Industrial Properties Show Promise and Opportunity Amid Downturn

Even just a few weeks into the pandemic, it became evident to economists at CoStar, the publisher of LoopNet, that the industrial sector would likely fare best among major commercial real estate property types through the economic downturn.

One such expert, CoStar's managing director and senior economist Abby Corbett, declared it likely that industrial real estate would even outperform the market. And so far, it has, as the coronavirus pandemic spurred a surge in online ordering and home delivery, in turn catalyzing demand in last mile distribution and logistics space.

Now, almost six months into the pandemic, CoStar has indicated that there’s “no such thing as obsolete” in the industrial warehouse market, noting that there’s strong demand for even “functionally challenged industrial assets” — namely, older spaces with shorter clear heights than more modern spaces demand.

LoopNet spoke with Corbett and CoStar managing analyst Chris LeBarton to get a broader sense of how the industrial space is performing through the throes of the pandemic and providing opportunities for institutional and independent investors alike.

Would you say industrial has been one of the most resilient commercial real estate sectors during the pandemic?

As expected, swelling demand from e-commerce tenants and retailers has industrial commercial real estate not just surviving, but thriving. While not discounting the pain felt at neighborhood and submarket levels, major metropolitan areas are seeing continued leasing opportunities and room for owners to bump asking rents.

The industrial sector was benefiting from a structural shift in consumer shopping habits even prior to the pandemic. The pandemic accelerated that shift once millions of Americans, quarantined at home, turned to online shopping channels to help stock up on necessity goods. Estimates throughout the industry indicate that the pandemic has ‘fast-tracked’ online shopping adoption rates by at least a few years, if not more, spurring a 23.5% increase from June 2019 to June 2020, with 88% of that growth having occurred since February.

Are there ways in which the pandemic is changing industrial real estate operations?

Many businesses are reconsidering their supply chain systems. You’ve probably heard the term ‘just-in-time’ supply chains, whereby companies and distributors increasingly tighten their inventory reserves to run as leanly as possible.

With COVID-19, supply chain strategies are expected to shift towards a more conservative inventory approach, holding more inventory in the event another disruption occurs. They will ultimately need to balance redundancy with efficiency. The more inventory held, the more industrial space needed — and this potential trend, which is still developing, is a direct result of COVID-19 and the new era in which businesses operate.

Why do we hear people saying that industrial is the new retail?

The lines between retail and industrial have blurred, and industrial real estate space has quickly emerged as an integral part of the country’s broader retail ecosystem. Grocers, pharmacies and retailers of all kinds are all investing in their last mile fulfillment strategies to meet the changing needs of consumers who expect to receive or pick up goods in less than a day.

And that trend is being witnessed throughout the retail segment as demand for quick fulfillment of retail goods means merchants need to come up with creative solutions to be close to consumers, and thus, even smaller players and small spaces are viable. For example, Simon Property Group CEO David Simon said on an August 10 conference call with analysts, according to CoStar reporting, that “More and more retailers are distributing their e-commerce orders from their stores,” and are turning to curbside pickup and other available fulfillment options, and “that’s a good trend long term for us."

With consumer expectations driving innovative fulfillment strategies, tenants are now reconfiguring their supply chains to locate closer and closer to the consumer, which ultimately translates to demand for more industrial space.

In many cases, finding good infill space is becoming increasingly difficult. As a result, retailers and distributors are also turning to vacant big-box retail space that they can redevelop into a last mile alternative.

That said, we’ve heard about the decline of the retail segment — especially for apparel and department stores. How does this impact industrial?

Since mid-March, a trove of storied names in retail have announced plans to file for bankruptcy and/or close numerous stores. Some, such as J.C. Penney, have closed distribution centers that would otherwise support those stores’ brick and mortar-based sales. Others, such as Kohl’s, have entered into sale-leaseback agreements with institutional players to access much needed liquidity.

Sale-leasebacks were gaining momentum prior to the downturn, and CoStar expects that trend will only grow, especially for retailers needing to free up cash. At a national level, less than 3% of industrial space is occupied by apparel retailers, which isn’t necessarily an overly concerning figure. Some markets are more at risk than others, though. Baltimore, Maryland; Columbus, Ohio; the Inland Empire, in California; and Charlotte, North Carolina are a few examples of markets with relatively higher shares of apparel-oriented and department store retailers occupying industrial space.

In many of the nation’s main distribution markets, vacancies are in the single digits, meaning there’s still a large pool of demand to draw from when releasing such space. For example, a bankruptcy judge approved J.C. Penney’s exit of two of its distribution hub leases, which introduces to the market a large, move-in-ready, 1 million-plus-square-foot contiguous distribution hub in Utah. Market participants remain optimistic about the prospects of leasing this space because contiguous blocks of space such as this are hard to come by in a tight, growing market.

Other than retail distribution and warehouse space, what are some important subsectors for investors to consider and why do they stand out?

Logistics assets, such as warehouse and distribution centers, are front and center as options for investors targeting the safer end of the spectrum. But several intriguing options exist across the industrial market’s landscape, especially given the shifting nature of shopping and ‘need vs. want’ consumption.

CoStar continues to track the strength in data center investment, as one such example. Data centers were in a strong position even prior to COVID-19 due to explosive growth in internet-connected devices and streaming services. Yet, amid COVID-19, when many professionals are working from home, schools are teaching virtually and Americans are filling their free time with Netflix and Disney+, an even more bullish case for data center demand arises.

Traditionally localized in specific corridors, data centers are now popping up anywhere fiber infrastructure, renewable energy or favorable utility pricing, water cooling optionality and other key necessities are present. Facebook, for example, recently announced plans to build an $800 million data center an hour west of Chicago.

While much of this segment is dominated by a select few players that specialize in this space, the market is also yielding opportunities for smaller investors, who are gradually becoming more active.

Cold storage is perhaps one such opportunity for some. A change in food shopping habits fostered by e-commerce and accelerated by the pandemic has ignited demand for refrigerated buildings. Shoppers have stocked up on frozen food at the supermarket, while a record number of shoppers have also started using online services such as Instacart and others to avoid trips to the grocery store during the pandemic.

Both tenants and investors are racing to acquire refrigerated warehouses for food and medicine storage during the pandemic. According to an industry source, “Brick Meets Click,” online grocery sales surged 30% in March; 37% in April; and 24% in May. While this acceleration may taper off as various states reopen, many shoppers have now realized the immediate benefits of online grocery shopping. The pharmaceutical industry is also growing as a prominent player in the cold storage sector as companies need to develop and test new medicines.

Finally, large distribution centers with strong connectivity via rail and highway stand to benefit as the share for e-commerce grows to new highs.

The July 2020 sale of a 20-acre assemblage in South Florida highlights just how intriguing geographically advantaged land is in the race to develop additional specialized storage. Marketed on LoopNet in the summer of 2019, the development site sits directly between Florida’s Turnpike and Interstate 75 in Hialeah and is under an hour from port, rail and international airport access. The parcel sold to a joint venture planning a 312,000-square-foot cold storage facility that will break ground without a tenant.

What are some key factors among industrial subsectors diverging from the norm during the downturn?

We expect to see an ongoing bifurcation in the industrial sector, especially in a recessionary periods such as this one.

Manufacturing businesses, particularly those that produce nonessential goods or that are highly dependent on various segments of the global economy, are more exposed to dampened consumer spending and to supply chain disruptions caused by the coronavirus pandemic.

Distributors, third-party logistics operators and manufacturers that produce essential goods are comparatively more protected right now. As a result, the logistics segment is expected to witness more leasing activity. Yet this segment was already facing the largest development pipeline, so we expect some logistics markets to see a more pronounced deceleration in rent growth due to supply and vacancy pressure. Meanwhile, the ‘specialized’ segment, which encompasses various light manufacturing properties, along with the ‘flex’ segment, has seen less new supply, but more tempered demand.

Is it possible to find a quality deal in this environment?

Investors looking to acquire space don’t need to feel as if the demand profile is strong only in the large, 500,000-square-foot and up big box distribution spaces. The fact remains that shallow bay industrial properties that offer multi-tenant opportunities to smaller- and medium-sized tenants ranging from 25,000 – 50,000 square feet remain in high demand as well. Markets such as San Francisco and Sacramento in California; Pittsburgh, Pennsylvania; Cleveland, Ohio; Austin, Texas; and Minneapolis, Minnesota have relatively higher concentrations of leasing across these smaller segments.

And investors hoping to access the industrial investment landscape shouldn’t necessarily be dissuaded by the view that only pricey properties are available. More than 13,000 properties under $5 million sold just since the start of 2020. This set of properties had an average sale price of $1.2 million with a 7.8% cap rate, a $56 price per square foot value and an average size of 29,000 square feet.

Moreover, many of these properties sold at a discount to list price averaging 10.6% — so deals are still out there. Certainly, during periods of heightened uncertainty and recession, many sellers wait to transact, hoping to achieve pre-pandemic pricing. Yet, even just since the start of April, over 6,500 industrial properties have traded with an average sale price of $1.2 million, a 7.8% cap rate and an average footprint of 22,000 square feet. More than 73% of these buyers were private, with a vast majority of sales considered individual asset sales. The majority of these sales were one-, two-, and three-star properties, but 18% of these were still classified as four- or five-star, which reflects relatively newer and higher quality space for a given market and submarket. And, of the four- and five-star properties, many were located in growing markets such as Katy, Texas; Orlando Florida; Goodyear, Arizona; and Portland, Oregon.

What sort of attributes should an investor seek out?

Anyone can enter the industrial game, but as with any real estate investment, it is imperative the person or group of investors possess market knowledge and secure financial resources.

Every deal is unique, but in today’s environment there are certain tenants, locations and property specifications that ostensibly limit risk profiles. While CoStar and LoopNet offer third-party, non-biased data and not financial advice, it does see consistent trends that correlate with positive returns for owner-operators, such as the following:

Flight to Quality: Tenants, particularly credit tenants, such as Amazon, Walmart or Prologis, among many, are seeking new and technologically advanced buildings in an increasingly e-commerce-driven landscape.

Location, Location, Location: Regardless of subtype — be it logistics, manufacturing or flex — proximity to multimodal transportation options offer a significant advantage.

Aim High: Although it pales in comparison to the recent multifamily amenity arms race, there are a handful of clear separators in today’s warehouses and distribution centers. Perhaps chief among them is “clear height,” or the safe clearance level for racking and storage within a building. The industry norm has soared from the mid-to-high 20-feet range to roughly 36 feet over the last decade.

Are there opportunities for smaller-scale, non-institutional players to get in on investments in the industrial space, such as through REITs?

While the underlying fundamentals between public and private real estate investment are similar, there are many differences. The public markets (REITs) offer investors with less capital or less experience to participate in the industrial investment theme.

Prices for the logistics- and supply chain-focused REIT Prologis, for example, which has a market cap of over $78 billion at the time of writing, has a stock price of $105 with a 2.19% dividend yield and a P/E ratio of 41. There are currently over 14 publicly traded industrial REITs. Some invest across a variety of facilities, while others take on a specific area of focus such as data centers, cold storage, distribution or cell towers.

REITs come with an inherent degree of liquidity — meaning they are easy to buy and sell — and, with that, volatility, as investors can trade in and out of the investment more freely than, say, private real estate investments. REITs offer investors with little operational or industry experience to take part in the industrial space without needing to be involved in the management of the property or the execution of the business plan.

Private real estate investment in the industrial market offers investors more direct control over the investment but requires the investor to maintain a longer hold period, and generally, to accept more diversification risk.

These investments have the potential to generate millions in net income and offer an investor significant tax advantages, if managed properly. A private investor should be aware of the capital expenditures potentially needed for that given property, as well.

Non-institutional investors looking to buy a single asset in a submarket of a major metropolitan area would need to carefully research the market and underwrite the deal with appropriate assumptions. Factors such as credit quality of the existing tenant, the quality of the asset itself — including considerations such as its age, specifications and design, and the prospects of demand — are essential to the investment process.

If the recession gets worse, how does your outlook on the industrial sector change?

Regardless of what happens to mitigate the virus, industrial has been well positioned to withstand an economic downturn as a result of historically low vacancy rates, strong rent growth — at above 7% leading into the pandemic — and consistent tenant demand even throughout the pandemic thus far.

Moreover, on the capital markets side, high-net worth, institutional, private equity and REIT investors will continue to aggressively target industrial acquisition opportunities because they offer strong options for exit liquidity. Smaller investors looking for an opportunity to reposition or develop a property, therefore, have many options in terms of eventual buyer sources. The challenge on the investment side becomes finding an asset with appropriate pricing and not overpaying going in.

All these positive qualities shouldn’t obscure the fact that industrial demand is ultimately susceptible to broader economic downturns, as tenant demand is correlated to consumer spending, business production and investment — all of which do falter in the near-term during periods of significant economic distress.

The need for e-commerce distribution presents as a strong tailwind for industrial, one that is growing even amid unprecedented broader economic distress, yet many industrial players are struggling with disrupted supply chains, lower trade activity and lower consumer orders — both domestically and globally.

Are there any other caveats to the sector’s strength?

With any investment in the age of COVID-19, the only certainty is uncertainty. CoStar still believes industrial commercial real estate is well positioned to handle the economic and societal changes wrought by the pandemic, but there are already headwinds building and more may materialize.

Disrupted supply chains are still bedeviling port markets and industrial distribution operators, for instance. Development delays, caused by shuttered worksites and labor disruptions, place further pressure on industrial operators, distributors and manufacturers. On the flip side, under-construction stock remains near an all-time high of just over 300 million square feet, and with so much speculative development, that market could face prolonged leasing battles.

Remember those in-demand cold storage facilities? While the availability of preferable locations and infrastructure is growing, these are still difficult concepts to pull off. Development data shows cold storage buildings can be as much as three times as expensive to bring to market as more traditional warehouses. The expertise to do so is also in shorter supply, not surprisingly.

Are there other interesting angles to consider during this time?

Definitely. Obsolete office or retail space is increasingly finding new life in the industrial ecosystem, whether it be a fairly simple conversion to storage or low-tech manufacturing/flex space or something more unique. There is a growing universe of big box or even mall space that has gone dark and been renovated into modern day logistics operations. One such example is the Westgate Shopping Mall in Macon, Georgia that’s been converted into a 395,000-square-foot, six-building industrial park.

Many big box retail properties have the layout, docks and accessibility necessary to facilitate last mile distribution. While many municipalities have been hesitant to concede retail to industrial repositioning due to concerns over noise, pollution, traffic and reduced sales tax receipts, expectations are for this type of activity to increase as the realization of the permanency of the retail shift softens local opposition to projects that remove blight and create jobs.

Lastly, depending on strategy and expected hold frame, investors need to be mindful of changes within the industry that could shift demand sources in the future. Parking garages are already being built to be adaptable enough to maintain relevance in a world with significantly fewer cars, while self-driving trucking technology continues to inch closer to feasibility. Projects that allow for operational flexibility will be best positioned to adapt to our rapidly changing world.

This conversion story also takes form as a two-way street, and an established rebirth model has played out in empty warehouses and manufacturing sites across the country. Whether it is for the latest and greatest hipster-friendly, loft-style apartment community, or the craft brewery that drew them to another local residence, there are myriad buildings in former industrial corridors to investigate.