The AGONY and Ecstasy Of Office and Industrial

Industrial real estate, driven by manufacturing and the basic needs of a growing US population, continues to outshine the office sector on the road to recovery. Companies soaked up distribution and manufacturing space at an accelerated pace in the second quarter despite slowing economic growth at home and a looming recession in Europe.

Net occupancy of industrial properties grew by 19.8 million square feet, according to Cassidy Turley Real Estate Services. While that activity was insufficient to budge the industrial vacancy rate, which remained flat at 9.1%, it did outstrip the 19.1 million square feet of net absorption logged in the first quarter, the St. Louis-based firm found.

Office users, on the other hand, absorbed a more modest 11.9 million square feet nationwide in the second quarter, improving on the previous quarter's 7.8 million square feet of absorption. The office vacancy rate ticked down 20 basis points from the first quarter to 15.7%. Office rent averaged $21.70 per foot, Cassidy Turley found, and has been creeping up ever so slightly for several quarters.

Real estate investors can take heart in the knowledge that both office and industrial fundamentals are performing at least as well as, if not better than, the national economy. Annualized GDP growth slowed to 1.7% in the second quarter from Q1's rate of 2.0% growth. Employment growth has been fitful, with August representing a net gain of only 96,000 jobs after 163,000 in July.

"A slow recovery is still a recovery, and even the office sector has been consistently absorbing space," says Kevin Thorpe, chief economist at Cassidy Turley's office in Washington, DC. "But when you juxtapose office to industrial right now, the industrial sector at this point in the cycle is the brighter spot in the recovery."

From the production of automobiles and automotive components to residential building materials and medical equipment, manufacturers are a powerful engine driving demand for industrial real estate in 2012. "Manufacturing accounts for 35% of all warehouse inventory, so it's a huge component to the industrial sector," Thorpe says. "We've had 10 straight quarters of positive absorption in warehouse space and, of those, the past six had robust demand rivaling what we saw pre-recession."

US manufacturing output had recovered from recessionary declines by the first quarter of 2011, and the sector continues to fill warehouses and distribution centers today. US exports of manufactured goods reached $252.5 billion in the first quarter of this year, up 43% from a low point three years earlier and even surpassing the previous high of $245.2 billion recorded in Q2 2008, according to Cassidy Turley.

Industrial output contracted in June and July, but the slowdown is likely a shortterm result of market uncertainty in an election year weighed down by crises in Europe and slowing economic growth in China and the US, says Jim Dieter, who leads the industrial platform at Cushman & Wakefield from his office in Chicago.

"Weve had a pretty good first half and vacancy rates have fallen," Dieter says. "We're probably at the lowest vacancy rate in this country that we've been at since 2008. That's very positive news." C&W pegged the national industrial vacancy rate at 9.3% at midyear, down from 10.4% a year earlier.

In the US markets tracked by C&W, companies absorbed 65 million square feet of industrial space in the first half of 2012, nearly 23% more than the first half of 2011. But to Dieter, the more important statistic is the 200 million square feet of leasing activity that occurred in the same period, as users of industrial space shifted and expanded from one place to another.

Ultra-efficient, big box warehouse and distribution centers measuring 500,000 square feet or larger have dominated leasing, to the detriment of smaller and less efficient properties, experts agree. Dieter explains the trend as a flight to efficiency as well as quality.

"The American company today is working as hard as they can on efficiencies. That's what you have to do in a global, competitive marketplace," he explains. "So when you have an older, rather obsolete building, you're fighting that trend for a company trying to improve their efficiencies."

The concentration of leasing in the relatively small subset of mega-sized properties has swallowed up available properties and enabled some landlords to demand higher rents. "We've seen a nice increase of rental rates in the big-box space in most markets across the country," Dieter says.

Cassidy Turley calculated that US industrial rent averaged $5.05 per square foot in Q1, up exactly one cent from the prior quarter. Market-wide rents across the top 20 industrial markets are anywhere from 12% to 25% below peak levels, which occurred around Q2 2008, according to Dwight Hotchkiss, executive managing director of client services in the Los Angeles office of Colliers International.

Strong corporate demand for industrial space of 500,000 square feet or larger has touched off pockets of speculative construction in markets where demand is highest. "A lot of the markets are looking at speculative construction," says Hotchkiss, who oversees Colliers' brokerage and client services in the US. "In Southern California, the Inland Empire has about 6.3 million square feet of construction under way and quite a bit planned for next year."

Seaports and distribution hubs around the nation aren't far behind with new projects. Dallas developers are just beginning speculative construction this year, but have as much as 2.2 million square feet set to begin in 2013, Hotchkiss says. Chicago is adding roughly one million square feet of spec space this year and may gain another two million next year. Pennsylvania's Lehigh Valley marketplace is adding three million square feet of new space and more is on the drawing boards for next year.

"The problem in the industrial market has been that just 25 million square feet is going to be developed this year and 20 million was developed last year, so there just hasn't been enough in the pipeline to satisfy demand at all," Hotchkiss says.

Looking ahead to 2013 and later, industrial experts expect distribution channels from the Eastern Seaboard to receive greater emphasis once larger container ships are able to pass through the expanded Panama Canal, slated for completion in 2014. Coastal cities have been improving their ports to prepare for the opening, Hotchkiss says, but most developers are still waiting to learn more about anticipated demand before launching new projects there. "Development has just scratched the surface," Hotchkiss relates. "We'll see more people looking at those markets to do development moving forward."

The expanded canal will certainly result in greater shipping traffic and efficiency at East Coast ports and particularly in Norfolk, the nation's deepest port, says C&W's Dieter. The appeal of shipping to the East Coast will increase in the future if rising diesel prices increase the cost of trucking goods from the Los Angeles and Long Beach ports to population centers in the eastern states. "The East Coast has great advantages in general," Dieter said. "You'll find some efficiencies by gaining close proximity to the consumer."

The energy and high-tech sectors are generating impressive growth in office-using jobs, so it is no surprise that office leasing is above average in energy markets like Houston and Dallas, and in the major technology centers such as San Francisco and New York City. Asking rent in the Big Apple averaged $57.02 per square foot in the second quarter, up 10.8% from a year ago, Cassidy Turley found. San Francisco's asking rate of $44.70 per square foot was up an incredible 28.5% year-over-year.

But for most of the nation, demand for office space is only growing as fast as the economy. And a few markets including Nashville, Phoenix and Sacramento saw their average asking rental rates drop several percentage points in the second quarter from a year ago. In all, about 20% of the nation's metropolitan areas are still experiencing rent declines, says Thorpe, the Cassidy Turley economist.

"The recovery is merciless in choosing winners and losers," he notes. "There are certainly strong markets out there, but it's not across the board. Other markets are still seeing declines."

The saving grace for commercial real estate and office landlords in particular throughout the downturn has been the lack of new supply. Cassidy Turley tracked 18.1 million square feet of office space added to the US market in 2011, which is a fraction of the historical construction average of about 60 million square feet per year.

The near-empty pipeline has enabled leasing activity to nibble away 10 million to 15 million square feet of office space each quarter since early 2011. In a healthy economy, absorption is about 20 million square feet per quarter, Thorpe says.

"No one is satisfied with this recovery, but the United States has created over three million jobs," Thorpe points out. "Given that supply has been essentially shut off, even minimal job growth is enough to drive increased demand for office space and drive vacancy down.

Nine consecutive quarters of positive absorption have nursed the national office market back toward health, but the sector is far from robust, observes Bill Krouch, chief executive officer of markets in the Americas for Jones Lang LaSalle. "Absorption has been very slow," he says. "It's not like we're seeing needle-moving improvements."

The challenge for office landlords continues to be weak demand, and the few business sectors that have driven absorption of space since the recession have begun to slow down. "Seventy percent of the net absorption in the office market comes from technology and energy, with technology being the bigger driver," Krouch relates. "But that is tapering a bit as we go into the second half of the year."

Why the slowdown? For one, many tenants with leases originally scheduled to expire in 2012 or 2013 have already modified and extended their contracts to take advantage of low market rental rates. That so-called "blend and extend" activity that took place in 2010 and 2011 left fewer leases to be renewed this year, he says.

Krouch also points to a combination of factors that are forcing companies to be more cautious in making space commitments today. The primary gateway markets of New York and Washington, DC, for example, drove the lion's share of leasing activity in 2010 and early 2011. That has changed in 2012, he says. "We're not seeing net absorption in those markets."

New York's historical growth engines—financial services firms—are holding off on office lease commitments while they deal with increased regulation and with economic uncertainty, particularly in Europe, Krouch says. And in Washington, many government agencies and businesses that work with government are delaying lease decisions pending the outcome of the November election.

Among office users in all industries, advancements in the way space is used are translating into reduced demand for offices on a per-person basis. Digital data storage and hoteling or shared work stations are enabling companies to grow headcounts without adding square footage, or at least not at the rate they once did. "The footprint of professional service firms is not expanding," says Krouch.

That leaves the technology and energy sectors to drive demand for office space during the remainder of 2012 and in 2013. It means leasing demand will continue for offices in technology hubs, including San Francisco, the Silicon Valley, Seattle, Austin, TX and Raleigh-Durham, NC, he predicts. Energy companies will fuel demand for offices in markets like Houston, Denver, Pittsburgh and Calgary. "Most net absorption is only occurring in those markets," Krouch says.

Within markets, office tenants are upgrading to the newest and best-quality properties, particularly in amenity-rich central business districts. Roughly 95% of net office absorption over the past two years has been in class A product, he observes.

That trend creates contrarian development opportunities. In Tempe, AZ, local developer Metro Commercial Properties and San Antonio, TX-based USAA Real Estate Co. are readying plans to construct Fountainhead Park Summit, which could deliver as much as 384,300 square feet of office space in a 14-story tower as the next phase in Fountainhead Corporate Park.

Mike Beal in the Phoenix office of C&W is marketing the project, which will either be a build to suit or, if it achieves at least 50% preleasing, could be built on a speculative basis, says Dirk Mosis, USAA Real Estate's executive managing director.

As many as a dozen companies, mostly high tech or financial services providers, are combing the Phoenix market for blocks of office space measuring 100,000 square feet or more, Mosis says. Most want parking for as many as six vehicles per 1,000 square feet of office, far exceeding the market's typical ratio of three per 1,000, he says. "These are not necessarily call centers, but the trend is to put more people in less square footage."

Large users have few options to choose from in the existing inventory, however. "Even in the hardest-hit markets, it's hard to find 100,000 square feet of contiguous space," Mosis explains. "And with new construction, you can lay it out much more efficiently."

Many office landlords look to the November presidential election as a potential watershed moment that will usher in a period of economic growth and increased demand for office space. Krouch is doubtful that office demand will change significantly this year, however, regardless of which party controls the White House.

Substantial increases in office demand will require robust job creation driven by strong consumer spending, Krouch maintains. But consumers have cut back on spending due to concerns over Congressional gridlock, the national debt and economic uncertainty at home and abroad. "And I don't believe most of those issues will be resolved in the next three quarters," he said. "Until we see real job growth, we're not going to see those absorption numbers improve materially."

Cassidy Turley's Thorpe is slightly more optimistic about the potential for job growth and healthier demand for office space in 2013, provided Congress deals effectively with the fiscal cliff of expiring tax breaks and spending cutbacks slated to take effect next year. Housing prices are beginning to stabilize, he points out, and stronger household balance sheets have positioned consumers to boost economic growth. "There are some pretty clear economic engines forming," he said, "so those are reasons to be optimistic going into 2013."