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December 27, 2018

Industrial Solidifies Position as Darling Asset Class in 2018

The industrial property sector has never been known as a dynamic, sexy asset class. To be sure, the property category was more likely recognized as a steady performer for investors seeking a low risk profile. That perception has changed over the past couple of years and the reality is industrial real estate has become the darling property type.

There are a number of factors driving this industrial boom ranging from a strong economy, and job growth to solid market fundamentals and online shopping trends. Perhaps the main driver of the trend is e-commerce, though. As consumers have shifted the way they buy goods online, and their expectation to have those items arrive at their home quickly, it has resulted in massive chunks of industrial space being needed for fulfillment and distribution centers near population centers. The follow-on strategy of “last-mile” facilities in urban infill locations has continued to support the sector’s growth.

That demand has investors chasing deals and developers building just about as fast as they can. In some cases, office space is being torn down for new modern and efficient industrial facilities close to the densest consumption clusters.

Kidder Mathews’ Rick Putnam says what he sees driving investor interest and demand in the industrial sector are a few things. First, institutional investors have become major players. As a result of pension funds changing their allocations to real estate from five percent to 12 to 15 percent their appetite for all classes of commercial real estate is growing and that will have a significant impact on the industrial sector.

The capital reallocations follow studies that show over the last fifteen years multifamily and industrial have been the most efficient of all asset classes, notes Putnam. He says that’s because of the distributed cash flows to revenue have been the highest.

“The net lease structure, rollover costs, build-out or lower lease commission payouts for industrial properties are the least compared to other products out there,” says Putnam.

Set against that lower cost backdrop, the industrial sector has had to rejigger to accommodate an e-commerce surge that’s experiencing an ongoing 8 to 15 percent per-year growth. In short Putnam says, “that’s creating a rush for land.”

A developer may even consider tearing down an older obsolete property because of the land value. Putnam says an example might be an office that occupies a five-acre piece of ground. If an owner has to invest higher rollover costs for that asset versus a lower cost industrial asset next door that generates $1 net rent, and is less capital expensive, he says, that’s a recipe for a far more valuable piece of industrial land compared to office.

Once those new efficiencies get factored in against the high demand on West Coast by e-commerce users, it is easy to see why industrial has emerged as a darling asset class. Putnam says, “e-commerce demand is probably 20 to 30 percent of the demand in a market. And it is coming from users like Amazon or Walmart or other retailers who are building out networks to serve customers or needs to augment its sales strategy with an e-commerce component and seeks a new location or wants to add a closer infill location.

A popular narrative among industrial REIT CEO’s today is that industrial square footage is supplanting showroom footage for retail consumers, notes Putnam. He says, consumers simply want delivery of goods. They go to a mall for an experience, entertainment or to gather with friends, but commodity purchases are done over the web now, and owners are converting to a warehouse facility strategy for quicker deliveries.

“It is the perfect storm for industrial sector and office and retail has suffered,” says Putnam. “Assets with personality such as TOD, 24/7 CBD, or garden properties on the water may not, but “dad’s” office in suburban locations with large floorplates where you have to drive to, are out of favor.”

As a result, from pricing perspective a Class A industrial property in a favored market is like a treasury bond index, notes Putnam. He points out, the spread to invest in more office assets in suburban markets can result in an increase of 200 to 400 additional basis points by taking the risk on office. “A suburban office deal in tertiary Southern California market might do 7.5% to 8% cap, while the same industrial asset will trade for 4.5% to 5% cap rate. That’s the widest spread it's ever been,” says Putnam.

The impact of population, employment and e-commerce growth, which have served as key drivers of the industrial development and investment market, are not expected to soon abate. That translates to the industrial sector’s future prospects remaining bright.

Market Snapshots

West Coast Snapshot

Industrial’s strong run continues into the first half of 2018 as the ecommerce industry expands into uncharted territories. Some perceive this asset type as cycle-proof due to a fundamental change in the way Americans consume products, which has driven construction higher than for all other property types. Leasing has kept up with supply, though much of the product delivered prior to 2016 was built-to-suit. In turn, rents have grown vigorously since the first quarter of 2015.

Inland Empire Snapshot

Kidder Mathews’ David Burback notes the statistics on the Inland Empire market make it nearly impossible not to be bullish about it. “It truly has exceeded expectations. Both investment and development have exceeded expectations the past three years.” Over the coming year, Burback predicts rental growth will land in the neighborhood of 6% to 6%, though he points out “we did 13% year-over-year, that’s a good market.”

He believes the market will remain positive for the coming year to 18 months, as there is a “good balance” between supply and demand. It has been an “unprecedented ride” the last three to four years with rental rates, building and land values, he says. “We may have jumped a shark and are now catching our breath, but I don’t think the market retreats until 2Q 2019, when it may start to level out.”

Los Angeles Snapshot

Record-low vacancies and soaring rents continue to bestride the Los Angeles Industrial market. With the fundamentals of the industrial market remaining strong, the sector is performing at the highest levels. Despite the lack of product to transact, at 8.3 million square feet this quarter, leasing activity is stable and healthy, setting the stage for gains later in the year. Although direct occupancy gains declined this quarter, the vacancy rate stands at a mere 2.3% in the second quarter - up 42 basis points (bps) year-over-year.

San Diego Snapshot

The San Diego industrial real estate market continued to thrive with support by groundbreaking work in the biotech and life science industries, as well as expansion within the defense industry, which adds yet a further layer of demand for the already vastly lucrative market. Record breaking metrics across the board this year have indicated the consistent demand in the market. Overall employment growth continues to flourish, as the San Diego County unemployment rate dips almost 100 basis points to 3.4%, below the year-ago estimate of 4.3%.

Silicon Valley Snapshot

The Silicon Valley industrial and warehouse markets had a relatively quiet third quarter, but maintained low levels of vacancy and high rental rates that have become normal for this active market. Net absorption of industrial and warehouse properties was down slightly for a second consecutive quarter, finishing the third quarter down 103,509 square feet and 91,249 square feet respectively. Despite the slight dip in net absorption, vacancy rates remain at historic lows, and average asking rates for industrial and warehouse space remains at or near historic highs on a per-square-foot basis.

Seattle Snapshot

After the starting the year slowly, the Puget Sound region’s industrial market returned to a strong performance over the last two quarters. Nearly two million square feet was absorbed in the third quarter, bringing the year to date absorption to 2.7 million square feet. Despite strong leasing activity, nearly 2.7 million square feet of new product was delivered in the quarter resulting in a slight upward bump in the vacancy rate to 3.5% compared to 3.3% from the prior quarter. Regardless, a 3.5% vacancy indicates a very tight market region wide.

Portland Snapshot

Q3 was another outstanding quarter for the Portland industrial market. All the primary indicators of market health and vitality were fundamentally strong. Market-wide direct vacancies, for instance, dropped 30 basis points from last quarter, reaching 3.3 percent; while rental rates climbed to an average of $0.65NNN per-square-foot, the highest on record. Meanwhile, leasing activity, both for the quarter and year to date, was extremely strong, exceeding 1.8 million square feet for the quarter and 6.3 million square feet for the year. Moreover, both developers and investors remain bullish about the near-term prospects of the Portland industrial market, with roughly 3.9 million square feet under construction at quarter’s end, and cap rates on investment sales in the range of 6-6.5%.

Phoenix Snapshot

The Phoenix industrial real estate market remained steadfast and unwavering during the third quarter, producing strong activity yet again and reflecting the consistent demand this industrial market has shown cycle after cycle. Leasing activity continues to be strong and the volume of sales transactions more than doubled compared to this time last year. Furthermore, the development pipeline has hit a post-recession record high with approximately 6.9 million square feet currently under construction, a level the market hasn’t experienced since 2007. With relatively few barriers to development and positive economic and demographic trends, Phoenix has emerged as one of the fastest growing industrial markets in the nation and is expected to finish the year out strong.

Sources: CoStar & Kidder Mathews Research

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