Industrial Outlook

Despite the economic downturn, the future is strong for this sector.

Faced with a significantly weaker economic outlook and the financial crisis fallout, the industrial sector is hunkering down. Decision making has slowed considerably as investors try to assess the impact of the macro economy during one of the most unpredictable and unsettling financial environments in modern history.

The general softening in the industrial market is reflected in the absorption figures for the national markets, which remain in the negative range, with the current vacancy rate standing at 10.7 percent as of 3Q08. And the outlook isn’t any better for the near-term future: The national and global economies are expected to deteriorate significantly going into 2009.

However, industrial development-based companies that have focused on market fundamentals will be well positioned to accelerate out of the downturn with long-term earnings potential enhanced. Such fundamentals include focusing on critical locations in the global supply chain and predominantly infill submarket locations within those trade hubs.

With a long-term focus on major international seaports and airports, prospects for long-term earnings are strengthened by the fact that current economic uncertainty has eliminated some global competition and that market conditions pose significant barriers for new entrants. In addition, the market downturn offers opportunities to acquire land and assets at reduced prices.

Factors Affecting the Market

Several factors that move this sector will be instrumental in achieving market stabilization in the industrial market’s future.

Demand Decrease. In 2Q07 industrial net absorption began decelerating and then turned negative by mid-2008. This was largely due to negative gross domestic product growth caused by the housing bubble and the credit crisis. GDP growth bounced back in 2Q08 but was almost entirely driven by a growth in exports attributable to a weakened dollar. However, the effect of the boost to the economy generated by increased exports as well as by government-issued rebate checks is fading as the dollar gains in value.

The outlook for imports, which have a larger effect on the demand for industrial space than exports, remains positive. While imports have recently declined -- U.S. container imports were down 6.7 percent in 3Q08 -- they are expected to increase in the near future. The current decline is a temporary adjustment largely caused by lower demand for building materials and furnishings. Over the long haul, consumers will continue to need food, clothing, and other imported goods that are produced cheaper overseas.

Inventory Decline. The drawing down of retail inventories also leads to a decreased utilization of and demand for industrial space. The good news is that current inventories are very lean, so even an incremental demand increase will lead to new orders and increased production as well as increased absorption of industrial space. The 1990s’ cyclical downturn followed a high-tech boom and equity bubble that produced a massive buildup in inventories with the usage of inventory taking a long time. Today’s extraordinarily lean inventories, which represent a considerable difference from previous downturns, bode well for the industrial sector.

Employment Growth. Each additional new job generates demand for approximately 110 additional square feet of industrial space. Through June 2008, the nation lost a total of 412,000 jobs. However, when the level of job loss starts to flatten, as it is expected to in the second half of 2009, the demand for industrial space will increase.
Coastal Markets. Much of the recent weakness has occurred in coastal markets, especially the West Coast, which took the biggest hit as a result of weakened consumer confidence and the recent drop in imports. But while the current weakness is centered on the coasts, they were still healthier than their non-coastal counterparts such as Memphis, Tenn., and Columbus, Ohio. Overall, Los Angeles/Long Beach ports remain the nation’s most robust areas with the New York/New Jersey and Savannah, Ga., ports also experiencing strong seaborne container growth.

Warehouse/Distribution Centers. These building types have taken the biggest hit, due to their close link with imports. The demand for such facilities is strongly tied to imports of bulk products, such as building materials and furnishings. Also, in times of economic uncertainty, customers are less likely to sign a new lease for a large building, choosing to renew their current lease or downsize to a smaller facility instead.

Industrial’s Future

Though 2009 will start out tough, the outlook is expected to improve in the latter part of the year, as labor and credit markets stabilize. Growth, while still anemic, will be sufficient to generate positive industrial demand, especially in emerging international markets such as China, Mexico, India, and Brazil.

Inventories will need to be lean before consumption can lead to increased orders and production, increasing demand for industrial space. The pullback in U.S. imports due to a housing-related decline in demand will moderate. Currently, housing prices already are beginning to stabilize in some parts of the country and transaction volumes are accelerating. Finally, global trade, which is expected to grow by more than 7 percent per year over the next five years, will continue to play a big role in the demand for industrial space.

The industrial sector can take heart from the fact that every cyclical downturn eventually comes to an end. Traditionally, as an asset class, the industrial sector has demonstrated the least volatility and offered the highest risk-adjusted returns, resulting in a strong long-term commitment from institutional investors. Additionally, as a result of the slowdown in the development pipeline due to the credit crunch and other increased barriers to entry, companies emerging from their bunkers with strong portfolios in 2009 will find an increased market share and numerous attractive opportunities to expand.

David Twist

David Twist is vice president of research for AMB Property Corp. in San Francisco. Contact him at dtwist@amb.com.