Industrial Sector Performance
The U.S. industrial market is settling into what could be one of the sector’s more challenging times as interest rates are to remain ‘higher for longer’ and absorption decelerates. However, vacancy rates are below the 20-year average, and rent growth is positive. Facing conflicting fundamentals, how are investors faring, and what is their overall sentiment? Is industrial still a safe bet even though the sector’s future is a bit up in the air?
Current Market Fundamentals
As of August 2023, year-over-year transaction volume is down 30%, according to Real Capital Analytics. The decrease is on par with other major asset classes after investor interest slowed due to the current debt environment at the beginning of the year. However, the pace of activity is on par relative to history. Cap rates are adjusting upward, averaging 5.7% for the month of August, according to Real Capital Analytics. Leasing also slowed as some of the nation’s largest retailers are pausing expansion to wait and see how consumer spending changes in the next few quarters. Additionally, declining imports to the West Coast ports are affecting absorption. West Coast imports have declined since November 2022, but Southeast ports are still performing well, taking imports from Asia.
New supply is expected to push vacancies up, which is currently at 5.1%. Supply is set to grow 3%, the highest percentage in 30 years, with 535 million square feet under construction, according to CoStar Group.
Although positive, annual rent growth is expected to weaken in late 2023 due to the new market supply and the upward adjustment of interest rates. Some markets, including Phoenix, Fort Lauderdale, and Northern New Jersey, outperformed the national average in rent growth. This success is due to robust population growth, proximity to transportation hubs, and an increase in manufacturing.
Investor Sentiment
The industrial sector has (more or less) been immune to economic headwinds, but that changed this year. Now, investors are seeing decelerating sales velocity, plateauing growth, and cap rate expansion. Although there is fluctuation in the asset type’s fundamentals, investors are holding steady on the industry’s long-term growth opportunity and profitability.
The commercial real estate market has a wide bid-ask gap, with sellers expecting the same sales price they received 12 to 18 months ago, while buyers are looking for lower pricing to combat the expensive debt market. This gap has caused several players to exit until the market stabilizes. At the September Fed meeting, the Fed did not initiate a hike but indicated interest rates will stay at the current level for much longer than originally anticipated, meaning predictions that the Fed would lower rates in 2024 are unlikely. The announcement may help investors on the sidelines return to the market as they accept the higher rates instead of trying to “wait them out.” The rate realization may also help narrow the gap between buyers and sellers as owners realize they must adjust pricing to address buyers’ needs.
Some industrial investors are seeking opportunities in tertiary markets to receive higher yields. Several large logistic firms and industrial warehouse developers are seeking space in secondary markets to build at a more reasonable price, bringing investor interest to them. Overall, industrial will face minor setbacks until the market stabilizes and adjusts to the current debt market, but its long-term outlook is favorable.
Trends to Watch
There are a few trends industrial owners and tenants should keep an eye on during the close of 2023 and enter 2024, that will likely have an impact on the sector’s future performance.
Nearshoring: COVID-19 spurred a need for closer-to-home manufacturing. Specifically for the U.S., the breakdown in the global supply chain encouraged companies to look at moving or expanding their manufacturing and distribution plants in North America instead of Asia. This move is referred to as nearshoring and it may influence the industrial market, but most likely not for several years. For example, Mexico has received an onslaught of industrial investment, but the country lacks the supply chain networks that Asia has conquered for decades and building that similar success will take time.
Semiconductor & EV: The industrial construction pipeline slowed dramatically at the start of 2023, but semiconductor and electric vehicle manufacturing continue to prop up the sector. CommercialEdge reported that since the beginning of 2022, most of the 94 million square feet of industrial space under construction was devoted to semiconductors, batteries, and EV plants.
Office-to-Industrial: As developers face increased development regulations and markets lack land availability, investors are finding creative ways to readapt current spaces to fit their industrial needs. The newest trend is converting old office buildings into industrial spaces. There are specific needs for this type of rehab, including proximity to major highways, expansive acreage, and single-tenant occupancy, but if the office fits the needs, it can present an excellent opportunity to bring new life to the property.
Industrial real estate faces hurdles caused by high inflation, increased interest rates, and declining sales volume. However, the industry is holding steady as the market adjusts to the macroeconomic market. Investors are bullish on the sector and continue to search for opportunities.
