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Can Industrial Performance Persist?

The commercial real estate industry’s industrial sector has separated itself from the performance of all other sectors over recent years. As shown in Figure 1, warehouse total returns have outperformed total NCREIF Property Index (NPI) returns each year since 2011. Furthermore, since 2016, the industrial sector’s total returns dramatically exceeded that of all other sectors, maintaining double-digit returns each calendar year. This is due to a change in pricing and strong fundamental performance.

Rent growth in the industrial sector has averaged roughly 4.9% annually since 2012, outpacing rent growth in other asset classes by an average of 2.8%, according to CBRE. The industrial sectors’ fundamental performance has been strong, and its resiliency throughout the pandemic is undeniable. It could be argued that the pandemic has been beneficial to the sector.

Another component of the industrial sector’s recent success is high net occupancy. “This segment has remained resilient throughout the pandemic, with the logistics segment on track to surpass the net occupancy growth of 2019,” according to Jason Tolliver, Global Head of Logistics and Industrial Research at Cushman & Wakefield. The lease-up time for new warehouse space has decreased significantly, putting pressure on retail distributors to enter the market aggressively. As soon as new warehouse space hits the market, retailers and logistics companies are moving in to secure more space for their business, increasing net occupancy. The combination of rapidly leasing highly occupied property at growing rents leads to a sector with dramatic income growth. All else being equal, income growth leads to rising values.

In addition to rising income from the strong fundamental conditions, industrial warehouse pricing has strengthened over the past ten years. It is true that required yields, or cap rates, have decreased for all sectors. The industrial cap rate has decreased at a faster rate than that of the other sectors. Pricing has driven industrial values higher over the past several years. Combining growing income with declining cap rates yields the compound value growth witnessed in the industrial sector. This explains the double-digit returns and the relative performance shown in Figure 1.

Figure 1 — Source: National Council of Real Estate Investment Fiduciaries

Figure 2 — Source: ConstructConnect

Warehouse construction has attempted to respond to the sector’s strong performance. To keep up with high occupancy and demand growth, the pace of warehouse construction increased. According to ConstructConnect’s Spring 2021 Construction Starts Forecast Report, “warehouse building, in particular, was boosted by investment in logistics capabilities as customers moved en-masse towards online shopping.” Figure 2 highlights the increase in both warehouse construction starts and completions since 2016.

Because of the pandemic, developers had to contend with delays and stay-at-home orders cutting off the supply of contractors able to do the work. Despite this, Figure 2 shows that starts and completions continued to rise. Going forward, the industry will likely see further increases in warehouse construction starts and completions to allow the supply of warehouse space to catch up with the demand. Projects started in late 2020 will be completed and projects delayed through the entirety of the pandemic will have the opportunity to hit the ground running.

The industrial sector has been a popular and well-performing asset class recently, especially throughout the pandemic. But why? The simple answer would be e-commerce. The rise of e-commerce has been a prominent trend over the past couple of years. The pandemic has only accelerated the trend into 2021. E-commerce dramatically shifts the demand for warehouse space as consumers transition from brick-and-mortar to online shopping. According to CBRE, “an additional 400 million square feet [of warehouse space] will be needed over the next five years simply to process returns,” and “for every $1 billion in additional e-commerce sales, retailers required 1 million square feet of warehouse space.” The demand for warehouse space will continue to drive the price per square foot of such assets up. However, why does e-commerce demand more warehouse space than typical brick-and-mortar retail sales?

Warehouse building, in particular, was boosted by investment in logistics capabilities as customers moved en-masse towards online shopping.

Shifting retail sales to an e-commerce platform has a substantial effect on the amount of warehouse space needed to process, package, and ship online orders for customers. Online sales distributors command more warehouse space compared to brick-and-mortar retailers for a variety of reasons, according to CBRE. To start, brick-and-mortar retailers typically keep a portion of their inventory in the physical stores. On the contrary, e-commerce distributors keep 100% of their inventory in warehouses, which, according to Prologis, “allows for greater product variety, deeper inventory levels, space-intensive parcel shipping operations, and additional value-add activities such as processing returns.” Secondly, there are generally more return orders for online sales than there are for brick-and-mortar sales. The returned stock must be re-stored in warehouses, again increasing the need for more space. Lastly, online sales inventory is often packaged individually, meaning each item requires safety stock. This differs from brick-and-mortar sales inventory, which can be packaged in groups with each group having a specified amount of safety stock. Having more safety stock stored in warehouses creates the need for more warehouse space. These differences in inventory storage practices between brick-and-mortar and online retail distribution highlight the main reasons why e-commerce generates more demand for larger warehouses as the trend continues into the foreseeable future.

Industrial property has been a hot asset class for the past several years due to rent growth, increased demand, and net occupancy growth. Developers have been chasing demand growth by constructing more warehouse space to increase the supply coming out of the pandemic. To date, this supply has not exceeded or matched demand. A prominent factor in changing warehouse demand is e-commerce, which has shifted the way the industry thinks when compared to brick-and-mortar retail. E-commerce demands more space to store, package, and ship goods to customers justifying the claim that e-commerce has changed the sector and driven recent performance.

These trends show no signs of slowing down. However, how long will the trend last? The comparison between income and capital returns for the warehouse industry, as shown in Figure 3, demonstrates how dramatically the sector’s performance has changed. From 1980 to 2004, warehouse investors earned higher returns on their income than they did from capital appreciation. During that period, the industrial sector was viewed in a drastically different light than it is today. Investors were much more intrigued with the retail and office sectors, two appealing asset classes at the time. After the recession in 2009, the story changed for industrial investors. Capital appreciation recovered quickly and surpassed income returns, reflecting investors’ confidence in the future of the sector. Since 2013, the rise of e-commerce boosted demand leading to significant capital appreciation. The industrial sector has lived up to recent expectations set by the market, and it continues to deliver. Nonetheless, if at any point the sector does not deliver the expected level of appreciation, it could return to its traditional market position. In that case, yields will rise, and asset values will adjust.

Figure 3 — Source: National Council of Real Estate Investment Fiduciaries