By Elizabeth Campbell

The market for industrial real estate in the U.S. has been under pressure from the doldrums that have afflicted the broader economy over the last few years. After strong growth in the 1990s, contracting demand has resulted in rising vacancies, and falling rents have beset the industry. However, not all is gloomy in the industrial sector. A low interest rate environment and stable transaction conditions for most industrial product types have provided some haven for industrial real estate owners and investors.

Standard & Poor's currently rates nine REITs with industrial holdings. The consensus outlook for those companies is for steady growth, although the sector's recovery is heavily reliant upon the health of the U.S. economy, which, despite some lingering uncertainties, shows signs of improvement.

The industrial sector includes warehouse and distribution facilities, manufacturing plants, and research and development space. Demand for this sector is probably more closely linked to the economy than any other property sector. Supply currently exceeds demand, which has driven the national vacancy rate over 11 percent, its highest level since 1991. However, recent positive Institute for Supply Management (ISM) data indicates expansion within the manufacturing sector, which would certainly lead to a more favorable demand environment for industrial space than was the case a year ago. New completions are expected to remain modest, but will continue to impact absorption and slow the pace of occupancy improvement.

Credit Strengths

Of the nine real estate companies with meaningful industrial investments that Standard & Poor's currently rates, four are pure industrial REITs and five own portfolios that are a mix of industrial and office properties. These REITs primarily invest in warehouse and distribution facilities, as well as flex space, and tend not to invest in manufacturing facilities. The nine companies have a total market capitalization of nearly $25 billion, and over $10 billion in rated debt and preferred stock (comprising roughly 13 percent of Standard & Poor's rated REIT securities). The corporate credit ratings for these companies range from "BB" to "BBB+," with the majority clustered at "BBB."

From a credit perspective, the industrial sector's strengths are triple-net leases, cash flow stability, short construction periods, minimal capital expenditures and a tenant base that is both diversified and generally creditworthy. Triple-net leases provide predictable cash flows and returns, as medium-term to long-term leases (five years to seven years), some with rent increases, produce a stable cash flow.

This property type's cash flow stability is attractive to institutional investors, resulting in very good liquidity for the sector. Many of Standard & Poor's rated industrial REITs have created joint ventures in part to tap this capital source.

The short construction periods ensure that most industrial supply is built on demand. While the contraction in demand over the last few years has resulted in excess supply, there is a silver lining in this cloud—new supply was relatively modest (at less than 2 percent of inventory per year) even during the robust period of the late 1990s.

Also, capital expenditures associated with re-leasing vacant warehouse and distribution space are minimal (particularly when compared to other property sectors such as office, retail or multifamily), as this space tends to be fairly fungible. While more specialized facilities could require a greater investment on the part of the landlord; rents would typically be higher as well. Lastly, tenant diversification for the large, rated industrial REITs is very good, as is tenant credit quality. The larger REITs have primarily invested in modern facilities located in hub distribution markets, which are appealing to large, multi-national tenants. Top tenants for our nine rated industrial REITs include the U.S. Government, retailers, food companies and automotive companies.

Credit Weaknesses

Although the sector exhibits many credit strengths, it also has some weaknesses, including product obsolescence, changes in tenant's regional market preferences, greater costs associated with on-tarmac "high throughput" warehouses, and the ac-tions of less-rational market participants.

Product obsolescence in the industrial sector is common, as large mechanized distribution has made smaller facilities less cost effective. Some of the larger national and multi-national tenants prefer buildings with 300,000 to 1 million square feet, which accommodate deep bays, higher dock ratios and offer cross-docking capability.

Preferred regional warehouse markets have changed as tenants consolidate into fewer, but larger, more efficient distribution buildings, which impacts demand. Demand is also negatively affected by companies shifting manufacturing operations to lower cost regions of the world.

Also, on-tarmac "high-throughput" product (industrial properties typically located near airports, seaports and ground transportation systems that attract tenants who desire the rapid movement of goods) is generally sited on land leased from an airport authority, rather than owned land. This product type is more expensive than typical bulk warehouse space as land is scarce on or near airports, leading to a land premium.

With a low overall market penetration, industrial REITs are subject to the actions of less-rational market participants, including large, regional merchant builders who build to sell, rather than hold a property over the long term. Additionally, while REITs have shrunk their speculative development pipelines dramatically, many continue to develop build-to-suit product for existing and new tenants. Despite the potential to cannibalize existing space, REITs derive meaningful margins and earnings from development profits, and entering into build-to-suit activity can allow the REIT to leverage its existing organizational infrastructure as well as maintain tenant relationships.

Differing Strategies

The industrial REITs vary significantly in terms of size, geographic focus, product type, tenant mix and financial profile. REIT management teams also differ materially in the strategic approaches they've pursued, such as the use of joint ventures, development, capital recycling and international expansion to boost returns. Each of these strategic approaches can impact a company's credit profile, beneficially or detrimentally, depending upon execution and financing, therefore Standard & Poor's looks to the ability of a REIT's core portfolio to support these potentially more volatile endeavors:

Industrial As of Dec. 31, 2003
# of REITs	9
Industry Market Cap.	$13,059,000
% of Industry	5.8%
Average Dividend Yield	5.04%
One-Year Return	33.14%
Three-Year Return	18.83%
Five-Year Return	17.53%
Weighted Average Daily Volume (shares)	117,824
Weighted FFO Growth (2002–2003)**	–8.34%
Source: NAREIT. Data as of Dec. 31, 2003. *Includes PLD, AMB, CDX, CNT, FR, EGP, KTR, FPO and MWRTA. *Note: Year-over-year percent change, as of second quarter 2003.

• Joint ventures—ProLogis (NYSE: PLD) and AMB Property Corporation (NYSE: AMB), among others, have established joint ventures (or investment funds) that are meaningful in size. In these instances, the REIT typically retains control of key management functions that allow it to generate fee income and leverage its existing operating infrastructure while retaining only a moderate ownership stake in the properties. Joint ventures also allow the REIT to limit capital investment while maintaining key tenant relationships.

Analytically, Standard & Poor's consolidates those REIT ventures characterized as strategically integral or meaningful in size. Analytical consolidation of ventures leveraged with mortgage debt can result in a weakening of certain of the REIT's financial measures (such as secured debt-to-total assets and unencumbered net operating income (as secured NOI to total NOI increases)).

• Development and capital recycling—CenterPoint Properties Trust (NYSE: CNT), First Industrial Realty Trust, Inc. (NYSE: FR) and ProLogis are among the more active industrial REITs engaged in development and capital recycling programs. Standard & Poor's looks to stable core portfolio cash flow to offset the potentially more volatile (but higher yielding) merchant building and sales gains. Average fixed-charge coverage for these three industrial REITs is 2.6 times including these fees and gains, but declines to 1.9 times (which is considered low for the "BBB" rating category) once we exclude all merchant building fees and gains.

• International expansion—Currently, two industrial REITs, ProLogis and AMB, have an international presence. The benefits of greater geographic diversification are somewhat offset by new market risk and currency exposure.

• Niche product—AMB has invested in on-tarmac "high-throughput" property (although modestly), and CenterPoint has a meaningful investment in a large intermodal facility. Managing unique product types requires a different skill set from managing traditional warehouse products. Additionally, less typical property types may be more volatile and the pool of available capital providers tends to be less deep compared to traditional warehouse property.

Standard & Poor's Rated Industrial REITs Key Statistics As of Sept. 30, 2003
REIT	Ticker Symbol	Corporate Credit Rating/ Outlook	Industrial as % of R.E. Investment	Market Capitalization ($000s)	EBITDA Interest (X)	Total Debt/ Total Cap. (MV)	% ABR	Top 5 Tenants
Pure Industrial AMB Property Corp.	AMB	BBB / Stable	Nearly 100%	2,837,540	2.8	42	8.6	U.S. Government, FedEx Corporation, Deutsche Post AG, Harmonic AG, International Paper Company
CenterPoint Properties Trust	CNT	BBB / Stable	Nearly 100%	1,722,780	3.5	33	13.0	American Bottling Co., Cornerstone Brands, DSC Logistics, U.S. Postal Service, APL Limited
First Industrial Realty Trust, Inc.	FR	BBB / Stable	100%	1,595,320	2.2	46	4.9	General Motors Corp., Venture Industries, U.S. Government, Whirlpool, Best Buy.
ProLogis	PLD	BBB+ / Stable	100%	5,822,060	2.3	33	9.8	Deutsche Post AG, TPG N.V., Exel Logistics, Unilever, NYK Line
Mixed Catellus Development Corp.	CDX	BB / Positive	66% of NOI	2,201,280	4.3	39	19.1	The Gap, APL Logistics, Inc., Exel Corporation, Ford Motor Company, J.C. Penney Company
Duke Realty Corp.	DRE	BBB+ / Stable	52% of NOI	4,656,770	4.1	31	5.6	SBC Communications Inc., Nationwide Mutual Insurance, General Electric Co., Pearson Education PLC, General Motors Corp.
Highwoods Properties, Inc.	HIW	BBB- / Negative	10% of NOI (wholly owned assets)	1,514,690	2.3	47	9.9	U.S. Government, AT&T Corp., PriceWaterhouse Coopers, State of Georgia, Sara Lee Corp.
Liberty Property Trust	LRY	BBB / Stable	45% of ABR	3,282,610	3.3	37	4.4	TJX Corp., Kellogg Co., U.S. Government, Vistakon (division of Johnson & Johnson), DSC Logistics, Inc.
PS Business Parks, Inc.	PSB	BBB / Stable	9% of SF Industrial andB 73% Flex	1,171,760	34.0	5	13.6	U.S. Government, Citigroup, Intel, IBM, Hughes Network Systems
Source: Standard & Poor’s Ratings and Outlooks as of Jan. 26, 2004 Notes: ABR=Annual base rent, Cap.=Capitalization, MV=Market value, NOI=Net operating income, SF=Square feet.

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Recovery Weak, But Few Surprises Expected

Standard & Poor's maintains a stable perspective on the industrial sector. The recovery will likely be slow, but few surprises are expected. The nine industrial related REITs rated by Standard & Poor's have above-average asset quality (in hub locations), moderately leveraged balance sheets (43 percent based on market value), and low dividend payout ratios (84 percent of funds available for distribution (FAD)). Near-term refinancing needs are manageable, and development pipelines have contracted sharply as well, all of which provides support for our stable sentiment.

Industrial REIT occupancy at 91 percent exceeds the national average of 89 percent, and is expected to improve modestly over the next few years, given the improving outlook for demand. While leasing related capital expenditures are generally modest for this sector, market softness has created a competitive environment for landlords, prompting some to offer leases with low initial face rents with the expectation for rent step-ups in later years.

As such, the recovery for REIT earnings may be slow. Coverage measures are expected to remain stable (at over 3.0 times EBITDA/interest coverage and 2.5 times fixed charge coverage) before improving into 2005, as the near-term potential remains for modest compression due to rental rate declines on lease rollovers. It is expected that the industrial REITs will continue to engage in development and capital recycling programs in order to boost coverages and returns, as well as to strategically manage their portfolio holdings.

Industrial landlords will likely continue to benefit from a low interest rate environment and strong investor demand for owning hard assets, which bolsters liquidity and buffers key credit measures from deteriorating revenue, and the rated industrial REITs appear well positioned to continue to outperform the national market average.

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Elizabeth Campbell is a director of the Real Estate Companies Group at Standard & Poor's.