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Record Demand Brings New Heights and Challenges to Industrial Real Estate Market

The continued growth of e-commerce, promised infrastructure upgrades, and new and creative development are some of the trends affecting the industrial real estate market.

Q1 2017
For U.S. industrial real estate, 2016 is best defined with one word: demand. Record leasing activity for warehouse and distribution space exceeded 260 million square feet as companies recognized the need to advance and perfect supply chains to reach customers more efficiently and cost-effectively.

While demand still outweighs supply, the industrial sector will be defined by much more in 2017. The current political climate raises many uncertainties. Questions loom regarding trade policies and regulations, and how they will impact global supply chains. That said, domestic infrastructure investment is imperative and when combined with low interest rates and a booming e-commerce industry, the sector should experience another strong year.

There are a number of factors we believe will push industrial and logistics real estate in the coming year:

Infrastructure investments will revive the Rust Belt and U.S. ports system.
A simple eyeball test determines that many U.S. cities are home to rather functionally obsolete roads and bridges, and continued urbanization and the movement of goods and materials cannot occur without upgrades to vital infrastructure. Historically there has been heavy resistance to fund unglamorous modernization projects, but President Trump’s proposed $1 trillion investment over the next decade is a good starting point. In fact, U.S. infrastructure was given a grade of D+ on the American Society of Civil Engineers’ recent quadrennial report card. (The next report card is due out in March, 2017.) Needless to say, upgrades are a necessity to support logistics in the United States.
Along with new developments, reconverted assets are becoming viable options as companies are all but squeezed out of main markets.
As upgrades come to fruition, raw materials will be required, as will warehouses to contain them. Investing in the Rust Belt’s infrastructure would mean reviving dozens of waterway terminals along the Mississippi River, which once served America’s manufacturing-based economy.

Following 29 consecutive quarters of declining national vacancy rates, reviving these ports would drive industrial real estate demand even higher in cities along the Mississippi waterway such as St. Louis and Kansas City. Off the waterway, Tampa Bay, Charlotte, and Richmond also stand to benefit, as high entry barriers in primary markets are forcing occupiers to look elsewhere.

Coastal ports in Los Angeles and New York/New Jersey have long been the star performers of the industrial sector. However, the revival of Rust Belt infrastructure and the overdue repurposing of obsolete terminals point to 2017 marking the year the Mississippi waterway reclaims its former global supply chain glory. Demand for industrial real estate in the region will follow.

While the Trump administration’s stated commitment to infrastructure investment may aid some of the continued demand, state budget crises indicate that private capital will be needed now more than ever. Institutional investors are well suited for infrastructure investments, and tax law and regulatory changes could open the door for more public-private partnerships (P3s) in the sector.

Under a P3, a government contracts with a private company to design, finance, construct, operate, and maintain an infrastructure asset on behalf of the public sector. Such partnerships have been successful in foreign markets. For instance, London’s major airports are privately owned and operated, while privately managed highways are common in Canada and Europe. Domestically, P3s are much less common to date. With regulatory changes, however, P3s could answer the call and bring forth even more infrastructure investment while benefiting both the private and public sectors.
Investing in the Rust Belt’s infrastructure would mean reviving dozens of waterway terminals along the Mississippi River, which once served America’s manufacturing-based economy.
The e-commerce and urban logistics evolution is far from the finish line.
According to eMarketer, e-commerce represented 8.7 percent of total retail sales globally in 2016.2 E-commerce projects to represent a full 10 percent of retail sales this year, and is only expected to rise for the foreseeable future. This trend is fueled by both the ease of online shopping and escalating consumer demand for rapid delivery, which are changing what, where, and how many distribution centers are needed.

As seen in the second half of 2016, the industrial market’s shrinking vacancy rate reached a 16-year low of 5.6 percent thanks to the growth of e-commerce and industrial occupiers expanding their footprints into new U.S. locations. As e-commerce and “last-mile” demands become even stronger, we expect that rate to drop even lower in 2017.

With companies expanding and restructuring their national distribution networks to improve “last-mile” efforts, it’s no surprise that 30.5 percent of Q4 2016 lease transactions over 30,000 square feet were signed by tenants new to a market. And e-commerce isn’t alone in lease activity; traditional retail and consumer durables companies are shoring up their distribution networks as well. Faced with a lack of available “large-block” space, both e-commerce and traditional retail tenants are being forced to consider new construction. All told, they were responsible for nearly 18 percent of total U.S. leasing for 2016. Meanwhile, “mega-box” and “big-box” spaces are in high demand, including five leases of at least one million square feet in the final quarter of 2016.
Industrial development activity continues nationwide as tenant expansions into new markets and tightening market conditions justify new construction.
With a promising end to last year, 2017 could bring even more impressive numbers. There is still 194 million square feet under construction, putting pressure on rental rates as new supply options become available. At such a low vacancy rate, this is good news for tenants, but also comes with caution for investors that continue to monitor pre-leasing rates of speculative construction. And despite global financial and political uncertainties, institutional investors continue to view industrial real estate favorably. Last year, industrial investment sale volumes surpassed $46 billion.

Construction continues to increase and new development outpaces previous highs.
Industrial development activity continues nationwide as tenant expansions into new markets and tightening market conditions justify new construction. Compared to a year ago, overall new deliveries in Q4 2016 increased by 26.6 percent. Year-over-year total space under construction rose by 11.2 percent, with 70.7 percent of the nearly 200 million square feet of projects being built speculatively. Construction is occurring in nearly every U.S. market, affirming landlord confidence and national industrial expansion.

New construction and leasing boosted net absorption gains, with newer spaces trending among occupiers, especially where quality options are limited. At year’s end, the rate of total net absorption was 2.1 percent of total inventory, up 11 percent from 2015. Big and small markets alike demonstrated the highest levels of absorption in 2016, including Dallas, the Inland Empire, Reno, Columbus, and Memphis. Looking ahead, we anticipate that strong consumer spending levels will lead to further expansions and warehouse demand in 2017.

Creative industrial real estate development is catching on.
As demand rises for industrial real estate, creative real estate alternatives will become a solution for some companies. The combination of unprecedented demand and a strong push for ‘last-mile’ delivery services is ushering new development in secondary and tertiary markets throughout the country.

Along with new developments, reconverted assets are becoming viable options as companies are all but squeezed out of main markets. Other “last-mile” solutions that should gain popularity in 2017 include smaller urban core warehouses and multi-story warehouses, a trend already utilized in land-constrained Asian markets like Tokyo and Singapore. This year could bring more multistory developments to U.S. cities facing similar dilemmas, such as Seattle or Los Angeles.

Following a bumper year for industrial real estate in 2016, we are positive for the sector this year. While it remains to be seen how much investment in infrastructure is accomplished, the stars are aligned for positive market conditions with more options for tenants and positive rental income for landlords.
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