Lending constraints slow construction but demand is resilient
June 2, 2023
Industrial development is experiencing notable headwinds as rising interest rates and a constrained lending environment push back against what has been a robust cycle of activity since the start of the pandemic. In this edition we take a look at the challenges ahead as groundbreakings slow, all the while, a large amount of new construction hits the market in 2023.
Industrial construction decelerates but demand remains resilient
As industrial development slows in response to rising interest rates and a constrained lending environment, the market is closely monitoring how a slowdown in groundbreakings will impact deliveries over the next 12 to 18 months. Tenants looking for newly constructed space may have limited options relative to prior years.
Rising vacancies and a record number of new deliveries in 2022 caused the industrial development pipeline to decline in Q1 2023 to the lowest level reported since Q4 2021. New construction ground-breakings topped out in the third quarter of 2022, with new ground breakings in Q1 2023 representing just 10.0% of the space under construction.
As construction financing curbed new speculative development, the U.S. industrial groundbreakings by quarter peaked in Q3 2022 at approximately 57 million square feet (msf) before tapering to 41 msf in Q4 2022 and then 21 msf in Q1 2023.
Demand for industrial space remains strong and despite economic and financial headwinds, industrial net absorption continues to show its resiliency. According to Avison Young research, new spaces continued to be leased as deliveries hit historic levels in 2022. Overall, demand has kept speculative space supply additions in balance.
From a historical perspective, construction activity also remains strong. Industrial construction deliveries have increased steadily since 2013, surging during the pandemic and then slowing in the fourth quarter of 2022. Activity across all size ranges dropped at year-end then fell more dramatically in the first quarter of 2023.
Demand for industrial space remains healthy, with approximately 65 msf of space absorbed in the first quarter, a 40% decrease from Q4 2022. As demand shifts back to pre-pandemic levels, there is also a significant amount of space in the pipeline that will deliver in 2023. Nearly 140 msf of space, a record level, delivered in Q1 2023 and is expected to push up vacancies in many markets.
Dallas-Fort Worth construction strong but slowing
The construction slowdown is impacting industrial markets across the country, including those that have been leading the space expansion over the last decade. In Dallas-Fort Worth, one of the top U.S. logistics markets, the development pipeline includes 218 properties totaling 65.5 msf, with 300,000 square feet (sf) under construction.
While vacancy has inched up recently, it remains well below its long-term average of 8.4%. This increase has been due to the significant deliveries hitting the market the last few years, driven by the region’s ongoing high demand. The vacancy rise is due to the lag in lease-up of new development, not any market imbalance or demand shortfall. For properties delivered in 2020 and 2021, vacancy is now below 6 percent, slightly tighter than the market average. In comparison, buildings delivered in 2022 are roughly 33% vacant as owners work to stabilize the assets.
While Dallas-Fort Worth and other markets will see vacancies rise due to the new construction delivering, those conditions are expected to tighten again next year in several regions across the country.
The long-range outlook for industrial construction remains strong as many companies are reexamining their capital spending plans due to higher debt costs and tighter lending conditions.
According to Construction Dive, Intel recently completed the first phase of its $20 billion semiconductor facility, located east of Columbus, OH. The project, the largest private sector investment in Ohio, spans nearly 1,000 acres and will include up to eight semiconductor factories.
The project is being completed with funding from the CHIPS Act, which allocated nearly $53 billion in grant, tax credits and other incentives for semiconductor research, development, manufacturing and workforce development. Despite a nearly 70% drop in manufacturing starts in April, manufacturing projects remain strong when viewed on a year-over-year basis and are being driven by these types of massive projects.
New players move into industrial
Despite the slowing demand and investment activity, some companies are diversifying into industrial to expand beyond other sections that are facing challenges, such as office and multifamily. One example is Chicago-based Glenstar Properties, which is looking to tap into the industrial sector’s resiliency and long-term growth potential by expanding into ground-up development, starting with a warehouse project in the Southeast.
Meridian Group shifted its investment strategy to include industrial development at the end of 2021, given the soaring demand for logistics space during the pandemic. The company is working on a three-msf development in the Northern Virginia/Washington, DC area and is also focused on warehouses in both West Coast and East Coast markets.
Industrial development is entering a challenging cycle with the expected slowdown in development. However, market demand drivers continue to point to a positive outlook, albeit one that is more normalized after the pandemic. Avison Young will continue to monitor market conditions as we move through economic uncertainty and shifting supply and demand scenarios.