Industrial is going thru a big change right now, and tenants are demanding better space to stay competitive. Buildings and tenants are adopting new technology to increase efficiency. On the investment side, this is creating an environment of rising asset values. Builders are scrambling to find new land. The case for new building and reclassifying old buildings is sound with positive net absorption, low vacancy and a velocity of demand for new quality space. North America and Europe has seen a chronic shortage of industrial space, with vacancy approaching or at historical lows, causing rises in rental rates. If they get it wrong, billions of dollars are at stake.
E-commerce still makes up a small fraction of retail sales. Online shopping continues to grow as reflected in new warehouse supply and high absorption rates. Los Angeles, constricted by geography, has limited new product availability. The healthy development activity here is due, in part, by the vacancy rate near 1% attributed to e-commerce related tenants.
US CITIES TO DOMINATE PER CAPITA EXPENDITURE GROWTH
Despite the ascent and dominance of emerging cities, cities in the US will still see the largest absolute growth in real per capita consumer expenditure over 2017-2030. This signifies the continued dominance of the US population in being avid contributors to consumption and economic growth.
Trend 1: Re-purposing of Class C Industrial
90 percent of construction activity in the US over the next ten years is expected to be on existing buildings. (source: the future of architecture in 100 buildings)
The demand for unique retail and creative office space industrial is growing and investors are snapping up older Class C space that is unsuitable for modern industrial use and are re-purposing them.
The end of easy analysis
No longer can Limited Partners insist on pure play investment strategies to easily screen for risk and yield. Increasingly, LPs and responsive GPs are changing their investment strategies to allocate to value adds within Core and Core plus type funds. In a low yield, cap rate compressed environment where interest rates are continuing to rise, its mandatory that strong operators balance these low yield Core and core plus assets with value add (re-purposing/reclassification) in a singular fund.
This strategy is no different than a private equity firm conducting bolt-on acquisitions to expand a portfolio company’s capabilities and better investment IRRs.
Bottom line is no GP wants a low yielding fund and value add doesn’t scale, you cannot buy a portfolio of potential value add- so the opportunities are limited to individual, small, and sporadic acquisitions- just like bolt-ons.
Trend 2: New Building tech
Innovation has piled into industrial, it has directly changed and revolutionized our lives. Building operators use state of the art building monitoring systems and drones to anticipate repairs keep operating costs down. Utilities are a large component of rent, to keep these costs low, buildings are using LED lighting, solar and implementing truck docking systems keeping cool air in and hot air out. Warehouses are physically changing, getting larger and taller to pack more inventory per square foot. This means support columns have to be farther apart, and floor cement has to be thicker.
For investors, technology will improve:
- Decision making via city data & algorithms for price discovery, site selection, divestment/acquisition, leasing, risk management
- Leading edge building monitoring and management software
- Supply chain integration, PERE firms to start acquiring/building construction materials suppliers/manufacturers to lower costs of building materials used to construct buildings within their funds
- New energy hedging and insurance derivatives on tenant leases and buildings
- The new PERE firms are more agile, are be vertically integrated and able assimilate assets and tech quickly
Trend 3: Continued Demand
A decade ago E-commerce comprised a small total of retail sales. Today that total has doubled and grown to 15% of total US retail revenue and continues to grow by about 20% YOY. Final demand for consumer goods is the key driver of the logistics supply chain. That final demand this year is higher than in the last seven years. Clearly, this growth trend has helped logistics operators and their investors owning to supply chain capacity expansion amongst online retailers. Vacancy and absorption rates are at historical lows in the LA area. That lack of space is mirrored nationally in the industrial segment by low vacancy and high absorption rates. In Los Angeles, that expansion is constricted by geography, ocean to the west and south west, mountains to the east, leaving a narrow corridor in which to build. Opportunities for infills or the practice of tearing down existing buildings to make room for new, doesn’t happen often in Los Angeles. The old warehouses are so small that its not economic and tenants are demanding larger space. As a result, these older warehouses are being converted to retail and creative office space leased out at a higher final per square rent.
These trends will pose new challenges for industrial tenets and building owners, if the reaction is passive, both will lose market share and capital. The underlying theme here is flexibility, information and vertical integration. Funds or REITs that are prohibited or constrained to seek profit aggressively will be wanting in their returns over the next market cycle.