By Art Gering

Following a couple of years of improving space demand and higher rents attributable to economic growth, change looms ahead for the industrial market. The first quarter brought signs of shifting fundamentals in the industrial property sector that could weigh on REITs' operating results in the months ahead and force investors to revise expectations. Indeed, property performance is not as strong as it was a few quarters back.

"If you do not like the way the U.S. property market feels at the end of 2006, it is not going to get a whole lot better over the next five years," cautions Hans Nordby, research strategist with Property & Portfolio Research (PPR).

Investors should be aware that demand growth is expected to decrease in the quarters ahead, while construction of new space is projected to increase. Rent growth has already begun to slow. Also, investors will want to monitor the effects, both positive and negative, of recent increases in leverage by industrial REITs and their continued employment of joint venture and fund management structures.

Beginning to Turn

First quarter statistics indicate that industrial property supply and demand fundamentals may have reached an inflection point. Steve Sakwa, first vice president with Merrill Lynch, reported a vacancy rate of 7.8 percent in the first quarter for the top 20 markets he covers in the U.S. While the current vacancy rate is 30 basis points less than it was in the same period one year ago, it is 10 basis points more than the rate at year-end 2005. Additionally, year-over-year rent growth slowed to 2.3 percent from 4.5 percent only six months ago.

What to Watch For: Industrial Market As the second half of 2006 unfolds, change is imminent for the industrial industry.

POSITIVES: » Industrial property space demand, though weakening, remains reasonably strong. » Sector consists of firms with large market capitalizations, increasing liquidity. » Companies such as ProLogis and AMB Property Corp. provide investors with exposure to international property markets.

NEGATIVES: » Rent growth is beginning to slow, and construction is beginning to increase. » International exposure by some firms creates some execution and currency risks that may increase operational volatility. » Joint venture and fund structures employed by some firms add complexity.

"During the first quarter, about 16 million square feet of space was absorbed, down 6.9 percent year-over-year, and down almost 38 percent from six months ago," Sakwa says. On a trailing 12-month basis, approximately 108 million square feet was absorbed, a reduction from an average of 110 million square feet over the previous three quarters, he says.

Nordby of PPR, which analyzes the top 54 industrial markets, foresees a slowdown in space demand this year and beyond. PPR reports a 9.3 percent vacancy rate average for all 54 markets for 2005, a decrease of 120 basis points from the year before, as demand jumped 29 percent against a supply increase of only 12 percent. Strong demand was attributable to factors such as robust retail sales growth, which triggered greater demand for warehouse space to facilitate the movement of consumer goods from manufacturers to stores.

Retail sales growth is expected to slow this year, dragging down warehouse and distribution space demand as a result. Additionally, import and export growth has been slowing for several quarters, Nordby points out.

"Wholesale trade inventory growth and wholesale sales growth are slowing," he adds. Nevertheless, Nordby expects demand growth to exceed supply growth again this year, but not to the same extent recorded in 2005.

"Our forecast calls for vacancy to bottom this year at 8.9 percent, and move up a little bit hereafter," he says. "That assumes that developers do not overcompensate," by pushing vacancy up higher than currently expected, he adds.

Development Could Outpace Demand

While there are no signs that developers have inclined to do this, construction of industrial space is expected to increase at a faster pace than demand growth, according to PPR. On average, 98 million square feet came online annually from 2003 to 2005. From 2006 to 2008, however, an average 111 million square feet of new space is expected to be delivered each year. Even with the projected increase, though, new supply appears to be within reasonable limits.

Sakwa reports 34 million square feet was delivered in the first quarter, and stresses that those deliveries represent only 1.3 percent of existing stock, a proportion in line with recent trends. He also reports approximately 80 million square feet are under way, a decrease of 18.8 million square feet from six months ago.

Industrial
# of REITs	6
Industry Market Cap. (in thousands)	$19,800,000,000
% of industry	5.4%
Yield	3.13%
YTD Total Return	9.51%
One-Year Return	30.25%
Three-Year Return	20.09%
Five-Year Return	23.07%
Average Daily Trading Volume (Shares)	1,670,000
Source: NAREIT. Data as of May 5, 2006

No one needs to raise concerns about overbuilding yet. Indeed, the short construction cycles required for industrial assets limits the possibility of supply getting too far ahead of demand.

"We think a lot of REITs are well protected from the effects of new supply," says Matthew Gallino, senior director and REIT analyst at Fitch Ratings. "Our BBB rating for the sector incorporates our view that REIT management teams will be able to read the tea leaves and cut back on building, thereby preventing them from holding a lot of real estate that's dark."

The possibility that developers may step on the gas pedal lingers, Nordby cautions. "A lot of properties are trading at premiums to replacement costs. What is a bigger build bell to a developer than that?," he asks. "Developers can sell it for more than they spent to build it."

To be sure, buyer demand for industrial properties is very strong. According to CoStar Group Inc., a real estate information provider in Bethesda, Md., the median price of properties valued at $1 million and more rose 13 percent in 2005 to $79 per square foot. In deals so far this year, the median price has climbed to $90 per square foot. So long as robust investor demand for industrial assets persists, merchant builders, developers and REITs will be tempted to develop properties and flip them. Some REITs have profited nicely from this approach, though it may be shortsighted.

"Traditionally, REITs buy properties and hold them for a very long time, and simply collect rental income," Gallino explains. Transaction business is great in the current market environment, but "the market is not always going to be this favorable for buying and selling properties and reaping a quick gain," he concludes.

Gaining Leverage

One of the consequences for REITs of a strong industrial property investment market is a modest increase in leverage on their balance sheets. "Yields on real estate have declined recently because there is so much liquidity in the market," Gallino says. "Investors have been willing to pay more for real estate assets, even with rents staying virtually the same. In order for a REIT to maintain the same yield or the same shareholder returns, it has to increase its leverage."

Though increases in leverage were common in 2005, leverage in the sector is not yet troubling, Gallino stresses, assuming issuers' risk profiles do not change. Fitch has a stable ratings outlook for the sector, but a negative outlook for industrial REITs' investment and funding strategies. Among the issues the rating agency will focus on in the months ahead is the continuing use of joint ventures and fund management strategies. As Christopher Haley, an analyst with Wachovia Securities, points out, firms such as ProLogis (NYSE: PLD), AMB Property Corp. (NYSE: AMB), and First Industrial Realty Trust (NYSE: FR) have fund management programs in place.

"We're seeing all major food groups starting to get into the asset management side of the business, and it's not as if they're just getting into property management and services," he says. "They're putting in their own capital alongside institutional partners and generating fees off of those investments."

Joint venture and fund management structures are good up to a certain point, but "they add a tremendous amount of complexity to balance sheets," Gallino says. "That creates concerns with respect to recovery and liquidity. To the extent these things do not perform as well as expected and one of the partners wants to get out, there may be problems monetizing the assets."

Another issue Haley points out is that industrial firms with fund management structures report their gross fee revenues, but not the expense allocations associated with generating those fees. As a result, some difficulties arise attempting to properly assess the value of the REIT, he says.

In spite of this concern, Haley has assigned a market weight rating to the sector relative to the entire REIT universe. "We are looking at an increased supply cycle that is approaching or beating demand levels today," he says. "Therefore, we're looking for less robust earnings power for the warehouse sector versus some of the other property types."

With weaker earnings expected on the domestic front, REITs with significant portfolios of properties in foreign markets may be positioned to outperform their counterparts with solely domestic portfolios. Indeed, firms such as ProLogis and AMB Property Corp. have followed their customers to different countries over the years. While an international exposure may bring with it currency and other risks, the wisdom of assuming an international exposure may pay off handsomely when the domestic market slows.