Net Absorption Reaches Record

The Inland Empire market remains the most sought-after warehouse/distribution market in the United States with the lowest vacancy rate and highest rental rate of comparable markets with major distribution hubs. Developers remain interested in new speculative construction activity. In the past 12 months, a total of 28.5 million square feet of new supply was added to the base. During this time, the vacancy rate remained low as nearly all new supply was absorbed by large tenants seeking modern distribution centers.

Vacancy fell 50 basis points to 3.8%, its lowest point on record. Vacancy remains tightest at 1.8% in the West Inland Empire compared to 6.5% in the East Inland Empire. Industrial demand was a record-setting 10,834,800 square feet of positive net absorption, the 35th consecutive quarter of growing industrial demand. Sales and leasing activity totaled 14,258,400 square feet this quarter. This was broken out into 27 sales (2,499,100 square feet) and 76 leases (11,809,300 square feet).

Average asking rates were flat at $0.59 PSF NNN over the quarter. Low vacancy rates and growing industrial demand continue to put upward pressure on asking rents. Much of the newer industrial space currently on the market does not have a marketed asking lease rate, making rental rate comparisons challenging. E-commerce tenants continue to drive demand. Landlords for these larger companies are seeing increased need for tenant improvements, as well as longer free rent periods to make the necessary improvements. In exchange, they are getting longer lease terms at higher rates to compensate.

Construction completions totaled 8,469,500 square feet this quarter, while 19,792,500 square feet of industrial space remains under construction. Development is heavily concentrated on buildings greater than 500,000 square feet, which account for 45% of all space currently under construction. Capitalization rates rose slightly over the quarter to 5.0%. Investment-grade product traded with capitalization rates as low as 4%. Average investment sale prices increased to $120 PSF.

Key Takeaways:

  • Net absorption was 10.8 million square feet for the second quarter of 2018, the greatest amount of net absorption to occur in the market in a single quarter. This was due to a number of pre-leased buildings finishing construction this quarter. 
  • Construction completions were 8,469,500 square feet for the quarter with 60% of new construction being in large buildings over 500,000 square feet. 
  • There remains 19,792,500 square feet of industrial product under construction, of which approximately 20% is pre-leased or pre-sold.
  • Record-setting absorption has caused the vacancy rate to fall 50 basis points to 3.8%. 
  • Average monthly asking rents held steady at $0.59 per square foot (PSF) triple net (NNN) over the last quarter and have increased $0.04 over the past 12 months.

Outlook:

Demand remains strong and average time on market remains low as tenants quickly absorb industrial space, anticipating future rental rate increases. Construction remains high but continues to be outpaced by strong tenant demand. Demand remains strong for larger e-commerce companies. Online retail has grown from 3.5% of all retail sales in 2007 to 8.5% of all retail sales currently. The pace of this growth has not slowed and will continue for the foreseeable future as consumer preferences continue to evolve. As internet retail continues to grow, so too will the need for industrial space.

New supply may raise vacancy rates in future quarters, albeit at a slow pace due to increased industrial demand. Absorption is likely to remain positive for future quarters as fully leased buildings are constructed. Growing tenants have few options in Southern California, and the Inland Empire will attract tenants from infill markets who cannot find space to meet their needs.

Rents are at an all-time high. This is due to rising market conditions for new buildings with state-of-the-art features, which is reflected in the rental rate. These newer buildings allow tenants to be more efficient by lowering operating costs and increasing the velocity at which goods can be sorted and shipped. This is especially true for tenants related to e-commerce that require specialized build-outs. Record-high absorption and record-low vacancy rates will lead to increased demand for larger industrial buildings. Large fully leased assets in a prime location command a significant premium in the Inland Empire, which is considered a core market for institutional industrial investors.