Operating Fundamentals Improving in the Industrial Sector

The long-term operating picture for the industrial sector is bright after it pushes through some short-term challenges.

In the short term, operating fundamentals for industrial have softened, with new supply triggering a pullback in demand, according to an analysis by Al Pontius, national director of office and industrial at Marcus & Millichap. Typically, this causes vacancies to rise and rental rates to flatten to attract new tenants, but reality varies from market to market. A large amount of new supply has been concentrated in high-growth markets, and there also has been a trend toward larger big-box formats of a million square feet or more, said Pontius.

Across the country, industrial vacancy averages about 6%.

Long-term, operating fundamentals will be driven by a dropoff in the oversupply that has marked the industrial asset class over the past five years. Meanwhile, e-commerce continues to grow at a steady pace, and manufacturing is rebounding, which will positively impact the industrial asset class.

Technology is favorable to industrial demand both on the consumer side and on the user side, where it can be deployed to operate more cost-effectively, he said.

On the capital markets side, there has been a pullback corresponding with current operating fundamentals. New supply introductions have impacted pressure on rents, and tenants are approaching the search for new space with caution.

“The opportunity to raise rents – the opportunity to see cap rate compression – is off the table today compared to where we were on that run up between 2018 and 2022,” said Pontius. He cautioned against expecting a repeat of that fundamental and said the sector is in a more balanced relationship operationally with pricing expectations demanding higher yields than during the 2021-2022 period.

“The experience between 2018 and 2022 was really due to some remarkable circumstances we had, ultimately, within that period – the pandemic and the supply-chain-related issues that were causing rental rates to go up literally month after month,” said Pontius. “Correspondingly, cap rates were coming down essentially month after month, and that was also in response to interest rates in a debt market that was essentially free money. We don’t expect anything like that again.”

The historical relationship between cap rates and the 10-year treasury remains narrow, said Pontius. His advice to investors is to look at gains in NOI and strengthening supply/demand fundamentals rather than expectations for cap rate compression.

“While this could exist in certain properties in certain markets, that’s not the bet I would make,” said Pontius. “I would look to good old-fashioned fundamentals of how properties have typically appreciated and not look at the period from 2018 to 2022 as the appropriate benchmark.”