Why I Think An Industrial Real Estate Bubble Is Forming

Most of us know that the CRE industrial market has been on a tear the last few years, but the hefty rent increases and lofty valuations are becoming very scary. Cap rates for the once sleepy and benign industrial market have compressed to the 3%-4% area from about 7% only five years ago and public industrial REITs are trading at sub-four percent cap rates. According to a first-quarter report from Cushman and Wakefield on the industrial market, asking rents nationally have increased 16% since Q1-21. In some of the hot markets around the country like the Inland Empire of CA, rents have increased 41%, in Orange County up 20%, Boise, ID, up 18% and Miami, FL, up 15%. There are also over 660 million new square feet of industrial space coming to market in 2022, which is a historical amount and 4% of the total inventory of 16 billion square feet. In a normal year, only about 100 million square feet of industrial space is under construction. 

On May 10, 2022, Prologis, the giant public industrial REIT, made an offer to buy another industrial REIT, Duke Realty, for .466 shares of its stock for each share of Duke’s common stock. The offer represented a price for Duke of $61.68/share, a premium of 29% to Duke’s share price and a mind-blowing 3.5% cap rate. This type of outlandish pricing for CRE assets was last seen during the frothy period from 2004 to 2007 and right before the start of the Great Recession in mid-2007. Most investors willing to buy industrial real estate at these low cap rates are relying on 5%-10%+ rent growth, which may or may not happen, and carries significant risk. The formula for the cap rate is the risk-free rate, usually the 10-Year Treasury note, currently 3.0% plus a risk premium, which historically has been between 3% and 10% and today is about 8% less than the growth in rents. A generic cap rate for industrial properties with rent growth of 5% would be 3% plus 8% -5% or 6% and much higher than the 3% cap rates discussed above.

All of this strongly suggests that the industrial CRE market is in a bubble. Eventually, the supply chains will readjust to some normalcy, tenants will begin to balk at paying $16 or $20 per square foot or more in net rent, tenants will begin building their own warehouses (like Amazon) and companies will begin manufacturing more of their products in the US. These market adjustments will bring the industrial market back to normal pricing and value as the supply and demand curves will normalize. I have often discussed on Globest.com, the fallacy of “ultra-high rents.” Property rents cannot go up forever and when they do, it’s just a matter of time before they hit a ceiling and come tumbling back down again. Eventually, tenants will pull back and not agree to these lofty rents and seek other options for their warehouse space needs. Two good examples of this rent fallacy in the CRE sector were retail rents five years ago on Fifth Avenue in New York and apartment rents in Silicon Valley in 2018.

Retail stores located on Fifth Avenue were a very hot commodity back in 2013 to 2017, with high demand, limited space availability and many high-end tenants like Louis Vuitton, Prada, Hermes, and others, forked over crazy rents of $3,000 to over $5,000 per square foot for their marketing palaces on the famed street. Fast forward to today, and a third of the stores on Fifth Avenue are boarded up or closed and rents are down to the $1,000 to $1,500 per square foot area. In the apartment sector, monthly rents for new one-bedroom apartments in Silicon Valley that were built in 2017 and 2018, were pushed up to over $4,000 per month, when many tenants recoiled at those high rents. A year later, many of those rents fell back down to earth and today are in the $3,100 to $3,500 range per month.

The industrial market may continue to outperform with ever-rising rents and lower and lower prices, but eventually, it will be subject to the old economics of supply and demand and the ultra-high rents will decline sharply, values will rise and cap rates with them.

Joseph J. Ori is Executive Managing Director of Paramount Capital Corp., a Commercial Real Estate Advisory Firm