February 24, 2011
Sustained Double-Digit Rent Growth is on the Horizon
By Rene Circ, Vice President, National Director of Research, Industrial
It is difficult to come out and predict two to three consecutive years of near or above 10 percent rent growth following the three worst years in most people’s memories. However, this is precisely the time to start considering the possibility.
Most of the shadow space has already been absorbed
Industrial real estate has been slow to come out of its recession. Aggregate demand, measured by net absorption, did not turn positive until three quarters after the official end of the recession. The slow recovery can be attributed to the unprecedented amount of shadow space – space that is occupied, but not utilized – that needed to be absorbed before companies started to need new space. Grubb & Ellis calculates that total industrial shadow space, at its peak, exceeded 100 million square feet. Three recorded consecutive quarters of positive net absorption demonstrate that the above-equilibrium shadow space has been absorbed and business growth is driving demand for new industrial real estate.
U.S. economy is expected to grow at above its potential
The U.S. economy grew 2.8 percent in 2010 and currently stands just above its pre-recession high. From the total output perspective, the economy is officially out of recovery and in a new expansionary cycle. Most recent indicators suggest that economic growth will accelerate in 2011 to between 3.5 and 4 percent. Growth of this magnitude will translate into stronger job creation and consumer confidence. Also, near record-high corporate profits and cash positions will spur business investment as revenue-growth driven profits replace cost-cutting driven ones. Economic risks, such as rising oil prices due to the unrest in the Middle East, exist, but the current outlook for 2011 remains positive.
Net effective rents are down 30 to 50 percent across the nation
On a national level, net effective rents are down 30 percent from their peak. In some markets, rents have fallen as much as 50 percent over the past two to three years. The total decline is the aggregate of lower face rents and rising landlord concessions. New, longer-term tenants still receive one month of free rent per year of term, which alone reduces the effective rate by approximately 8 percent. Additional concessions, such as moving allowances and larger tenant improvement packages, push the effective rates still lower. Meanwhile, Grubb & Ellis statistics show that the national vacancy rate has declined 50 basis points from its peak and net asking rents are stabilizing. The two-year downward pressure on rents is easing across the nation and landlord concessions can tightened very quickly as new tenants absorb key vacancies.
New construction is not profitable without significant rent growth
At the end of fourth quarter of 2010, only about 12 million square feet were under construction. At this rate, 2011 may be the year with the lowest new deliveries on record. Yet, current rent levels do not justify new construction. If developers require a 10 percent unleveraged return, assuming zero cost of land and $47 per square foot total soft and hard costs, tenant improvements and leasing commissions, they need a triple net rent of $4.32 per square foot. The table below shows the required net rents assuming land costs are $2 per square foot, keeping the other costs unchanged.
Exit Cap / IRR 10% 15% 20%
7.0% $4.47 $4.75 $5.05
7.5% $4.78 $5.09 $5.40
8.0% $5.09 $5.42 $5.76
Today, market net effective rents are below these rent figures, preventing most developers from starting projects on a speculative basis – only 2 million square feet are currently under construction on a speculative basis across the country.
Net effective rents must rise considerably
The next three years will see strong tenant demand and Grubb & Ellis expects vacancies to fall into the single digits by the end of 2011. It is difficult to generalize the industrial real estate market, as rents and land prices vary considerably market-to-market. However, on average, net effective rents are 20 to 30 percent below rents necessary to justify investments in new, speculative industrial projects. The combination of strong demand and profit-constrained supply will create a space scarcity and push rents up quickly and considerably. Rent declines were unprecedented over the past two years and the experienced double-digit declines will need to be reversed at similar speeds, if market equilibrium is to be achieved.
Source: Grubb & Ellis
