This article is sponsored by Clarion Partners.
US industrial property has continued to be the best-performing commercial real estate sector amid historically robust demand. Institutional-quality industrial investments have significantly outpaced the overall NCREIF Property Index since 2011, as well as the other core CRE property types over recent years. The enduring strength of the sector has been extraordinary, driven in strong part by the ongoing rise in US consumer spending, omnichannel expansion and expanding global trade.
Our short- and long-term outlook for the sector is positive, given structural transformations in both global supply chains and last-mile distribution. Over the next few years, we believe that three main factors will drive greater industrial space requirements and higher rents: first, ongoing supply chain disruption and inventory rebuilding; second, the continued e-commerce boom; and third, higher construction and replacement costs.
Strongest property fundamentals on record
Nationwide, US industrial property fundamentals are the strongest on record, with all-time-low vacancy and soaring rents. New leasing activity has been historically high, and nearly half of product under construction has been preleased. These high-demand conditions have created a market where landlords have a greater ability to increase rents at warehouse and distribution properties in most markets.
- Vacancy at all-time low. As of Q3 2021, US industrial vacancy reached a record low of 3.6 percent. All top distribution hubs saw vacancies well below long-term averages (LTAs).
- Robust rent growth. Recently, rent growth also reached the highest pace in over two decades. Average asking rents rose by 10.4 percent, while same-store asking rents were up 4.5 percent year-on-year as of Q3 2021.
- Demand outpacing new supply. Over the last several years, net absorption has continued to outpace new supply and reach record levels, and shows little sign of slowing down.
Supply chain disruption and inventory rebuilding heightens warehouse demand
The onset of the global covid-19 pandemic precipitated a rapid and unprecedented demand shock that interrupted normal business conditions. Many suppliers quickly scaled back production, which led to widespread inventory shortages and distribution delays. A synchronized global economic recovery, or demand comeback, is now well underway. US retail sales are now 20 percent above pre-covid levels, and the inventory-to-sales ratio has fallen to an all-time low.
This supply chain disruption has led more and more logistics occupiers to adopt a ‘just-in-case’ management strategy, often referred to as inventory rebuilding. This both hedges against potential future disruptions and ensures timely last-mile fulfillment. We expect US business inventories to rise swiftly in the years ahead.
It has been estimated that a 1 percent rise in inventories is consistent with approximately 100 million square feet of net absorption; therefore, a 5 percent increase in US business inventory levels would require an additional 400 million to 500 million square feet of warehouse space.
Strong momentum in e-commerce sales boom
The ongoing expansion of e-commerce logistics is by far the largest secular tailwind for industrial demand. E-commerce users usually utilize three times more warehouse space than traditional retailers, augmenting the demand for warehouse and distribution space.
The covid-19 pandemic dramatically accelerated the recent pace of e-commerce sales. Online sales now account for about 20 percent of total core retail sales (as of mid-2021), which could grow to about 30 percent in the US by 2030.
By 2026, total US e-commerce sales are forecast to exceed $1 trillion, double the $500 billion just three years ago in 2018. Industry estimates indicate that every $1 billion of new e-commerce sales growth requires 1 million square feet of additional warehouse space. Consequently, an estimated 340 million square feet of new space will be needed over the next five years to accommodate e-commerce expansion alone.
As e-fulfillment becomes more dominant, minimizing delivery time and costs will continue to be essential. We expect that there will continue to be attractive investment opportunities ahead in the last-mile segment based on recent demand growth trends:
- Surging absorption levels for light-industrial. Absorption of light-industrial space, which is less than 400,000 square feet and largely made up of regional and last-mile users, has greatly increased in the 10 largest US metro areas in recent years.
- E-commerce giants pay premium for last mile. The most competitive occupiers, such as Amazon, FedEx and UPS, will pay a high cost to be near end-consumers amid escalating delivery costs, which have been exacerbated by limited land availability.
Higher replacement costs likely to hinder new supply and boost rent growth
Over the past year-and-a-half, there has been an unprecedented surge in US construction costs. Subsequently, CRE development and renovation costs have risen significantly.
As of Q3 2021, overall building costs remained elevated, up by approximately 35 percent from early 2020. On a year-on-year basis, industrial land costs in East and West Coast markets were up by 50 percent and 75 percent, respectively.
Higher construction costs will negatively impact project timelines and budgets for the 1.4 billion square feet of warehouse space planned over the next five years. At the same time, much of US existing stock is dated and does not well serve the demands of modern-day omnichannel distribution, and there is a shortage of high-quality modern warehouse space.
- Shortage of Class A inventory. Class A warehouse and distribution property is only 15 percent of overall US industrial inventory, about 2.2 billion square feet of the total 15 billion.
- Widespread functional obsolescence. About 75 percent of total US industrial inventory was built before 2000.
We anticipate that tenant demand for industrial property – in particular, modern Class A facilities – will be strong amid limited new supply. Many logistics tenants will be required to pay a premium for high-quality facilities in premium locations, and landlords will be able to sustain and escalate rent levels. We expect effective rent growth levels to range between 5.5 percent and 6.6 percent from 2021 to 2023.
Investor allocations to industrial rise
Investor interest in US industrial assets has continued to escalate. Consequently, NCREIF Property Index portfolio allocations to the sector have swiftly risen from 14.2 percent in 2017 to 25.6 percent in 2021. Looking ahead, the more recent phenomena of inventory rebuilding and higher replacement costs will continue to drive growth within the logistics industry, along with the ongoing e-commerce boom.
We are optimistic about the near- and long-term appreciation and income growth potential for well-located, high-quality industrial investments amid the ongoing strength of consumer spending and rise in global trade. Thus, the outperformance of the industrial sector will likely continue over the next few years.