Monday, October 30, 2023

Industrial Real Estate: A Normal Market for a Somewhat Normal Time

Recently coming off the effects of nearly two years of rising interest rates by the Federal Reserve, the real estate market has been in a state of constant change for the past 18 months. As this blog has extensively discussed, real estate is very dependent on interest rates, as they influence property loans, cap rates and ultimately, property prices. Despite the recent period of adjustment, the economy seem to show signs of normalization, with mortgage rates, consumer loan rates and even treasury rates settling at levels much higher than those of the previous two years. By all indicators, it seems like our economy and we seem headed for a soft landing. No market has internalized the current state of the economy more than the Industrial Real Estate market.

For the past few years, industrial properties were the calm in the storm—while other property classes were being hit by the effects of either the pandemic, the economy, technology or changing sensibilities, the demand for warehouse and tech spaces increased. This demand accounted for a large portion of the real estate growth over the past 3 years, leading the industry in new construction, price increases and absorption. This recent strength of the industrial real estate market is demonstrated in Avison Young’s Third Quarter Industry Report, found here. Now industrial property finds itself in a differnt situation and in response to an economy that has settled around higher than normal interest rates, it seem to be cooling off.

Though the term “cooling off” may at first seem to have a negative connotation, in this context, it is merely an indication that industrial properties are normalizing. For example Cushman Wakefield predicts industrial property to trend to 5% vacancy nationwide, which is up over 250 bps from the record low vacancy of 2.3% that was hit 18 months ago, but it is still significantly lower than the 15 year average of 6.8%. The same of can be said of the cooling of industrial property new construction seen in the Avison Young and Cushman Wakefield reports and the resultant lower net absorption of the properties happening in most metropolitan areas in the country. After being real estate’s champion for so long, industrial property is normalizing.

It’s interesting that normalcy makes the industrial market interesting, but there are a few reasons for the recent slowdown in the market. The first is that warehouse space has become overbuilt. The pandemic lead to an increased demand for many items, which meant that more warehouse space was needed to store these items. A resultant decrease in productivity led to supply shortages immediately after the pandemic and the pent-up demand led to the appearance of a need for more warehouse spaces. Builders have attempted to keep pace with this demand, but the market has finally indicated that more space is no longer necessary.

Another factor contributing to the normalizing of the industrial property market is the very same interest rates that have been a topic many recent posts on this blog. With lending restrictions tightening and capital more expensive in the current high interest rate market, many investors have checked out of the industrial property market, leaving owner-occupiers as the primary purchasers. Typically owner-occupiers are known to pay a premium for industrial properties, given their familiarity and dependence on the property. While the increased percentage of owner occupiers purchasing properties many be great news to landlords holding an industrial lease, this state of affairs also means that there are less buyers in the market. Moreover, as owner-occupiers realize their larger presence in the market, many of them have begun to lower the premium that they would normally offer to purchase a property. Realizing that they’re one of the few games in town, they are beginning to flex their increased buying power.

Yet another factor contributing to a cooler industrial market is the lower absorption rates. Consumer demand is shrinking for many reasons and less secondary operators are needed for the retail chains of large companies like Amazon and Walmart. As a result, less industrial properties are being leased. Additionally, as the companies begin to settle their technology needs, less new technology spaces are needed, reducing net absorption among all industrial properties.

Like most markets today, the industrial property market is finding a way to settle into the current economy. Where it goes from here is largely dependent on whether the economy has a soft landing or goes into a recession. One thing is for certain—it’s no longer the lone outlier, propping-up the real estate industry. It’s also not a tragic case of dramatic loss. It’s just normal, and that’s fine. 

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