No End in Sight for Industrial’s Strong RunNo End in Sight for Industrial’s Strong Run
WMRE’s seventh annual industrial survey shows continued confidence in market fundamentals.
July 6, 2021
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No Harm Done
The industrial sector was one of the star performers throughout the pandemic as social distancing measures largely boosted demand.
A year marked by periods of uncertainty for most property sectors ended up being something quite different for industrial real estate.
The demand for home delivery of more types of goods and services provided extra fuel for fires that were already burning even before COVID-19. It also generated demand for once niche parts of the market, such as cold storage. The strong and consistent performance also caught the eyes of new investors looking for a safe haven. And as social distancing measures have eased, the demands for industrial real estate have not waned. All of that adds up to a lot of runway to go for what’s already been a long run of expansion for the sector. And overwhelming majority of respondents to WMRE’s seventh annual industrial market remain bullish on the prospects for occupancy and rent growth and other fundamentals.
Predictions on how long the expansion phase will last moved very little compared to the 2020 survey, which polled industry participants in February just before the massive effects from the COVID-19 pandemic set in. In all, 41 percent believe the sector’s expansion phase could run another 13 to 24 months, while 18 percent think it could be longer than two years. In addition, 22 percent predict that the cycle could continue for 7 to 12 months and 15 percent said six months or less. Those who feel the expansion has already ended represent a fraction at 3.65 percent—far fewer compared to the 7 percent who held that view in 2020 and 12 percent in 2019.
Among the optimists who believe the expansion could continue for more than two years, the two main reasons commonly cited are growth in the economy and e-commerce. “I feel the economy and markets are opening back up and an expansion phase with infrastructure spending will increase economic growth for the next several years,” wrote one respondent. Those who have a shorter-term view of the expansion window of one year or less generally believe that industrial expansion could be derailed by higher taxes under the Biden Administration and a drop in consumer spending once stimulus money runs out.
“Government actions will have negative effects in the long term, ultimately raising interest rates, spreads and creating headwinds to physical development of plant through more stringent regulations and increased tax burdens on companies and consumers,” wrote one respondent.
E-commerce has been a key part of the industrial growth story for the past several years, and more consumers shifted to online shopping during the pandemic. According to the U.S. Census Bureau, e-commerce represented 14.0 percent of total retail sales in the fourth quarter 2020, which was up from 11.3 percent in fourth quarter of 2019. Although forecasts on e-commerce growth vary widely, some predict that the share of global sales could grow to 21 percent by 2025.
“There is a fairly large runway on e-commerce in our space, and you combine that with the GDP growth that we have seen over the last 90 to 120 days coming out of the pandemic, and it has really been driving demand for space,” says David Fazekas, a senior managing director and chief investment officer of industrial at Black Creek Group, a real estate investment management firm. GDP grew at an annualized rate of 6.4 percent in first quarter as compared to 2.4 percent in fourth quarter 2019. Tenant demand also is very broad across the spectrum of different types of industrial space, he adds.
Survey methodology: The WMRE research report on the industrial real estate sector was completed via online surveys distributed to readers of Wealth Management Real Estate in April 2021. The survey yielded 200 responses. Recipients were asked what regions they operated in (and were allowed to select multiple regions). Overall, 47 percent said they operated in the East, followed by the West (38 percent), South (36 percent) and Midwest (34 percent). Forty five percent are private investors and 26 percent financial intermediaries represent with the balance a mix of developers, REITs, lenders, service providers and occupiers. About half of respondents (51 percent) hold the titles of owner, partner, president, chairman, CEO or CFO.
Rents Continue to Rise
Survey respondents remain confident on more rent growth ahead.
Although the pandemic caused tenants in other real estate sectors to hit the brakes on new leasing, that was not the case in industrial. The industrial market saw a robust year of leasing activity in 2020 that has carried over into 2021. According to Cushman & Wakefield, net absorption for 2020 reached 268.4 million sq. ft., surpassing the 240.9 million sq. ft. reported at year-end 2019 by 11.4 percent. Demand roared into first quarter with 82.3 million sq. ft. of net absorption—a record high for a first quarter. Cushman & Wakefield also reported a healthy national average vacancy rate at 4.9 percent and annual rent growth of 7.8 percent.
Survey respondents remain confident on more rent growth ahead. Nearly three-fourths of respondents (74 percent) expect rents to rise in their region in the next 12 months. Although a clear majority, sentiment has pulled back slightly compared to previous surveys. Expectations for rising rents have hovered around 80 percent for the past six years.
“The industrial market has some good strong legs on it, and all of this is being driven by e-commerce,” adds Craig Meyer, president, industrial, Americas, JLL. “There was peak demand in an unusual year, but we were on a growth path irrespective of COVID,” he says. Early in 2020 prior to the pandemic, JLL had forecast that there would be a need for 1 billion sq. ft. of additional industrial space over the next five years, solely attributable to demand drivers from e-commerce. In particular, there continues to be strong demand for warehouse and distribution space, both in large scale fulfillment and also for infill and last-mile facilities that are closer to the end consumer, he says.
Respondents are also predicting higher occupancies ahead in the coming year. Nearly two-thirds (65 percent) predict an increase in occupancies in their regions compared to 49 percent who held that view a year ago.
New Supply Maintains Healthy Balance
Views were mixed on how much new supply their respective markets could absorb.
The majority of respondents are also not worried about over supply. Those who think there is “too much” development occurring have remained in the minority for the past five years with a range of 7 percent to 11 percent, including 8.6 percent in the current survey. More respondents (42 percent) view the volume of new development occurring as the “right amount,” while those who think there is “too little” being built climbed from 22 percent in 2020 to 29 percent in this year’s survey.
According to Cushman & Wakefield, new supply totaled 352.9 million sq. ft. in 2020—a 5.7 percent increase compared to 2019. In addition, the firm was tracking 397.1 million sq. ft. of space under construction as of the first quarter of 2021.
Views were mixed on how much new supply their respective markets could absorb. Overall, 43 percent believe their markets could absorb 15 percent to 24 percent more new supply, while 38 percent said less than 15 percent of current inventory and 19 percent predict that their market could absorb more than 25 percent.
Mohr Capital is one firm that is planning to double its industrial development in 2021 with about 4.5 million sq. ft. of construction starts. The developer builds bulk warehouse facilities that it typically sells after securing leasing commitments from long-term, single net lease tenants. The group is developing a 7.5 million-sq.-ft. industrial park in suburban Indianapolis. They recently broke ground on a new 827,000-sq.-ft. spec bulk warehouse project at the Mohr Logistics Park. That project comes on the heels of a recently completed 1 million-sq.-ft. facility at the park that was fully leased to Cooper Tire & Rubber Co.
“The industrial market did take a pause last year, and everybody thought it was going to take a little bit longer to come out of the pandemic and turn around. But the industrial market is probably as hot as it’s ever been,” Bob Mohr, founder and chairman of Mohr Capital, a Dallas-based privately held real estate investment firm.
In many cases, product being built is nearly half pre-leased before it delivers, adds Fazekas. “So, we’re not seeing oversupply in any markets today. Demand is generally outpacing the new supply,” he says. The one market that was potentially concerning was Houston, which was hit by the pandemic and drop in oil prices. However, Black Creek has seen dramatic improvement with substantial demand and absorption over the last 90 days.
Although 55 percent of respondents report that their markets continue to see the removal of obsolete industrial space due to conversions to new uses, historical results show a clear downward trend in that activity over the past five years from a high of 70 percent in 2017. In addition, the removal of space is generating mixed results. Forty four percent believe that the removal of older space is balanced by new construction, 39 percent said it was resulting in lower overall industrial inventory and 17 percent continue to see net growth due to new construction.
Investors Continue to Target Industrial
Because of competition for industrial assets, investors are looking to alternative types of industrial product.
The solid performance and positive outlook for expansion have helped to position industrial as one of the favored property types for investors. Survey respondents rated industrial and multifamily as the two most attractive sectors at an average of 7.4 on a scale of 1 to 10, well ahead of hotels at 5.0 and office and retail each at 4.5.
Industrial sales during the first quarter of 2021 totaled $19.6 billion. Taking disruption from 2020 out of the equation, that volume represents a 11.4 percent increase over the $17.6 billion in the first quarter sales volume that occurred in 2019, according to Real Capital Analytics (RCA).
“Fundamentals are strong in industrial real estate. Vacancies in many markets are at record lows. Demand is very strong from tenants, and rental rates continue to increase. So, I don’t see fundamentals causing investors to shy away from industrial real estate,” says Erik Foster, principal and head of industrial capital markets at Avison Young. “We could see some outside headwinds, such as rising interest rates and inflation that could curtail some of the bullish behavior in the industrial market, but generally, the tailwinds will continue for the remainder of 2021,” he says.
Similar to last year, most respondents (55 percent) say they plan to hold onto industrial assets or buy more (36 percent), while those who plan to sell assets are in the minority at 9 percent. The percentage of respondents who said they plan to buy industrial in the next 12 months has maintained a steady level over the past five years with those respondents who said they plan to buy industrial in the coming year ranging between 33 percent and 38 percent.
Black Creek’s portfolio of industrial assets is giving the firm good insight into operations. “Rent collections were substantially better than any other asset class in real estate, and we had very good visibility into leasing demand given some of our development projects,” says Fazekas. The firm executed 4.4 million sq. ft. of new industrial leases in first quarter, which represents a record high for the firm. That demand is coming from a diverse pool of tenants. “We’re seeing extraordinary leasing activity and demand from tenants right now. So, we’re very bullish on the market,” he says. Vacancies remain extremely low, and it’s really a great time to be an investor in the space, he adds.
The property types most in demand have remained consistent, with warehouse/distribution facilities topping the list at 56 percent, followed by last mile facilities (48 percent) and flex industrial (35 percent). It’s no surprise that warehouse/distribution and last-mile tops the list.
Most attribute that to the Amazon effect and acceleration of e-commerce during the pandemic. “As the brick and mortar retail landscape changes, the distribution and last mile efforts will take their place,” wrote one respondent. Manufacturing ticked higher from 10 percent in 2020 to 14.6 percent in the 2021 survey, followed by R&D at 11 percent. “Changing market dynamics and new opportunities will demand flexible, low cost spaces for new ventures and R&D,” wrote another respondent.
Because of competition for industrial assets, investors are looking to alternative types of industrial product, notes Foster. For example, Avison Young’s industrial capital markets group led by Foster recently was the exclusive advisor for the sale of a transportation-focused portfolio on behalf of CenterPoint Properties.
The portfolio included 53 trans-load and truck terminals in key markets such as Chicago, Dallas, Atlanta and Philadelphia, and it was purchased by a large institutional investor for approximately $300 million. Demand for logistics real estate is spilling over to these niche sectors, such as truck terminals, as well as areas such as cold storage, he says.
Approaching a Bottom on Cap Rates?
Expectations for higher cap rates could be tied to rising interest rates.
Strong buyer demand along with rent growth have contributed to continued cap rate compression. According to RCA, industrial cap rates averaged 5.9 percent in the first quarter, which reflects a 20 basis point decline year-over-year. In addition, the RCA CPPI for the industrial sector grew at a 9.1 percent year-over-year pace in the first quarter of 2021.
“You continue to see so much demand and bidding up of prices,” says Meyer. “Where you see that the most is in the spreads between the core markets and secondary and tertiary markets. Those smaller markets have really closed the gap, and I think that is where you will continue to see compression.”
Cap rates have been moving steadily lower since the first survey in 2015 when the reported average was 7.1 percent. Survey respondents reported a further decline in cap rates in the regions they operate to 5.2 percent as compared to 5.8 percent a year ago. Respondents also view national cap rates dropping to 5.4 percent, which is lower compared to 5.9 percent a year ago.
However, most respondents believe the market has likely hit a bottom on cap rates. Half of respondents (51 percent) anticipate that cap rates will increase in the regions where they operate over the next 12 months, which is a sizable shift compared to 26 percent who held that view in the 2020 survey. One-fourth of respondents expect no change in cap rates in the coming year, while 24 percent think rates could decline further. The average increase anticipated is 18.4 basis points. Views are comparable for the outlook on national industrial cap rates with 52 percent who predict the same increase of 18.4 basis points.
Expectations for higher cap rates could be tied to rising interest rates. There has been a big shift in sentiment around the outlook for interest rates and the risk premium (i.e., the spread between the risk-free 10-year Treasury and industrial cap rate). Nearly two-thirds (65 percent) think rates are more likely to increase compared to 15 percent who held that view in the 2020 survey, while 43 percent said that the risk premium is likely to increase versus 18 percent a year ago.
“Rising interest rates could affect cap rates, but I don’t think we’re going to see it in the near term because of the demand pressure from investors, as well as the different sources of capital,” says Foster. For example, there are more foreign buyers from Asian and Europe that are targeting industrial than ever before. In addition, there continues to be cap rate compression in secondary markets and B buildings as those tenants have shown that they can make it through the pandemic successfully. “They have proved that their businesses are viable, and they are looked upon more favorably in the marketplace,” adds Foster.
Competition is especially heated for single tenant net lease industrial assets. In all, 44 percent of investors are reportedly seeing new competition pursuing net lease industrial assets. Although, competitors run the gamut from small private investors to institutions and REITs, respondents who responded that they are seeing new competitors believe that the most new competition is coming from smaller private investors (53 percent) and 1031 investors, HNWIs and family offices (49 percent).
Debt Remains Available
Respondents appear more confident on access to debt.
There continues to be good liquidity for industrial assets. Nearly half of investors say that equity is more widely available than it was a year ago, which is a jump from 37 percent who held that view a year ago. One-third say there has been no change, and only 7 percent say it is less available. Respondents also appear more confident on access to debt with 42 percent who say debt is more available compared to 31 percent a year ago. In addition, 34 percent said access to debt is unchanged, while 11 percent say it has been less accessible.
As it applies to specific financing terms, more than half of respondents believe loan-to-value (LTV) ratios (57 percent) and debt service coverage ratios (59 percent) will remain the same. However, there was a slight uptick in expectations that both could increase in the coming year as compared to the 2020 survey. Twenty eight percent now think LTVs could increase compared to 20 percent a year ago, and 34 percent said debt service coverage ratios will increase versus 21 percent a year ago.
Black Creek Group invests on behalf of retail investors and institutional investors. “Across the board, all investors are trying to allocate more of their dollars to industrial and less to other real estate asset classes,” says Fazekas. “The returns, rent collections and tail winds in the industrial space are very different than the other asset classes. So the investor base wants to be in a growing subset of the real estate sector.”
“I think there’s more runway ahead. Some developers are getting nervous that the market is so frothy,” says Mohr. However, it is important to remember that e-commerce is not only driving demand for space, but e-commerce requires about 3x the amount of warehouse space compared to traditional physical retail due to the pick and pack required for order fulfillment, he adds. That being said, industrial demand is very focused on the top 50 metros, and the coastal markets in particular are leading due to population density, he says.
When respondents were asked to rank the relative strength of their regions (on a scale of 1 to 10). The South scored the highest with a mean score of 8.2, followed by the West (7.6), East (7.7) and Midwest (7.3). Although numbers were comparable to last year’s survey, the strength of the West slipped 60 basis points from 8.2 to 7.6.