The recent migration of jobs and people from coastal gateway metros to secondary markets in the south and west has generated much discussion in the commercial property market. At the same time there has been a less discussed shift in demand on the investment level, from office and retail toward industrial.
Buoyed by changing social and technological trends and exacerbated by the COVID-19 pandemic, industrial real estate has evolved in recent years from a slow moving and stable asset class to one with dynamism and rapid growth. That has drawn the attention of the largest and most opportunistic investors, including Blackstone, KKR, J.P. Morgan, AXA Investments, PGIM, Westcore and Allianz Real Estate, all of which have jumped into the industrial segment in force in recent years.
The influx of institutions demonstrates that some of the largest and most sophisticated commercial real estate investors have determined that the industrial surge is no flash in the pan. A considerable amount of smart money is betting that the growth in industrial real estate is still in its beginning stages.
GROWTH ACCELERATED BY PANDEMIC
Underpinning the industrial investment revolution is the sector’s fundamentals, which are driven by demand emanating from the growth in ecommerce that has been accelerated by the pandemic. As shelter-in-place orders and social distancing rules were put in place this past spring, people almost immediately shifted the bulk of their purchases to online shopping. Ecommerce/non-store retail sales increased by 23.4 percent through the third quarter of 2020, while food and beverage sales grew by 10.4 percent, according to Cushman & Wakefield.
The growth in ecommerce is not new; online sales have been growing by 15 percent per year since the early 2000s. That has increased demand for well-located logistics space with high ceilings and modern technology with robotics and sorting suitable for distribution. Absorption of industrial space — which barely topped 25 million square feet in 2010 — has exceeded 200 million square feet annually since 2014 and rose to a whopping 273.5 million square feet in 2020, according to real estate services firm JLL.
Rising demand for space with modern amenities has boosted industrial construction, and deliveries have barely been able to keep up with demand even as volume skyrockets. Deliveries totaled a record 327.2 million square feet in 2020, up 29 percent year-over-year, according to JLL. More than 300 million square feet was under construction as of year-end 2020, so the spigot isn’t likely to be turned off soon. The influx of supply prompted a small increase in the industrial vacancy rate in 2020, although it remains just over 5 percent and well below the long-term average. Rent growth increased 4.2 percent in 2020, per JLL.
Growth in ecommerce will drive demand for an additional 1.5 billion square feet of industrial space in the next five years, or around 300 million square feet per year, reports CBRE Econometric Advisors.
OUTPERFORMING OTHER PROPERTY TYPES
Strong fundamentals have helped industrial to outperform other commercial real estate property types. According to the MSCI PREA U.S. AFOE Quarterly Property Fund Index, which tracks returns of institutional money managers, the industrial sector has had the highest returns over the past one-, three- and five-year periods. As of year-end 2020, industrial produced annual returns of 11.4 percent for one year, 13.0 percent over three years and 12.8 percent over five years. Industrial property returns far exceeded any other asset class and the total index, which produced annual returns of 2.4 percent for one year, 5.4 percent for three years and 6.3 percent for five years.
The same story held for the public markets, where industrial topped every other property type and has been the only property category other than self-storage to have positive returns over one, three and five years. Annual returns for industrial REITs are 7.7 percent for one year, 21.2 percent for three years and 23.2 percent for five years, while the FTSE Equity REIT Index returned –5.0 percent for one year, 10.6 percent for three years and 9.1 percent for five years, as of Feb. 25, 2021.
Investors have taken note of the bullish performance, enabling industrial to attract an increasingly larger share of commercial real estate capital, both equity and debt. One example of this trend is the MSCI/PREA index. Industrial represented 23.3 percent of the index’s investments at year-end 2020, up by 7.6 percentage points (a 48.1 percent increase) from 2017, when it represented 15.8 percent of the index. In dollar terms, the amount of capital allotted to industrial in the index over three years grew by $29.5 billion, to $76.1 billion. Over the past three years, industrial accounted for more than 80 percent of the growth of the index, which totaled $316.9 billion in fourth quarter 2020, up from $280.5 billion in fourth quarter 2017.
Industrial is also taking up a greater amount of debt capital, in part because property values are increasing but also because lenders are eager to hold in their portfolios loans on what is considered an exceptionally safe asset class. While all commercial lending was down by 30 percent in 2020 and by 18 percent year-over-year in the fourth quarter, lending on industrial properties was only down 18 percent for the year and was up 15 percent in fourth quarter 2020 compared to a year earlier, according to the Mortgage Bankers Association.
CMBS is another example. Industrial loans have been a relatively small share of the market until recently. Loans backed by industrial properties comprised more than 10.5 percent of annual CMBS issuance only once between 2000 and 2018, with a high of 11.2 percent in 2015, according to Commercial Mortgage Alert. However, the market share of industrial loans increased to 16.2 percent in 2019 and a record 22.7 percent in 2020. Over the last three years, securitization programs floated $37.4 billion of loans backed by industrial properties, almost as much as the $39.3 billion securitized the 10 prior years combined, per Commercial Mortgage Alert.
What’s more, industrial loans are performing better than any other property type. Coming into the pandemic, only 1.4 percent of industrial loans in CMBS pools were delinquent, compared to 2.2 percent delinquency for all CMBS, according to data analytics firm Trepp. Industrial delinquencies peaked at 1.8 percent in May 2020 and have fallen to 0.9 percent as of January 2021. In contrast, the delinquency rate of all CMBS peaked at 10.3 percent in June 2020 and stood at 7.6 percent as of January 2021, per Trepp. CMBS delinquencies are being driven by hotel (19.3 percent as of January 2021) and retail properties (12.7 percent).
GROWTH LIKELY TO CONTINUE
The commercial real estate industry is undergoing tectonic shifts in demand and investment strategy. Population is moving from high-cost coastal metros to warm weather metros with more affordable housing and pleasant lifestyle amenities. Meanwhile, how we shop and use office space was evolving even before the pandemic.
Industrial real estate, which is a critical component of the growth in ecommerce, was a beneficiary of social trends even before the COVID-19 crisis. The pandemic produced a sharp spike not just in the volume of deliveries, but in the scope of products delivered, such as groceries.
While the outcome of the impact of the pandemic remains a question, there seems to be little doubt that there is no going back on the way people live their lives. Shopping seems a good bet to change permanently. As a result, occupier and investor demand for industrial real estate seems destined to take up a larger share of commercial real estate capital.
Paul Fiorilla is director of research at Yardi Matrix.