Warehouses Outperform in Cloudy Commercial Real Estate Environment

Antonio Uve

Despite recent negative headlines surrounding the commercial real estate sector, there are still a few bright spots. Industrial warehouses are one of them. The sector has been red-hot for a number of years now and even with a slowdown in the number of new warehouse transactions, is still outperforming.

The latest report from research group CommercialEdge, shows that average industrial rents – including warehouses – have increased every month over the last year and stood at an all-time high of $7.15 per square foot as of March. Vacancy rates are also extremely low at 3.9%. Nationally, 636.6 million square feet of new industrial space was under construction as of March, including warehouses, according to CommercialEdge data.

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Brian Lawrence, senior vice president and commercial real estate team leader at Univest Bank and Trust Co., expects that headline numbers like these will remain elevated over the near to medium term.

“We have seen a significant increase in demand for warehouse space with the uptick in use of e-commerce and delivery services since the start of the pandemic,” he says. “There are also a large group of CMBS lenders in this space including insurers and banks who are still transacting even though the cost of capital has increased.”

The growth of delivery services for things like groceries and household items is driving the need for so-called ‘last-mile’ warehousing, Mr. Lawrence said. These are warehouses that are within a 2-4 hour drive time delivery window and facilitate services like grocery delivery. “We’re seeing some of these facilities built on spec as they get approvals, which indicates confidence in being able to get tenants,” he says.

Stuart Katz, CIO at wealth management firm Robertson Stephens, believes this demand is part of a long-term secular trend. “Many people developed new habits during the pandemic and we don’t see them going back,” he says. “This was the case before the pandemic, but people spending so much time at home brought the trend forward a few years. The large coastal markets are leading the way in terms of total demand but we are seeing growth everywhere.”

Anyone who has been frustrated by having to track down a keyholder at a retailer to unlock everything from detergent to a single can of soda and never returned, is driving current and future warehousing demand.

Institutional investors aren’t blind to these trends. Warehouses are taking up a bigger and bigger part of global property funds. This month, Blackstone made a bid for a listed UK property investment trust offering landlord Industrials REIT (MLI) a 42% premium to take over its warehouse REIT in the UK.

Mark Reinikka, managing director for asset management at real estate investment firm BentallGreenOak, adds that there’s another pandemic-trend driving demand and that’s the need for nearshoring. Many companies fresh off pandemic induced supply chain woes are looking for space to bring storage onshore or at least on the same continent. “This is a fairly long-term shift that we’re going to see because you can’t just find space and write contracts overnight,” he says. “But what we’re seeing is a combination of storage and the need for warehouses that can support critical manufacturing.”

Curves ahead

The tightness in the market for warehouses could surprise some investors that have been burned by this sector before, says Stephen Dye, global analyst at Duff & Phelps Investment Management.

During previous periods of economic uncertainty, warehouses haven’t always performed as well. They were plagued by some of the same issues we now see in office space – over building and difficulty refinancing. There were some hints that a similar issue might arise for warehouses again, when Amazon started readjusting its contracts with warehouse landlords after overestimating its square footage needs. However, those issues were relatively limited and haven’t led to significant underperformance, Mr. Dye adds.

Mr. Dye says there is still the potential for refinancings to be difficult in the current rising rates environment, but it’s unlikely to be at the level of previous downturns in the sector. Financing new projects might still be difficult if they require a significant amount of debt, given the rising rates environment and tighter liquidity overall.

Warehouse developers are now facing a new problem, however. Some communities are pushing back against industrial sprawl and are limiting how many warehouses can be built and where. But Univest’s Lawrence says this could be a boon for investors that could see elevated rents as the result of higher competition for space.

Automation could also solve the problem of warehouses being pushed further out and away from denser urban and suburban areas. In recent years, large retailers have invested in automated fulfillment, which means they can run a warehouse with fewer human workers, making it easier to put warehouses in areas where the potential labor force is smaller.

“This is probably a net neutral for the sector,” Mr. Katz says. “Tenants are generally going to pay for these upgrades, but landlords might add-on some capabilities on their own if it proves to be valuble.”

Mr. Reinikka notes that developers may take a closer look at ways to add value to projects, because much of the existing warehouse stock in the US is old and in lieu of brand new buildings updates could be a net positive. “There is a demand for bigger truck bays, modern column spacing, automation, concrete floors,” he explains. “The obsolescence of the existing stock is becoming a negative factor.”

Warehouse developers also could make their bids for new space or redevelopments more attractive by incorporating solar panels into building construction. Mr. Lawrence notes that some states like New Jersey are pushing warehouses to install panels and sell their excess power back to the grid. “These are large buildings with flat roofs – it’s sort of a natural fit and could be a value-add down the line,” he says. “It also makes the buildings themselves more energy efficient.”

Even with these challenges, sources agree that warehouses are positioned to perform well over the long-term. “We’re going to see some new supply come online in 2023, which will eventually get absorbed. We should start to see vacancy decrease again in 2024, and perhaps a positive reacceleration in rent growth,” says Mr. Dye. “There is still strong demand coming to meet the 2023 supply wave, and with some developers pencils down on building, market fundamentals and rent growth within the sector will remain strong.”

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Tags: BentallGreenOak, Blackstone Group, Brian Lawrence, CMBS, commercial real estate, CommercialEdge, Duff & Phelps Investment Management, Mark Reinikka, Robertson Stephens, Special Coverage: Real Estate, Stephen Dye, Stuart Katz, Univest Bank and Trust Co., Warehouses

Antonio Uve

The abrupt spike in interest rates over the past 12 months has been bleak for commercial real estate, which depends on relatively short-term financing strategies. Those cyclical headwinds have combined with secular ones—a possible new normal of half-empty offices, for example, and the continued decline of brick-and-mortar retail shops—to create a perfect storm for the asset class.

As redemption requests have poured in, behemoth asset manager Blackstone has had to cap the amount of money investors can pull out of some of its private, non-traded real estate investment trusts. Over the past few months, another giant real estate operator, Brookfield, has defaulted on roughly a billion dollars worth of mortgages for trophy properties from Los Angeles to Washington, D.C.

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“The last 12 months have caused a shockwave to the capital markets, valuations, rental rates and the lending environment,” says Christopher Okada, CEO of real estate advisory firm Okada & Co. “Business plans have gone awry.”

But analysts and investors are starting to coalesce around a view that the Federal Reserve is likely to pause rate hikes and possibly even begin cutting them: Trading on futures markets suggests a likely November decline in rates. Could it be the reprieve CRE needs?

The answer is a resounding, “It depends,” experts say. That is largely because any decline in rates will likely be accompanied by a much softer economy—and, as a result, less demand for space.

But the credit picture is more significant than rental revenues, say experts like Okada—and that one is likely to remain difficult for some time, even if rates soften. It all suggests we’re in for an extended period of uncertainty—a “staring contest,” in the words of Jim Costello, chief economist of the real assets team at information provider MSCI.

“In the last handful of cycles, when rates have declined, spreads have increased,” says Drew Thornfeldt, a managing director at Chatham Financial. “Borrowing costs are still going up, even as rates decline, and lenders are less willing to lend.”

Roughly $900 billion of loans are set to mature in the next two years, according to early April calculations from Capital Economics. For maturing loans that were made in a period of ultra-low rates, lenders will likely ask developers or property owners to contribute more money to get new deals done. “The question becomes, do we put more money into this project or are we sending good money after bad?” Okada says.

Capital Economics forecasts a 30% drop in prices for office buildings, of which 25% is still to come, with a recovery not due until about 2026 or 2027. The group expects valuations for industrial space—warehouses, mostly—to fall 14% by the end of 2023, as the dramatic lurch to e-commerce at the onset of the pandemic unwinds a bit.

However, the latest report from research group CommercialEdge, shows that average industrial rents—including warehouses—have increased every month over the last year and stood at an all-time high of $7.15 per square foot as of March. Vacancy rates are also extremely low at 3.9%. Nationally, 636.6 million square feet of new industrial space was under construction as of March, including warehouses, according to CommercialEdge data.

Retail space, which has already been beaten down by the generational shift away from brick-and-mortar shopping, is expected to decline 6.5% in 2023 yet be the only sector to enjoy “positive annual capital growth” over the next four years.

The residential sector remains a mystery. The acute shortage of housing, particularly more affordable options, seems to suggest the sector could be relatively insulated from any market declines—particularly in Sun Belt metro areas, which have pulled in many Americans searching for cheaper rents, sunnier weather and more space.

But in early April, a Houston-area developer lost 3,200 units to foreclosure as rates spiked, a sign that some seemingly safe sectors may not be immune.

Another consideration: If real estate that’s already cash flowing is having trouble, what about projects that are still being built? Most new-build loans are written to extend for the duration of the construction phase, MSCI’s Costello explains. But that leads to the uneasy prospect of developers stalling half-completed work until rates come back to earth, not to mention new buildings being opened in a period of slower take-up.

The big question for investors is whether the opportunities available in the sector are worth the risks, particularly if the “staring contest” lasts for the next few years.

“If we plateau at this range of rates, there will be short term agita, but once it resets, I think there are going to be people who do very well to buy now,” Okada says. “This is the most opportunistic time that I have seen in 14 years. 2023 is a once-in-a-generation opportunity to buy at 50% off with half the amount of competition.”

Chatham’s Thornfeldt describes a more selective environment than the froth of the past decade. “A lot of people have made money investing in real estate in the last 10 years,” he says. “There’s a segment of the universe of real estate investors excited to see a little more challenge in the market. Returns are going to be more contingent on who has the best business model, who has the know-how.”

Alex Pettee is president of Hoya Capital Real Estate, which manages a high-dividend yield real estate investment trust. “Distress for some is an opportunity for others,” he says.

For investors considering deploying capital, Pettee draws a distinction between public markets where REITs have historically operated with conservative debt levels using long-term fixed-rate debt, and private markets, which account for many of the high-profile stories of distress rippling through the sector now.

Kiran Raichura, Capital Economics’ deputy chief property economist, advises entering into any investments with a conservative view on revenues for the next few years. “It’s going to be a tough slog for the next few years.”