With some fundamentals slowing down, normalization may be the trend for industrial
February 17, 2023
Moderation is the key word for 2023, as we all look for a less volatile, deal-making pathway forward. A review of current economic indicators and the performance of top industrial REITs points to a more stabilized year that looks more like 2019 than the pandemic-fueled frenzy of 2021.
Following the volatility and uncertainty in the economy during the second half of 2022, there are signs that the industrial sector will continue its strong, but stable and normalizing path in 2023. This follows two years of robust activity when the sector recorded record leasing and occupancy levels due to pandemic-related demand. Industry experts are predicting activity levels that are more in line with 2019 than 2021 or 2022.
With the second quarter on the horizon, we offer a look at Avison Young’s key economic indicators and how they are shaping market sentiment.
Inflation has been at the top of mind over the past six months, as the industry grappled with the fallout of high inflation and the Fed's efforts to counter it with higher interest rates. The most recent inflation rate from January shows that annual inflation dipped slightly to 6.4% from 6.5% in December. When viewed over the long-term, inflation is showing a marked retraction from the recent high-water market of 9.1% set in June. The not-so-good news is that inflation is also showing its staying power, which could begin to weigh down consumer buying power and future warehouse & distribution deal making.
After taking out food and fuel prices, which have more volatility, the core inflation rate climbed 0.4% monthly in January, matching its previous pace. This is a reminder that the fight to curb inflation is not over. The real test will be how the economy evolves over the next 12 to 18 months.
The outlook for REITs
Industrial REITs have been one of the best performing sectors since before the pandemic, due to the rapid growth in e-commerce, along with supply chain modernization and other factors. As the pandemic upended traditional retail businesses, industrial's reach expanded to support those businesses as they pivoted from in-store sales to deliveries from industrial facilities.
Among the industrial REITs posting solid returns is First Industrial, which reported occupancy on its 68.9 million square feet (msf) of space reaching 98.8% during the fourth quarter of 2022, an uptick of nearly 1% over the third quarter. Rental rates increased about 33% on leases beginning in 2023, reflecting about half of the leases that will roll over this year. While the number of prospects for new space is down slightly, the firm is expecting demand to be active and similar to levels seen in 2019.
Rexford Industrial reported 98% occupancy for its properties. Same-facility net operating income grew by 7.3% in the fourth quarter compared with a year earlier. The REIT is mostly active exclusively in Southern California, which had the highest year-over-year rent growth of any U.S. industrial market. A significant factor in the strong performance is Rexford's proximity to the Los Angeles and Long Beach ports. The scarcity of land, along with development constraints, as well as a continued strong occupier demand for infill product are supporting a supply-demand imbalance that is beneficial to existing property owners.
Prologis, the largest industrial REIT, noted similar trends in its Q4 2022 . The company said that conditions for a contraction in U.S. industrial space usage don't exist in the same way they did during the dot-com bubble of 2001 or the Great Financial Crisis of 2008. During both of those historic market cycles, Prologis' occupancy was around 91%, compared with the 98% recorded in Q4 2022. Prologis added that the level of demand is so high that even if there is a mild recession, a period of zero economic growth--or a complete halt to absorption--occupancy across their 1.2 billion-square-foot (bsf) portfolio would drop only by 3%.
While these earnings reports showcase many positive drivers of industrial activity, REITs are not immune to higher capital costs and issues with wider bid-ask spreads and slowing transaction activity. Several industrial REIT executives are projecting a return to a more normalized level of activity in the industrial sector, which would translate to more restrained returns for REITs.
Fitch Ratings, for example, is expecting slower growth for REITS overall in 2023, including those focused on the industrial sector. The company is projecting that industrial demand will moderate and leasing will slow amid a recessionary environment. As a result, industrial tenants will find further incremental gains in e-commerce more difficult to achieve.
According to Real Capital Analytics, industrial sales across all investment categories for 2019 totaled $94.5 billion, compared with $85.6 billion in 2020, as the pandemic emerged, and then $139.5 billion in 2021 and $111.4 billion in 2022, as robust demand fueled an unprecedented wave of e-commerce and logistics activity. The average sales price per square foot increased from $80 in Q1 2019 to $125 in Q2 2022 and decreased to $113 by Q4 2022.
REITs have been increasing their buying positions, moving from 8.4% of buyers in 2021 to 16.4% in 2022 and 28.1% for the first month of 2023. They have been slightly less active on the selling side, accounting for 5.5% of sales in 2021 and 17.6% of sales in 2022. There were no industrial REIT sales recorded in the first month of 2023.
Rent growth to slow, but stay positive
Rent growth also recorded solid gains over the past several years and the level of activity is expected to taper off in 2023.
According to , rental pricing at the end of 2022 remained volatile and in flux, depending on the market, asset quality and the availability within target submarkets. While rent growth is somewhat of a lagging and reactionary indicator, rents have continued to increase but at a moderated pace. If demand slows or the number of tenants competing for space becomes limited, it will create an environment where more concessions are needed or occupiers regain some power over higher rents or rent escalations.
Manufacturing activity increases
Another factor impacting industrial growth is the manufacturing sector, which has seen positive momentum in recent years, thanks to the expansion of onshoring in the U.S. and an increase in domestic production, led by the electric vehicle industry and semiconductors.
While there are many reasons why bringing manufacturing back to the U.S. has stalled, the current Administration's efforts to increase manufacturing through the CHIPS and Science Act (Creating Helpful Incentives to Produce Semiconductors and Science Act of 2022) and other initiatives is starting to pay dividends. The recently enacted CHIPS legislation is expected to funnel more than $50 billion into U.S. science and technology innovation. Other efforts to increase electric vehicle production has also spurred investment through the automobile industry. One example is Intel's $20 billion computer chip plan being developed in Columbus, OH, one of nearly 120 manufacturing facilities under construction in the country. According to Avison Young research, foreign direct investment in U.S. manufacturing topped $2,108.6 billion in 2021.