Industrial Supply Fueled by 'Extreme' Premium on Cap Rates

An extreme premium on cap rates for new assets has led to a surge in industrial supply, according to a new analysis from Real Capital Analytics. 

As consumers shifted buying habits and moved to online shopping amidst the pandemic, the need for industrial space increased exponentially, driving up investor interest in the sector. Now industrial property prices are at a record high—leading some investors to say it’s tough to find deals. And, as RCA’s Jim Costello notes, “if you cannot buy it, you build it.”

“The growing difficulty of sourcing deals in the industrial market can make development look like an attractive option,” Costello writes. “There are other reasons one might deliver new space, however. One notable issue is that while cap rates are at record lows, the premium on cap rates for the newest assets is at an extreme as well.”

US Department of Commerce data shows that the value of new construction put in place for warehouse assets was $39 billion in February 2021, an amount that’s 2.6 times higher than the average annual pace of new supply from 1993. And even without inflation, Costello notes, the value of new supply is twice as much as the annual average since 1993.

“Investment in new supply should follow trends in asset prices, and as cap rates plumb new depths, developers and investors will find it advantageous to construct new buildings,” Costello notes. “Developers often underwrite a project as a function of a targeted return on cost where they are willing to move a project forward. If they know that this target return on cost is achievable at a 6.5% cap rate, but then the market unexpectedly moves to a 6% or even 5.5% level, all other things equal they will attempt to bring even more projects to the market to capture the unexpected profits in front of them.”

This, Costello says, is where we find ourselves today, as industrial cap rates have fallen “well below” previous record lows. But, he says, it’s important to remember that the market average cap rate isn’t what a developer will use in underwriting a new project. Instead, they’ll look at cap rates on similar deals, and “these suggest the accelerating pace of new supply should cool,” he says. Cap rates for newly built industrial properties was at 5.2% at the end of last year, which is consistent with prior year averages.  But cap rates for existing properties have fallen consistently since the end of 2018 and hit 6.2% at the end of 2020.

This floor, according to Costello, is also reflected in the growth of new supply coming online.

“New supply is still at cyclically high levels but has been growing at a 23% YOY pace as recently as midyear 2020,” he says. “The value put in place has slowed to only a 7% YOY pace as of February 2021. Without that kicker to property values from the ongoing compression in cap rates, developers have a more difficult time hitting their targeted return on costs in an environment of growing material and labor costs.”