As COVID-19 disruptions ripple through the real estate market, one particular sector that has remained relatively unscathed is industrial, driven by continued demand for the warehouses and distribution centers that handle the storage, sorting, re-packaging, and distribution of e-commerce products and other goods.
Going into the pandemic, industrial real estate was already on a tear, outperforming all other property types over the past 20 years. The pandemic has only proven the sector’s continued resilience. Q2 2020 net absorption was a positive 19.2 million square feet, marking industrial real estate’s 41st consecutive quarter of positive net absorption. Most recently, August 2020 leasing activity outpaced the monthly average of the past five years by 13% as companies likely adjusted to the ongoing shift to online shopping.
E-Commerce Tailwinds, Accelerated
The key driver of industrial’s outperformance is the dramatic expansion of e-commerce and the additional demand it creates for the specialized facilities required to handle e-commerce orders.
The retail landscape has been changing for years, driven in part by demographic shifts, which give rise to changes in consumer preferences. Millennials have just passed baby boomers as the largest U.S. population group, and 65% of millennials in a 2019 survey said they preferred to make purchases online rather than in-store. Notably, millennials have yet to reach their peak income age, providing continued tailwinds to e-commerce growth in years to come, both in terms of e-commerce penetration and dollars spent.
When the pandemic hit the U.S. in March, this steady shift in consumer habits snowballed as lockdown orders forced retail stores to close, sending consumers online for almost everything. In Q2 2020, e-commerce sales surged 32%, while department store sales dropped by 15%.
Traditional retailers are increasingly aware that they need to evolve. Walmart, second only to Amazon in e-commerce sales, saw second quarter online sales grow 97% year-over-year. And as retailers transform, they are requiring more industrial space to house and handle goods outside of their traditional facilities. To more quickly reach customers in urban markets, some retailers are also either expanding their own last-mile logistics facilities or outsourcing to third parties.
E-commerce retailers, along with the logistics operators who support them, are working to meet the expectations of consumers who seek more product options, a seamless user experience, and faster delivery, all at low cost. Importantly, efforts to fulfil same-day delivery have contributed to an expansion of real estate needs from solely locations close to major transportation hubs to include in-fill sites nearer to population centers. Finally, additional warehouse space is needed to handle exchanges and returns, which require up to 20% more space than traditional outbound goods.
With e-commerce likely growing over time, the industrial real estate sector should continue to benefit from the shifting retail landscape. The trend towards more efficient distribution capability is a logical outcome as retailers race to get to the consumer faster and at lower cost. Despite the healthy demand, there is a shortage of state-of-the-art space sought after by today’s e-commerce tenants - modern e-commerce facilities generally require at least 28’ clear heights, to maximize the volume of goods that can be stacked and held before being re-sorted, repackaged, and distributed to the next destination. And the clear heights keep rising higher, with some mega distribution centers boasting 36’+.
Despite the strong outlook for demand, since the onset of the pandemic, speculative development of space has fallen, evidenced by the 37% decline in construction starts in Q2 2020 relative to Q4 2019. This moderation in the growth in supply should contribute further to maintaining healthy supply-demand fundamentals that favor landlords.
Cadre’s Approach to Industrial Investing
Given the attractiveness of this sector, it should be no surprise that there is substantial demand - and competition - among institutional investors to acquire existing industrial properties. This dynamic is reflected in the pricing of industrial REITs, which implies a 17% premium to private market pricing, compared to a 14% discount for multifamily and a 23% discount for office.
Before COVID-19 interrupted deal making, transaction activity had been growing steadily, with $89 billion in industrial deals in 2019, up from 2018’s $74 billion and 2017’s $56 billion. This increased investor demand, coupled with relatively limited product available for sale, has caused pricing on industrial properties to become very competitive, making it harder to generate value-add returns by buying existing stabilized industrial properties.
In contrast, the development of distribution space offers an attractive approach for participating in the sector and generating value-add returns. Specifically, the strategy involves building high-quality, state-of-the-art distribution centers targeted at e-commerce tenants and then selling to institutional buyers once lease-up of the space is completed. To mitigate risks associated with the development process, priority would be given to projects that are close to breaking ground (i.e. shovel-ready) and have minimal pre-development work remaining. Compared to other property types, the actual construction of industrial properties is relatively straightforward. Industrial warehouses are essentially large rectangular boxes that are erected using comparatively simple construction techniques.
As is always the case with real estate investing, market selection is critical. For industrial warehouses, markets with abundant affordable labor and good access to multimodal transportation - highways, airports, railways, and ports - offer the greatest promise. Proximity to end customers, stores, and businesses is equally important, as delivery speed is a key differentiator in today’s rapidly changing logistics environment. While local warehouses may only need to be located near highways, major distribution centers need to have easy access to a combination of transportation hubs, depending on the type of goods that flow through. Likewise, last-mile fulfilment centers, true to their name, need to be located near the customer, usually in urban infill locations or nearby suburbs.
Taking these factors into account, markets such as the Inland Empire, Dallas, Houston, Phoenix, and Atlanta, all of which are included in the Cadre 15, contain attractive submarkets for industrial investment. These markets have been among the top markets for tenant absorption and are likely to continue to outperform.
With e-commerce-driven demand for distribution space showing little sign of abating, the industrial sector is likely to enjoy strong performance. The trend towards ever more efficient distribution of goods should persist as merchants seek to meet the demand for cheaper and faster delivery. With the prospective demand for space likely to remain strong, building state-of-the-art space to satisfy this burgeoning demand is an attractive strategy for participating in the sector. Minimizing entitlement risk and pre-development exposure while targeting a return on cost at least 125 basis points greater than market cap rates, are key to successfully executing the strategy. Moreover, with e-commerce tailwinds persisting, and with more institutional investors moving into the space, there is potential for further compression in underlying cap rates, which would further amplify returns for investors.
NCREIF, March 2020 ↩︎
CBRE: Q2 2020 U.S. Industrial & Logistics Figures, August 2020 ↩︎
eMarketer: “More Millennials Buy Online,” April 2019 ↩︎
CoStar: Struggling Retailers are Shedding Industrial Space for Quick Cash, September 2020 ↩︎
Modern Retail: Walmart’s focus shifts to retention as e-commerce sales grow 97%, August 2020 ↩︎
Cushman & Wakefield: “Industrial - The Recession-Proof Asset Class?” September 2020 ↩︎
CBRE: Reverse Logistics, December 2018 ↩︎
CoStar: As of September 2020 ↩︎
Cushman & Wakefield: Industrial - The Recession-Proof Asset Class? September 2020 ↩︎
GreenStreet: US Commercial Property Outlook Webinar: “The Winners & Losers in the COVID Pandemic,” September 2020 ↩︎
CoStar: Warehouse Demand Surges as More Consumers Seek Home Delivery, September 2020 ↩︎
The Cadre 15 is a list of metropolitan statistical areas periodically identified by Cadre as commercial real estate markets with strong potential for risk-adjusted returns. The Cadre 15 is developed through a combination of quantitative and qualitative analysis, including predictive analytics and on-the-ground intel. Quantitative analysis involves forecasting two-year growth projections for each market and asset class based on variables known to drive market appreciation, including but not limited to population growth, employment, rent growth, new construction, and occupancy. Qualitative analysis involves a review of quantitative data by our industry experts. There is no guarantee that an investment in a Cadre 15 market will be successful. ↩︎
CBRE: Q2 2020 U.S. Industrial & Logistics Figures, August 2020; Cushman & Wakefield: Industrial - The Recession-Proof Asset Class? September 2020 ↩︎
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