With retailers pivoting to better serve customers both online and in stores, an important shift is underway in the industrial real estate sector. Warehouses, historically viewed as cost centers where goods sat waiting to be shipped to a store, are evolving into profit centers that help retailers maximize revenue and differentiate from their competition. With strategically-located fulfillment centers, retailers can get goods into the hands of impatient consumers faster. Warehouses located closer to customers also make it easier to attract workers to fill the abundant fulfillment job openings.
This shift has fueled tremendous growth in warehouse demand and rents. The resultant value creation has generated the potential for superior investment performance in comparison to other major commercial property types over the past five years. Anticipating continued strength, investors have bid cap rates down to new lows.
Industrial is typically less volatile than other property types and perceived as a stable investment but it is not normally viewed as a standout performer. In today’s market, that’s changing as total returns on industrial properties reached 12.8 percent in the 12 months ending in September, more than double the annual returns of other commercial property types, according to a recent report from NCREIF.
You don’t need to dig deep to understand what’s driving investment performance. According to an analysis of data from CBRE-EA, it appears the industrial availability rate is 7.7 percent nationally – its lowest level since 2001 – and in key distribution markets there is not enough modern space to meet current demand. New construction completions of about 200 million square feet over the past four quarters failed to keep pace with net absorption.
What’s driving the market’s strength is a fundamental change in the way consumer goods move through distribution and retail centers, prompted by the rise of e-commerce. According to the Census Bureau’s ecommerce data for the third quarter of 2017, online purchases grew to represent 11 percent of retail sales (excluding vehicles and gas), up from 4.4 percent a decade ago. Over the past year, online purchases rose by 15.5 percent, versus 3.1 percent for all other retail categories. As their businesses have grown, e-commerce companies have come under increasing competitive pressure to create efficient systems for order handling, delivery and returns. The location and layout of distribution space is key to offering the short delivery time’s customers desire. Distribution’s importance in retailers’ omnichannel sales strategies has surged.
The Last-Mile: A Boon for Infill Sites
Evolving consumer purchasing habits aren’t the only factor shaking up distribution modes. The increasing concentration of people in cities is forcing e-commerce and traditional retailers alike to focus more on urban centers. In return, demand is rising for efficient, modern space in infill locations to provide same-day delivery of high-volume items. This final leg of the journey from seller to consumer has been colloquially named the “last mile,“ but of course the greatest challenge is getting it reduced from many miles to as few miles as possible. Perhaps in some urban cores it will become an actual mile.
The challenge is that very little existing infill industrial space meets the emerging requirements of e-commerce distribution facilities. In particular, labor-intensive tasks such as packing and gift-wrapping orders mean higher employee headcounts, so facilities need more parking spaces than industrial sites have traditionally required. Additionally, rapid inventory turnover means buildings need to handle more delivery vehicle traffic than in the past.
Urban sites often have limited opportunities to add surface lot areas for truck maneuvering or employee parking. Older buildings with ceiling clear heights of 18 or 24 feet don’t make efficient use of cubic footage by today’s standards.
This opens up two types of opportunities for owners of old urban warehouses and manufacturing sites: redevelopment, or interim leasing of properties that a few years ago were on the verge of obsolescence.
Some infill sites have been redeveloped with bigger parking lots, more truck docks and, in some cases, mezzanine-level space to pack in more goods. But good locations are not easy to find, and developers often must contend with demolition, site remediation and zoning issues before breaking ground on a new state-of-the-art facility.
Over time, supply of new modern facilities will catch up with demand. This may be done, in part, through multistory industrial development. In the meantime, e-commerce companies and others in need of infill distribution space are often settling for smaller facilities that are less than ideal for their long-term needs, but have the advantages of proximity to customers and current availability. Tenants are seeking shorter-term leases of these older properties, reinforcing the idea that tenants view this as a temporary measure to remain competitive while waiting for more suitable space to become available. This is likely also an indication of the significant changes users anticipate in their e-commerce business in the years ahead as consumer demands and delivery methods evolve.
Part two of this series will explore why cold storage space is in high demand and how technology is disrupting the industrial property sector.