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December 12, 2013

State of the Market: Is a banner year on tap for industrial properties?

  • With most of the low-cost space options off the market, 2014 could see a push by landlords on rates and a downward trend on concessions.
    Kidder Mathews


    As 2013 draws to a close, we can reflect on a highly positive year for the region’s industrial submarkets. Vacancy has retreated to about 5.7 percent, cap rates have reached historical lows of 5 percent (and in some instances lower), and lease rates have improved by 8 percent to 12 percent depending on the quality and functional characteristics of the building.

    A key question heading into 2014 and beyond is the role of artificially low interest rates on the overall economy and the investment market. Cap rates and interest rates are intricately intermixed, and looking back a few years from now, we could be seeing the last days of a historical run on institutional quality real estate at cap rates and per square foot values that may not be again achieved for years to come.

    As we saw in third quarter 2013 when the Fed temporarily tested easing on interest rates, the stock market reacted violently and consumer sentiment quickly went sour. The Fed swiftly reversed course and now we are back to a record high Dow Jones industrial average and continued fervor in investment sales.

    At some point interest rates must rise, and when the days of cheap money are over the challenge will be to avoid stagnation.

    Fortunately for the Pacific Northwest, the broad spectrum of diverse and market-leading companies form the backbone of a resilient economy when compared to much of the rest of the nation, yet uncertainty is abound as to the future of our local business leaders. The continued labor clashes at Boeing take a toll that may be beyond a tipping point. The impact of what happens with the construction of the 777X aircraft will have a lasting effect on this region, good or bad, for decades to come.

    From a real estate standpoint, aerospace remains critically important for the health of this region. Some of the largest transactions in the past several years have been aerospace related, with VAS Aerospace expanding to a total of nearly 300,000 square feet and Carlisle Interconnect Technologies leasing 100,000 square feet, both in Kent.

    While Microsoft’s presence is more significant to the office market, the reorganization of the company’s leadership and structure has the potential to affect the region considerably given the number of high-income earners within the company and how those employees’ dollars are spent in the local economy.

    With Amazon there is no question that the company has fundamentally changed how consumers shop and the company continues to strive to diversify itself into seemingly endless markets. The question is what does Amazon do when it is done growing its retail presence, and will that result be sustainable? Amazon understands this risk and that is why it continues to seek ways to innovate and enter new markets.

    Image courtesy of Kidder Mathews [enlarge]
    Industrial vacancy rates are dramatically lower than the highs reached in 2010.

    New construction, leasing

    There is approximately 3.6 million square feet of new speculative industrial construction taking place.

    Fortunately, the U.S. General Services Administration determined that its Auburn facility was on the verge of collapse and relocated a number of operations to about 600,000 square feet of vacant newly constructed space in Sumner and Puyallup.

    Samsung is close to leasing about 180,000 square feet. FedEx is considering a 400,000-square-foot new facility to consolidate some existing local operations and for growth. Amazon is close to inking what is said to be a 2 million-square-foot build-to-suit, multi-story facility in Kent that will likely double as a fulfillment center and possibly an operation for Amazon Fresh. The Amazon deal, if it happens, will not benefit the speculatively constructed empty buildings.

    Market activity for larger deals has been less than ideal, and with all of the speculative buildings recently completed, under construction or planned in King and Pierce counties, it is critical to start seeing chunks of square footage leave what is now a flooded market primarily designed to satisfy requirements of 150,000 square feet and larger.

    Of concern on the new construction and leasing front is how few of the projects in the pipeline cater to smaller users looking for 20,000 to 80,000 square feet. Tenants in these sizes that require 30-foot clear height and ESFR sprinkler systems have very few alternatives in the market, and have accounted for most of the market activity since the market recovery began in January 2010.

    Recent comps for these smaller deals requiring state-of-the-art space demonstrate shell rates approaching (and in some instances exceeding) 40 cents per square foot, and most brokers would agree these tenant sizes are a category that should be able to have sufficient rent growth and market demand to support the underwriting for these new projects. There certainly remains a need for new space to be constructed in the years to come, and hopefully the sub 100,000-square-foot tenant size range will not go forgotten.

    Investment sales

    This year saw some dramatic trades in the industrial market. Northwest Corporate Park-Kent (2.8 million square feet) sold for $170 million in late June to KTR Capital Partners. Industrial Income Trust acquired Auburn 18, a 283,000-square-foot building, in October at an aggressive 4.76 percent cap rate.

    These trades, along with others, are a key factor in the increase in rent growth in the region now and going forward. A high percentage of the market has traded hands in the last few years, and these investors are not budging on their underwriting and are collectively raising lease rates across the region. With most of the low-cost space options off the market at this point, 2014 could see a push by landlords on rates and a downward trend on concessions for most of the marketplace.

    Thad Mallory, senior vice president with Kidder Mathews, specializes in industrial properties in the greater Seattle area. Mallory is president of the Washington State Chapter of the Society of Industrial and Office Realtors.

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