The Year Retailers’ Warehouse Strategies Came Down To Earth

It has been a time of extremes for retailers’ warehouse strategies.

When the pandemic hit, economic uncertainty and wildly undulating consumer demand threw retailers for a collective loop, as virtually every facet of how consumers shopped for, interacted with, and received goods was disrupted. Shipping and manufacturing costs skyrocketed and traffic at US ports snarled and retailers scrambled to play catch-up, leading many to stockpile goods at massive industrial warehouses near prime distribution thoroughfares.

Now the challenge is inflation and the threat of a possible global recession.

In response, late last year major big box retailers like Target, Costco, and Walmart told investors that they would be slashing prices in major sales to dispose of excess inventories they’d ordered to guard against supply chain disruptions.

“We’re coming back to earth this year — it’s a bit of whiplash,” says retail expert Garrick Brown of Brown Consulting, who has also led retail research for several major retail brokerages over the course of his career. “Recession or not, we’re finally going to see a normalization around whatever this new normal is.”

The pandemic jump started these extremes of the last few years, says J.C. Renshaw, Senior Supply Chain Consultant for North America at Savills. “There were plenty of companies that were out of inventory because they couldn’t get inventory in, and others that were a bit better prepared. And a lot of them erred on the side of swinging the pendulum all the way to the right and overbuying because hey, we don’t know what the future holds. But the carrying costs associated with that started being a drain on their operating costs, and they paid the price from that perspective.”

The explosion of e-commerce sales simply added to the mix. “During COVID, we saw such an immense amount of growth in 2020 because everyone had to shop online,” says Mark Russo, Senior Director, Head of Industrial Research for North America, Savills. “That was condensed in such a small time period.”

Now, a share of total retail sales is continuing to hum along, but growth has slowed as of late. According to Savills research, e-commerce accounted for 5% of industrial leasing as of year-end 2022, down from 11% in past years. And that too is impacting the market for warehouse space.

As lockdowns lifted and consumers returned to bricks-and-mortar retail, the warehouse market responded in kind.

“We are seeing significantly slower leasing activity in Q1, and a measurable increase in sublease availability,” Russo says. “It’s still a strong market from the landlord perspective, but data from the end of the year shows the trend there is changing and we’re kind of past this peak demand market for industrial space for the foreseeable future.”

According to Ben Harris, Senior Managing Director, Logistics & Industrial Services, Cushman & Wakefield, fewer retailers are holding onto goods in warehouses to guard against running out of inventory than at the height of the pandemic.

“Retailers didn’t really have control over what inventory they had available for sale for the 2022 holiday season,” Harris says. “Some of that inventory reflected pre-pandemic orders and some of it reflected orders placed at the height of the pandemic — meaning, things like athleisure and home goods that a lot of consumers left behind as they shifted back to going out, traveling, and even going back to the office (at least occasionally). And there was still inventory that retailers knew consumers wanted, but couldn’t make as much space for in their stores because of all the other stuff clogging up shelves.”

That excess inventory forced US retailers to cut prices to lure customers during the holiday shopping season, but Harris says economic headwinds kept some shoppers from coming out en masse. And while supply chain issues have abated somewhat, with prices for shipping containers down by about two-thirds year-over-year, costs are still twice as high as they were in 2020, leading many retailers to hold more inventory than they usually would at year-end. Nike, for example, noted in its latest quarterly earnings report that its North American inventories increased by 65% compared to a year ago.

THE HIDDEN COSTS OF HOLDING ON

Of course, stockpiling inventory for a rainy day creates additional expenses for retailers in the form of greater carrying costs, which vary from industry to industry. “The one number an operations executive will need to check with the finance department is the inventory carrying cost,” Cushman’s Harris says.

“Inventory carrying cost savings come in different forms: savings from freeing up cash and not having to pay interest on that cash; the ability to pay less insurance and lower taxes on inventory; labor savings associated with less material handling; the ability to rent a smaller warehouse; and other areas as well,” he says. “These are true savings, not just financial sleight of hand.”

For manufacturing companies, lack of access to strategic materials, raw materials, components, and subassemblies used in manufacturing processes can cost millions. For automakers, fines can be as much as $4,000 per minute for trading partners whose delivery failures cause production downtime. “As a result, the inbound warehouses often seek to have several weeks of inventory on hand,” Harris says. “Companies that run very lean in manufacturing, if not careful, end up pushing much of the inventory that used to be in the factory upstream.”

These dynamics are also having an outsize effect on smaller players, Harris says.

“Large retailers are demanding extra room to store excess inventories, driving up costs for smaller companies and in some cases driving them out of spaces. Bigger customers are willing to pay higher prices for increasingly scarce storage space, so it’s tough on the smaller guys out there,” he says. “This also puts added pressure on 3PLs to focus on retaining customers with a high turnover of goods because the handling fees bring in higher revenues. In other words, it puts pressure on warehouse operators to take a hard look at their customer base and navigate in such a way they can serve the biggest, most important and most loyal customers.”

A lack of modern industrial space is likely to also continue to push rents up: according to Cushman data, 64% of available logistics space is more than 20 years old, and more than half has clear heights below 28 feet. And “that limits options for tenants seeking modern fulfillment space and will continue to provide landlords with leverage,” Harris predicts.

CONSTRUCTION STARTS PULL WAY BACK The overall supply-demand imbalance continues relatively unabated for industrial space as a whole, experts agree, with a near-record amount of space currently under construction. Brokerage firm Savills, for example, puts the number at 885 million square feet. But construction starts for new projects breaking ground is also down by 40% over the past few quarters as uncertainty in the capital markets made financing became more difficult to secure and projects more difficult to pencil.

“We are seeing clear evidence of the pullback beyond mere anecdotes,” Russo says. “But because the average building takes around 12 months to go up, there’s so much space under construction that a slowdown won’t change the supply-demand dynamics until maybe later this year or next year, but it’s obviously something we’re thinking about.”

Russo says that over the next six months, he expects to see a “very robust pipeline” delivering — but “at the same time, we’re seeing some indications that demand is starting to cool.”

In a recent report, warehousing giant Prologis predicts US warehouse development starts will drop to a seven-year low, even amid rent growth in excess of 10%. Prologis expects starts to decline by 60% to less than 175 million square feet this year, noting that quarterly starts have already fallen 30% from their peak in Europe. And that pullback will compound the already tight supply picture in the US: the firm estimates the pipeline will drop from over 500 million square feet in the third quarter of 2023 to 275 million square feet by the end of this year.

“I think we will see developers spring for more build-to-suit opportunities as a result, as they are much closer to a ‘sure thing’ for developers,” Cushman & Wakefield’s Harris says.

An estimated 83% of industrial product currently under construction is speculative, with 21.3% pre-leased by tenants. Most of those projects will deliver this year, and analysts say it’s likely they’ll push the overall national vacancy rate higher over the next few quarters. Meanwhile, asking rents have begun to moderate, with the average asking rental rates rising just 1% in Q4 2022 over the prior quarter’s stats. But rents were nevertheless up by 18.6% year over year, making last year the strongest in history for annual rental rate growth.

And within the warehouse and distribution subsector, what Cushman analysts call “the key driver of the industrial market,” asking rents were up by 21.6% annually at the end of 2022, with cities like Charleston, Southern California’s Inland Empire, Phoenix, and Miami all posting eye-popping annual gains of 40% or more. Cushman predicts that supply will “finally” catch up in 2024, at which point rent growth will likely moderate into the 3% range.

“Vacancy will go up and rental rates will stabilize over the next year,” Savills’ Russo predicts. “We definitely have reasons to think the market will be resilient. But we do expect tenants to have some more leverage over the next year to be able to negotiate as opposed to this sort of ‘take it or leave it’ dynamic that’s been happening over the past few years.”

“We’re still seeing a robust industrial market and there is immense rental growth,” says Ra’eesa Motala, Industrial and National Corporate Solutions Advisor at Rokos Advisors. “And while spec development has been paused or halted due to interest rates, we’re still seeing a lot of that second and third gen space being leased.”

Experts agree that while demand for industrial space will likely remain on a positive trajectory, it will slow as consumer spending winds down from pandemic highs and the overall economic picture remains murky. What that means for tenants is less clear: some may move to the sidelines this year, preferring to wait out economic uncertainty, while others may turn an eye toward expansion.

MAKING SENSE OF SHIFTING PRIORITIES “Our job is to help a lot of these companies understand and identify where they have a bottleneck in their supply chain system or distribution route, and then figure out where it makes sense to take distribution space,” Motala says. “A lot of these companies aren’t fully aware of how much space they need at times, but they may know where they want to be, so it’s tricky.”

Motala says her focus remains squarely on how to help industrial users determine whether they’re using their warehouse facilities in the most functional way. For occupiers in highly land-constrained markets like Southern California’s Inland Empire or Northern New Jersey, for example, that means getting creative with the options you have.

“It really comes down to what is your end goal,” she says. “Maybe it’s a build to suit, maybe it’s partnering with an existing retailer to take down joint space, maybe it’s partnering with a developer to build. Sometimes the space that checks all your boxes may not even be your most efficient space — and that means we’ve had to get pretty creative in this market.”