Since the mid-1990s, the North American industrial market has experienced a record-setting run. As supply chains have become interconnected and the need for additional warehouse inventory has increased, we’ve registered some of the strongest leasing tallies and tightest market conditions on record. And while we’re forecasting another strong few years in the sector, trade policy is among the greatest risks to the industrial outlook.
The deadline to finalize a renegotiated NAFTA treaty is looming, and there have been mass amounts of speculation on how a revamped NAFTA, or non-existent NAFTA, might impact certain sectors of the economy. From a commercial real estate perspective, the politics and policymaking that comes out of these negotiations will be key determinants in how the North American industrial market performs.
First, a History Lesson
Those who follow CRE know that NAFTA has had a profound effect on the North American industrial market. Since the treaty took effect in 1994, the amount of truck traffic flowing between the U.S., Canada, and Mexico has increased dramatically, with annual loaded truck containers bound for the U.S. from its northern and southern neighbors increasing 184.1 percent.
As cross-border trade, traffic, and foreign direct investment flows have increased, so too has the need for additional warehouse inventory. Since 1994, North American warehouse stock has grown by over five billion square feet, with U.S. warehouse inventory growing by more than 3.5 billion square feet. This growth is one of the top reasons the industrial sector stands out in the commercial real estate market.
Under NAFTA, supply chains across North America have largely become supranational, allowing tariff-free trade flows between the U.S., Canada, and Mexico. In 2016, over three-fourths of exports from Canada and Mexico were destined for the U.S., and more than half of those countries’ imports came from the U.S. Although U.S. trade is more diversified than its neighbors, with its largest trading partners accounting for no more than approximately 20 percent of imports or exports, concentrated exposure to specific industries ties the U.S. economy to its NAFTA partners.
Still, the nature of our current production system extends beyond our neighbors to the north and south. A large portion of U.S. trade with the world, but especially with Mexico, is part of an interconnected global supply chain, where a product is produced in one country, then shipped to another country, and so on, until production is completed.
Think of automobile assembly as a way to envision this fragmented nature of production. For example, Ford and General Motors use regional supply chains which move semi-finished products across NAFTA borders multiple times before the final product rolls off the factory floor. This helps keep overall production costs low and allows automakers to compete globally by lowering the cost of their products abroad. So, while your Ford might come from Detroit, it’s parts are likely from Mexico.
This cost-effective strategy doesn’t hurt the U.S. financially. In fact, it’s contributing to a healthy economy. Lower production costs mean lower consumer prices, and that means more money in consumers’ pockets to purchase other goods that also generate demand for industrial space. If changes in trade policy were to make it costlier to access intermediate inputs, the disruption would cascade through regional supply chains, thus affecting demand for commercial real estate.
Back to the Present
The NAFTA negotiation process makes headlines every day, and the buzz won’t end any time soon. While progress is reported to have been made on topics such as digital trade and food safety standards, among the remaining sticking points is a U.S. proposal for a “sunset” clause that would automatically terminate the agreement after five years unless all parties expressly agree to keep it. The impact from such a clause on commercial real estate is unclear, but even the prospect of automatic withdrawal would likely hinder manufacturing-related investments, as manufacturers have a much longer time frame in mind when making such investments.
Under NAFTA, supply chains across North America have largely become supranational, allowing tariff-free trade flows between the U.S., Canada, and Mexico.
Even if you haven’t been keeping a close eye on NAFTA negotiations, it’s unlikely you’ve missed the rhetoric about bringing auto jobs back home. By far, the most controversial issue is the U.S. attempt to cut its auto-related deficit with Mexico by shifting auto production back to the United States. This proposal would add a clause that requires half of an auto’s content to be made in the U.S.
To receive duty-free treatment under NAFTA as it stands today, 62.5 percent of an auto must contain North American content. To put that number in perspective, it is the highest content requirement of any trade agreement in the world. The U.S. proposal would raise that requirement to 85 percent, with the added stipulation that 50 percent be U.S. content. While it’s highly unlikely that Canada and Mexico would ever agree to such provisions, it’s also not certain that higher content requirements would decrease the U.S. trade deficit either. What is certain is that this clause would send disruptions through the auto industry, which has one of the most heavily integrated supply chains of any industry.
Though the automotive sector tends to dominate attention, changes to NAFTA would make an impact on several North American industries, including agricultural trade. You may remember the headlines that came out last fall after news broke that the price of avocados would spike under a new NAFTA.
A World Without NAFTA?
In the absence of NAFTA, we are looking at two scenarios. Some production in Mexico would likely fall in favor of manufacturing in the U.S. or Canada. However, it is possible that many of the parts and components now crossing borders would continue to cross without the benefit of duty-free treatment, but also without the burden of proving rules of origin and at a higher cost to consumers.
Much of the production in Mexico, for example, is focused on lower-margin passenger cars, like the Ford Fusion or Chevy Cruze. It would be much less cost-effective to produce these vehicles in the U.S. or Canada. In some cases, companies could decide it is better to absorb higher tariffs than to absorb higher production costs by relocating manufacturing activities to the United States. In those instances, changes in commercial real estate demand would be minimal, although production of low-margin items in Mexico would be scaled back or eliminated entirely. The demise of the agreement might also drive U.S. automakers to source components from Asia instead of Mexico in order to pay a lower tariff. In either case, increased demand for commercial real estate is not likely to occur. In fact, demand for industrial real estate could suffer if firms chose to source product from outside of North America.
Though the automotive sector tends to dominate attention, changes to NAFTA would make an impact on several North American industries, including agricultural trade.
In addition to impacting the flow of goods, trade policy can affect the flow of people. Restrictions in the flow of workers would make an already tight labor market even tighter. The NAFTA professional visa program is the largest work visa program in the U.S., representing more than one third of its 2.3 million foreign-born workers and trainees. We rely on foreign-born workers to fill jobs as engineers, truck drivers, construction workers, and more. Considering labor shortages are becoming more prevalent — especially in the construction sector in the southern U.S. — policy changes could make the business of filling jobs much more difficult.
Best Guess
Here’s the truth: the fate of NAFTA, and any resulting shifts in commercial real estate demand, will take time to unfold. Trade negotiations of any kind, particularly those that are this influential, are seldom quickly accomplished. Even when an agreement is reached, it can take months or even years for the changes to take effect. For context, Canada has proposed a timeline of roughly two years for renegotiations, which reflects past negotiations. The original NAFTA negotiations took 20 months and another 13 months after signing before implementation.
And don’t count on the U.S. to speed things up. Over the past decade, U.S. free-trade agreements have taken even longer to negotiate and implement; on average, taking 27 months for negotiations and 58 months for implementation. So, the best bet is that uncertainty surrounding trade policy will last for quite a while.
Predicting with certainty what changes to commercial real estate after NAFTA would occur is difficult because it is impossible to know what tariff regime would replace it. It’s also difficult to quantify the impact of uncertainty on business investment and the broader spillover effects into non-trading industries. Because tariffs are a tax on trade flows and not on net production, even incremental increases could have a disproportionate impact on industries that trade extensively across the border. The dismantling of NAFTA would likely cause financial-market volatility, negatively affecting near-term business confidence, hiring, and investment — and, therefore, economic growth and demand for commercial real estate.
The take away? Negotiators seem far from reaching consensus on any of these issues in the next few months, and as a result, trade policy will remain the greatest risk to the North American industrial outlook.
Trade Policy Creates Risk for North American Industrial Outlook
The industrial forecast is strong. Will a revamped NAFTA change that?
Q1 2018
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