Industrial real estate may not be the most glamorous property type, but it’s increasingly become more of a head-turner across many aspects of our economy. Rarely will a passerby gaze in awe at a warehouse facility like they will at a modern newly-built shopping center or mixed-use high-rise. But as we’ve all learned at one point or another, you can’t judge a book by its cover, and you can’t judge industrial real estate by its facade.
These properties are the workhorses of the economy. When industrial real estate is “hot,” that can often be an indication of an expanding economy that is innovating, producing and shipping products. To truly understand this vital component of the commercial real estate space and economy overall, let’s start with the basics.
What is Industrial Real Estate?
Industrial commercial properties are those that can be used for the research and development, production, distribution and storage of goods, among other uses. A broad range of property types are considered to be industrial, with some of the most common being:
- Flex space: Typically hybrids between office and research and development facilities, which may include labs, testing space and light manufacturing. Flex space may also include a mix of office and warehousing.
- Light manufacturing: Assembly of products with lighter and more versatile machinery.
- Heavy manufacturing: Heavy-duty and customized equipment, large square footage and ample loading dock space.
- Food production facilities: Processing and packaging of foods and beverages for restaurants and grocery stores
- Cold storage facilities: Storage and distribution of food and beverage products to retailers. Can often be found in combination with food production facilities.
- Warehouses, fulfillment centers and other logistics facilities: Storage and distribution of goods to retailers or customers, crucial for e-commerce businesses.
Like other types of commercial real estate, industrial properties are categorized within three different classes: Class A - modern, amenitized facilities in desirable locations; Class B - older and perhaps slightly outdated properties in secondary and tertiary markets; Class C - rundown properties in need of renovation.
Single-Tenant vs. Multi-Tenant Industrial
One of the main classifications in commercial real estate is whether a property is single-tenant or multi-tenant. As the names suggest, the differentiating factor is the number of tenants in a single property - one or two or more.
Most industrial real estate is single-tenant due to the very nature of the type of business activities these properties house. Class A single-tenant properties are typically located close to major transportation hubs or, in the case of e-commerce last-mile fulfillment, in infill city locations or close to large population centers.
Only about 38% of industrial real estate is multi-tenant and many of these properties were built decades ago on the fringes of urban centers which have since grown and engulfed these multi-tenanted warehouse, distribution, R&D and flex spaces into the urban fray.
Typical Single-Tenant Elements
- Longer leases, usually 10-20 years providing predictable, long-term cash flow
- Typically a NNN lease structure, where tenants pay for property taxes, insurance, maintenance costs and any other expenses required at the property level
- Leases often include rent increases built into the lease, which allow for moderate rent growth and can hedge inflationary pressures
- High occupancy rates
Typical Multi-Tenant Elements
- Shorter leases, oftentimes fives years or less
- More potential for growth but may also carry more risks in terms of tenant vacancies, re-leasing and property management costs
- Typically a gross lease structure, where the tenant is only responsible for rent payments, while the property owner covers property taxes, insurance, maintenance costs and any other property related expenses that may arise
- With more frequent tenant turnover, ability to increase rents in bull markets
- Possibility of vacancies or hard-to-lease spaces
Industrial Commercial Real Estate Trends and Forecasts
2021 was a year of incredible growth for industrial real estate with industrial equity REITs bringing returns of 62% and an implied market capitalization of $202 billion, according to an investment performance analysis by Nareit. The growth story of industrial real estate over the past year is really a story of our times. Spurred by the pandemic, ensuing recovery and changed consumer behaviors, the prominence and preference of industrial real estate, particularly that pertaining to ecommerce, has increased among investors.
Ecommerce has Dominated Industrial Real Estate
Ecommerce sales are still above pre-pandemic levels and are following a trend line that has been steadily increasing since the introduction of online shopping. In the 10-year period between third quarter 2011 and third quarter 2021, ecommerce sales have increased 328%, while brick and mortar sales have increased 47%. We can expect the demand for strategically located 3PL (third-party logistics) last-mile facilities, fulfillment and distribution centers, and warehouses to continue to be strong and a mission-critical component of this sector’s growth.
Plot Twist: How Supply Chain Issues Led to Onshoring
During the past few years, the antagonist in the industrial real estate story has been supply chain issues. From lumber and toilet paper shortages to cargo ships lined up offshore at the Port of Los Angeles, one thing there wasn’t a shortage of was wrinkles in the supply chain. In 2021, the cost of ocean freight increased more than 200% and domestic freight costs increased more than 40%, according to Drewry Supply Chain Advisors and the Cass Freight Index.
With increasing demand for goods among consumers, elevated transportation costs are most likely to remain. According to CBRE, transportation costs amount to 40%-70% of a company’s logistics budget, while leasing and facility costs come in at around 3%-6%. As a result, companies are increasing inventories and looking to lease more strategic and mission-critical manufacturing and logistics space closer to their customers to avoid supply chain issues.
In a 2021 survey by Thomas, an industrial sourcing platform, 83% of North American manufacturers responded that they are likely to reshore production and add U.S. suppliers to their supply chain. This is further evidenced by the $204 billion in request for quotation (RFQ) bids in 2021 for American-based suppliers compared to $69 billion in 2018. Metrics for manufacturing space last year showed positive net absorption of 40 million sq. ft. (compared to 17 million sq. ft. in 2020), decreased vacancy and record rents. As with any good story the protagonist comes out on top and as onshoring plans and at-home supply chain goals come to fruition over the next few years, demand for industrial space, particularly manufacturing, isn’t likely to cease.
Supply Will Catch Up with Demand for Industrial Space
Supply and demand problems weren’t just an issue for store shelves but also for industrial real estate supply. Demand for industrial space hit a record high in 2021 with supply trailing significantly behind. Net absorption, or the amount of space newly occupied less space newly vacated, is estimated to be more than 507 million sq. ft. in 2021 with new construction of industrial properties coming in at 376 million sq. ft. Looking forward to 2022 and 2023, net absorption is expected to be 855 million sq. ft. with a new supply of 932 million sq.ft., slightly easing supply issues but nonetheless keeping supply tight, especially for Class A space. Class A industrial space is in high demand and, with vacancy rates near zero in coastal areas, much of the new development may come from the Midwest, particularly locations with proximity to transportation networks. In other words, companies are seeking strategic locations for their mission-critical business operations.
An analysis by Cushman & Wakefield showed that vacancy rates overall were also at record lows in 2021 at 3.8%. A slight uptick of 30 bps is expected by the end of 2023, making the vacancy rate 4.1%, still 170 bps below the 10-year average. Demand pressures are accordingly affecting prices as well with average rent per square foot expected to reach $8.72 by the end of 2023.
Source: Cushman & Wakefield
Source: Cushman & Wakefield
A Hot Market Means Cap Rate Compression
High demand and low inventory indicate a hot real estate market and rising property values. And when property prices increase, capitalization rates compress. Capitalization rates, or cap rates as they are typically referred to, are one of the most frequently used measures for assessing the relative value of real estate investments. They are used to estimate an investor’s potential return on a property and are calculated by dividing the net operating income of a property by its sale price or current market value.
In 2022, the demand for industrial is projected to further compress cap rates, and spreads between primary and secondary markets will narrow, according to CBRE, meaning prices are likely to increase across most markets with some rising more quickly than others
Cap Rate Compression for Industrial Assets
Industrial Real Estate to Remain Robust in 2022
Despite port congestions, material shortages and other supply chain issues, the sector has shown record transaction volumes, occupancy rates and rent growth in 2021. With supply remaining tight and increasing demand, industrial real estate has the potential to remain strong into 2022 and beyond.
Modiv’s Industrial Portfolio
Single-tenant net lease industrial properties are a core position of Modiv’s portfolio. Industrial assets make up over a third of our REIT portfolio with a wide breadth of tenants including Earthbound Farm, a leading producer of fresh vegetables; 3M, a multinational manufacturing conglomerate; and Kalera, a leader in the emerging low-water, low-energy vertical farming industry.
We focus on acquiring strategically important and mission-critical assets net leased to primarily investment grade tenants and leverage a proactive asset management strategy to create value. To ensure tenant retention, we seek industrial assets that are difficult to replicate or relocate.
Find more details about our industrial properties and overall portfolio here.
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The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.