January of last year marked “the end of the market frenzy,” according to Jeff Small, co-founder and CEO of Atlanta-based industrial investor/developer/owner MDH Partners, which has a portfolio totaling 36 million sq. ft. of industrial assets. As inflation and interest rates took off, it negatively affected deal financing, he noted. Before conditions changed in 2022, industrial investors could borrow at 3.0% rate and buy at a 3.5% cap rate, while realizing improved cash flow through rent growth.
Research from real estate data firm MSCI Real Assets shows a change in investment sales volumes in the sector as interest rates rose. Following an initial drop in activity at the start of the COVID pandemic, industrial sales volumes began increasing in the latter months of 2021, with the year eventually exceeding pre-pandemic, 2019 sales levels by almost three times with $179 billion. Sales volume continued to increase by double-digits year-over-year through the first two quarters of 2022, reaching $42 billion in the second quarter.
For the past three quarters, however, industrial sales volumes have been dropping. In the first quarter of 2023, they declined 52% year-over-year, to $19.6 billion, with steep drops in both portfolio and entity-level transactions.
A changing landscape
Today, in addition to inflationary pressures and higher interest rates, new factors have begun negatively impacting industrial investment sales activity. A post-pandemic slowdown in online shopping is causing a decline in demand for warehouse space, just as a massive amount of new industrial product is being delivered to the market, according to a report from real estate brokerage and advisory firm Newmark. The report noted a 40.4% quarter-over-quarter drop in absorption levels in the first quarter of 2023, considerably higher than the historical average of a 5.0% to 10.0% decline for that period.
Meanwhile, a record 138 million sq. ft. of new industrial space was delivered in the first quarter and more is coming on-line later this year, according to the Newmark. That’s happening at a time when demand for industrial facilities is normalizing after the pandemic era acceleration, and many markets are likely to experience increased vacancy levels and more sublease availability, Newmark researchers noted.
The report does note that the softening in the sector may be temporary. New construction starts already dropped by 38% year-over-year in the first quarter, with the construction pipeline declining to 664.4 million sq. ft. With almost 70% of banks tightening their lending conditions for commercial construction loans so far this year, that will likely further limit new construction starts.
In addition, while both space absorption and rent growth in the sector have slowed down in recent months, they remain extremely strong. At 65 million sq. ft., it was the best quarter for absorption on record compared to pre-pandemic history, and at 21.1% rent growth has also posted its biggest gain ever, Newmark’s data shows.
“Demand may not be what it was in 2022, but is still incredibly strong relative to historical standards, and we are returning to a more normalized lease-up timeline for assets,” said Robert McCall, partner and head of U.S. industrial and Brazil acquisitions at GTIS, a New York-based commercial real estate investor/developer. Industrial tenants continue to be active as they expand operations, especially in facilities of 250,000 sq. ft. or smaller, McCall noted. But the decision-making process for new leases has lengthened from one-two months in 2022 to three or four months today.
Conditions in the market have gone from those where newly constructed warehouses were expected to pre-lease to warehouses leasing six, 12 or 18 months after completion, according to McCall.
“Assets are still pre-leasing, but not all of them,” he added, noting that facilities that are not pre-leased usually end up leasing up within 12 months. “The greatest vacancies, not surprisingly, are occurring in markets where land is available with little barriers to entry, whether that be from a permitting, topographical or other perspective.”
So far this year McCall’s company has closed on three deals, including existing assets in Nashville and Charlotte, N.C. with nearly 1 million sq. ft. of space and land in Houston where the company plans to build two warehouses with a total of 500,000 sq. ft. While he couldn’t reveal financial details behind the deals, “We successfully brought tenants to the two existing assets and have been able to achieve an attractive return on cost for the investments relative to spot cap rates,” McCall noted.
A change in strategy
While positive absorption and declining construction starts are inspiring continued investment in the industrial sector, current market conditions, especially the decline in demand and a glut of new product deliveries, have caused a paradigm shift in investment strategy, according to MDH Partners’ Small.
Many investors, especially those newer to the sector, have shifter their focus from large (500,000-sq.ft. to 1-million-sq. ft.) assets with investment-grade tenants and long-term leases to smaller, multi-tenant facilities with short-term leases, he noted. The idea is that these assets will make it easier to achieve lease-up and generate greater returns by raising rents as leases roll over.
As a result, competition for such buildings is strong, especially for facilities in infill locations with short lease terms, Small said. He noted that these assets are trading at fairly low cap rates, while cap rates have increased by 100 basis points on average for other types of industrial assets in core markets and went up even more in secondary markets.
According to McCall, across the board, industrial cap rates have moved up by about 75 to 100 basis points from their low level at the beginning of 2022, as higher interest rates are forcing investors to bring more equity into transactions.
MDH Partners acquired a large warehouse in Fort Worth, Texas during the first quarter and has a couple other similar-sized deals in the works, but had not acquired any assets in the previous six-month window. The company’s investment approach remains conservative and focused on investing in deals where long-term cash flow is ensured. Small noted that an investment strategy that relies on short-term lease turnover to grow rents could have the opposite effect in a market where demand for space is decelerating and vacancy is increasing.
He added that the pandemic was a once-in-a-lifetime event that accelerated growth in online shopping and demand for industrial space, causing exuberance for investing in industrial real estate that drove prices too high. As a result, he avoids auctions where there are 30 groups bidding on one asset, contending that the winner always ends up paying too much.
In addition to a potential recession on the horizon and tightening lending standards, Small cited the decline in institutional capital available for new deals due to the “denominator effect,” where the higher value of real estate relative to stocks and bonds makes institutions over-allocated to the sector. He expects this will make it more difficult for industrial investors to raise new capital. Acquisitions by both MDH Partners and GTIS are being made out of existing fund vehicles. But McCall noted, “We did, however, raise capital for the Charlotte MSA and received a very strong response from capital [sources], raising the money in a matter of days.”
In addition to new challenges in raising equity, a tighter lending environment will likely negatively affect debt available to both investors acquiring new assets and those needing to refinance maturing debt, according to the Newmark report.
Developers will likely be forced to refinance their construction loans at higher interest rates with more equity as banks are lowering their loan-to-value (LTV) rations from 60%-65% to 50%-55%, Small noted. “Developers will be in trouble if they don’t have ready capital to cover the difference,” he added, suggesting there will be some distress in the development community.
While this has not yet materialized, he said there are already warning signs of it in certain markets with massive amounts of recent new development. He cites Savannah as an example, where a growing port and increases in international imports resulted in zero vacancy, setting off a development spree at a time when import traffic is slowing.
Small also noted that Dallas, which has experienced more industrial construction activity than any other U.S. market, will see an increase in industrial vacancy from the current 6%, especially in large buildings, though the situation is not as precarious as the one in Savannah, because Dallas is a much larger market.
Given continued rent growth, McCall said his company remains bullish on the industrial sector and active in the marketplace, just not to the degree it was in 2021 and 2022. “Acquiring today is very location- specific, and we remain active on both the development and existing asset side, as we see opportunities to create value in excess of spot cap rates.”
Property fundamentals continue to support investment in the sector, he noted, especially in those markets that continue to benefit from on-shoring and changes in supply-chain routes.