Industrial tenants across the country are bracing for rental rate sticker shock — the kind of hefty increases experienced in Southern California. Demand for Class-A properties will undoubtedly remain strong in 2008, though investors can expect tougher lending standards to dampen sales.

“Despite the projection for a slowdown in the economy, the demand for industrial space — particularly on the coasts — is fairly robust,” says Sam Chandan, chief economist at New York-based research firm Reis. “Newer warehouses that are spacious and in key coastal port markets will continue to do well.”

National rental rates are expected to follow the lead of Southern California, where monthly rents for industrial properties spiked by about 33% over the last two years as vacancy rates declined, and competition heated for Class-A properties, says Michael McKiernan, executive managing director of industrial brokerage at Chicago-based Cushman & Wakefield. The Inland Empire's strong warehouse market benefits from its location near the port of Long Beach, which moves more cargo than any other U.S. port.

The months ahead will likely prove troublesome for older, second-tier properties as a result of rising interest rates and a slowing economy. The 2% industrial vacancy rate forecast for Los Angeles in 2008 will no doubt outshine expected double-digit vacancy rates in markets like Columbus, Ohio or Charleston, S.C.

A drop in new construction should help to keep supply in check. Indeed, new deliveries are forecast to drop from 94.1 million sq. ft. in 2007 to 83.5 million sq. ft. in 2008, according to Reis.

But higher rents and growth in global trade should keep most markets healthy. Nationally, average asking rents are projected to rise 3.4% to $5.13 per sq. ft. in 2008, reports Reis. Analysts may disagree on whether the country will slip into recession, but their consensus for the sector is optimistic. “Based on inventories, I'd say we're already in recession. Inventories have been going up for the last 10 to 12 months,” says McKiernan. “The only question is how deep and how long it will be.”

Regardless, McKiernan says the shrinking national vacancy rate will have a positive impact on the sector. The overall vacancy rate for the nation's top 35 industrial markets fell by 40 basis points from November 2006 to 7.1% in November 2007, and the third-quarter vacancy was the lowest since June 2001.

No-leverage deals rule

Despite weakness in secondary markets, Dan Fasulo, managing director of research firm Real Capital Analytics in New York, says bidding should remain strong for Class-A properties in strong markets, which attract pension funds and other buyers using little or no leverage. During the first nine months of 2007, industrial sales totaled $37 billion, up 18% from the same period in 2006, reports Real Capital Analytics.

“There should be plenty of demand for high-quality properties that benefit from global trade,” says Robert Bach, chief economist for Grubb & Ellis.

Despite strong demand, look for slightly elevated cap rates in 2008. Bach forecasts that next year the national average cap rate will rise 25 to 50 basis points, up from 7.6% in the third quarter of 2007. The rise stems from the mixed national outlook, and soft secondary markets.

REITs snap up Class-A properties

Strong demand for Class-A properties has particularly boosted industrial REITs, which tend to focus on top-quality properties in primary markets.

Through Nov. 26 of this year, the Equity REIT Index posted total returns of negative 17% compared with total returns of negative 1.1% for industrial REITs, according to the National Association of Real Estate Investment Trusts, a trade group in Washington, D.C.

Industrial REIT ProLogis expects to develop $3.8 billion worth of properties around the globe in 2007, only $700 million of it in the U.S. and Canada.

“We expect to do 80% of our development outside the U.S.,” in areas where economic growth outpaces that of the U.S., according to Melissa Marsden, a senior vice president of investor relations for ProLogis.

Even so, domestic port projects are still a good bet. Chicago REIT First Industrial Realty is developing a 45-acre site to serve Seattle-area ports, says spokesman Sean O'Neill.

The project is a joint venture with the California State Teachers' Retirement System. “Occupancy in our properties is 95%, and there is plenty of demand for more space,” says O'Neill.

For investors, 2008 may be a mixed blessing. “I think you're going to continue to see vacancies fall slightly,” says McKiernan. “Some corporate customers will put expansion plans on hold.”