Photo: Greg Pease/Getty Images

By Ward S. Caswell

Undaunted by a downturn in the housing sector and a weakened U.S. dollar, the industrial sector has been enjoying a recovery from the relative weakness of the sector as recently as two years ago. The industrial REIT expansion has been driven by strong demand growth founded on continued U.S. economic expansion, increases in industrial production as well as employment and income growth.

Industrial
# of REITs	7
Industry Market Cap (in millions)	$24,864
% of Industry	7.23%
Yield	3.90%
YTD Total Return	-7.95%
One-Year Return	3.55%
Three-Year Return	19.35%
Five-Year Return	19.30%
Average Daily Trading Volume (Shares)	797,300.89
Source: NAREIT data as of Jul. 30, 2007

"Industrial fundamentals are as healthy as they have been in several years," says John Stewart of Credit Suisse, who provides analyst coverage for the sector.

Driving Demand

The growth of shipping is the primary driver of the industrial sector's growth, as expanded output requires more efficient distribution facilities.

The good news for the sector is that vacancy rates have fallen to less than 10 percent, down from a high of 11.7 percent at the end of third quarter 2003, according to CB Richard Ellis. Additionally, the industrial sector has seen an increase in rents of approximately 3.0 percent in port and high technology markets, with the best performance in markets, with the best performance in markets such as Raleigh, San Francisco and San Jose, Calif.

Construction Boom

As a result of the strengthening demand and other fundamentals, the industrial sector finds itself in the middle of a construction boom, according to CB Richard Ellis. While a development surge often raises the concern that oversupply will drive down rents, current conditions suggest that this is not likely to become a major issue for the industrial sector.

In addition to growth of international trade, development is also being driven by demand for more modern facilities and green construction. During the first half of 2007, a quarterly average of 27.8 million new square feet arrived on the market, as compared to 40.5 million square feet per quarter in 2006 and 27.5 million square feet per quarter in 2005.

However, while construction and development will continue at a brisk pace in the industrial sector, rising materials prices are likely to keep construction in check. According to the Institute for Supply Management, prices for aluminum, lumber, stainless steel and steel jumped in May, while construction services and contractors were in short supply.

"Companies always face a choice between growing by acquiring existing properties or by development," says Brad Case, vice president, research and industry information for NAREIT. "REITs are creating sustainable projects and supplying their clients with products that they need. The new developments are likely to reduce demand for older, functionally obsolete facilities, rather than the higher-quality stock generally held by REITs."

One REIT with development activity is AMB Property Corporation (NYSE: AMB), which has approximately 15.7 million square feet in the pipeline as of mid-July. That represents an increase of more than half over its January 2005 mark of 8.9 million square feet under development.

John Kriz, managing director—real estate finance for Moody's Investors Service, points to continuing strong world trade conditions as well as warehousing demands as two strong spots for the sector, and also notes that the weak U.S. dollar is a plus for American export businesses.

"The industry is healthy," Kriz says. "The challenge is simply that finding opportunities continues to be tough and the focus has been on construction not only because it tends to be a natural part of the business, but also because returns, as well as risks, are higher in development."

Kriz agrees with Case that the challenge of finding appealing and lucrative acquisitions, along with a sustained interest in build-to-suit spaces, continues to support industrial REIT development activity.

Advantages and Challenges

Overall, the outlook for the industrial sector is optimistic. The next few quarters should show stable or rising rents despite the increase in construction. Eventually, the trend toward green construction techniques, combined with the already high cost of building materials, may lead to rising rents.

However, the near-term challenge is that the pace of economic expansion in the U.S. has slowed, and some observers are concerned that economic growth may be dampend because of tightened debt markets. "We have higher rates and also tighter liquidity conditions than a few months ago, much of that reflecting some of the turmoil in the financial markets," Kriz says.

Ultimately, the industrial sector seems capable of handling these difficulties both now and in the future. According to Moody's, industrial REITs tend to be better positioned than most competitors to profit from the disruption of the financial market, as they tend to be large, well-organized firms with moderate leverage and good access to liquidity.