Industrial real esate in 2018: what to expect

Despite GDP growth hovering around two percent annually for the past seven years, industrial real estate will continue to outperform due to e-commerce driving the market

Industrial has been the most sought-after property type for the real estate investment community over the past three years, and all indications point to that continuing in 2018.  Historically, industrial property demand has been a function of economic growth; however, the recent growth of e-commerce, 15 percent annually, and the need for “one-day delivery” has fueled a secular shift in industrial use and tenants. Forecasters predict that, for every $1 billion in additional e-commerce sales, another 1.25 million square feet of distribution space is required. This means that at least another 85 million square feet of additional distribution space will be demanded in 2018. Therefore, despite GDP growth hovering around two percent annually for the past seven years, industrial real estate will continue to outperform due to e-commerce driving the market.  

Transaction Volumes/Sizes Continue to Rise

According to Real Capital Analytics (RCA), total industrial volume has increased from a low of $10.3 billion in 2009 to a high of $78 billion in 2015.  After a drop in volume in 2016, 2017 had the second highest transaction volume in history at $72.2 billion, a 20 percent year-over-year increase. The Northeast alone accounted for more than $8 billion of that activity.  In the Northeast, we have seen year-over-year growth of seven percent attributable to a combination of single-asset sales and larger portfolio transactions, including the sale of The Hampshire Companies’ 1.25 million square foot northern New Jersey portfolio as well as Duke’s purchase of a 3.4 million square foot portfolio, of which 2.3 million square feet are in northern New Jersey.  There is a significant amount of capital demand for large Class-A portfolios, and the scarcity of opportunities is creating pricing premiums of seven to 12 percent.  The capital markets are willing to pay these premiums for core industrial product with size.

Industrial Pricing Remains Strong

Investors have flocked to the industrial sector because of its impressive year-over-year rent growth (approximately seven percent nationally), historically low vacancies (approximately five percent nationally) and positive economic fundamentals, including strong absorption and limited development. Surplus capital and increasing demand has driven pricing for Class-A distribution space in core locations to the 3.75 percent to 4.5 percent cap rate range. We expect north of $200 per square foot for Class-A distribution space in core locations to become the new normal.

Funding Deficits Largest Among Investors

With dry powder at all-time highs, increasing industrial allocations and foreign investment up approximately 30 percent in the segment, we expect to see record pricing and significant activity in 2018.  Institutional industrial allocations will be surpassing retail allocations over the next year, as investors increasingly meet their retail targets with industrial product. This is possible due to the amount of cross-over in e-commerce between retail and industrial property types. Insurance companies and sovereign wealth funds have 200 to 300 basis point funding deficits relative to their targets, which results in large inbound queues among fund managers. It is clear the under allocation has been amplifying demand for industrial product.

Expanding Market and Product Types

Due to increasing demand and competition between debt providers, investors are more willing to expand to secondary markets and unique product types, including those with higher levels of office fit-out, Class-B and C-product, short-term single tenant opportunities and cold storage, in return for higher yields.  Class-B, light industrial product is seeing a significant amount of institutional interest at a 25 percent to 30 percent premium to replacement costs. In addition, as many investors have noted, no industrial asset is too small in northern New Jersey, as the urbanization trend makes smaller, but well-located buildings useful as last-mile distribution centers.

Capital Deployment via Large Development Sites

Despite the demand for industrial product over the past three years, development has remained limited due to the lack of entitled land sites, increasing construction costs, and bank regulations on development opportunities. Consequently, pre-leasing rates in the Northeast are among the highest in the country at over 85 percent in 2017. In addition, capital is adopting speculative build-to-core strategies in secondary markets to meet return requirements and satisfy immediate tenant demand. The Rockefeller Group acquired a 228-acre site with plans to develop 2.2 million square feet in Piscataway, New Jersey, a branch of the New Jersey Turnpike Corridor, with the first phase already 100 percent pre-leased to a large national retailer. We had significant institutional interest from all investor types to provide joint-venture equity up front for a multi-phased project.  

We expect higher transaction volume in 2018 as investors continue to be under allocated industrial product when compared to other asset classes. In addition, we expect larger portfolio sales and recapitalizations to be a significant trend in 2018 as developers take chips off the table while still maintaining partial interest.

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