“Pre-pandemic, industrial was operating on all cylinders. Enter the pandemic, and industrial fired up another engine,” says Jimmy Ullrich, a director at Stan Johnson Company. It’s hard to find a better way to express the industrial activity over the last year. The market for warehouse, distribution and logistics facilities was already red-hot, but the pandemic managed to turn up the heat.
Ecommerce demand has been the catalyst for increased industrial activity during the pandemic. Many people turned to online shopping and food delivery during stay-at-home orders last year, and the activity has spilled into 2021. The Adobe Digital Economy Index estimates that Americans will spend between $850 billion and $930 billion online this year, and next year, the number will hit $1 trillion. In the first quarter alone, online spending totaled $199 billion, up 39% year-over-year, and March was the highest month on record with $78 billion in sales. “The increase in all types of e-commerce has compressed five years of anticipated supply chain evolutions into 18 tumultuous months,” CJ Follini, managing partner at Noyack Capital Partners, says.
The activity has sent the industrial real estate market into overdrive, but it has also put pressure on an already tight industrial supply. Before the pandemic, most major industrial hubs were operating at record low vacancy rates, and now vacancy rates have compressed even further. “The rubber band snapped exponentially in response to the pandemic, creating an acceleration of cultural trends—and their impact on industrial real estate,” says Follini. “The rapid adoption of ecommerce put a massive strain on existing infrastructure almost overnight.”
This has meant a flurry of demand, limited space to support it and, as a result, soaring rent growth. Both investors and developers are hurrying to take advantage of the attractive fundamentals. “Investor demand increased in response to the fundamentals, as well as the superior performance and brighter outlook when compared to retail and office,” says Ullrich.
Noyack Capital Partners is responding with an aggressive appetite for acquisitions. “We haven’t changed or adapted. We’ve accelerated,” says Follini. “In our upcoming investments, we see big box, dry goods warehousing as the least attractive of all types of industrial—even though that’s what a lot of capital is chasing.”
Instead, the firm is focused on industrial facilities that serve what it calls next-mile needs, or properties equipped to evolve alongside changes in technology and culture. Examples of these changes include autonomous vehicles and buildings that support foodservice and grocery delivery as well as changes that Follini says haven’t yet been anticipated.
Cold storage is also at the top of the list of target assets. Food and grocery delivery has increased demand for cold storage facilities, but there is a limited supply. “Cold storage is a much more complex build and requires significant attention to specialized infrastructure like climate-controlled environments and concrete that won’t freeze and deteriorate,” explains Follini. “This has built-in a generational undersupply for this asset class. It will take a lot more development and management effort to increase the supply and it won’t happen overnight.”
While the pandemic accelerated the firm’s existing investment strategy, it also guided them to new markets. “Population shifts as well as new working paradigms such as remote and hybrid work models are now highlighting Tier 2 and Tier 3 cities. Gateway cities no longer are required, nor do they have the ability to be, the distribution hubs they once were. Population movement to suburbs and smaller communities has created a new demand for infrastructure across the nation and expanded the need for new local warehousing in markets outside of the traditional core markets,” explains Follini.
Despite the increased investment appetite for deals, Ullrich says that many owners are having trouble parting with their assets, which is limiting investment volume. “Most of our clients realize that they are deep in the money of the industrial deals they bought pre-COVID, but they are hesitant to sell for fear of finding adequate replacement property,” he says. “Some are looking to reverse 1031 exchanges to solve that issue, and some are refinancing and using the proceeds to buy more deals.”
The overnight acceleration in demand has also catalyzed speculative industrial development. “The market is adjusting by developing land and building as much product as possible,” says Ullrich. “Buildings take a year to build whereas the demand accelerated overnight. So, there is a lag between demand and supply, and the result is increased rental rates, naturally.”
Industrial investor Stream Realty is targeting land acquisitions for new development. “We are mostly focused on land sites for industrial development that offer proximity to the population base and labor first, and logistics second. Locations that offer this proximity are more important than cheap land,” says Cannon Green, executive managing director of Stream Realty Partners’ industrial development services division. “Cheap land has historically been a major driver and that dynamic has changed materially during this cycle.”
Like core investors, Stream is also targeting growth markets, like Austin, Nashville, Denver and Charlotte. However, the firm is most active in markets with challenging development regulations and entitlement periods. “Generally speaking, in markets where entitlements are a longer duration and more risky proposition, demand far outweighs supply,” says Green. “In markets where there is a reasonable entitlement profile, supply and demand is more balanced. Demand continues to be strong across all of the markets where we are focused and we are seeing continued unprecedented rent growth due to increased land costs, commodity pricing and supply-demand fundamentals.”
Follini, on the other hand, is more cautious about new construction. Demand accelerated rapidly, and he says there is some uncertainty if and how quickly the market will normalize. “Market demand is there now, but once supply chains normalize past the pandemic disruptions, we could see a return to a more traditional just-intime supply chain model requiring less domestic warehousing, bandwidth that is needed now to ensure product on hand and mitigate transportation bottlenecks,” explains Follini.
Existing players have anted up, but new capital is also flooding into the industrial market, lured by the phenomenal growth over the last year and the promise of more to come. “The exuberance is warranted,” says Follini, but he says it could lead to an oversupply if investors get too enthusiastic. “Disruptive events like the pandemic create supply-demand imbalance,” he says. “We are seeing that now. New warehouses are comparatively easy builds. The current lack of available product is spurring a massive wave of new spec development for the first time in decades, possibly leading to oversupply.”
New capital is coming from other asset classes. Office and retail investors are obvious examples. They are looking for a defensive play, but Ullrich is also seeing capital come from other stable asset classes, like multifamily. “We’re seeing tremendous interest from NYC groups who own large multifamily portfolios. They are working hard to understand the industrial market in other parts of the country and many of them are heading south for industrial deals,” he says.
Ullrich agrees that the activity along with increased asset value is merited, but he says that investors, even those new to the market, have remained disciplined. “Fundamental tailwinds of rent and occupancy are driving the lion’s share of value increase,” he says. “If you talk to some of the larger tenants, they will tell you their increased demand will continue for a few years. The new entrants to the market are highly disciplined investors. They are underwriting carefully, and I think they will stick around even after the veneer is off of the new toy.”
Although industrial demand rapidly spiked as the pandemic set in, it is likely to become the new normal. “The pandemic escalated the ecommerce push that was already in process and heightened the need for onshoring. The permanency of the demand will slow when these movements are complete. I do not see any major derailers in the next two years,” says Green.
Likewise, Ullrich expects sustained growth for the next two years. “Rents and occupancies will increase in the next two years,” he says. “Relative cap rates are tougher to project. Interest rates may chase inflation and cap rates may widen as a result. Nothing is permanent. But it’s not tulips, rather it’s a decade of change compressed into the first 12 months of the pandemic.
Follini echoes Ullrich’s caveat. The pandemic accelerated the online shopping trend, and because construction takes time, the relationship between supply and demand has become misaligned. “The compression of the timing means the market pulled forward five years of increasing demand into one year,” says Follini. “What we don’t know is if additional demand is going to backfill future time periods. We don’t see a significant contraction in demand, but at some point, supply will reach equilibrium with that demand.”
This is the exact point at which Follini sees a potential challenge in the mid-term. “If developers aren’t aware of this tipping point, we could end up with enormous oversupply within the next two years,” he says, adding that it is why the firm is sticking to next-mile assets. “Demand side is much greater for cold storage in the long run because you don’t have the same amount of supply and the easy money coming to the market won’t chase these complicated builds.”
While there is reason to practice caution, the current fundamentals are exalting and opportunity is abundant. While supply is likely to catch up with demand sooner or later, industrial assets are king in today’s market.