Industrial: The Ugly Duckling, or a Beautiful Swan?
In just two years, industrial real estate values have appreciated by an impressive 18%, according to Green Street's Commercial Property Price Index. The sector’s explosive bull run was not entirely unexpected, since there were early indicators of increasing demand. The magnitude, however, continues to surprise to the upside. Ecommerce, the key demand driver disrupting the space, is creating an environment where forecasting is particularly difficult. The same forces driving demand in the U.S. are at work in Europe. Global industrial investors may find opportunities by looking at the stages of ecommerce penetration in the European market. The question remains, how long will the good times last?
In 2016, analyst Eric Frankel first quantified the dramatic impact that ecommerce was having on warehouse demand.
“The amount of warehouse square footage that is required to deliver goods via ecommerce is a lot greater than standard brick-and-mortar,” Frankel said. “We’ve seen demand increase by roughly 20% over the last several years, to 30-40% this year.” Frankel’s estimate on the 30-40% demand boost from ecommerce still holds.
It’s all about efficiency
Supply chains of retailers and logistics companies are quickly adapting to accommodate higher volumes and faster speeds in package shipping by locating warehouses in densely populated areas. The bull case for industrial demand rests on the thesis that a much greater amount of warehouse space is required to serve ecommerce compared to brick-and-mortar sales. Green Street believes warehouse sales productivity will become an important metric over time, offering investors a number of insights. Amazon’s warehouse network provides a good starting analytical framework, especially relative to a supply chain predominantly geared toward brick-and-mortar sales, like Walmart. A review of these two companies reveals that ecommerce sales require at least 2.25x more distribution space than brick-and-mortar retail.
More demand = more supply
As industrial fundamentals have gradually improved, vacancy rates have dropped to record lows and market rents have reached all-time highs. Green Street expects the strong pace of market rent growth to continue. In past real estate cycles, strong rent growth has at times spurred too much development. “New supply could be a danger sign for the market,” Frankel said. “But to date, demand has been so good that there has been no problem with supply being absorbed.”
This healthy equilibrium between supply and demand is likely to hold over the next several years. “It is more difficult and costly to add new supply than it has ever been,” Frankel says. The complexities associated with identifying and entitling sites to meet tenants’ location density requirements, along with rising land and construction costs, is helping to prevent oversupply.
Location, location, location
REIT development pipelines are not as big as they were in 2007, but they are more profitable. The REITs have been relatively conservative and selective this cycle, targeting locations in densely populated areas that make long-term sense. Last year, Frankel started highlighting the attractiveness of dense markets along the coast. "Coastal markets are expected to continue outpacing the rest of the United States over the next five years in terms of rent growth," he wrote in Green Street’s 2017 U.S. Industrial Outlook. During periods of high demand, coastal markets often significantly outperform as higher barriers tend to limit supply, create rent spikes, and keep vacancy rates low.
Is there risk?
Frankel previously highlighted two potential risks for the industrial sector - consolidation in the ecommerce space, and the adoption of protectionist trade policies under the Trump administration. How large will Amazon (i.e. the 800-pound gorilla) become as it continues to gain market share as both a dominant online retailer and a leading logistics provider? Amazon is in the process of acquiring organic grocer Whole Foods for ~$14 billion (view report), as it aims to broaden its business and gets closer to customers’ doorsteps. While consolidation risk is still top-of-mind, concerns over potential protectionist trade policies have gradually waned over the past year. “Amazon is a greater risk than trade,” Frankel said recently. Generally, however, all industrial demand drivers remain in good shape despite a modest slowdown in retail sales.
A glimpse across the Atlantic
“Demand is greatly increasing in Europe,” Frankel says, and that is being driven by modest economic growth and increasing online penetration rates. Robust trade growth in recent years has led to growing supply chains that have helped drive demand for big box industrial real estate. While this trend is not showing signs of slowing in the near term, could saturation be an issue in the longer term?
Amazon continues to expand globally to support its sales growth – in 2016, it accounted for nearly a quarter of the 35 million square feet of take up in the United Kingdom. Green Street's European team has found that the ecommerce market is generally more mature in North-West compared to South-East Europe. Demand for industrial space has spilled into markets like Poland, where the cost of order fulfillment to neighboring markets such as Germany is materially cheaper. Like in the U.S., demand is keeping up with new supply.
Locally-listed European REITs own a modest amount of institutional-quality stock at nearly €15 billion ($17.8 billion) compared to U.S. REITs, which own roughly $65 billion. Prologis has been Europe’s most prolific developer over the past two decades and it remains the largest owner and manager of industrial properties; 13% of the REIT’s overall portfolio is dispersed throughout five countries in Europe.
Green Street remains bullish on industrial fundamentals in the United States and Europe. Developers are innovating and looking to turn properties from other sectors into potential sites of redevelopment for warehouses. However, many communities remain reluctant to support industrial projects. For now, the sun is shining on the industrial sector, so let the good times roll.
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