Twenty-fourteen saw so much demand for industrial property that we’re calling it the ‘sexy sector.’ Research Director Rene Circ from CoStar came by Studio One to explain the ins and outs of this unique corner of the commercial real estate market.
“On the one hand, the market couldn’t be healthier. Vacancy contracted by 60 basis points to 6.8%. Rents grew 4.7%, outpacing the office and apartment sectors by 100–150 basis points. You don’t see that every day.”
But demand numbers look ‘just okay,’ Circ pointed out, and actually ticked down about 3.0% to 159 million square feet. He stresses that’s not, however, due to a weakness in the market, but to a lack of quality space available. Scant construction in recent years has resulted in an inadequate supply, which is frustrating this sector.
What’s in the Pipeline? That’s a story of two subsectors, says Circ. Overall construction is still somewhat weak. One hundred million sq. ft. were delivered, about 80 million less than what we could have been filled. And all of that shortage is in the light industrial subsector.
Logistics saw 116 million sq. ft. of new construction, just 5-6 million short of 2005-2007 levels. That is the market that still needs a little bit of recovery, but by the end of this year construction will pick up.
Who’s Demanding Space? Last year we saw a shift from mega-warehouses toward the smaller centers. The typically strong markets are all doing very well: Atlanta, Dallas and Chicago. But the encouraging news is that smaller tenants and tertiary markets are where business is accelerating. Recovery is filtering down to local businesses like homebuilding, supply and rehab firms. This is a good indicator of strength for the overall economy.
In the Crystal Ball
“We’re looking at 2015 as a transition year,” says Circ. “We’ve had 16 consecutive quarters of improving occupancy. Costar is forecasting about 20 basis points in vacancy decline, showing up towards the end of the year. Construction will begin to slowly outpace demand, 6.5% overall, and 7.5% in the logistics market.
“We expect rent growth to slow to a little over 3.0%, still at least 100–150 basis points stronger than inflation, and as much as 3 times the long-term trend for industrial. The party isn’t exactly over, but it will slowly turn back into just work.”
On the positive side, he noted, we can expect the Pennsylvania corridor, Lehigh Valley and Harrisburg, to do quite well. A great number of containers move through there serving the big box market.
On the negative side, they’re getting concerned about Houston. Not that demand will be negative, but numbers are expected to slacken due to the development pipeline. Growth is expected to slow from 6% to as low as 1% this year.
Plenty of capital is still available, up at least 10% year over year, which places downward pressure on cap rates. Sub-4.0%s are not unusual for the most desirable areas. There aren’t all that many places for big investors to put their capital, so this isn’t expected to change.
Capital is also flowing to secondary and tertiary markets, into light industrial, not by choice as much as necessity. This market is missing at least 10% sales volume because of buildings that were never built.
Slow growth has been very healthy for the industrial market, and it’s especially desirable because the sector is under-allocated in many investors’ portfolios. That’s causing capital to continue to pour in.
The REIT Story
“Total returns for industrial REITs were a bit of a disappointment in 2014,” says Steven Marks, Managing Director of Fitch Ratings. “Only 17%, compared to 30% for all sectors, due to supply concerns earlier in the year.
Going forward, we have a positive outlook for the sector, based on the favorable fundamentals and definitely improving liquidity. We expect absorption to continue to outpace completions, and that results in good fundamentals: occupancy, leasing spreads, and NOI growth. The one risk we see is spec development, a risk for this sector in particular.
Fitch thinks there will be cap rate compression and growth in underlying cash flows and thus, values will increase.
What’s Unique to Industrial REITs?
Investors need to keep in mind that development cycles are very short in this sector since properties go up quickly. This means that using permitting trends to estimate supply is not as accurate as for other sectors. Also, some industrial REITs are more focused on development, while others take a buy-and-hold approach to bypass those development risks.
There is more tenant demand right now, with increased confidence from positive economic and consumer activity. Fitch predicts GDP growth at 3.0% in 2015 and 2016. We see an increase of manufacturing continuing, particularly in the Midwest. China will always be a competitor, but manufacturing is definitely enjoying an onshore comeback.
While Dallas and Houston are in the news, it takes a while for these macro fundamentals to affect the marketplace. We may see reduced demand for space, based on some employment pullback. Less capital deployment in Texas could begin to have a dampening effect.
The US labor market is improving, and the dollar is strong; we’re on a good trajectory and it isn’t slowing down. Even the energy situation is a big plus for the consumer and will benefit the supply chain, which is a positive for industrial. The sector is poised to perform well, as long as supply stays in check.
“I’m your most optimistic guest today. Low vacancy numbers are a good signal to us. Businesses need more space. Slow economic growth is a good thing, and there is relatively little space for the next deal.
“Companies are re-orienting their supply chains, foreign companies are coming in: industrial space is in demand in all classes and regions. With this continuing pressure the only way to keep up is to build new buildings. The downturn has made us wiser, and the market is clearly calling for new product.
“We see demand and spec development in all major markets: LA, Chicago, Dallas, Atlanta are strong and improving. Confidence is improving among the builders and the lenders. And, I’m optimistic about more inland markets as well. We’ve been building in Greenville/Spartanburg, SC, and we’ve filled every project before it was completed. Now some of those tenants want to expand.
“We’re coming out of an extended period when we were badly under-supplied, driven by an oversupply of caution leftover from the downturn. But now capital is available for expansion, for both builders and tenants.”
What Tenants Need to Know
For a long time so much space available that tenants had a buyers’ market. Now that’s changed: fewer concessions, more limited termination options, and increasing rents. In fact, in many markets, rents are now at or above pre-recession levels.
The cost of construction is the one thing that didn’t go down during recession. One reason for the current lack of supply is that prevailing rents couldn’t justify new building. Real recovery means that rents will have to cover development costs.
When you’re shopping for space, start early, it takes longer than you think! Too often we meet a potential customer and they want something in 3 months that will take 7-10 months. Companies tend to expect that the space they want will be there. But with vacancies where they are today, that’s often not possible.
Get good advice; hire a good firm with people you can trust. Bet on communities that give you a clear signal that they want you. Be confident, and get moving to lock in a lease now, since rental rates are heading up.
Advice for Owners & Investors
There is tremendous demand for first class industrial property, and it’s been red-hot for a while; there is a lot of capital searching for that steady return. Current owners: if you are thinking about selling, now is the time.
Investment companies, insurance companies are all trying to allocate more of their portfolios into industrial, and driving demand for trophy properties. As a result demand is spreading out to other markets, and less ideal properties.
If you are searching for opportunities look to the smaller and inland markets, and properties that aren’t as sexy. Holders and developers are reallocating resources, liquidating assets. The REITs in particular are refocusing their portfolios, and may be liquidating just what you need.
It’s a sellers market for leased industrial property. If you’re a business that owns real estate, consider selling and taking a lease back. It’s a great way to raise capital for your business while controlling the property long term.
Choose your partner and get out on the dance floor, the industrial sector is hot.