With retail sales slowing, vacancy rates are climbing in the industrial warehouse sector. The volume of property sales also has dropped sharply and forced investors to rethink their strategies. Worried about the slowing economy, developers have quickly reduced new construction levels.

In the first quarter, construction starts totaled 33.8 million sq. ft., down from the recent high of 53.3 million sq. ft. in the second quarter of 2007, according to Grubb & Ellis. “We should not have big oversupply problems,” predicts Jim Dieter, director of industrial business for CB Richard Ellis. “By the first quarter of 2009, things will begin turning positive.”

But for now the industrial market is coping with an economic slowdown. The national vacancy rate climbed to 7.9% in the first quarter, up from 7.7% at the end of 2007, reports Grubb & Ellis. Space completions hit 37.4 million sq. ft., while only 21.3 million sq. ft. was absorbed. With the economy weak, the picture should continue deteriorating, says Bob Bach, chief economist at Grubb & Ellis. “The vacancy rate should drift higher and reach 8.5% by the end of this year,” Bach says.

Pinpointing the problem

Most of the trouble centers on the warehouse segment. With retailers facing a slowing economy, the warehouse vacancy rate hit 8.5% in the first quarter, up from 7.8% a year earlier. Ironically, general industrial properties, which house factories, posted a vacancy rate of 6.4%, about the same figure as a year ago.

Analysts say manufacturing is getting a boost from a weak U.S. dollar, which spurs exports. “For a lot of large manufacturers, U.S. sales are soft, but the global business is still healthy,” says Dieter.

Buoyed by rising manufacturing sales and exports, some markets remain healthy. Of the 50 markets tracked by Grubb & Ellis, 18 reported declining vacancy rates in the first quarter. The strongest market in the country was Los Angeles with a vacancy rate of 1.6%. In Southern California, construction has been limited since little land is available.

While auto sales are slowing, many Midwest markets are thriving as a result of demand for exports from companies such as John Deere and Catepillar. Vacancy rates remain below 4% in Wichita, Kan. and South Bend, Ind., and rents throughout the industrial market remained firm. The rate for warehouse space nationally was $4.67 per sq. ft. in the first quarter, up 2.7% from last year.

Slowing development pipeline

Despite the rising rents, developers have cut back on speculative construction. “In the past, we did a lot of spec building, but that kind of development has almost completely stopped,” says Larry Harmsen, managing director at ProLogis. The Denver-based REIT, ranks No. 1 on NREI's top industrial developers list with 50.5 million sq. ft. completed or under development globally at the end of 2007, up from 35.6 million sq. ft. in 2006.

Developers have become cautious partly because of a sharp drop in transactions. Through April of this year, industrial sales totaled $17.2 billion, down 38% from the same period in 2007, according to Real Capital Analytics. With transaction volume down, property prices are likely to fall a bit this year, analysts say.

But gauging prices in this environment is difficult, says William Maher, director of North American strategy for LaSalle Investment Management. In late 2007 and early 2008, a number of prime properties sold for cap rates of around 5%, an indication of strong demand, says Maher. Since then markets have frozen.

Buyers of industrial properties today are on the prowl for bargains, while sellers demand last year's prices. At the same time, arranging financing has become more difficult. “There are so few deals being done in some markets that it is hard to know what prices may be,” says Maher, who is telling clients to underweight their holdings of industrial properties.

Buyers will likely blink first and prime properties should hold their values, predicts Harmsen of ProLogis. How can he be so sure? “A lot of pension funds and institutions are eager to buy in California and other strong markets,” he says.

Asset quality and location play a critical factor in any downturn. Class-B and C properties in secondary markets could be the most vulnerable. A year ago, such properties commanded cap rates of about 7%. But investors' appetite for risk has fallen greatly. Expect cap rates for Class-B and C properties in secondary markets to reach 9% this year, says Harmsen. “With the economy slowing, prices of weak properties will drop.”