Low cap rates and rapidly rising rents reflect industrial real estate’s status as the leading sector in commercial real estate development. Record levels of capital are flowing to industrial real estate while tenants are willing to pay higher rents to secure additional inventory and shorten delivery timelines. Kevin Welsh, executive managing director at Newmark; Juan Arias senior consultant at CoStar Advisory Services; Jim Clewlow, chief investment officer at CenterPoint Properties; and Mary Lang, head of Americas direct logistics strategies at CBRE Investment Management, discussed current trends in capital markets at I.CON East 2021 this week in Jersey City, New Jersey. The panelists shared their thoughts on how low cap rates, rising rents, and a shift in the priorities of both investors and tenants are affecting investment in the industrial sector.
Panelists agreed that recent strength in the industrial sector is the product of structural changes in the U.S. economy. Clewlow recalled that years ago, industrial end-users were primarily concerned with cost control, and moved further and further out from major metropolitan areas in pursuit of lower rents. The acceleration of e-commerce has changed that dynamic so that distribution costs now matter more than rents: “We all know that logistics costs have a profound impact on our users and their bottom line. Therefore, I think the calculus has changed,” he said.
Lang noted that recent disruptions to global supply chains have only increased retailers’ tolerance for higher industrial real estate expenses. Retailers know that stockouts can damage their brand and lead customers to shop elsewhere. So long as customer experience is an important driver of a retailer’s revenue, they will be open to paying the additional costs associated with maintaining higher inventories.
Nonetheless, while end-user priorities have shifted, real estate fundamentals still matter. Clewlow pointed out that “really good and well-located real estate is always going to be valued more.” However, Arias observed that what qualifies as a good location has also shifted substantially in recent years. Locations adjacent to ports, intermodal facilities and rail have seen the strongest rent growth and are where investors are most comfortable buying at lower cap rates. Similarly, investors are predominately focused on the largest, best-performing industrial markets. Lang said that she expects that in the 15 top industrial markets that CBRE Investment Management focuses on, industrial rents will grow 25-30% over the next five years (or 5-7% annually).
Welsh asked the other panelists about their perspectives on investing in a low-cap rate environment where yields have continued to decline in recent quarters. Panelists observed that while cap rates are a useful metric, developers and investors are more focused on whether an individual project well meet or exceed a required internal rate of return. Clewlow noted that merchant developers have a different cost of capital and a higher hurdle rate than those that primarily work for large institutional investors. The number of years that capital will be available for a project also affects the yields that developers will accept for a project. CenterPoint Properties, which is owned by the CalPERS pension fund, has a very low cost of capital and a patient owner, and can invest in lower-cap rate, high-quality projects that have strong long-term potential.
Arias noted that international investors who have a low cost of capital and higher tolerance for lower yields have been attracted to the U.S. industrial market and are contributing to the decline in cap rates. Since Asia and Europe are far ahead of the U.S. in e-commerce adoption, these investors are already familiar with the sector and are comfortable making large investments in American e-commerce facilities now that adoption is accelerating in the U.S. Lang added that investors should feel comfortable that demand for ecommerce in the U.S. will soon meet or exceed levels in Asia and Europe. “I never want to underestimate our ability to want things as quickly as possible… As a culture, we desire everything yesterday.”
Recent widespread price increases have led some to question how inflation could affect the industrial sector. Clewlow observed that commercial real estate has historically acted as a hedge against inflation, and industrial real estate could attract more attention from investors in the short term. However, a long-term increase in inflation could have more negative macroeconomic consequences that could affect the sector. Clewlow recalled earlier bouts of high inflation in the 1970s and observed that persistent high inflation leads to higher levels of economic uncertainty and increases investor indecision, which can substantially hamper new development.
Fielding a question from the audience about whether spending from President Joe Biden’s recently passed infrastructure bill could contribute to higher inflation, Arias pointed out that the spending will be stretched out over several years, which should dampen its inflationary potential. Further, investments in key infrastructure like ports could help to relieve some of the congestion in the supply chain that is currently the main driver of rising prices. Lang shared that she is less concerned about the bill’s effect on inflation than she is about the potential for the spending to exacerbate labor shortages in the logistics industry. She said she suspects that many current and potential logistics workers might be drawn to new infrastructure construction jobs.
Panelists also touched on Amazon’s recent shift away from leasing toward purchasing or directly building its future facilities. Clewlow doesn’t expect this shift will substantially affect demand for industrial real estate so long as Amazon is absorbing more space. Arias shared his projections that Amazon will build out at least another 250 million square feet of industrial real estate over the coming years, on top of the roughly 300 million square feet currently in its portfolio.
As NAIOP Research Director, Shawn Moura manages the NAIOP Research Foundation research committee and day-to-day operations of the Foundation’s research projects.