.”

Along with higher vacancies have come lower rents. Though Colliers International reports rents held steady from January to April, it documented a nearly 10% drop last year. The Boston-based brokerage pegs current annual rents at $4.60 per sq. ft. for warehouse and manufacturing.

Navigating Through the Downturn

Some industrial owners are faring better than others. For example, San Francisco-based AMB Property Corp., which ranked No. 3 on NREI's Top Industrial Owners survey with 84.2 million sq. ft. of space, reported a 7.5% vacancy for the first quarter of 2003. Though the vacancy rate is up two points from last year, it's still three points below the national average.

According to AMB President W. Blake Baird, the San Francisco-based REIT has boasted a better-than-average industrial vacancy level every year since going public in 1997, based on statistics from the National Association of Real Estate Investment Trusts in Washington, D.C. While AMB ended '97 with a 7.4% vacancy rate, its subsequent end-of-year levels have not gone above 5.4%. Most years it has been below 5%.

The stock price of AMB (NYSE: AMB) hovered just over $28 per share in mid-June, midway between its 52-week high of about $31 per share and its low of $24.70. Merrill Lynch has set a 12-month price target of $29.50 for AMB. “Industrial tends to be more dependent on a build-up in inventories rather than a pickup in job growth,” wrote Merrill Lynch senior real estate analyst Steve Sakwa in early June.

Baird credits AMB's success to a three-pronged strategy: focusing on infill properties near airports, ports or major highways in 11 major markets; concentrating on high-throughput distribution facilities rather than warehouses; and forming partnerships or other alliances with the “best entrepreneurial real estate companies and leasing brokers” in each market.

AMB has decided to accelerate planned dispositions, Baird says, because poor returns in stocks, bonds and office properties have attracted investors to industrial real estate. “In the last couple quarters, we were actually net sellers,” he says.

In the first quarter, AMB sold $127 million in properties but spent only $10.87 million on replacements, acquiring 20% interests in the 111,890 sq. ft. Gratigny Distribution Center in Miami and the 126,400 sq. ft. second phase of Northfield Distribution Center in Grapevine, Texas. By contrast, last year it sold $244 million of assets but bought $403 million of product.

Bach says demand for industrial property is outstripping supply, driving down cap rates. “The cap rate took a dive in the first quarter, indicating stronger demand,” he says. “In the last six months it's dropped three quarters of a point to 8.8%.”

Bach of Grubb & Ellis says most industrial price gains apply primarily to single-tenant, net-lease properties, but Baird reports strong demand for all product types. Indeed, AMB's largest 2002 transaction was the $155.3 million sale of 4.7 million sq. ft. of multi-tenant buildings in Dallas and Houston to The Teachers Insurance and Annuity Association.

Areas of Expansion

The pricing trend has a flip side, of course. Replacing properties has become more expensive and more competitive. To compensate, AMB executive vice president Bruce Freedman says the company is aggressively seeking development opportunities and expanding internationally. In February, AMB and Miami-based Codina Group paid $29.7 million for a 438-acre master-planned development site in Miami and immediately launched construction of the first two buildings.

International investment comprises 6% to 8% of AMB's portfolio. The company expects to boost that figure to between 12% and 15% over the next five years. In addition to maintaining holdings in Guadalajara, Paris and Singapore, AMB has targeted Mexico City, Monterrey, Amsterdam, Frankfurt, Madrid, London, Tokyo and Hong Kong for eventual entry.

Whether the market turns around next year remains in question. While Bach believes a turnaround is not far off, Dean Violagis, vice president of research for CoStar, expresses doubt. “Even if the economy picks up, it takes time for companies to respond,” he says. “It won't happen overnight.”