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Is the boom over for industrial properties?
The industrial real estate sector has experienced unprecedented demand over the past two years, but that pace is beginning to decline. E-Commerce and supply chain modernization are providing support against the resulting surging supply. Can the sector continue its run?
Changing dynamics drive future performance
- Strong: Long-running tailwinds from e-commerce and supply chain diversification should continue driving strong demand, and the slowdown in new starts suggests new supply will slow.
- Slower: The combination of a weaker macroeconomy and accelerating near-term supply should translate to some sector weakening.
- Selective: Differences in age, size and location may affect performance. Coastal markets and infill locations typically have high barriers to new supply and should continue experiencing relatively low vacancies.1
- Size: Construction has been concentrated in larger buildings, while newer light industrial spaces should continue to experience low vacancies and solid demand.
Demand slows, but remains strong
Net new demand totaled more than 500 million square feet (MSF) in 2021, followed by more than 400 MSF in 2022.2 This trend pushed vacancy rates below 4% for the first time and spurred double-digit rent growth. Industrial transactions in capital markets surged, and nearly one billion square feet of new industrial space came under construction across all U.S. markets.
Demand for new industrial space remains healthy by historical standards, but the pace has declined in recent quarters as U.S. economic growth has slowed.2 This trend may continue as long as the economy flirts with recession into 2024.3
E-Commerce provides a tailwind
E-Commerce and supply chain modernization will likely support positive net new demand. Packaging and shipping individual orders to doorsteps requires more warehouse space than shipping pallets to a store, resulting in 2-3x more industrial space required per dollar spent to support e-commerce compared to brick-and-mortar retail.4
This rising e-commerce penetration rate could help offset a slowdown in consumer demand in a slowing economy, but the pace of demand growth is still likely to be slower than in 2021 and 2022.
Supply is surging, but new starts are easing
A large number of construction projects have been delivered in 2023 amid tapering demand, resulting in moderately higher vacancy levels versus historic lows. Nevertheless, the national vacancy rate of 4.3% in the first quarter remains below the sector’s long-term average and less than pre-pandemic levels.4
New construction starts have pulled back dramatically, with starts in Q1 2023 just half of the peak starts in Q3 2022. Higher interest rates and tighter lending standards have increased the cost of commercial real estate development. Industrial projects typically take five quarters to complete, suggesting that the pace of new deliveries should continue to slow noticeably in 2024 and 2025.
Regional challenges emerge, along with opportunities
Industrial fundamentals will likely remain strong by historical standards, even if the sector softens from its recent record performance. Of the top 80 largest industrial markets, only San Francisco has a vacancy rate higher than its historical average.
Even if all speculative space under construction is delivered completely vacant, overall vacancy rates would only rise to 6.4%, still below the historical average of 7.2%. This is an encouraging sign, as overall rent growth seems to have exceeded historical norms in every period where vacancy fell below historical averages.
Some markets and locations will be less affected by record oncoming supply. Coastal markets typically have less land available for development and have far less under construction, particularly in Mid-Atlantic and Northeast markets like Baltimore and Northern New Jersey. Even markets experiencing a wave of new supply have infill locations and submarkets with less competing supply under construction, meaning they should experience low vacancies and high rent in the near and long-term.
Bigger isn’t always better
With demand easing at the end of 2022, the completion rate (new deliveries as a percent of inventory) is greater than the absorption rate (new demand as a percent of inventory) for buildings larger than 500k sq. ft.4 Because the supply pipeline is also larger in this size cohort, vacancy is likely to rise despite higher demand for larger spaces.
By contrast, the completion rate for spaces less than 250k sq. ft. has slowed recently and continues to fall short of demand.3 The supply pipeline is far smaller, particularly in buildings less than 75k sq. ft. where less than 1% of the current stock is under construction.3
In this issue
1 Green Street, 2023.
2 Costar, 2023.
3 Moody’s Analytics, 2023.
4 Prologis Global Insights, 2020
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