A Case for Vacant Space: Why Industrial Buyers Want Small, Unleased Buildings

Fueled by growth motives, owner-users in select markets opt for vacant industrial space rather than fully-leased, stabilized properties.

The industrial sector is rife with “dry powder”—unspent cash reserves waiting to be invested. Investors, who mostly have sat on the sidelines for the past two years, made 13% fewer transactions year-over-year at the start of 2024. Private buyers were the largest source of commercial real estate capital last year, making up 62% of the U.S. buyer composition with $230 billion in total acquisitions. With growing optimism and mild hope for interest rate cuts later this year, many investors have started to deploy capital again.

Not only are buyers back, but they have returned in an unlikely way. Remarkably, the demand for vacant industrial buildings has surpassed that of fully leased, investment-grade buildings. The pattern is a notable outlier compared to historical supply and demand and suggests a departure from 2022 and 2023 trends. 

The demand for vacant industrial buildings has surpassed that of fully leased, investment-grade buildings in select markets.

While construction costs remain high and net absorption has slowed for larger, big-box industrial facilities, investors can expect to face premiums for vacant buildings under 50,000 square feet. Smaller U.S. industrial property is in such high demand, with comparatively low vacancy rates and strong rent growth, that developers and brokers often advise waiting to sign a lease and leaving a building vacant.

Making Sense of the Market

Since the start of 2023, newly built distribution centers and vacant industrial properties over 500,000 square feet have faced several challenges. Tenant demand for big-box industrial properties slowed substantially as the year progressed. As supply outpaced demand, the square footage of new U.S. industrial leases signed during 24Q2 was up about 10-15% compared to 23Q2 when adjusting for the typical lag at which deals are uncovered. Year-over-year gains have continued in the first several weeks of the third quarter.

However, this trend disproportionately reflects the market. While a slowed net absorption is prevalent among spaces larger than 500,000 square feet, demand remains generally healthy for properties below 50,000 square feet. Construction has also exacerbated vacancy numbers. As the result of widespread groundbreakings for new distribution centers during the pandemic, the stock of U.S. industrial properties is growing at its fastest in more than three decades.

Net supply additions peaked at 147 million SF, or 0.8% of inventory during the second half of 2023. That figure fell by 30%, to 0.5% of inventory during the second quarter of 2024, and is expected to continue falling through at least 2025 due to the pullback in groundbreakings that has been underway for the past 18 months. This is particularly true for larger industrial properties as developers have been focused on building projects 50,000 SF or larger in recent years. 

What’s happening is a fundamental shift in how empty buildings are perceived. In other words, vacancy in the industrial sector isn’t necessarily a bad thing. For speculative properties—ones built without a pre-leased tenant—it makes more sense for landlords who want the highest market rent or price to wait before leasing or selling and have the building remain unencumbered by an agreement.

For example, investors are advised to wait until a property is completed instead of pre-leasing it a year in advance. Otherwise, they may experience substantial “loss to lease” since the property was leased before market rents increased. In some industrial markets, especially those where strong demand exceeds supply, landlords can wait to close a deal without facing too much risk.

While industrial rents rise and vacancies remain low in select markets, it’s better not to lock down a tenant too early.

While interest rates are starting to see some breathing room after the Fed’s most recent announcement of a 50-basis point cut on September 18th, price dislocation gaps still persist between sellers and buyers. Sellers remember the prices they saw in 2021 and 2022 all too well, and buyers won’t buy at the exact peak pricing. This gap is expected to continue to narrow, but slowly. Owner/users have continued to take the lion’s share of transactions for most of the year while investors are slowly getting back in the game.

Investors are forgoing long-term leases to avoid “loss to lease” or the opportunity cost of leasing before substantial market rent increases.

 

Benefits of Vacant Space for Owner-Users

Investors and owner-users have different motives. The former, mainly institutions or REITs, aren’t involved in the tenant’s business and tend to be more change-averse. They make rental income from the property, typically a warehouse, distribution center, or manufacturing space pre-leased by a creditworthy tenant. The latter, building owners and operators, are motivated by growth. They have skin in the game and want a property they can grow with. For instance, a manufacturing company might buy an industrial building for production purposes. Owner-users are uniquely motivated to move into an unleased property if it helps their business. To them, a vacant property is invaluable. Owner-users reap several benefits from owning the property they use:

• Growth Benefits: Vacant properties appeal to owner-users looking to scale operations and benefit a bottom line.
• Long-Term Stability: By owning a property outright, owner-users can avoid uncertainties associated with lease renewals. This stability can help businesses establish a more permanent presence in a specific location.
• Ownership: Though more financially straining upfront, purchasing a vacant property allows owner-users to appreciate their property values over time.
• Flexibility and Control: A vacant building is a blank slate, which gives owner-users the utmost control over customizations and modifications to the space.

Key Price Shift Factors For Investors

Property Size

The demand for vacant industrial buildings is strongest among buildings 50,000 square feet or smaller. This has created a disproportionate share of new, large warehouses compared to small-bay and flex industrial properties. Specifically, several new developments in Denver larger than 100,000 square feet remain vacant while owners look to secure tenants. As a result, vacancy rates in Denver and other markets have been reportedly high, according to major news outlets. However, this is only half of the picture. Since developers focus on large industrial buildings, the demand for vacant flex and small-bay industrial properties is actually stronger, while vacancies are lower.

Cost of Construction

Property size directly affects the cost of construction. As costs remain high, it doesn’t make sense for developers to build projects smaller than 50,000 square feet. Most builders consider building large warehouses—and securing long-term leases from established businesses—a better use of investors’ dollars. But realistically, small-bay and flex buildings suit most industrial businesses with shorter lease expectations. As a result, small vacant industrial buildings have seen strong pricing and rent appreciation.

Diversification Within the Property Type

As more businesses expand and adopt omnichannel strategies, the industrial sector’s tenant mix continues to diversify beyond giants like Amazon. Tenants are expanding their logistics infrastructure and omnichannel operations to meet consumer demand better. Industrial’s tenant diversification bodes well for the property type, especially as economic conditions look to rebound from high interest rates and inflation, which ate into consumer wages and savings.

Supply Chain Bottlenecks

Disrupted supply chains have made new, up-to-date facilities more attractive to logistics tenants seeking more efficiency. Plus, consumer preferences for shorter delivery times and increased favorability of just-in-time manufacturing have increased demand for modern facilities. Boosted by tailwinds from major tenants, logistics buildings completed in 2020 and 2021 have seen accelerated lease-ups compared to new buildings built before the pandemic.

Looking Ahead

Certain markets will continue to experience strong demand for space despite the deceleration in economic activity within the last year, driven by elevated retail and e-commerce sales. With a record level of supply and a possible pull-back in leasing from major players in the market, upcoming deliveries are expected to continue seeing solid lease-ups, thanks to the diverse tenant mix propelling demand, and the appeal of newer properties to meet tenant preferences. Supply risk varies across markets. However, the large amounts of new supply delivered could outpace demand, especially if the properties are over the 50,000 square foot threshold of what investors/owner-users are looking for.