This article is sponsored by Macquarie Asset Management.
Industrial real estate, with its historically strong correlation to GDP growth and consumer spending, for some time has been a key component of institutional investment allocations. However, in recent years, and in particular since the onset of the covid-19 pandemic, dramatic structural changes across the globe have factored into significant increases in industrial demand and have created broad tailwinds for the sector’s fundamentals.
These changes in the US include not only the rapid growth in e-commerce penetration, but also ongoing supply chain reconfigurations, nearshoring and onshoring, and changes in inventory management by tenants. These strong demand drivers have been coupled with increased institutional investment in the sector, with US industrial transaction volumes rising more than 22 percent in 2021 over the prior year, and cap rates compressing by more than 100bps to among the lowest levels on record.
One of the most significant recent demand trends, the rapid growth in e-commerce, has been a large focus, given its higher warehouse and distribution space requirements relative to traditional brick-and-mortar retail – almost three times more for every dollar of sales, according to most estimates. E-commerce penetration of US sales is now over 13 percent, almost double the level from five years ago.
With US consumer household spending increasing by $740 billion since the start of 2020, the demand for retail goods continues to drive need for warehouse and distribution space.
As population density and access to ports and other transportation hubs continue to factor into logistics real estate decisions, the focus remains on ultimately producing, storing and delivering closer and more efficiently to end customers. With transportation comprising the majority of a company’s total logistics spend, the decision to increase inventories and lease incremental industrial space that minimizes transportation costs becomes easier for occupiers to make.
As user supply chains change and expand, this demand for space by these tenants has not only recently grown, but also diversified across markets and locations within markets. Labor and material shortages and constrained inventories, impacted by the covid-19 pandemic, also factor into this decision for users in their supply chain and leasing decisions. With retailer inventory-to-sales ratios at recent historical lows near 1.1x, the need for ‘safety stock’ to prevent similar issues has only grown.
In recent quarters, logistics and distribution, third-party logistics (3PL), machinery and materials, and e-commerce retailers have comprised the bulk of new leasing across the US. In Q3 2021, logistics, distribution and 3PL tenants comprised almost 30 percent of this total leasing volume. This can be attributed in part to suppliers looking to 3PL companies to assist in managing their supply chain requirements.
Impact of new industrial real estate supply
Today, a record development pipeline is under construction and planned in major markets across the US, with nearly 450 million square feet overall under construction. The markets with the highest volume of speculative development today include Atlanta, Eastern and Central Pennsylvania, Inland Empire in California, Dallas-Fort Worth and Chicago. Spurred by demand, almost 80 million square feet of industrial space were completed by developers in Q3 2021.
Contributing to this supply growth are the capital markets, which have seen no shortage of interest in the industrial real estate asset class. A number of new entrants are making moves into the sector, as competition for investment is buoyed by the availability of global capital. These factors, combined with the short construction timetable for industrial relative to other real estate sectors, can raise concerns about whether the threat of overbuilding can impact today’s positive fundamentals.
Despite this increased new supply, there continues to be a lack of availability today for tenants seeking space, as demonstrated by the recent large rent growth seen across US markets. Demand has outpaced supply for the past four quarters, driving vacancies down and rents up across almost all major US markets. Year-over-year US industrial rent growth was 10.4 percent in Q3 2021, the highest level in 20 years. Preleasing rates on new developments remain high, as tenants look to lock in and de-risk their near-term requirements.
Supply chain disruptions and changes brought about by the covid-19 pandemic have not only impacted the demand for industrial real estate, but also new development starts and pipelines. Pricing has increased across the board, with overall materials over 25 percent year-over-year in certain markets.
Beyond pricing, the timetables required to secure and bring materials onsite have increased significantly. The early procurement of materials has become important as development projects face lead times of more than 12 months for roofing structures in certain markets and significant queues for dock packages required for tenant improvement build-outs. In today’s environment of growing tenant and user demand, these limitations on building materials provide a speed bump for supply growth in the near term.
Additional, longer-term barriers to new supply of US industrial product include a lack of access to readily developable land in major markets, as well as overall longer entitlement processes. Infill and greenfield sites and large plots remain significantly constrained in coastal and gateway markets that have seen some of the strongest recent demand growth, further supporting near- and medium-term fundamentals. Coastal markets close to ports like the Inland Empire and New Jersey have seen five-year rent growth of 83 percent and 75 percent, respectively.
From an entitlement perspective, processes vary by region and, as such, new supply outlook and relative pricing will vary. Overall, municipalities remain focused on managing traditional public pressures and zoning and permitting concerns for a sector that is in demand.
For tenants, space that meets requirements and is ready to occupy is hotly sought after, particularly in the coastal markets with the tightest vacancy levels. This increased demand for space remains bounded by construction pricing, timing and development processes, helping mitigate the threat of overbuilding.
In addition to the structural changes driving higher demand, the industrial real estate sector is increasingly seeing changes to design and systems to meet tenant requirements. These factors further exacerbate the demand for newly constructed and renovated space. These changes focus on flexibility and overall productivity improvements, as older product can lack the capacity from a technical perspective for modern industrial and logistics usage. With an average age of approximately 34 years, the overall US industrial stock faces increasing obsolescence risk.
One key design element within most modern logistics real estate includes higher ceiling clearance heights, with more usable space and varying pallet loads and mezzanine floors. This feature is frequently leveraged with the increased usage of automated systems and robotics. Another design element is the use of larger truck courts and greater parking for employees and trailers. This facilitates not only storage, but also the efficient flow of labor and materials to and from the site.
With an increased focus on health and well-being, properties are including amenities like gyms and basketball courts beyond more standard build-out requirements like HVAC and lighting. These amenities, which began in the hospitality industry and have become widespread in the office sector, can help tenants stay attractive, especially among millennial employees, in tighter labor markets across the US.
While demand for US industrial today is supported by broad structural tailwinds, supply growth remains constrained by current supply chain disruptions and longer-term barriers. The need for modern logistics space for today’s tenants will remain a focus, as sustainability and preparing for a net-zero future come into the forefront.
How logistics can fight climate change
Beyond design changes aimed at productivity, Class A, modern logistics properties increasingly focus on sustainability
From electric charging stations to the ability to install solar rooftop generating capacity, modern logistics facilities are being designed and built with significant energy efficiency improvements over older product.
Macquarie Asset Management (MAM) is committed to managing its portfolio in line with net-zero emissions by 2040 and became one of the first large asset managers to sign the Climate Pledge. Real estate is an important part of meeting this commitment, as the construction and operation of real estate is estimated to comprise approximately 36 percent of global energy demand and 37 percent of energy-related global carbon dioxide emissions per latest research from the UN Environment Program.
MAM works together with its specialist operating platform in the US industrial sector, Logistics Property Company, to focus on ways to build modern logistics and distribution properties targeting a net-zero future. These include utilizing recycled building materials and incorporating efficient and ‘future-proof’ design elements into properties. We are working with tenants on ‘green leases’ and ensuring we are able to take advantage of the green and renewable electrification of the grid, as well as other technological and market advances. These changes are becoming more important for real estate investors in the US and around the world.