Stabilization in both economic and financing expectations could encourage more investors to begin transacting again

After months of economic uncertainty, the Fed's softening stance on interest rates is welcome news. Will slowing inflation and more clarity over capital costs bring investors back to the market soon? We break down the current economic and financial market climate and look at what's ahead for industrial capital markets as we move through the first quarter of 2023.

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Have we turned a corner?

After months of rising interest rates, economic uncertainty and a pullback in capital markets activity, this week's decision by the Fed to soften the blow to a 25 basis points rate increase is welcome news. While it may not spell the end of rate increases over the course of this year, it does provide a ray of hope that increasing stability is around the corner. The Fed's move emphasizes that key indicators are moving in the right direction. Inflation is moderating, the job market remains resilient despite layoffs in multiple industries and, while headwinds persist, the economy is on more solid ground.

The question on many investors' minds is whether we are turning a corner toward more normalized deal flow. Given the high level of uncertainty in the industry in recent months, this Fed action could serve to quell some nerves and refine the market outlook. As capital costs become more stabilized, it will likely lead to renewed confidence and a thawing of the current bid-ask spread that is influencing deal flow. Ultimately, it may be another catalyst for investors moving back into the market and lenders being more willing to make deals.

Here's a look at key market indicators that will help determine the path forward:

Investment volume shrinks

According to Avison Young research and Real Capital Analytics, the U.S. industrial sector experienced a 20.3% year-over-year decrease in investment volume and a 12% decrease from Q3 to Q4 of 2022, as rising capital costs and economic uncertainty pushed many investors and lenders to the sidelines. While annualized 2022 volumes declined after a record year of investment in 2021, the fourth quarter of 2022 still posted consistent volumes relative to earlier in the year, at $27.8B, but down from significant year-end closings from 2018 to 2021. The deals that we have launched in the marketplace since the first of the year are garnering significant activity, so the appetite within the sector from both foreign and domestic sources is strong. However, rising interest rates do create some uncertainty, yet we do not see a pause in activity, but there is a change in risk-adjusted return assumptions from early ‘22.

As more clarity returns to the market, a pricing reset is on the horizon and will lead to more stability and an increase in investment activity. Given e-commerce trends, supply chain risk mitigation, growth in new industries and the potential for increased reshoring, the industrial sector remains well positioned to weather any type of price adjustments compared to office, hotel and retail. As the economic climate continues to improve, investors who have favored industrial real estate are more likely to return to this sector due to its strong long-term performance. In terms of risk tolerance, lenders and investors with a deep understanding of potential risk surrounding a particular property will be best positioned to succeed in this dynamic market.  The Fed may continue their actions increasing rates, the real lending costs will moderate, and even flatten in the coming days as lenders compress spreads.

Rent growth expected to remain above inflation

The industrial sector has seen robust rent growth for many years and while those numbers are set to moderate, they are expected to be well above both historical norms and current performance of most other asset classes. Global industrial rents grew by 30% year-over-year in 2022 as restructuring of global supply chains and build outs of e-commerce capabilities created robust demand of space, with vacancy remaining low in many markets. Increased land scarcity, rising regulatory barriers and rising construction costs slowed new supply in prime locations, according to the recent Prologis Logistics Rent Index.

Markets with high-quality infrastructure that is close to the end consumer are expected to outperform the market. Prologis expects rent growth to normalize somewhat due to the slower pace of deal-making and increased supply, but still remain at a healthy level above inflation.

Fundamentals still strong

While the U.S. industrial aggregate vacancy rate rose 10 bps from the third to fourth quarter of 2022, the 4.2% level remains strong. Net absorption in the fourth quarter was down a slight  0.7% from the prior period, but down 29.2% from the fourth quarter of last year, according to Avison Young research.  As un-leased speculative deliveries continue to hit the market and some demand begins to slow, pockets of vacancy are materializing.  However, leasing fundamentals continue to be buoyant and, given how persistently tight the market has been, conditions could release some pent-up demand and allow occupiers new opportunities to expand.

Construction deliveries in Q4 2022 were 132.3 msf, a 30.8% increase over the same period in 2021. Development has continually escalated since the end of 2013, and demand has supported this activity – especially given low levels of vacancy in many markets and the push for new, highly-efficient logistics space.

The new development pipeline has been curtailed in recent months, however, given the impact of interest rate increases, the correlating higher cost of capital, pervasive uncertainty over the trajectory for inflation and the hangover effect of rising construction costs. While construction activity may be lower than expected in 2023, there remains a scarcity of space unless the pre-leasing of speculative development slows considerably and/or newly delivered product sits on the market for extended periods.

What's ahead?

The current bid-ask spread is narrowing fast, many buyers and sellers who used to be at odds over valuations are finding congruency as new debt levels are becoming the norm; equity pressure continues for buyers, so there will be more assets come to the market in the coming days.  Given economic shifts and the lower level of activity and comparable sales in recent months, lenders and appraisers will be working with new assumptions and changing requirements in determining valuations.

The good news is that the industrial sector remains the most coveted asset class and is likely to fare well despite some market challenges. Given the recent economic upheaval, a pricing reset is a necessary step in regaining a healthy level of sales activity. This week's Fed announcement provides a step forward toward finding that new sense of normalcy.

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Sources: Avison Young, Real Capital Analytics,  CNBC, Forbes, Prologis