Industrial Real Estate: Opportunities Amidst Supply And Demand Boom

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Industrial real estate has been red hot for the past 4 years with demand growth skyrocketing as companies clamor to earn superiority in logistics. In 2022 and 2023, the demand boom started to be matched by equally ambitious development of new warehouses. With the strong demand absorbing the new supply the sector is overall in a healthy place, but both the supply and demand are lumpy in location and timing. As such, there are pockets of both unusual strength and unusual weakness.

This report will dig into the fundamentals of industrial real estate with an aim to discern the future winners from the rest of the pack. Valuation in the sector varies greatly making some of the REITs a bit bloated and others opportunistic.

We believe a combined study of valuation and operating fundamentals provides an advantage in ascertaining which industrial REITs are the best buys right now.

Let us begin with a look at industrial real estate at a national level and then hone down to submarket specific fundamentals.

Industrial Supply and Demand nationally

The post-pandemic need for better logistics fueled enough demand to bring occupancy rates for the sector all the way up to 96%. That is a remarkably high figure for a sector that sits in the low 90s in a balanced or normal environment.

In response to the unprecedented demand as well as the low vacancy, developers saw a lucrative opportunity to build industrial real estate. A Yardi Matrix Industrial report quantifies the new supply:

More than 1.1 billion square feet of new industrial space (5.7% of stock) have been delivered since the start of 2022.

5.7% of existing inventory delivered over just 2 years is quite a bit of new space to lease up, so even with still strong demand the supply led to higher vacancy.

Specifically, vacancy rates rose from 4% to 4.8% as of the end of February, 2024. That is still 95.2% occupancy which remains high, but closer to a balanced market.

Forward supply growth is more moderate; only 314 million square feet started in 2023 (to be delivered in 2024 or 2025). This is a drop of roughly 40% from the last few years.

Yardi Matrix

Demand growth is still strong but has shifted in type. Logistics warehouse demand for E-commerce is slowing down a bit but is being replaced by new demand from onshoring of manufacturing.

The Census Bureau reports manufacturing construction spending at $224 Billion annually, which dwarfs that of previous years. While the massive manufacturing plants themselves are unlikely to be owned by the REITs, production facilities of this size require entire logistics networks around them to bring in input parts and then distribute the finished products.

So while population centers were the epicenter of the E-Commerce last mile demand boom, the major manufacturing plants are likely to be the powerhouses of the next cycle’s industrial real estate demand.

Near-shoring is also a major source of incremental demand. Mexico is now America’s top trading partner, surpassing China. As tensions continue to rise between the U.S. and China there could be even more strain on trading relations. Overall this weakens demand for logistics facilities on the West coast and increases demand for warehouses in the South and particularly those near the Mexican border.

Regional and submarket specific supply and demand

Development is more visible than it used to be as there are readily accessible documents of how much development there is and where. Here is the breakdown of new supply by submarket as a percentage of existing buildings.

Yardi Matrix

2.2% of standing inventory is under construction with another 3.3% planned to be built taking total construction and permitted to 5.5%.

The national datapoint provides a nice baseline from which to assess which submarkets are relatively high and low construction. A few standouts:

  • Phoenix at 28.7%
  • Kansas City at 17.2%
  • Inland Empire at 9.2%

The impact of supply is of course related to demand. So while Phoenix has high supply, it is also a fast growth market for population and jobs. Phoenix population went up 5.6% in the last few years and average household income is projected to rise double digits.

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In contrast, the inland empire like many coastal cities has been losing population.

The combination of high supply and reduced population might make it quite challenging to absorb the new supply.

On the positive side, there are some MSAs that seem to have highly favorable supply/demand dynamics. Columbus is the site of major chip manufacturing development which will stimulate industrial demand for supporting facilities. Despite this demand driver, Columbus has below national levels of current and planned industrial construction.

This will likely cause low vacancy and rising rental rates, benefiting industrial landlords.

Southern cities also appear well positioned as they will benefit from near-shoring. In particular, I like Houston, Laredo, and DFW as demand appears to be outpacing supply.

The fundamentals discussed above come into play by impacting forward changes to market rental rates. This is a concept that often gets lost in real estate because in the short term it is overshadowed by mark-to-market.

Mark to market versus forward rental rate growth

This next table contains a ton of information, so I want to take a bit to discuss how to consider it. The left column is the current rent of each city, while the column labeled “avg rate signed” is the rent per square foot at which new leases are being signed. The difference between these 2 columns represents the mark-to-market.

Yardi Matrix

Nationally, rental rates are presently $7.74 per foot, but new leases are being signed at an average rate of $10.12 per foot. That means, on average, rents will need to climb $2.38 per foot to get to market rates. This is the 30% rent growth that would happen if market rates stop going up.

On top of this mark-to-market will be the future change in market rates. Overall, rates have been rising rapidly and are generally anticipated to continue rising, albeit at a slower clip. Future rental rate growth will vary significantly by location.

Based on supply and demand drivers discussed above, I think coastal cities are in their late innings of market rent growth while southern and midwestern markets have more runway for market rate growth ahead.

Potential risk factors for industrial real estate

There are some concerns about the health of E-Commerce. Companies are realizing that shipping everything is quite expensive, particularly with the percentage loss involved in returns. This is of course a boon for brick and mortar retail, but it has led to a pullback in demand for e-commerce fulfillment warehouses.

It shows up in the employment data.

Census

Note that this is raw number of employees rather than growth rate, so in recent periods there has actually been a net reduction in employees for warehouses.

There are two ways to interpret this data point.

  • The bullish interpretation is that headcount is down due to improved automation. In other words, the same logistics output can increasingly be done with fewer employees.
  • The bearish interpretation is a more widespread pullback on logistics networks. Bears point to slightly elevated subleasing from e-commerce companies as an indication of this sort of pullback.

I think the truth is somewhere in the middle.

With E-commerce slowing near-shoring and onshoring will take over as the primary drivers of growth. This should be factored into valuations.

Valuation

Here are the FFO multiples of the industrial REITs.

S&P Global Market Intelligence

Note that multiples range widely from 11.6X to 26.5X. There is also some variance in net asset value (NAV).

S&P Global Market Intelligence

Transactions so far in 2024 are at about $150 per square foot. Most of the industrial REITs are trading at significantly less than $150 per foot despite the REITs collectively owning properties primarily in the top quartile of quality.

Overall, the sector looks about fairly valued on cashflow and a bit undervalued on NAV. The real opportunity comes from mispricing within the sector.

Skewed valuation toward mark-to-market

Presently, valuation is quite skewed toward the REITs with higher mark-to-market. In areas such as the inland empire, current rents are about $9.70 compared to new rents of $15.43 which gives it a mark-to-market of about +60%.

With high visibility in cashflow growth as rents get marked up, the REITs with properties in these areas such as Rexford (REXR) and Terreno (TRNO) should indeed trade at premium multiples.

Southern and midwestern markets have mark-to-market closer to the +20%-40% range. These REITs are presently growing significantly slower as the mark to market multiplied by the percentage of leases rolling in a given period is the main delta to net operating income. As such, the REITs in these markets such as STAG Industrial (STAG), and Plymouth (PLYM) tend to trade at lower multiples.

Directionally, the market is correctly pricing in the differences in mark-to-market growth. However, I think there are 2 aspects current valuation is not reflecting.

  1. Magnitude of multiple spread
  2. Future market rent growth

The FFO multiple range of 11.6X-26.5X is really wide. Such a wide range would be appropriate for a growth range of slightly negative to strongly positive. Phrased in mark-to-market terms the spread would imply a range of +0% to +60%.

11.6X is a really low multiple relative to the rest of the market which would be appropriate for essentially no growth. Yet all the submarkets have strong mark-to-market. Some simply have really strong mark-to-market.

The higher end multiples look about right to me but the low end multiples seem off given the associated REITs are still looking at about 30% rental rate growth to get to today’s rates.

Another aspect to consider which doesn’t appear to be priced in at all is future market rent growth. Areas that have more rate growth ahead will get to continue growing well beyond the mark-to-market. If market rates keep rising, the mark up opportunity will grow with it. What might look like a 30% roll-up today could turn out to be a 60% roll-up in a few years.

Regionally, the Midwest and south are positioned to continue growing rents while the coastal markets are approaching oversupply as population stagnates.

As such, I think the FFO multiples in the sector should be much tighter. The lower multiple industrial REITs are actually the ones with longer growth runways.

Valuation adjustments for land banks

First Industrial (FR) and Prologis (PLD) have extensive land banks which by their nature are not cash flowing today. Thus, land does not contribute FFO which can make their FFO multiples look higher. Over time, strategically located land will contribute to growth by allowing them to develop in high value locations that otherwise do not have free developable land.

Valuation adjustments for special situations

Innovative Industrial’s (IIPR) leases were signed substantially above market rates so it, unlike the other industrial REITs likely has a negative mark-to-market which should lower its multiple.

Americold (COLD) has struggled with operating efficiency, particularly on the cost side. Getting a handle on that could be a source of extra growth as 3 or so percentage points of extra margin are achievable. However, it is also an indicator of weaker quality as some of their peers in cold storage did not seem to have similar cost containment issues.

Lexington (LXP) is its own worst enemy when it comes to real estate transactions, having frequently bought at peaks and sold at troughs. Unless they can correct this behavior, it should trade at a reduced multiple. The adjustment here comes down to a subjective judgment on management’s skill, or lack thereof.