Inside the Recent Pause in Industrial Sales

Gregg Healy, EVP and head of industrial for North America at Savills, has no worries about the industrial asset class’ long-term prospects. Reshoring, for example, is causing more companies to invest in the US with a diversified portfolio of manufacturing. “It will increase the demand for industrial sites and that, along with companies’ desire to maintain more inventory as well as the continuous growth of e-commerce will all serve the long term,” he tells GlobeSt.com. 

The short-term, though, is another matter. Simply put, industrial is experiencing a number of headwinds ranging from supply chain challenges to rising inflation and interest rates. It doesn’t help that until recently the market was overheated, he adds.

The outcome of these various pressures has become clear: transactions have paused in many markets as investors try to navigate new price discovery trends. At the same time, capital markets activity for industrial has been slowing or stopped in some cases as lenders revisit risk-reward ratios for investment.

“There are fewer bidders and properties literally are not trading,” Healy, who is based in the Inland Empire, says. “Developers want to reassess what the new asking price is for these buildings.

“We are seeing properties marketed at low 3s in core markets and sub 3s for some markets—that is an aggressive number. I think sellers will have to pull back to make deals attractive to investors.”

Healy declines to guess how cap rates will ultimately shake out. “Certain markets have higher cap rates but for core markets it is very hard to say because there still is an influx of new investors in industrial. I don’t think there will be a large reversal though.”

Seen This Before 

The industrial sector, indeed, almost all of commercial real estate, saw similar dynamics right after COVID-19 hit two years ago, but then, at least in the case of industrial, the market resumed activity and industrial went on to post phenomenal growth.

This time will be different, though, Healy explains. First, there has been a little bit of value erosion due to rising interest rates. That means investors will either have to increase lease rates to make targets or accept an erosion in returns, he says. Typically lease rates are 5% of overall supply chain costs or less and Healy reports there is definite pressure to increase the rates.

Another wrinkle is space supply. There has been a shift in the way retailers and companies are now thinking of inventory due to COVID-19 and supply chain shortages. These businesses are wanting to maintain a higher level of inventories and they will struggle to find space until the market catches up. Right now, there is over 750 million square feet of industrial development, perhaps the highest amount seen in several years. Still, supply will remain a long-term macroeconomic challenge.

A sharp recession would bring more balance to the industrial market, Healy says. Or just a change in consumer behavior. For instance, as COVID-19 dissipates, consumer spending has shifted back to travel and services and away from home goods. “Consumer spending is tapering off of large items,” Healy says. “Many companies like Wayfair and Target got inventories so late they blew out projections and now they can’t justifiably hold on to their inventory in an environment with rising rates. They’ll be selling at a discount.”

But the overriding factor for industrial tenants will be location. Despite the current noise in the sector, “it’s still all about a flight to quality,” Healy says. “It’s not the price of real estate but the price of transportation that matters, so it’s crucial that tenants have the right location.”