by Lesia Bates

The industrial real estate sector remains one of the strongest segments of U.S. commercial real estate. Strong tenant demand, steady absorption of supply and continued economic growth support the impressive performance of the industrial market. Opportunities from e-commerce and the Internet have also contributed to the positive results posted by the industrial real estate sector.

Revenue and earnings growth is healthy in spite of a mild nationwide economic slowdown in the second and third quarters, and U.S. industrial REITs have been among the best-performing sectors in the REIT industry in 2000. We expect continued healthy industrial market conditions and return performance for the industrial market and for industrial REITs over the near-term.

Disciplined development and a strong economy have kept the national industrial real estate market in balance. Construction of new facilities is happening in response to growing customer demand. According to Torto Wheaton Research, the trend in industrial vacancy is extraordinary. Vacancy rates declined in 31 markets and were up by less than 1percent in another 17 as of the third quarter of 2000. Leverage has, on the whole, remained stable despite greater development activity by industrial property companies. However, should increased speculative development and higher leverage become prevalent, some downward pressure on some industrial REITs' ratings may result.

There are several major trends that will shape future industrial real estate demand, and, in turn, could lead to increased ratings volatility for some industrial REITs.

New Tenants Drive a Shift in the Demand Mix

In line with general growth patterns in the United States, an increasing number of companies either directly involved in, or closely dependent upon, the high tech sector are requiring more industrial space. Business-to-consumer commerce and fulfillment companies, such as Fingerhut, which help e-commerce companies with tasks such as packaging and returns, are driving much of this new demand. For these users, speed and transportation access are essential. As such, these companies tend to gravitate towards markets that are densely populated and have good rail, air and highway access.

The growth in and the early success of many "New Economy," Internet and technology-related firms is increasing the demand for industrial and office space, and is leading some firms, such as First Industrial Realty Trust and AMB Property Corporation, to shift their business models to meet this demand. These firms have been actively redeploying capital from property sales into development and/or acquisitions of assets located in markets that are more appealing to e-commerce and Internet companies.

Other firms, such as Duke-Weeks Realty Corporation, remain primarily focused on well-established national and regional companies with strong credit quality. In addition, these REITs remains committed to their long-term investment philosophy and generally do not engage in the development of special-purpose facilities.

Despite the potential benefits, those industrial REITs with overexposure to Internet tenants or Internet-driven dynamics pose some risks. Many of these new tenants have limited operating histories and earnings, which may increase their cash flow volatility. Companies' need for shorter, more flexible lease terms is also an issue. In general, these REITs seek to minimize their exposure with less-established companies by requiring credit enhancements, such as letters of credit and cash deposits.

More Service-Oriented

Shifting tenant demands are compelling many industrial property firms to place greater emphasis on customer relationships. This change in emphasis marks a cultural shift for landlords. The real estate business has historically been very commoditized in terms of product. Tenants were looking for a certain product, in a certain location at a certain price. To be competitive, real estate owners are becoming much more service-oriented.

Many industrial property owners are now offering a broad array of "value-added" services to meet their customers' needs. The level of services and the professionalism of execution are also important. Firms such as ProLogis have established strategic partnerships to offer their customers a comprehensive menu of industrial real estate solutions. These services range from facility design and construction to the design of innovative software for transportation management.

To meet these challenges, company managements are hiring executives with a greater mix of skills and a broader track record of business experience. The ability to navigate the cultural and operational challenges involved in this shift will be a key factor separating the companies who will succeed spectacularly and those that will merely survive the change.

Landlords who are successful in adding value for their customers will generally retain tenants longer and extract above-market rents, which in turn lower ongoing costs, contribute to stronger financial performance and enhance company franchise value. We believe that industrial REITs who can meet these new tenant demands will be better positioned for growth and stability going forward.

Demand for More Complex Industrial Buildings

Companies are increasingly looking for ways to reduce costs and to accelerate product delivery. The Internet and e-commerce are not only transforming supply chain management and distribution, but also contributing to changes in the physical characteristics of many industrial property types, including distribution and warehouse facilities. Warehouses are getting bigger and the space is becoming is becoming complex. Important considerations include automation, broadband high-speed Internet access and other data services, as well as energy management systems.

Tenants' need for speed is also affecting the locational choices of industrial buildings. Because transportation access is critical, tenants are increasingly favoring densely populated regional hub markets such as Chicago, Oakland and Atlanta.

The need for newer, more technologically advanced industrial facilities will likely accelerate the obsolescence of older stock. Landlords that focus on smaller, older properties will likely face competitive pressures, potentially resulting in increased vacancy and lower rents.

Moody's recognizes that tenant demand in certain markets does not dictate modern facilities, some upgrades to older industrial facilities will likely be required to enable industrial property owners to retain their tenants longer and to achieve the highest possible rents. Industrial REITs that have the ability and capacity to recycle these assets into new and profitable use should maintain a competitive advantage.

A Likely "Win-Win" Scenario

One question that remains is whether or not the higher capital costs of new developments will constrain industrial REITs' bottom line. While it seems inevitable that the new technologically-oriented facilities will be more expensive to build and maintain, it is unclear whether or not REITs will be able to make up the difference by charging significantly higher rents. In addition, continued slowdown in the economy could lead to weakening tenant demand and rising vacancy rates.

For the foreseeable future, the level of services and the professionalism of execution are also important. Moody's believes that REITs with modern, state-of-the-art and well-located facilities will be best positioned to capitalize on an expanding marketplace. The result should be higher tenant retention rates and strong revenue and earnings growth.

Industrial REITs that offer a broad range of industrial real estate solutions and have established strategic partnerships with their customers will emerge as the true winners in the industrial real estate sector. Industrial REITs that proactively respond to ever-changing tenant demands should be able to position themselves to benefit, regardless of their size. Defensible business propositions, strong balance sheets and well-located assets in the top industrial markets remain key differentiating factors.

Lesia Bates is a vice president/senior analyst with Moody's Investors Service in New York City.