The following article is sponsored by Panattoni Development Company.

It is hard to argue that the industrial real estate market from approximately the fall of 2020 to early in 2023 was not the sector’s “golden age”. Defined by unprecedented demand for warehouse and fulfillment space, rapidly decreasing vacancies in many markets across the country and the compression of exit cap rates into numbers we could have never imagined would happen, this period was remarkable. This combination, despite the obvious constraints on everyday life brought on by the pandemic, led to an enormous boom in industrial real estate development. Despite record production in many markets across the country, development did not keep up with ever-growing demand. This demand led to double digit rent growth as tenants panicked that they would not have space and landlords were able to raise rents quarterly if not monthly. The insatiable demand for space also led to escalating land and construction costs.

To give some context to the growth in the industrial sector the country saw from 2019 (the pre-pandemic year) to the end of 2023, let us look at the following statistics:

1. According to Colliers International, the country’s industrial base grew from 15,946,000,000 SF at the end of 2019 to 18,260,000,000 SF at the end of 2023. This is an increase of more than 13 percent. What is more remarkable is how steady the new supply deliveries increased year-over-year as illustrated below:
   1. 2019: 288,000,000 SF
   2. 2020: 348,000,000 SF
   3. 2021: 370,000,000 SF
   4. 2022: 465,000,000 SF
   5. 2023: 607,000,000 SF
2. In order to ensure reasonable vacancy rates to justify the continued development starts, the market needs to have net absorption (as opposed to gross absorption to more accurately track vacancy rates) to closely match with these deliveries. Note the corresponding net absorption nationally:
   1. 2019: 239,000,000 SF
   2. 2020: 273,000,000 SF
   3. 2021: 579,000,000 SF
   4. 2022: 480,000,000 SF
   5. 2023: 230,000,000 SF
3. Landlords naturally want the vacancy rates low so they maintain the ability to push lease rates, seek the best tenants and lease up their product quickly. Conversely, tenants naturally want choices in terms of the selection of available properties, the ability to take their time in choosing a property that conforms to their internal protocols, and of course, get the best possible economics. Based on the total new supply versus the net absorption during the same period, the delta of available new supply is approximately 278,000,000 SF, thus the increasing vacancy across the country, notably in some markets more than others.
   
   
4. It is clear that calendar year 2021 saw the biggest net absorption over the last five years and undoubtedly, that delta led to the amazing rise of lease rates over the same period. According to Colliers International, average lease rates in the country went from $6.09/sf NNN per annum at the end of 2019 to $9.72/sf NNN per annum at the end of 2023.
   
   
5. During this same five-year period, cap rate compression reached levels never before seen in the industrial sector. Developers who build to a yield with an expected exit cap had to essentially play “jump rope” in determining when to start a project and do their best to forecast exit caps when the project was stabilized. When rates started increasing (both short term and long term), many were caught in a situation where their yields were at or below the anticipated exit cap.
   
   
6. Finally, this five-year period had unprecedented increase in construction costs, elongated delivery schedules due to supply chain and labor constraints, entitlement delays, and increasing land pricing. Land sellers saw the opportunity to sell at the highest rate to developers who were responding to tenant demand and were able to pay these higher prices, at least for a period of time. Rental rate increases, at least for new projects, were warranted to offset these longer schedules and increased costs. Anecdotally, as an exercise for the brokerage community in a western city, we did an internal review of a 200,000 SF project built in 2018 and updated the pro forma based on 2022 land and construction costs and the building doubled in cost.

Clearly, the industrial market was in favor with property owners and developers but remarkably, the fundamentals of real estate underwriting remained solid. The Great Financial Crisis made an indelible impression on developers and property owners as well as lenders and capital. With the exception of a few markets, there was no discernible overbuilding in the sector as the product deliveries kept pace with demand and vacancies remained low until the last 12 months.

In many markets across the country, vacancies are rising and rising fast. Perhaps it is due to an oversupply of product or perhaps it is a decrease in tenant leasing activity. But more likely, it is a combination of both. Looking at the absorption over the last few years, developers proceeded with projects and deliveries are still occurring. It should be noted, however, that lenders and capital hit the brakes after the Fed starting increasing rates beginning in early 2023 has materially decreased the number of projects that went forward; otherwise perhaps the vacancy rate increases would be even worse. The question is, what do we do now?

Option One: Do Nothing

Developers normally cannot do this – due to either personality or for practical reasons. Developers need to develop as they have overhead obligations. But certainly, waiting for the inevitable recovery in the market is a plausible option.

Option Two: Continue to Seek Opportunities

Development can take many forms. Working as fee developers for clients who want to own their own buildings but don’t have the expertise to navigate a confusing process, seek “buy” opportunities such as distressed properties or properties needing revitalization, pursuing IOS as an option for vacant land given the amount of trailer marshalling required in today’s industrial market, and looking at markets not in an overbuild situation and where tenant activity remains strong are all viable options.

Option Three: Continue to Entitle Projects/Re-Assess Design Criteria During a Slow Period

Generally, entitlements throughout the country continue to become more complicated and elongated. It would be wise to use a period of slow tenant activity as well as lender/capital reluctance to start projects to complete any required entitlements, including utility will-serve letters, etc. to ensure the project is ready to go should the market indicate. Perhaps the owner can pivot to a build-to-suit should a tenant or buyer indicate interest in a building. Given the rapidly changing tenant requirements in response to their customers or even employees, it would likely prove accretive to the project’s overall attractiveness to the market if a design review reveals the need for added amenities such as trailer parking, extra employee parking, additional power capacity or even a façade change that would cater more to e-commerce companies who use an industrial building as a storefront.

Option Four: Full Steam Ahead

There are many reasons to remain bullish on the country’s industrial sector given several key metrics.

On-shoring/near-shoring is a growing phenomenon given what the pandemic taught us with respect to the country’s supply chain. Having products either warehoused in our hemisphere or ideally, manufactured and housed in our hemisphere, puts the country in a better position to fully control the supply chain. By all metrics, manufacturing in the US and Mexico is on the rise and will continue to grow. Secondly, e-commerce is still experiencing massive year over year growth, which naturally feeds the need for more industrial product. According to the International Trade Administration, a federal agency, B2B e-commerce growth will continue to grow at a compounded rate of 14.5% at least through 2026 and B2C 14.4% through 2027. Finally, according to NAIOP’s Research Foundation 3Q report, calls for forecasted quarterly net absorption increases ranging from 57.5MM SF in the 3Q of 2024 to 79.5MM SF in 2Q of 2026.

Whichever option one chooses, there is no reason not to believe in the future of the industrial sector in the United States. There continues to be in-flows of capital for industrial investment – both in terms of development as well as acquisition. Given the factors cited above, the industrial market is on strong footing for years to come.