Is the Red-Hot Industrial Market Beginning to Cool?
In the last decade, industrial real estate has become something of a darling in CRE, producing phenomenal returns for investors. And while 2022 ended with record-low vacancy rates averaging around 4%, this year economic headwinds and an increasing rate environment might subvert the seemingly insatiable appetite for investment in the sector.
Matt Kovesdy, associate VP of Matthews Real Estate Investment Services, sees these headwinds complicating the picture, at least near-term. While investment appetites remain strong, the higher cost of capital and concern over tenant performance is fueling increased caution. Meanwhile, he expects investment velocity to slow and investment volumes to contract.
Industrial Fundamentals Shift
Industrial fundamentals are changing. Rent growth is going to be much less aggressive, especially for speculative development. In addition, although there is still strong occupier demand, tenants are looking for flexibility and better terms to hedge against economic uncertainty.
Kovesdy notes that interest rates are the primary perpetrator of changing market fundamentals, both for investment underwriting and tenant business health. “The fundamentals of the space are still very healthy, but it all comes back to the cost of capital,” says Kovesdy. “As rates continue to tick up, you are going to see overall investment volume cool.”
Industrial investment volumes could pick-up in the second half of the year. The cost of capital is likely to stabilize, but also Kovesdy expects to see more demand for sale-leasebacks. Retailers that own their industrial buildings might be looking to unlock tied-up capital. That would serve to drive more investment numbers.
“I think you will see more of that toward the end of the year,” he says. “But again, tenants are going to want flexibility baked into their lease.”
Landlords Focus on Tenant Quality
In light of the increased risk and higher capital cost, investors are making strategic changes. One is a sharp focus on tenant quality. “Landlords are chasing the security of income along with income growth. If you don’t have a strong tenant on the end of that, you are exposed,” says Kovesdy.
To hedge against recessionary pressures, landlords are showing a preference for tenants specializing in needs-based goods. Kovesdy also sees good opportunity and great yield potential, provided that the landlord understands the tenant’s business and potential stability during a time of uncertainty.
Another is to diversify away from standard e-commerce-related real estate, like warehouses and last-mile logistics facilities. Industrial outdoor storage is a top target this year. While the property type is an extension of e-commerce, in that it serves last-mile delivery, truck terminals, container storage, equipment rental and heavy equipment storage, it offers lower risk and more attractive return profiles.
“It is still fragmented among the ownership pool,” says Kovesdy. “You have a lot mom-and-pop owners that don’t know what they are sitting on.”