Rents in a handful of top warehouse distribution markets posted year-over-year rent gains of 5% or more in the second quarter, virtually unheard of in the property sector more accustomed to 1.3% annual rental rate growth.
For the U.S. warehouse market as a whole, the average asking net rent rose to $4.75 per square foot, a 2.1% increase from one year ago. The upward trend in rents was boosted by 37.3 million square feet of positive net absorption during the quarter, the second largest quarterly absorption since the recovery started, and reflected continued steady demand from warehouse-distribution tenants at a time when very little new space is being added by developers.
While we have seen some previous rent growth in terms of diminishing free rent and concessions, now landlords in a larger number of markets have begun raising actual asking rents, And it's a good cross section with 142 of the 210 submarkets we track seeing rent increases during the quarter. We're seeing very good rent growth across the board.
A handful of major warehouse distribution markets have seen rents rise more than 5% over the past year. Orange County, CA, Indianapolis, South Florida and Edison, NJ all posted annual rent gains above 5%. California's Inland Empire and Dallas-Fort Worth each had 6.1% in annual rent growth and Portland saw a staggering 7.8% increase.
These are epic rent numbers for the industrial property sector, and go a long way towards offsetting the drop in rents we saw during the recession. While industrial rents this year are still down about 8% for leases signed five years ago that are rolling to current market rates, in markets such as Portland, the rent is essentially flat for leases that are rolling over.
While some of the markets seeing strong rent growth are supply-constrained, others are not. The virtual shut-down in construction has served as a great equalizer among markets at this point in the cycle where supply hasn't caught up with demand. We're seeing strong rent growth in markets that typically don't see big pops in rent.
Rents Playing Catch Up
However economists cautioned that the rent growth seen in the industrial property sector during the second quarter is a short-term phenomenon resulting from the fact that developers continue to shy away from building new warehouses, despite an average vacancy rate that's dropped 88 basis points over the past year to 8.5%.
A 6.1% annual rent growth in Dallas is not what anyone would consider to be normal. It's not a growth rate that is sustainable. Right now, rents are playing catch-up. Once developers start building again and supply catches up to demand, we expect rent growth to return to a more typical rate for these markets.
A total of 50.7 million square feet of new warehouse distribution space was under construction at the end of the second quarter, well below the peak of 228 million square feet under construction in the third quarter of 2007, and up from the first quarter of 2010, when construction of new warehouse distribution space bottomed out at 30 million square feet under construction.
While warehouse rents have increased, they have not yet risen to levels in most markets needed to justify construction. Conditions vary market to market, but on average rents are currently about 5% below where they need to be to justify a significant increase in new construction.
The models all say we should build more,But developers continue to surprise in terms of the amount of space they are not building.
While a handful of markets have advanced to the stage in the market cycle in which developers are adding speculative space and contributing to increasing vacancy, the majority of markets are still bunched up in the early expansion stage, in which rents have begun to increase and occupancy is increasing but building has not begun in earnest.
Economists expect it will take another six quarters for developers to ramp up construction to the point where supply catches up with demand. Then vacancy should begin to rise and rents level off.
Meanwhile, as vacancies decrease and move-outs remain extremely low, businesses are gaining confidence in the economy and more developers have announced plans to start new warehouse-distribution projects in several markets.
While the GDP growth rate is not as strong as many would like, we are seeing confidence in the market build as mostly positive indicators show encouraging progress, including in goods consumption and production, truck tonnage and housing starts. The one big weakness remains business confidence as reflected in the purchasing manager's index for manufacturing, which remained negative for the second quarter and reflects the expectations of companies.
Still, the economists point out, industrial production remains positive, and output and goods fill warehouse space, not job growth.
Investors Remain Active
Investors continued to flock into the warehouse distribution market during the second quarter.
They like the yields, they like the demand story. We're seeing lots of interest in the space from non-traditional players, most of whom show a clear preference for the institutional-
In terms of potential opportunity, the economists said more upside may exist in smaller, older distribution space, where investors can still acquire buildings at a 16% discount, whereas the top-line, institutional quality bulk warehouse buildings are trading at replacement cost.