Why Industrial Is Falling Back to Earth But Not Off a Cliff
Demand for new product is shifting—not disappearing, observes CRG's Susan Bergdoll.
Despite a recent Wall Street Journal headline announcing “the end of the great American warehouse building boom,” industrial development is falling back to earth in 2024, not off a cliff.
We’re essentially returning to pre-pandemic levels, reflecting moderated—but still robust—consumer demand and e-commerce growth. Strong metrics, including rental rates and absorption, also make this time far different than after, say, the Great Financial Crisis. In this environment, well-capitalized developers will have the opportunity to build with less competition, and investors can rest assured industrial continues to be one of the strongest CRE sectors.
GFC vs. 2023: A tale of two market cycles
Rising interest rates, tighter lending standards and a dip in demand did cool new construction starts last year, with approximately 450 million square feet under construction nationally in Q4 2023, a 34 percent decrease over a year earlier, according to Cushman & Wakefield. The vacancy rate was 5.2 percent, net absorption was 41 million square feet and asking rents were $9.79 per square foot. By contrast, in Q4 2019, there were 321 million square feet under construction, a 4.8 percent vacancy rate, net absorption of 69 million square feet and asking rents of $6.51 per square foot.
As someone who has been in commercial real estate for 25 years and was working in industrial during the run-up to and aftermath of the GFC, I can say with confidence the cooling of the market right now is nothing like that time. New construction dropped from 189 million square feet in Q3 2007 to 123 million square feet in Q3 2008, 31 million square feet in Q3 2009, and 25 million square feet in Q3 2010.
The vacancy rate hit 10.7 percent by mid-year 2010, according to Cushman & Wakefield research, and did not return to long-term historical averages until Q1 2015, when it was 6.8 percent.
Given that environment, developers have been relatively constrained in the post-GFC era. In the cycle before the GFC (2002-2007), 90 percent of new construction was speculative, according to Cushman & Wakefield, but 62 percent after (2012-2022). However, in 2023, 84 percent of new product was speculative, a number I think may start to decrease again this year as developers seek to mitigate risk.
E-commerce, manufacturing drive demand
According to the U.S. Department of Commerce, e-commerce sales reached $284.1 billion in Q3 2023, up 2.3 percent from the prior quarter and 7.8 percent from a year earlier. We keep ordering stuff, as the prevalence of the Amazon delivery truck on our streets each day attests, and we want it delivered ever faster, necessitating more warehouse and distribution facilities.
Another reason for optimism in industrial growth is the increasing consensus that we need to make the U.S. supply chain more resilient, which means more reshoring and nearshoring of manufacturing operations, particularly on the coasts and borders. As David Wagner at Fidelity noted:
“After decades of underinvestment in the U.S. industrial base, supply-chain difficulties during the pandemic and geopolitical tension have highlighted the advantages of greater U.S. self-sufficiency. As a result, hundreds of billions of dollars in federal funding and other incentives are set to pour into infrastructure, onshoring/reshoring, combatting climate change, and the ‘electrification of everything,’ through legislation such as the 2022 Inflation Reduction Act and the 2021 Infrastructure Investment and Jobs Act. This massive investment could help drive long-term growth for the sector.”
The Creating Helpful Incentives to Produce Semiconductors and Science Act of 2022 also will help spur development, according to a report from Deloitte. Funds and tax incentives to fuel U.S. manufacturing already are driving record private-sector investment in manufacturing and increased construction, although persistent labor shortages need to be addressed.
Smaller footprints, big opportunities
The year won’t be without its challenges, of course. While the Fed is expected to begin cutting interest rates, the degree and timing of such decreases remains unclear, creating uncertainty in the capital markets. We predict lenders will favor smaller industrial projects of 300,000 square feet or less, which are less risky and reflective of current market demand. Leasing activity for 300,000 square feet or more fell by almost a third in Q2 2023 compared with the year-earlier period, according to CBRE, as Fortune 500 companies braked expansion plans due to economic uncertainty. E-commerce, in particular, prioritizes decentralization and smaller fulfillment centers closer to consumers. Many developers, including my firm, CRG, will be focusing on smaller infill developments and acquisitions over the big-box and mega developments we did more of in the past few years.
Conditions will vary by submarket, and I do think we’ll see correction in certain areas. But I expect rental rates to continue to be strong and vacancy to stabilize at historically average 5-6 percent levels. Far from falling off a cliff, I believe the market has settled into a sustainable growth trajectory that will make it a safe bet for developers, lenders, owners and occupiers in the years ahead.
Susan Bergdoll is senior vice president & partner, Midwest Region, for CRG.