Empty Space - Declining imports and plummeting demand for distribution

By Lori Johnston

Hans Nordby was in disbelief. A report last fall from a colleague said that 18 million square feet of warehouse distribution space would be under development in Dallas this year.

“I bet with him that it couldn’t possibly happen—and I lost money,” said Nordby, an economist with Boston-based Property and Portfolio Research (PPR), a real estate research firm that tracks the 54 largest
metropolitan areas in the United States.

Now, that figure has risen to 22 million square feet, Nordby says. It’s the most warehouse space under development the company has ever tracked in that market. Unfortunately, that surplus of supply has impacted warehouse vacancy rates there, which are projected to grow from 9.2 percent last year to 12.5 percent this year. “Dallas did what Dallas does. It overbuilt,” Nordby says.

Other U.S. markets are experiencing a similar oversupply of warehouse space, thanks to a surge of development activity from 2004 to 2006. Spending on warehouse construction nationwide increased 19 percent from mid-2006 to mid-2007, according to Norcross, Ga.-based Reed Construction Data; increases of, respectively, only 4 percent to 5 percent are anticipated in 2008 and 2009.

The overbuilding comes at a time when supply and demand for warehouse space are out of balance. Last year, supply in the United States reached 143 million square feet, a figure essentially unchanged since 2006, Nordby says. This year, supply is expected to decline 6.3 percent to about 134 million square feet and to 64 million square feet in 2009. But the demand for distribution facilities this year also will plummet a disproportionate 57.6 percent to about 50 million square feet, compared to last year’s 118 million.

This means that vacancy rates are on the upswing. In the markets surveyed by PPR, average warehouse vacancy rates are expected to reach 10 percent by the end of this year; rates hovered at 8.8 percent last
year. If the recession persists, that number could increase to 11.5 percent.

For developers of industrial and warehouse space, this means a push to reduce starts in struggling markets and to deliver new product to existing customers. Craig Guers, senior vice president and general manager for Opus East in Philadelphia, says the development firm slowed land acquisitions 18 months ago and is not
starting jobs without at least one committed tenant. “They become turtles,” he says of companies in the current economic climate. “They just pull back into their shells.”

TOUGH TIMES
So far, this year has been “fairly grim,” says Jim Haughey, Reed’s chief economist. “I would interpret this as some nervousness about the economy. I think people in the warehouse development business are a
little nervous about renting space they complete four months from now.”

That may indeed be the case, as the number of starts has decreased for the world’s largest developer of warehouse space, ProLogis. The Denver-based owner, manager, and developer of distribution facilities, which has $29.9 billion in assets currently under development, says the situation is grim but not yet dire.

“We have certainly seen the slowdown in the activity levels, but it has not been overwhelming,” says Chuck Sullivan, managing director for North American capital management at ProLogis. “Global trade has continued to prosper. We are starting to see maybe a little bit of the weakening dollar having a positive effect on exports. [But] it’s too soon to tell there.”

Sullivan is right. U.S. gross domestic product is slowing, and imports are on the decline. Reed reports that the goods section of the GDP rose a mere 1.9 percent in 2007, as compared to 4.1 percent in 2006.

As a result, Sullivan says ProLogis expects to look beyond North America. This year, the firm will start roughly 80 million to 90 million square feet of warehouse construction, about 80 percent to 85 percent of
which will be outside of the states in markets such as China and Eastern Europe. “That is down dramatically from what we started last year in North America,” Sullivan says. “However, I think that’s indicative and
somewhat of a commentary of where we are in America today.”

Demand is down, particularly from retailers such as Target, Lowe’s, and The Home Depot, Guers says. The Opus Group, though, is digging deep and finding opportunities. Th e Minneapolis-based, full-service real estate development company has 14 million square feet of warehouse and distribution facilities planned or under development in markets such as Pennsylvania, Tennessee, and Georgia.

A LOCAL GAME
Still, as in all real estate, warehouse demand is fundamentally a local game. For the first quarter of 2008, ProLogis reports that absorption in the top 30 industrial markets in North America was 21.1 million square feet, “significantly less” than last year, Sullivan says. Specifically, demand is slowing in Chicago, southeast
Atlanta, and parts of New Jersey.

Nordby of PPR concurs. Super-regional distribution centers such as Atlanta are in particularly bad shape, with vacancy rates of 14.8 percent last year, he says. Demand was “stupendous” from 2005 to
2007, but the problem was that the supply was “über-stupendous. They’re working a good horse to death,” Nordby says.

Along the West Coast, however, the outlook is less gloomy. A drop in imports has demand in Los Angeles this year at its lowest levels since the last recession seven years ago, but vacancy rates are still relatively
low at 4.5 percent this year, Nordby says. “A bad year in Los Angeles is better than a good year in most markets,” he adds.

Indeed, ProLogis’ largest market in North America continues to be the L.A. basin, where the firm owns about 45 million square feet of space. Further north in Tracy, Calif., about 60 miles east of San Francisco, the firm’s biggest U.S. project- a 1.2 million-square-feet distribution center with two buildings for Crate &
Barrel—broke ground this summer.

ProLogis’ biggest client segments are third-party logistics providers, manufacturers, transportation companies, retailers, and companies with large-scale distribution needs. In spending time with customers, Sullivan says he’s seeing that they’re being careful in their planning, but their buildings are full. For instance, ProLogis is developing about 1.2 million square feet in distribution centers for BMW of North America in eastern Pennsylvania and suburban Chicago. Th e automobile maker is seeking additional space as facilities reach capacity and it consolidates in some markets.

“They’re not going off a cliff ,” Sullivan says of the company’s clients. “[But] they are very cautious about development starts in North America.”
- Lori Johnston is a freelance writer living in Athens, Ga.