The industrial market goes into 2019 with record absorption and rent growth as companies focus on expanding and retooling their distribution networks. While industrial has always enjoyed a favored position within most asset manager’s portfolio composition due to its lease profile and comparatively low capital expenditure nature, those that have chosen to overweight their portfolio with industrial in recent years have been riding a wave of strong performance and are likely outperforming their index.
NCREIF returns as of Q3 2018 show industrial leading all major property types both on a short-term basis, at 3.36 percent for the quarter, and long-term, at 8 percent compound average return over the last 10 years. The delta in industrial returns versus other property types becomes wider when looking at performance over the last three years; industrial averaged a 13 percent return versus 6-7 percent for the other major property types. This is due to a balanced combination of both income and capital appreciation.
Looking at large-scale public and private sector portfolio deals in the last 12-24 months, many have traded at a premium; Blackstone’s Gramercy acquisition, for example, at 5 percent premium and Prologis’ DCT at a 26 percent premium to NAV. Lately, we have seen non-homogenous portfolios come to market that have failed to generate the same level of activity and pricing; a sign that buyers continue to have discipline on what they are willing to pursue. Overall, transaction volumes continue to be at all-time highs with $64 billion of trades through Q3 2018 versus $55 billion at the same period in 2017, a 17 percent uptick according to Real Capital Analytics.
Based on a belief that we are late-cycle, if you factor in the strategy that a lot of institutional managers have employed with regard to low-CAPEX sectors, then the divergence in transaction volume becomes even more evident as low-CAPEX property types have taken on a larger share of overall volumes in the last few years.
How does property performance correlate to these historical returns/transaction volumes and what does the future hold for property-level fundamentals? Since 2010, demand has continued to outpace supply for 33 out of the last 34 quarters according to CoStar. That gap has narrowed significantly in the last few years due to an increase in the construction pipeline, but it was still expected that demand would be 10 million square feet more than completions/supply in 2018, according to Prologis’ Q3 earnings call. Same-store NOI grew 5.4 percent across the sector for the public REITs and, according to CoStar, overall annual rent growth stood at 6.2 percent with a number of supply-constrained markets continuing to see double digit rent growth as of Q3 2018.
E-commerce key to outperformance
This year should be more of the same but less robust growth based on concerns about whether the market can keep up with the torrid pace of recent years in the face of more uncertainty regarding global trade. CoStar projects rent growth of 5 percent for US industrial US in 2019. Last-mile product is also likely to continue to drive rent growth as it has in recent years. So how does the market outperform projections for 2019? The likely answer circles back to e-commerce and overall retail sales. E-commerce accounts for nearly 50 percent of all industrial absorption. While overall retail sales are expected to grow another 4 percent in 2019, e-commerce is expected to grow 15-16 percent, according to Business Insider/US Census Bureau data, and result in a tremendous amount of absorption. Besides Amazon, there are several other large retailers – Best Buy, Home Depot, Lowe’s, Five Below, Costco, Wal-Mart, Kroger – currently in the middle of significant expansions to supply chains via additional regional distribution centers as a result of focusing on the e-commerce space.
We believe the sector is in a strong position to continue outperforming the broader real estate space due to the underlying supply/demand fundamentals, ability to turn off the future supply pipeline faster than other product types and an increasing focus by tenants, both large and small, to compete in an environment that continues to value getting goods to the individual consumer in a faster and more efficient manner.
Go forth and seek value
Three suggestions for opportunities in 2019
- Continue to develop in markets where demand is outpacing supply
- Invest in niche property like cold storage and truck terminals, which are becoming more mainstream
- Pursue smaller one-off trades that may historically fall a bit below the radar of most institutions