This article is sponsored by Realterm.
Post-global financial crisis, operating fundamentals in the industrial sector have been exceptionally attractive. A half-decade of record-level demand growth for industrial space, combined with vacancy rates as low as they have been in 20 years, have led to several years of near double-digit rent growth.
Today’s underwriting in many cases incorporates an expectation that current conditions persist. Notwithstanding this optimism, a supply response has substantially eroded overall rent gains across the sector in most previous market cycles. As the current cycle matures, proper asset selection becomes critically important to generating higher returns in the industrial property sector going forward.
Historically, the best predictor of user demand for industrial space has been GDP growth. Over a 20-year period, the correlation coefficient between GDP growth and industrial net absorption lagged by six months is 0.88. GDP includes many drivers of demand for warehouse space (primarily retail sales and global trade) and general industrial space (manufacturing output, construction and equipment investment). Since the end of the GFC, the US economy has been in a record-length expansion phase. This growth has fueled the need for industrial properties, especially warehouse space, with US warehouse occupancy 1.8 billion square feet higher at the end of 2019 than in 2009.
Despite the length of the current expansion, economic growth was weaker in 2019 than in the previous two years. A significant corporate tax cut fueled healthy economic growth in 2017 and 2018, but the impact of that fiscal action was muted in 2019. In addition, conflicts with US trading partners, especially China, resulted in weaker import growth and an actual decline in exports in 2019.
The impact of weaker tradeflows has been felt through the supply chain across most major transportation modes. Year-to-date container volume through November 2019 at the Ports of Los Angeles and Long Beach was 8.2 percent lower than a year ago. US rail container volume in the same period was down 3.8 percent. Overall trucking volume was mostly unchanged from the previous year, but some long-distance truckload carriers have struggled because of weaker revenues against already thin profit margins.
Economic uncertainty and increasing barriers to trade have led many logistics tenants to pause leasing decisions until more clarity over the direction of the global economy emerges. Consequent to this pause, demand growth for industrial space appears to be decelerating. CoStar reports that after topping 230 million square feet annually between 2014 and 2018, warehouse net absorption was about half this level in 2019.
While growth in demand for industrial space is slowing, the pace of construction is accelerating. According to CoStar, warehouse inventory under construction totaled 265 million square feet at the end of 2018. By the end of 2019, that level had risen to 295 million. This growing oversupply and weakening demand will cause the vacancy rate to continue to rise from the record low of 4.4 percent recorded at the end of 2018. There is little reason to expect any sudden collapse in demand or major increase in vacancy, but a rising vacancy rate will likely mean weaker rent growth going forward than the annual pace above 5 percent observed over the past five years.
E-commerce propelling industrial property demand
Nevertheless, there are several macroeconomic trends that will help to mitigate the impact of an economic slowdown on the industrial sector. The largest of these trends is the rate of e-commerce growth as a percentage of total retail sales. The US Census Bureau reports that around 11 percent of retail sales in 2019 were conducted online, up from 5 percent in 2012. E-commerce has grown by 15.3 percent annually over the past decade. Furthermore, it has accounted for almost all inflation-adjusted growth in the retail sector since 2000.
In response to this trend, retailers have been expanding their supply chains to serve the direct-to-consumer segment of the market in addition to bricks-and-mortar retail centers. The additional warehouse space required to serve the online consumer market contributed to the record absorption in previous years, and it has partially offset weakening demand in 2019 from an economic slowdown.
The impact of these cyclical and structural trends will have a disparate impact on industrial properties. The industrial sector is quite heterogeneous. While warehouse properties comprise approximately 80 percent of value in the sector (and are themselves highly varied), there are other important sub-types, including light industrial, flex, manufacturing and high flow-through (HFT) logistics uses. Looking forward, e-commerce will play a crucial role in determining return outperformance of the property subtypes within the industrial real estate sector. Realterm believes that high flow-through properties are uniquely configured to benefit most from this trend.
E-commerce driving HFT demand
HFT properties are infill industrial properties best suited to capture growth in space demand from e-commerce users, and they are almost fully insulated from the potential for supply growth to present new competition. Optimal characteristics of HFT properties include a high ratio of loading positions relative to the building’s size, and substantial excess land for staging and equipment parking. These features accommodate rapid inventory turnover and speed the movement of freight to the final destination, which is increasingly the consumer.
Warehouse space is often viewed as a commodity by its users; one regional distribution center is little differentiated from another. As a result, many price-sensitive tenants may freely move to competing lower cost properties to avoid paying higher rents, which becomes a risk to the landlord in an oversupplied market. Rental growth in these buildings is often a function of the cost of new construction, which in turn is a function of the cost of available land. While rising e-commerce sales will help to fuel increasing use of these properties, the prospect of new supply growth will constrain future potential warehouse rent growth.
In the current real estate cycle, peripheral locations in major national hubs like central New Jersey and southern California’s Inland Empire have attracted an outsized share of new construction. During this boom, year-on-year rent growth in these areas has at times surpassed 10 percent. However, in previous downturns, these areas have experienced serious market corrections, with rents declining by at least 10 percent in the past two recessions. There is also a disparity in rent performance between supply-constrained and unconstrained submarkets in the nations five largest real estate markets – Greater New York, southern California, Chicago, Dallas-Fort Worth and Atlanta – through the last recession and recovery.
Infill industrial properties, which include HFT properties, are less exposed to the risk of supply growth eroding rent gains. Because they generate considerable noise and pollution, HFT properties are often difficult to entitle for new development. Moreover, they do not generate as many jobs as traditional warehouses. For these reasons, municipalities are often reluctant to approve this use for undeveloped parcels. Restrictive zoning, the lack of competing vacant land and the expense of redeveloping older industrial properties protect infill HFT owners from new competition and contribute to the potential for sustained rent increases even through a downturn in the real estate cycle.
Tenant demand for these properties also helps to drive rents higher. This point has become especially evident with the proliferation of e-commerce users. Properties used for e-commerce distribution are optimally located as close as possible to their consumer base to maximize delivery route efficiency. Transportation costs account for around two thirds of the total logistics expense, while rent accounts for around 5 percent of this total. Logistics tenants are willing to pay proportionally much higher rents for efficient facilities near their consumer base in order to keep transportation costs low.
Sources such as eMarketer and Forrester Research believe e-commerce is likely to total around 30 percent of all retail sales by 2040 from a base of 11 percent in 2019. This growth will need to be accommodated mostly through the existing stock of HFT properties due to their locational benefits and efficient building configuration to accommodate high inventory turnover. The acceleration of freight volume through these facilities enhances the value of these properties to the transportation user. This higher value to the user is reflected in a willingness to pay substantially higher rents. Consequently, HFT properties are likely to continue to benefit from this secular demand shift despite otherwise fully priced and slowing general industrial performance.