A reflection on the industrial market as we mark the third anniversary of the COVID-19 pandemic
March 17, 2023
Lockdowns, Zooms calls, bleach wipes and mask mandates. Looking back at the last three years is difficult, realizing how the pandemic dramatically changed our daily lives. At the three-year anniversary of this historic event, reflecting on a multitude of economic whirlwinds, political divisiveness and social upheaval - how did the industrial real estate navigate through those years of supply chain chaos, disruption and resilience?
In March 2020, the first COVID-19 lockdowns began in many states, shutting down businesses, schools, stores and community gatherings as government agencies took extraordinary steps to stop the spread of the virus. What began as a wave of temporary closures and virus mitigation plans would lead to dramatic reshaping of norms across every sector of society.
Here are some observations of then and now. The change and disruption have been constant since the spring of 2020, but let’s dig into how the pandemic has impacted and redefined the industrial sector.
Economic conditions shift up, down and sideways
Economic conditions shifted and turned significantly over the course of the pandemic in reaction to the healthcare emergency and its impact on health and medical concerns, employment, business operations, and myriad of other issues. In the first year of the pandemic, inflation was fairly steady, moving from 2.5% in January of 2020 down to 1.5% in March and then back up to 2.6% in March of 2021. As we now know, the next two years would see a notable uptick in inflation due to supply chain shortages, persistently low interest rates, an oversupply of stimulus funding for the pandemic, the war in Ukraine, amongst other factors. In fact, March 2021 was the last time monthly inflation was under 3%.
Inflation kept building over 2021 and into 2022 before hitting its peak of 9.1% in June of 2022. As the Federal Reserve stepped in and still continues its aggressive approach to interest rate hikes in an attempt to slow consumer spending and bring inflation down to 2%, the impact has been felt across the commercial real estate sector.
Inflation has eased for eight months and is currently at 6%. Consumer prices climbed 6% year-over-year in February 202?. Considering core prices, which exclude food and energy costs and are closely watched by the Fed, shows the level rose 5.5% year-over-year, down slightly from 5.6% from January 202?.
Given the recent bank failures and concerns over broader weakness in the banking sector, all eyes are on the next Federal Open Market Committee (FOMC) meeting, slated for the week of March 20th. Some economists predict the Fed may pull back from further interest rate increases in the near term to limit further market angst, although others see a 25 bps increase as likely.
e-commerce expands sales, global reach
During the early, lock-down days, e-commerce saw significant gains as dramatic shifts in demand pushed online activity to record levels. As many consumers adapted or expanded their online buying habits, others embraced it for the first time and remained part of the e-commerce ecosystem, giving it a significant boost.
Global yearly e-commerce sales jumped by 19% in 2020 to reach $2.86 billion, with food and personal care products having the highest increase (26%). The surge in online sales jumped another 22% to reach $3.28 billion in 2021.
All of this pandemic-related activity boded well for the industrial sector, as it drove warehouse and distribution space usage, along with demand for transportation services. From the beginning of the pandemic until early 2023, average hourly wages in the transportation and warehousing sector increased by 13.1%.
Energy, commodities suffer with war in Ukraine
The geopolitical environment also has significantly magnified global tensions since 2020 and caused further current and future potential shocks to already fragile global supply changes, most notably with the fallout from Russia’s invasion of Ukraine that began in February of 2022. In addition to the widespread human suffering, the war has created volatility in the supply and transport of grain, fertilizer and oil. Consumers have been feeling the pinch at the gas station in recent months, but added supply and other factors are helping to improve this issue.
Current concern over the banking system is weighing on markets worldwide and has pushed down the price of oil in recent days to below $67, its lowest price since November 2021 and down from $80 a week ago. This week’s plunge follows data on slower domestic demand and a steady build up in inventories. The American Petroleum Institute reported that inventories rose for the 10th straight week, ending March 10.
This level is in stark contrast to 2020, however, when oil was $57.52 per barrel in January and then $29.21 in March and $16.55 in April. As lockdowns ended, commuting or vacation travel picked back up and overall demand increased, oil prices rose to $52 in January 2021, then $83 in January of 2022.
Sector real estate fundamentals continue to demonstrate resilience
Industrial fundamentals remain strong, despite rising interest rates and uncertainty in the market. The overall U.S. industrial vacancy rate was at 4.2% at year-end 2022, an increase of 10 basis points from the third quarter, the first increase during the pandemic era and since Q3 2020. Vacancy at its most recent cyclical low in 2018 was still 60 bps higher than it is now, however. And, it remains well below the 10-year quarterly average.
Development activity has steadily increased since 2010, but accelerated in 2022. Low vacancy rates across the country and the persistent demand for modern, efficient space have been key factors. There was 132.3 msf of industrial space delivered nationally in Q4 2022, a 30.8% increase over the same period in 2021. In addition, there also another 752.1 msf remaining in the construction pipeline.
The industry has been hamstrung at times by material shortages and the resulting cost increases, but supply has continued to move through the pipeline. According to research by AVANT by Avison Young and CoStar, annual deliveries as part of overall existing U.S. inventory increased by 3.5% as of Q4 2022. Overall, there remains a scarcity of space unless more speculative development delivers unleased and remains on the market for extended periods of time throughout 2023.
Rents strong but tapering
An Avison Young review of rent growth shows the impact of both e-commerce demand as well as supply chain normalization as the pandemic settled in at the end of 2020 and into 2022. At Q3 2019, quarter-by-quarter rent growth was just above 1.5% and it declined to 0.18% by Q3 2020 as the pandemic manifested, only to resume an upward trajectory averaging 2.8% growth throughout 2021 and 2022. Quarterly rent growth has risen steadily to reach 4.5% at Q2 2022 before dropping to 4.2% at Q4 2022. This translates to a 16.6% annualized rate and is also 13.3% higher than at Q3 2021. There are several factors at play, including limited availability options, competition for space, increasingly inadequate land for new development, the difficulty in negotiating concessions over the last few years and the trend in landlords pushing up escalations. Those dynamics may shift if demand slows or the competition for space becomes more limited.
Capital flow surges then slows
The surge in e-commerce activity during the pandemic further accentuated the benefits of investing in industrial facilities, fueling sales that reached record levels in 2021. While sales volume remained strong throughout the pandemic when compared with historical figures, 2022 ended with a significant contraction in activity as many investors put “pencils down” and moved to the sidelines in search of more certainty around interest rate hike and future capital flows.
According to Real Capital Analytics, U.S. industrial sales volume was $94.5 billion in 2019 and $85.6 billion in 2020. The figure jumped significantly for 2021, reaching a record $139.5 billion as the heightened focus on online shopping continued to stick with consumers.
While rising interest rates began to stall deal flow in the second half of 2022, the quarterly sales figures remained higher than those typically seen in the pre-pandemic era. Sales for Q3 2022 reached nearly $26 billion, down from $30.1 billion in Q2. The year ended with nearly $28 billion in sales in Q4 2022 and a total of $111.4 billion for the year.
Average cap rates compressed from 6.0% at Q1 2020 to 5.7% a year later and 5.3% at Q1 2022. They dipped to 5.2% for the next two quarters and then ended the year at 5.3%. Cap rates for top assets, however, compressed further, from 5.0% at Q1 2020 to 4.6% at the end of 2020 and into Q1 2021, dipping to 3.9%at Q3 2021 and ranging from 4.3% at the beginning of 2022 to 4.4% at the end.
All-in-all, the industrial sector not only weathered the impacts of the pandemic, but as supply chain congestion cleared, thrived from it. There are new headwinds to face in 2023, but a significant level of resiliency is expected as 2023 progresses.
Sources: Associated Press, AVANT by Avison Young, Federal Reserve