This article is sponsored by Clarion Partners. It appeared in the Investing in Logistics and Distribution supplement with the February 2019 issue of PERE magazine.
Logistics real estate in the US has already seen sharp cap rate compression as investors pile into the sector. The market still has considerable runway left, however, even in the event of a US-China trade war, argue David Confer, managing director, and Tim Wang, managing director and head of investment research, at New York-headquartered investment manager Clarion Partners, which has owned and managed industrial assets for more than 30 years and currently manages $15.4 billion of US industrial property.
PERE: What is the outlook for US industrial real estate?
Tim Wang: Over the past year, the US industrial sector provided an unlevered return of 14 percent, more than twice the benchmark index and head and shoulders above the other core property sectors. We think that outperformance will likely continue for the next few years. Net operating income (NOI) growth of about 5 percent year-on-year is very strong, and we think the cap rate for US core industrial is still relatively high at 5.1 percent, compared to other core property sectors, so there is a high probability that cap rates will continue to compress as more capital flows into the sector.
David Confer: There is still very strong demand for space at a time when supply is being held in check, so we are looking forward to some rental growth in most markets. E-commerce has been a big driver for that demand and that will continue. Before the year 2000, less than 1 percent of sales were online – now the number is 12 percent and rising.
TW: That process is less than halfway through. E-commerce’s market share is projected to at least double to 25 or even 30 percent, so the warehouse boom should last several more years yet. E-commerce sales in the US have been growing at 20 percent year-on-year compared with general retail sales growth in the US of 3-4 percent. Demand for retail space is being transferred to warehouses. Today vacancy for US warehouses is about 4.2 percent, more than 300 basis points below the long-term average of 7.4 percent. Many e-commerce orders are being delivered in one-day, or even two-hour, delivery slots. In order to serve that market, warehouses must be located much closer to the population in dense infill areas. It is a landlord’s market in which property owners have the ability to drive rents, which means strong NOI growth.
PERE: How is that affecting investors’ capital allocation decisions?
DC: Industrial has been the best performing US real estate sector now on a one, three, five, seven and 10-year perspective and investors have been taking notice of that. In addition to US funds, we have seen European, Asian and Australian investors very actively looking at the space. On an absolute basis, real estate pricing is historically high, but compared to stocks and bonds, it still looks pretty attractive as foreign investors weigh the strong fundamentals of the industrial sector with the alternative investments available around the world.
TW: Investor allocations to industrial within their real estate portfolios right now are only 14 to 15 percent on average. We think that is very low. Our current allocation to industrial in one of our core funds is 22 percent and our target is 25 percent. That is how much conviction we have about the sector. The pace of the tech-driven shift from retail to warehouse has caught many investors by surprise, so suddenly they are realizing they’re severely under allocated to the industrial sector. They are increasing their investment in the asset class in order to catch up, but it is not that easy because warehouse assets tend to be smaller in value terms than a downtown office block. Building a portfolio takes time and expertise.
PERE: What are the most effective strategies for investors to access US industrial assets?
TW: They need to partner with a reputable, highly experienced platform. Relationships with tenants, brokers and developers are very important to investors’ ability to effectively can deploy capital in the sector. They can partner with an operator to source deals one at a time, but sometimes a more efficient way to allocate capital is to invest in an open-end fund so they can achieve instant diversification and leverage the portfolio cash flow from day one.
Vacancy rate for US warehouses today, compared with a long-term average of 7.4%
DC: It is still possible to achieve attractive risk-adjusted returns through value creation strategies and active portfolio management. Adopting and maintaining a robust build-to-core strategy is also an attractive way to acquire assets compared to simply outbidding other investors in an auction process. The competition for land right now is very tough; because finding good sites and getting land entitled is such a challenge, we have seen supply and demand remain balanced. If it was easier, given the amount of capital seeking higher-than-core returns, there would probably be a bit of an oversupply. We prefer owning modern assets that are located close to the larger local and regional population bases in markets that possess really good local infrastructure. Access to labor has become a very important part of occupiers’ decision-making. Online retailers prefer locations where they can find plenty of good quality labor. That is causing some markets to be stressed while creating opportunity in others. In some traditionally strong markets, for example certain sub-markets in Central Pennsylvania, labor is harder to find and some tenants are starting to look elsewhere.
TW: One of the new markets we are betting on is Las Vegas – partially because compared with Southern California the land is less expensive, and labor is cheaper and not unionized.
PERE: Are there any potential downsides that investors should look out for?
DC: Obsolescence is always a concern. Investors are very focused on buying buildings with adequate parking and good truck access, and with clear heights likely to be attractive to occupiers. A little under half of US warehousing was built before 1980, and we will see more buildings approaching obsolescence in the coming years. That could create build-to-core opportunities for investors and covered land plays, where investors have the opportunity to buy an existing investment in a location where the land may have a higher-value use in the long term.
TW: Technological changes like driverless cars and drone delivery may impact warehouse demand or locations. Another concern is a potential full-scale trade war between the US and China that could shift global trading patterns. That hasn’t caused any major changes in tenant demand so far, although some of them are a little bit cautious. Ultimately, whether US consumers are buying goods from China, or from Malaysia, India and Vietnam, the demand for warehousing will continue to grow along with US consumption. A trade war could affect the attractiveness of some locations though. Perhaps the US west coast might become less important over time.
DC: Product returns are a bigger challenge for e-commerce businesses than for traditional retail stores. Substantially more product purchased online gets returned – around 30 percent compared with 10 percent of products bought in a store. How companies adjust their strategies to try to minimize the impact on their bottom line will be interesting to watch. Some are rolling out brick-and-mortar stores where they can sell returned products, others are very aggressively trying to figure out their reverse logistics, and some will change their pricing policies to disincentivize returns.
TW: Because there are more processes like returns to accommodate, e-commerce requires three times more warehouse space than traditional brick and mortar retail. Every $1 billion of new e-commerce sales will translate into 1.25 million square feet of new warehouse demand. If you believe the projections on e-commerce growth over the next five years, we need at least 260 million square feet just to contain that.
DC: That is another reason why people are betting on the industrial market. The structural shift in the way people buy their merchandise is having a big impact in our sector and causing people to look at it as a good place for their money to be in the long term.