Investing in industrial real estate has been an investor favorite for decades, especially for institutional investors. The industrial sector has consistently demonstrated resilience, even during economic downturns, making it an attractive opportunity due to its stability and profitability.
With the rise of e-commerce and the increasing demand for warehousing and distribution centers, the industrial real estate market is thriving. In this article, we will delve into the economic trends behind industrial real estate (including a new driver of growth) and look at some of the key benefits and risks of investing in this asset class.
What is Industrial Real Estate?
Before we go too far, let’s first set the stage – what is an industrial property? Industrial real estate refers to properties used for industrial purposes, such as manufacturing, warehousing, distribution, and research and development. These properties can be standalone buildings or multi-building complexes, and can include features such as loading docks, high ceilings, and heavy power supplies. You’ve probably driven by them and not even realized what they were used for. But this sector of real estate is essential to the growth and vitality of the U.S. economy.
And if you haven’t been following trends for this asset class in recent years, it’s actually experiencing a huge boom. What is happening?
Growth Trends in the Industrial and Manufacturing Sector
Industrial real estate values have been flourishing in recent years, far outpacing other forms of commercial real estate like retail and office buildings.
There was an initial boost to industrial real estate in 2008-2009, rising in pace with retail and office. We can also see in the chart above, that inflation (the dashed blue line) has been growing steadily over the past 40 years. All forms of commercial real estate have been pretty close to the inflation line over all that time. But over the last 10 years, industrial real estate has been skyrocketing, now surpassing retail in the last few years. So, what’s been causing this surge in valuations?
This next chart shows the supply and demand trends for industrial real estate.
The gray bars are the number of completions (or newly constructed properties) in a given year, being brought to the market. The orange bars show net absorption, meaning the properties being leased up (or absorbed), and taken off the market. In the past two years we’ve seen record absorptions.
Even with record levels of industrial real estate being developed, these properties are being absorbed even faster. If you follow the yellow line, we see the net vacancy rate is dropping. Vacancy rates now are hovering around 2.9%.
So what’s going on?
Key Drivers of Growth in Industrial Real Estate
The large growth for industrial real estate can be attributed to several factors: the rapid rise in eCommerce, supply chain disruptions, and the reshoring of manufacturing to US soil.
Rising E-commerce Strengthens Demand for Industrial and Manufacturing Space
E-commerce has been a huge driver of the industrial boom over the past several decades. As e-commerce has grown, the need for keeping inventory and for distribution and warehousing has massively increased.
In the above chart, you can see e-commerce sales spiked substantially in 2020 as the pandemic hit and people weren’t able to leave their homes and instead needed to get things delivered to them.
But after that spike, it very quickly dropped and then started to plateau. We believe that e-commerce growth as a percent of total sales will probably continue to increase, but at a much slower pace, as people still prefer to shop in person for certain things.
E-commerce growth, which has been one of the biggest drivers of industrial real estate for so long, is starting to slow down. But at the same time, we’re now seeing several new trends causing a resurgence of industrial growth – bringing manufacturing back to America and the “re-inventorying” of critical manufacturing components. And we believe that’s going to be another big rocket booster to industrial real estate.
Supply Chain Disruptions Highlight Importance of Resilient Operations
We have all seen plenty of headlines in the last few years about supply chain disruptions. Here’s an interesting case study.
Ford, like many other automakers, has been dealing with the effects of a severe microchip shortage. Tens of thousands of Ford trucks are sitting in parking lots, unable to be sold. The missing microchips, which are needed to complete the cars, have been held up by supply chain disruptions. This is a byproduct of having outsourced the manufacturing of these critical components overseas.
Because of this, Ford has over $2 billion of potential revenue that they can’t capture just sitting in parking lots. So the question is, “how valuable is it to Ford to control the manufacturing of this critical component?” The answer is very important!
And Ford isn’t just an isolated case, this is happening all across U.S. (and even European) manufactures. Supply chain disruptions have had a significant impact on industrial real estate in recent years. The pandemic has disrupted global supply chains, leading many companies to reassess their logistics and storage strategies. This has resulted in increased demand for industrial real estate as companies look to bring their supply chain operations closer to the end customer.
Reshoring Manufacturing Drives Need for Industrial Real Estate
For decades, we shipped our manufacturing jobs overseas for the most. But it has started to shift in the last few years. The number of manufacturing jobs that will be brought back to the US is projected to hit 350,000.
Here’s another chart showing manufacturing employment.
If you look back to the 1990s, the manufacturing employment trend was pretty clearly heading downward. But instead of continuing to see a decrease, we’ve started to see an uptick in US manufacturing jobs in the last 10 years.
Outlook on Industrial Growth
Despite very strong underlying growth factors over the long-term, stubbornly high inflation and economic slowdown concerns may make for slower growth in the short-term. Commercial Property Executives (CPE) research highlights that “although both investor and occupier demand is still high, absorption, rent growth and sales activity are simmering down.” Though CPE expects labor shortages and rising construction materials to be some of the biggest challenges for industrial developers this year, it also forecasts that “industrial assets are anticipated to be among top performers across the commercial real estate sector in 2023.”
Deloitte’s research is also showing a positive outlook for commercial real estate in 2023 from survey results. “When it comes to real estate fundamentals—cost of capital, capital availability, property prices, vacancy levels, leasing activity, transaction activity, and rental rates—most respondents (66%) expect improving or stable conditions for next year. Respondents point to leasing activity, tightening vacancies, and rental growth as having the strongest potential for improvement.”
From An Investor’s Perspective – Is Industrial a Good Investment?
When it comes to assessing the actual opportunity for investors in industrial real estate, there are several things to consider.
Risks of Investing in Industrial Real Estate
- Risk of vacancies: Many times these properties can be occupied by a handful or even a single tenant. If that tenant stops paying or becomes insolvent, that impacts potential cash flow in the short-term.
- Build-to-suit risk: When a developer undertakes building an industrial property to the specifications required by the tenant, that’s called build-to-suit. This customization means the property may be harder to lease out again should the tenant ever leave or stop paying rent.
- Speculative Development: On the other side of the development coin are “speculative” developments, meaning no tenant(s) are identified prior to construction. This could result in a vacant property if not developed correctly or it’s in a non-growth market.
- Modernization risk: The industrial sector is always evolving, meaning requirements for machinery, loading docks, HVAC equipment loads, or building access could change. This can potentially leave the building outdated and in need of expensive modernization.
Benefits of Investing in Industrial Real Estate
- Strong demand: The demand for industrial space has been growing due to e-commerce growth and the increasing need for warehousing, manufacturing and distribution centers.
- Long leases: Because moving large-scale operations to another industrial facility can be a big undertaking, most tenants stay put for a while, and leases can be much longer than in other types of commercial real estate.
- Long-term appreciation: Industrial properties tend to appreciate in value over time, and as shown in previous charts, values have significantly outpaced other asset classes and inflation.
- Inflation hedge: Inflation can increase operating costs, but rental income from industrial properties can also increase, offering protection against inflation.
- Tax benefits: Industrial real estate investments can offer favorable tax benefits, including deductions for depreciation and operating expenses.
- Less oversupply risk: While other real estate asset classes may hit market saturation with more available properties than demand, this is less likely in the short term for industrial real estate, given the steady e-commerce trends, historic undersupply, and growing industrial space needs with the reshoring of manufacturing processes.
Investment Opportunities in Industrial Real Estate
While we are not investment advisors and you should speak with your own financial counsel, at Aspen, we are very excited about the opportunity in Industrial real estate, both in 2023 and in the longer-term.
If you’re curious to hear more about these trends and a specific investment opportunity, register for our webinar on Thursday, Feb 16, 2023 at 2pm Central.
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Ben Fraser is the Managing Director and Chief Investment Office of Aspen Funds. Prior to Aspen, Mr. Fraser was a commercial lender at First Business Bank specializing in government backed loan originations (SBA & USDA), for one of the top SBA lenders in the nation. Prior to that he was a commercial credit underwriter for Crossfirst Bank, personally responsible for underwriting over $125MM in C&I and CRE loans across a variety of industries.