Double-Digit Returns Forecast for Industrial, Despite Headwinds
With a potential recession looming and a certain e-commerce giant announcing that they have leased too much space, uncertainty has begun to surround the industrial sector. Additionally, when you factor in a construction pipeline of industrial space that sits at an all-time high, this further heightens concerns about a coming imbalance for industrial properties.
For context and perspective on these and other forces, LoopNet interviewed Sabrina Unger, head of research at American Realty Advisors, to discuss the company's outlook for the U.S. industrial sector and where they see the industrial market heading over the next 12 to 18 months.
There’s been much talk recently about a coming slowdown in industrial fundamentals. Can you discuss what’s feeding that view and whether or not you agree with that outlook?
There are several clouds on the horizon that investors in the sector are watching. The first is the drawback in the e-commerce penetration rate in recent quarters. People are used to seeing e-commerce’s share of total retail sales tick up consistently over time. So, when the share declined from 16.4% — the pandemic high in the second quarter of 2020 — down to 14.3% in the first quarter of 2022, despite total retail sales having increased in the same period, the immediate reaction was to interpret that to mean that peak penetration is roughly 15% of sales.
In reality, that 16.4% peak in the second quarter of 2020 was an anomaly brought about by the physical lockdowns that occurred early in the pandemic. Under normal circumstances, we would have expected e-commerce share that quarter to have been somewhere in the range of 12% to 13% based on the trendline. So, what we are really witnessing, in our view, is a normalization or return to the trendline, rather than a “cap” on how high e-commerce can go.
The other component that’s jostling some nerves relates to recent headlines coming from some of the behemoth occupiers of industrial space. A certain e-commerce giant has stated they are essentially over-warehoused and likely to sublease some of their space. Other major retailers with a significant e-commerce presence may be struggling against higher costs and need to slow their expansions in the event of a recession. You combine those two things, plus the potential for an economic slowdown, and demand seems like it could really soften.
So what do these conditions mean for future demand of industrial space?
Our view is that e-commerce is still slated to trend upward over time, and that will continue to fuel demand for warehouses. Our forecast is predicated on a conservative growth outlook that assumes e-commerce growth will slow to less than half of the pre-pandemic trend, or a roughly 6% compound annual growth rate. This suggests e-commerce sales could reach $1.21 trillion by 2025, which in turn could produce upwards of 315 million square feet of incremental demand over the next five years.
Even if a handful of the biggest players step back for a couple of quarters, it may give other occupiers, that were not able to secure space, an opportunity to expand and shore up their footprints. Interestingly, despite the pullback headlines, the first half of 2022 set a record for the number of leases signed that exceeded 1 million square feet, suggesting there remains unsatisfied demand in the market.
Are fundamentals and returns going to moderate from the breakneck pace we’ve seen over the last two years? I think it’s safe to say yes. But a moderation from all-time highs still keeps things at above-average levels.
How might moderating demand stack up against a construction pipeline that is sitting at an all-time high?
Depending on the universe of markets you are measuring, industrial space under construction today in the U.S. measures between 665 and 700 million square feet. That sounds like a really large number, but roughly one third of that total is already spoken for. Though there are few outliers, the current development pipeline in most markets is the equivalent of roughly 3.6% of existing stock, whereas net absorption has been averaging more than 5%.
So even if demand slows, supply and demand seem like they will be broadly matched. There will come a time when supply overtakes demand more broadly, but given delays in entitlement and construction timelines, that might not happen any time soon.
How are you assessing industrial cap rates in a rising-rate environment? What sort of impact is that having on pricing and transactions?
It’s no secret that industrial properties carried, and continue to carry, some of the lowest-trading cap rates in commercial real estate today. Much of that stemmed from the incredibly robust demand and rent growth over the last several years creating competition for assets. The appeal was further compounded by low borrowing rates below that of cap rates, making debt accretive, as leverage increased investment cash flows.
With interest rates increasing above going-in cap rates, some higher-leveraged buyers are being sidelined. But thus far, there is still a relatively deep pool of lower-leveraged, value-add and core buyers willing to step into the gap and transact at more attractive pricing than what they could have secured six or seven months ago for the same high-quality asset. If anything, the environment has taken some of the froth out of the market, which should add to the sector’s longevity.
We are seeing deals transact at 5% to 10% below peak pricing. There isn’t a massive shift in pricing because most industrial owners have portfolios comprised of high-quality assets that are either highly leased and/or offer a meaningful opportunity to raise rents and “mark to market” as existing leases expire. This puts them in a position to hold on to assets if it means taking a material haircut on the price. We anticipate this will materialize in modestly lower transaction volumes in the second half of the year, though we’re also expecting a sizable pipeline of deals to hit the market post-Labor Day.
Give us your prediction: where do unlevered industrial total returns end up for 2022?
My current forecast still calls for a double-digit total return year for the industrial sector, call it in the range of 14% to 15%. Beyond that, the resiliency of the U.S. economy against the trajectory of interest rates will dictate how strong 2023 will be.
This interview has been edited for brevity and clarity.