Industrial market heats up in second quarter

After a bit of a cooling off period at the start of the year, the Greater Phoenix industrial market gained momentum during the second quarter. Businesses continue to expand in the Phoenix area, and developers are meeting this demand by moving a mix of spec and build-to-suit projects through the pipeline. Net absorption in the local industrial market has exceeded 1 million square feet in each of the past eight quarters, averaging nearly 2.4 million square feet per quarter in that time.

The clearest measure of the health of the local industrial market is the vacancy rate, which at 7.2 percent is at its lowest point in more than a decade. The rate has continued to decline even as new spec projects have come to the market. Vacancy has averaged just 7.6 percent over the past year, the lowest 12-month average since 2006. The total amount of vacant industrial space has been trimmed in half from the peak of more than 44 million square feet in early 2010 to just over 21 million square feet as of the second quarter.

Investment activity for industrial assets accelerated in the second quarter, closing out a very strong first half of 2018. Sales velocity during the first six months of 2018 was more active than in any first half since 2007. The volume of properties changing hands is being reflected in pricing trends; the median price during the first half of 2018 was nearly $100 per square foot, building on double-digit price gains recorded in 2017.

Cap rates have compressed slightly this year, averaging in the high-6 percent range, even as interest rates have begun to push higher. This trend of rising borrowing costs and declining yields is not sustainable in the long term, but cap rates could stay near current ranges in the coming quarters due to strong investor demand and competition for performing assets.

Key Takeaways:

  • The Greater Phoenix industrial market continued to post strong performance during the second quarter. Net absorption accelerated, vacancy ticked lower and investment activity gained momentum. These healthy conditions set the stage for a strong second half of 2018.
  • Net absorption topped 2.3 million square feet in the second quarter, outpacing the more than 2.1 million square feet of new development. Year to date, net absorption has totaled more than 3.9 million square feet, while completions have exceeded 2.8 million square feet.
  • Development is scheduled to accelerate in the second half of 2018, with more than 6 million square feet of space currently under construction. The bulk of the projects that are currently under construction are expected to be completed in the second half of this year.
  • Industrial asking rents rose to $0.58 per square foot, per month, during the second quarter and are 3.0 percent higher than one year ago. Some of the strongest annual gains have been recorded in the big-box distribution segment of the market.
  • The investment market continued to show signs of strength. More properties changed hands and the number of transactions thus far in 2018 is ahead of last year’s pace. The median price year to date is $98 per square foot, while cap rates have averaged approximately 6.8 percent.

Outlook:

The outlook for the Greater Phoenix industrial market remains healthy. After a slower start to the year, the market rebounded in the second quarter. For the first half of 2018, conditions were generally stronger than during the first half of 2017, which proved to be a record-setting year for net absorption.

At some point, the tenant demand for local industrial space will taper off, but that is unlikely to occur between now and the end of the year. Developers are bringing new product to the market to meet the demand, but spec construction has trailed levels during the previous expansion and oversupply is not expected to be a significant market threat in the short-term. Even though vacancy dipped below 10 percent in 2015, developers have only delivered an average of about 6 million square feet of new space annually since 2015. In comparison, completions averaged more than 10 million square feet per year from 2006-2008.

Investment activity has generally been on the rise throughout the economic recovery over the past several years. The market gained ground again in the first half of this year, suggesting that activity will likely remain consistent in the months to come. Pricing has been pushing higher and cap rates have compressed thus far in 2018, but it remains to be seen how long those trends can persist if interest rates continue to creep higher.