Rising Costs, Limited Supply Place Pressure on Thriving Industrial Property Market

Trent Agnew

Heading into 2022, industrial real estate market fundamentals have never been better. The struggles right now are surrounding supply to keep up with the overall demand and adjusting to the rapidly rising costs.

In first quarter 2022, the U.S. market delivered 89.9 million square feet of industrial space and continued the torrid pace of absorption with 110.8 million square feet, pushing overall vacancy to 3.4 percent, a historical low for the sector.

According to JLL Research, labor and material costs are up more than 13.6 percent over the past 12 months. For warehouses, they are up as much as 20-25 percent. These increases are putting amplified pressure on rents and making it more challenging for development deals, particularly those with long lead times, and forward sales, which are quickly gaining in popularity.

While the industrial pipeline was considerably robust pre-pandemic, the pandemic itself caused significant delays and cancellations. Labor shortages and COVID-related restrictions further delayed many projects, and the volatility of construction material pricing was unparalleled to any point in history.

As a result, developers are getting creative in markets where space and land is severely strained, like the Inland Empire, Los Angeles, and New Jersey, where current vacancy sits below 1.00 percent. The idea of converting underutilized retail, office, and manufacturing sites to logistics use has been popular as has the adoption of multi-story development concepts to maximize space and revenue from each square foot of urban land.

Population growth and migration patterns have played a factor in which cities are seeing the highest number of new deliveries hit the market, with Dallas/Fort Worth, Atlanta, Inland Empire, Phoenix, Houston and Memphis leading the pack.

Amid favorable market conditions and demographic trends, Sun Belt markets have seen some of the largest year-over-year increases in project costs and rents as well. As such, there has been a shift in investor sentiment towards smaller markets in the past six months, including Salt Lake City, Nashville, Austin, Raleigh, Las Vegas, Reno and San Antonio, resulting in significant cap rate compression.

Due to the market’s overall strength, there continues to be robust investment from both private capital and institutional advisors/REITs. For example, the ODCE (Open-Ended Diversified Core Equity) index has seen industrial allocations double to 28 percent as a result of both income and appreciation and a bigger push into the sector by some of the largest buyers.

The sector currently seeing the most material impact on pricing is the single-tenant, long-term lease component of the market (10 years), with anywhere from 25 basis points on single-asset trades to 50-plus basis points on portfolio transactions depending on contractual rent increases offered within the lease. Coupled with rising interest rates and borrowing costs, investors are shifting capital deployment away from longer lease terms and focusing on vacancy or shorter lease terms, which could create opportunity for some buyers to emerge.

Class A and Class B cap rates continue to narrow and are probably at an all-time low in terms of their spread; however, as Class B product tends to have shorter lease terms, they are providing increased mark-to-market opportunities in comparison to Class A product and the shallow bay segment of the market continues to outperform on overall rent growth.

Near term outlook

According to JLL Research forecasting models, rents are expected to increase by more than 8 percent across the entire base in 2022 and could be accelerated by year-end. Given continuing tightening in the market, vacancy rates will remain below the 4 percent threshold through the balance of the year.

As projects currently in the pipeline are not expected to deliver until 2023, the market will remain in a supply shortage and continue to struggle to meet the short-term surges in demand. While there continues to be an influx of new deliveries hitting the overall market, development timelines across the country have increased and are expected to remain high.

Intense competition for space will give landlords in the hottest markets (New York City, Mid-Peninsula, Silicon Valley, Long Island and Los Angeles) the ability to hold space vacant and be selective on leasing strategy.

For institutional investors, it would be wise to pivot some capital back towards the longer-term lease and/or multi-tenant products, which have a weighted average lease term of five to 10 years and will likely have a larger mark-to-market spread over the next couple of years. These core assets have continued to perform through various cycles. Matching that strategy with a continued push into development to take advantage of rent growth should allow an investor to achieve a strong blended yield.

Trent Agnew, is senior managing director & co-head of JLL Industrial Capital Markets platform.