Developers have greater influence this market cycle than ever before

Developers have greater influence this market cycle than ever before December 2, 2022

The days of unstoppable industrial development may be winding down or at least taking a short-term respite to catch up with the rest of the world. Interest rate hikes,  more restrictive lending requirements, and shifts in consumer demand are all pushing back against what has been a robust development cycle over the last several years. In this issue, we explore what development experts are seeing at the end of 2022 and how they are navigating this volatile economic period into the New Year.

Erik Foster

Head of Industrial Capital Markets
[email protected]
+1 312 273 9486

Construction pipeline strong, but now reactively slowing

The industrial construction sector has seemed unstoppable in recent years, as pandemic-induced demand accelerated an already healthy flow of new distribution and warehouse facilities across the country. That picture is changing, however, as developers feel the pain of the cumulative impact of interest rate hikes impinging upon tenant deal velocity and the uncertainty around future increases impacting longer-term underwriting assumptions.

Rising capital considerations combined with the correlating slowdown in lending activity has put a damper on construction starts and is forcing many developers to re-assess their plans for the next 12 to 24 months. While projects nearing completion and those with already committed capital are moving forward with fewer impediments, many new starts are logically moving more to the sidelines as developers re-examine their market positions over the next few years.

"The cost of capital is really what has put a damper on development right now," said Molly McShane, Chief Executive Officer of The McShane Companies. "The demand from tenants is slowing a bit but remains at relatively high levels in many markets."

Industrial, more than most asset classes – can shut down the development spigot more abruptly – and contain overbuilding concerns that plagued prior downturns

A look at industrial construction activity shows that the national pipeline is nearing an all-time high of 766.2 million-square-feet (msf) in major U.S. markets.. Deliveries reached more than 113.6 msf for the third quarter of 2022, a modest increase from the second quarter when 98 msf was delivered.

Chart of under construction historical volumes

While those numbers are strong, they represent construction that was in the works before the Fed began its quest this summer to combat inflation. Those statistics do show that the pace of absorption decelerated at the quickest pace since the third quarter of 2021, indicating a tapering of demand as occupiers react to recent economic shifts. Research shows that new construction starts have slowed about 2% over the last quarter but are still at a strong level and are significantly higher than pre-pandemic levels. In essence, the market is recalibrating and adjusting to life beyond the pandemic era leasing and construction frenzy.

Double immunity – development in already tight major markets offsets many near-term concerns

Development activity remains concentrated in many of the typical growth markets:  Dallas-Fort Worth (DFW), Phoenix, the Inland Empire, and Atlanta. Avison Young shows that the DFW market has 83.0 msf under construction across 229 properties. The market's record demand spurred significant construction with 30.0 msf delivered in 2021, slightly ahead of a typical annual number. Year-to-date net absorption for 2022 was 20.5 msf, which is also ahead of past trends. This more than double the typical DFW average but it is mostly speculative, suggesting that lease-up may be weakened for all but the best assets.

Nationally, an aggressive industrial market is beginning to see some nascent pull back from anxious industrial occupiers, most notably with Amazon tapping the brakes earlier this year on about 20 projects. Given current economic conditions, other large occupiers are also taking another look at the growth plans put in place during the rush to secure space during the pandemic. There is always the possibility of smaller, not necessarily scaled-back activity. However, for site selection decisions to occur across multiple markets for the long-held claim of “just-in-time” versus “just-in-case” that will have to be proven in significant time series data.

Working our way back to equilibrium? 

McShane notes that while the long-term outlook for demand is positive, the huge spike in demand for space that started during the pandemic is not sustainable. "So many companies realized that they had taken on more supply risk than they thought when the shock in the supply chain happened," she said. "Now you see an increased demand for space to hold safety stock. Eventually we will get to a point with the increased warehouse demand that tenants are no longer playing catch-up."

Chart of inventory growth vs vacancy

In search of debt and more equity

The cumulative impact of the Fed's interest rate hikes are now being seen in the debt and equity markets, as lenders tighten their requirements and some large banks pause commercial real estate lending. While property performance remains strong for many assets due to the strong investment climate in 2021 and the first half of 2022, the uncertainty around financing variables makes underwriting a challenge.

Michael Powers, Senior Principal with Molto Properties, expects underwriting to be difficult until the market settles down. "Projecting terminal cap rates is very difficult.  When we start a project, we assume a sale after +/-36 months. In this environment, it’s hard to say where cap rates will be in three months, let alone 36 months."

This level of uncertainty around the cost of capital makes it difficult for developers to plan for projects that often take 24 months to build. Powers notes that his company has evaluated whether to add in joint venture partners on future projects instead of funding them solely with internal capital sources. "In the last 12 to 18 months, we've been exploring joint ventures, though they have become very difficult to execute, in light of the volatility in the market."

Build, stabilize, hold, sell – an ever-evolving but changing dynamic?

Molto Properties is also stress-testing deals to gauge how they would perform with a longer hold time. "Historically we have built buildings, leased them and sold them individually or as part of portfolios, shortly after stabilization," said Powers. "Now we are taking time to evaluate different holding periods. We want our financing to allow for holding assets longer in the event the capital markets are not favorable to a sale."

This scenario is occurring as developers are emerging from the days of significant occupier labor as well as construction material shortages and the correlating cost increases during the early days of the pandemic. While many of those costs have now normalized to a great degree, there are still fluctuations.

"All the major inputs we use to underwrite deals--hard costs, interest rates, cap rates, rents--are in flux right now, so it's challenging to evaluate new projects, particularly on sites we don't already own," said Powers. "There is a level of uncertainty in the market we haven't seen in the last five to seven years."

The question on everyone's mind is how long will this uncertainty last? When will inflation subside and interest rates slide back to more palatable levels?

"It's not just that interest rates are moving up, but it's all the uncertainty," says McShane. "It's hard to underwrite deals when the rates are still moving. We can adjust deal economics once rates plateau. Until then, I think it will be slow in development for at least the first couple months of 2023. Now is the time for developers to be patient, which is not typically what we're good at."

Sources: AVANT by Avison Young Innovation & Insights, Bisnow, Construction Dive

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