Where to find value in the U.S. industrial market
Considering the recent tear that the property sector has been on over the last few years, the industrial market goes into 2019 on strong footing with record absorption and rent growth as a result of increased focus by companies to expand and re-tool their distribution networks. And, while industrial has always enjoyed a favored position within most institutional asset manager’s portfolio composition due to its lease profile (predominantly longer-term, net-lease structures) and comparatively low capital expenditure nature, those managers who have chosen to overweight their portfolio with industrial in recent years have been riding a wave of strong performance to likely outperform their index. First let’s take a quick look back at that performance and then turn our attention to where the property sector goes in the coming years.
Looking Back at Industrial Over the Years
When looking at NCREIF returns as of the third quarter 2018, the industrial sector led all major property types in return both on a short-term basis with a 3.36-percent return for the quarter as well as a long-term basis with an eight percent compound average return over the last 10 years. Industrial was followed by retail (7.6 percent), apartments (6.4 percent), office (5.2 percent) and hotel (4 percent). The delta in industrial returns versus the other property types becomes much wider when you look at performance over the last three years, as industrial has averaged a 13-percent return during this period versus six to seven percent for the other major property types. This is due to a balanced combination of both income and capital appreciation. When you look at the public REIT sector, industrial has been a stellar performer with a 20.58 percent return in 2017 that pulled back to -2.51 percent in 2018, which still put it near the top of the list of performers in a weak year for the sector, according to Nareit data.
As you look at large-scale portfolio trades, there continues to be a premium associated with Blackstone’s Gramercy acquisition trading at a five-percent premium and Prologis’ DCT acquisition trading at a 26-percent premium to NAV. Many private-sector trades in the last 12 to 24 months reflect a similar premium, though we have lately seen non-homogenous portfolios come to market that have failed to generate the same level of activity and pricing, which is a sign that buyers continue to have discipline on what they are willing to pursue. Overall transaction volumes continue to be at all-time highs with $92.4 billion of trades in 2018 versus $73.8 billion in 2017, a 25.3 percent uptick according to Real Capital Analytics. Based on a belief that we are “late-cycle,” if you factor in the strategy that a lot of institutional managers have employed with regard to low-CAPEX sectors, which include multifamily, student/manufactured housing, healthcare, industrial and self-storage, then the divergence in transaction volume becomes even more evident as low-CAPEX property types have taken on a larger share of overall volumes in the last few years.
What About Property Performance?
So how does property performance correlate to these historical returns/transaction volumes and what does the future hold regarding property-level fundamentals? If you look at supply/demand going back to 2010, demand has continued to outpace supply for 33 out of the last 34 quarters according to CoStar. That gap has narrowed significantly in the last few years due to an increase in the construction pipeline, but it was still expected that demand would be 10 million square feet more than completions/supply in 2018 according to Prologis’ third quarter earnings call. Same-store net operating income grew 5.4 percent across the sector for the public REITs, and, according to CoStar, overall annual rent growth stood at 6.2 percent with a number of supply-constrained markets continuing to see double-digit rent growth as of the third quarter 2018.
What Should Investors Expect from Industrial Real Estate in 2019?
What is projected in 2019? More of the same but less robust growth based on some concerns about whether the market can keep up with the torrid pace of the last few years in the face of more uncertainty regarding global trade. CoStar projects rent growth of five percent in 2019, while J.P. Morgan projects FFO growth of 2.7 percent for the REITs they cover in 2019 followed by a rebound to 5.6 percent in 2020. Last-mile product is likely to continue to drive rent growth in 2019 as it has in recent years following rent growth of 9.4 percent in 2017 and 7.3 percent in year-to-date 2018 through the third quarter, which puts it on pace to eclipse 2017.
The question is how does the market outperform the projections for 2019? The likely answer there ties back to e-commerce and overall retail sales since e-commerce accounts for nearly 50 percent of all industrial absorption as depicted in the chart below. While overall retail sales are expected to grow another four percent in 2019, e-commerce is expected to grow 15 to 16 percent and result in a tremendous amount of absorption. While everyone thinks of Amazon as the dominant player in the category, there are several other large retailers that are currently in the middle of significant expansions to supply chains via additional regional distribution centers as a result of their focus on the e-commerce space. Among these are Best Buy, Home Depot, Lowe’s, Five Below, Costco, Wal-Mart and Kroger.
Where Should Investors Look for Industrial Opportunities?
Numerous clients ask how and where they should look for opportunities going into the new year, and I advise them that there are still a number of ways to find value across the industrial sector. Ideas include continuing to develop in markets where demand is outpacing supply as several core/value funds are doing currently, investing in niche property types like cold storage and truck terminals that are becoming more mainstream and even being more willing and aggressive in pursuing smaller one-off trades that may historically fall a bit below the radar of most institutions.
You may chalk it up to “broker-speak,” but we strongly believe that the sector is in a strong position to continue to outperform the broader real estate space due to the underlying supply/demand fundamentals, ability to turn off the future supply pipeline faster than other product types and an increasing focus by tenants both large and small to compete in an environment that continues to value getting goods to the individual consumer in a faster and more efficient manner.