The U.S. industrial real estate market now appears to be headed into recovery after several quarters of negative absorption.

With the economy sending out mixed signals but generally gaining strength, absorption of industrial buildings turned positive in the second quarter following six consecutive quarters of net loss, CoStar Group reported in its State of the Commercial Real Estate Industry Mid-Year 2010 Industrial Review & Outlook. The national industrial vacancy rate declined for the first time in two years, according to the company's most recent analysis of industrial property markets.

For owners, the warehouse sector is still working through some significant market turbulence. Broad-based growth in rental rates probably won’t resume until 2011, and the investment sales market remains choppy, with total transaction volume still well below the historical average. Liquidity hasn't yet returned for owners and industrial capitalization rates and pricing, though improving, still show a mixed picture.

But overall, "we think the outlook is better than it has been in a few years," said Jay Spivey, CoStar Director of Analytics, who teamed with CoStar Director of Advisory Services Hans Nordby earlier this week to present the findings and forecast to CoStar clients.

Leasing: Activity is Up

CoStar Group reported 13 million square feet of positive net absorption in the second quarter -- the first positive reading since mid-2008, a period that has experienced far more severe and dramatic demand declines than the years of the dot-com collapse and economic recession of the early 2000s.

"It’s been a long time coming. We think the outlook is good and we’ll continue to see positive absorption," Spivey said.

In 2009, every major metro market except Houston saw negative absorption, including significant losses in Chicago, San Francisco and South Florida. Fast-forwarding to second-quarter 2010, more than half of the top 20 industrial markets tracked by CoStar saw positive absorption, led by the warehousing and distribution powerhouse Inland Empire region in Southern California at 4.8 million square feet; Orange County, CA (4.5 million sf), South Florida and Philadelphia (each gaining 2.8 million square feet).

San Francisco and Los Angeles have been slower to recover, leading the nation with negative absorption of around 5 million square feet each.

Little New Supply in Sight

New industrial deliveries as a percentage of total inventory continued to decline in the second quarter -- a trend expected to continue through 2012. And 2010 will likely mark an all-time low in deliveries, with little new supply entering the pipeline over the next two years. In fact, more properties are being taken out of inventory due to obsolescence and other factors than are being added in new construction.

Lending constraints will continue to keep a clamp on new construction and the lack of new supply will allow the market to recover more speedily, Spivey noted.

The Inland Empire led the nation in space under construction at 3.4 million square feet -- but that's still a 90% decline from the 30 million square feet under construction at the peak of the market. The numbers tell similar stories in major distribution markets such as Atlanta, Philadelphia and Chicago.

Vacancy: Steady Gains Ahead

Given the positive absorption and low levels of construction, the national vacancy rate edged down in the quarter from 10.1% to 10%, the first drop in over two years. Availability (space being marketed even though it may not yet be vacant) also edged down from 14.8% to 14.7%.

While the dot-com era saw almost four years of relentless vacancy increases, the most recent downturn saw only six quarters of erosion in vacancies. CoStar believes vacancies have leveled and will decline steadily over the next four years down to about 8%. The rate of vacancy increases actually peaked in second-quarter 2009 and has slowly decreased ever since, finally reaching a tipping point last quarter, Spivey noted.

Similar to positive absorption, more than half the top U.S. markets are now seeing vacancy rate declines, including Inland Empire (-0.6%) Northern New Jersey (-0.4%) and South Florida and Minneapolis (each -0.3%).

As they have since 2008, rental rates continued to fall in the second quarter but at a less rapid rate. Despite positive news on vacancies and absorption, positive rent growth is still probably a year or two away.

Investment Sales: A Market in Transition

On the down side, sales transaction volume remains low by historical standards. Liquidity has not returned to the industrial market and the time that properties sit on the market before being sold -- and the number of properties withdrawn from the market without being sold -- continues to rise.

However, the second quarter saw a slight narrowing of the gap between asking and actual sales prices, possibly an indication that buyers and sellers are starting to agree on pricing.

Significant trades during the quarter included the sale by Industrial Developments International (IDI) of a nine-property bulk portfolio to Cabot Properties, Inc. on June 2 for $115 million, and IDI’s sale of the 687,118-square-foot Weston Business Center to RREEF America LLC for $65 million. The former DHL distribution facility in Breinigsville, PA, sold for $58.3 million in May.

Industrial cap rates still reveal a bit of a mixed picture. On industrial deals of $20 million and above, cap rates fell to 8%, largely because of the demand for high-quality assets by institutional investors who will pay more for bigger and newer assets, Nordby said.

Over the last couple of quarters, most of the lower sale price tranches are also seeing stabilized or declining cap rates in the 8.5% to 9% range, showing increased and broad-based interest in industrial by investors, Nordby said.

But the higher-end deals are still garnering the most attention. On trades exceeding $120 per square foot, the average price per square foot on deals of $20 million or more is starting to spike upward, while transactions at lower price points are still flat or down on a per-pound basis.

"What I’m hearing from our institutional investor clients is that gateway CBD office markets, and also coastal apartments, are becoming a little rich, and those investors are starting to look at other asset classes," Nordby said. "There’s more institutional investor interest in warehouses. It's coming and it will eventually show up in the price per pound."