Industrial market fundamentals continue to slip as supply begins to mushroom nationally. Grubb & Ellis reported 132 million sq. ft. of industrial space under construction during the first quarter of 2007 — a record volume. A bigger concern is that 109 million sq. ft. of that space is being developed on a speculative basis.

To put those numbers into context, the 132 million sq. ft. total exceeds the peak of the last expansion cycle when 122 million sq. ft. was under development in the fourth quarter of 2000.

Fundamentals aren't immune to this new supply, either. Net absorption in the first quarter totaled 5.5 million sq. ft., the lowest level in three years, according to Grubb & Ellis. Weak leasing activity also kept vacancy flat at 7.7% for the third consecutive quarter.

“It's still too early to say we are in the red zone for overbuilding as I don't see this leading to chronic oversupply,” says Bob Bach, national director of market research for Grubb & Ellis.

But Bach expects new supply to stymie many landlords attempting to raise rents. Since most of this space is speculative in nature, it has more potential to weaken conditions in markets where new product is delivered. Bach forecasts that average warehouse rents will increase by 1% in 2007 compared with 5% in 2006, the early stage of the current building cycle.

Local market conditions vary

Still, some markets are bulking up faster than others. In California's booming Inland Empire, located 35 miles east of Los Angeles, 24.2 million sq. ft. of new industrial space was in the pipeline during the first quarter. In short, roughly 20% of all industrial space under development nationally in the first quarter was in the Inland Empire.

The hard hit home building sector hasn't helped drive demand for industrial space in recent months.

But economic activity in the manufacturing sector expanded in May for the fourth consecutive month, according to the Manufacturing ISM Report on Business.

Many real estate economists view this influential report issued monthly by the Institute for Supply Management (ISM) as a leading indicator of industrial demand because it tracks inventory. If suppliers are sending out more goods, that bodes well for the warehouse market that stores these items temporarily.

Valued statistic

One closely watched metric that leads each monthly report is the Purchasing Managers Index (PMI), which increased by 0.3% to hit a reading of 55 between April and May. A reading above 50 generally suggests that the manufacturing economy is expanding.

“The user demand should come into play and fill many of these new buildings,” says Patrick Gallagher, senior vice president at Chicago-based industrial development firm The Alter Group. “While it's easier to put up industrial projects, it's also easier to turn off the pipeline once it becomes too crowded.”

The Alter Group reported 1.8 million sq. ft. of development either completed or under construction as of Dec. 31, 2006. The company's current pipeline of industrial projects is valued at $758 million. The Alter Group is targeting Southern California for new development. The firm broke ground on a 600,000 sq. ft. distribution center in Fontana, located in the heart of the Inland Empire region.

Gallagher admits that new supply is being developed at a torrid pace in the Inland Empire, but he's quick to add that industrial vacancy registered just 2% at the end of the first quarter in the market. “So even if supply piled up, your vacancy is so low to begin with in markets like this,” he says.

Investor attention

Meanwhile, the large amount of capital attracted to real estate is creating cap-rate compression. Nationally, the average cap rate — the yield during the first year of ownership based on the purchase price — fell from 7.5% to 7% during 2006, according to Manhattan-based Real Capital Analytics. Roughly $42.3 billion worth of industrial properties were sold last year.

Average cap rates also have fallen since the end of 2006. Part of the reason: Sellers put roughly $13 billion worth of industrial properties on the market through the end of April, up 45% from the same period in 2006.

“There's a lot of capital still focused on buying industrial real estate,” says Gallagher. “And I expect to see many properties bought and sold through the end of 2007.”