Breaking Down Industrial Real Estate

The industrial asset class is considered one of the four major pillars of commercial real estate investing, along with office, retail, and multifamily. While industrial assets may not have the curb appeal of other property types, demand for industrial investments has surged over the past few years as the sector transforms to accommodate high-growth industries. The proliferation of e-commerce, internet technology companies, and manufacturing is demanding new industrial spaces to accommodate their growing presence. In this article, we will dive into the fundamentals of the industrial sector and highlight what we see as the specific demand drivers in the current market cycle.

The Makeup of Industrial Real Estate

Typically, industrial properties are segmented into three categories – warehouse and distribution, manufacturing, and flex industrial.

Warehouses

Warehouses play a critical role in the modern industrial supply chain. These facilities support storage and distribution activities, which demand large space, elevated ceiling height, and loading capacities. These facilities are typically located in industrial parks –  areas zoned and planned for the purpose of industrial development. In a race to deliver goods to the end consumer faster and more reliably, tenants are looking for areas with the significant logistic advantage that minimize the facility’s mileage between both customers and materials. Compared to other industrial facilities, large industrial warehouses and distribution facilities typically command the lowest per square foot asking rent.

Manufacturing

Manufacturing industrial properties – which host assembling and casting space, smaller warehousing, and some office space – is the second largest category of industrial property. This type of industrial property may be less demanding than warehouse and distribution in terms of square footage but has specific requirements regarding infrastructural support. Properties may host extensive power, specialized machinery, pressurized water, and other utility features to fulfill a varied set of tenant demands. Scalability and flexibility are crucial to manufacturing facilities. To allow a manufacturing facility to optimize its operations and productions, these sites typically have accommodating storage space, laboratories for research and development, and offices for administrative (payroll, billing, collections, and marketing). Some states provide qualified manufacturers with property tax deduction benefits on properties that principally conduct manufacturing, processing, and other industrial activities. In the state of New York, for example, qualified manufacturers and manufacturing properties are entitled to receive a 20% deduction on eligible real property taxes.

Flex Space

Flex space, the third type of industrial asset, is a hybrid between warehouse and office space. This property is typically located in suburban areas with abundant parking spaces for commuters. Hosting an array of tenants from small operation manufacturers to research and development (R&D) departments of corporations, flex buildings can support numerous operating activities. Flex spaces were originally designed for manufacturers that needed both office and manufacturing space in one building, but the versatility of industrial flex space is now attracting new tenants like tech start-ups. Offering more amenities than other industrial buildings, these flex spaces feature superior exterior and landscaping design and include functional build-outs to satisfy office workers while accommodating industrial activities. As a result, flex space is often ideal for manufacturing, distribution, and storage but can also easily convert to a regular office. A major benefit for the tenant is the ability to configure the flex space at will and adjust the proportion of office and warehouse according to the business’s changing needs. As an alternative to the traditional office, the leasing cost of a flex space industrial property is significantly lower than average leasing cost of class C office space in many U.S. real estate markets.

Considerations for Industrial Real Estate Investing

NOI & Cap Rates

Real estate value is mainly driven by two factors – net operating income and capitalization rate. For industrial properties, operating income can be maximized by various levers.

Although the average per-square-foot rent is lower in comparison to other asset types, with square footage ranging anywhere from 50,000 to above 500,000, the sheer size of industrial property can magnify the collectible rent, generating considerable top-line revenue.

Industrial property operators can also maximize net operating income through cost reduction. Unlike other commercial properties, industrial assets do not have common areas that require periodic maintenance and ongoing improvements. Industrial property owners often sign a triple net lease (NNN) with the tenant, shifting payment responsibilities over building maintenance, insurance, and property taxes to the tenant. Thus, the property will have a lower cost and potentially have an even higher net operating income.

Longer Lease Terms

Besides the NNN feature, industrial lease terms are typically longer than other asset classes, ranging between three to fifteen years, with rent escalation on an annual basis. This lease feature makes industrial property ideal for real estate investors seeking longer investment horizons. In contrast to asset classes such as multifamily, where the lease term and tenant quality are in flux, industrial properties might be viewed more favorably for investors looking to lock in their capital longer term while hedging inflation risk.

Quick Construction

Investors and lenders are often attracted to speculative development due to not only strong underlying fundamentals but also due to quick delivery times. Industrial buildings can have completion timelines as quick as eight to twelve months depending on certain variables – generally a shorter development time frame than with other real estate property types.

Incentive Programs

Federal and state legislatures often use incentive programs to attract industrial tenants and developers. Local governing bodies often introduce business-friendly incentives, such as expedited permitting, tax abatements, tax credits and other stimulus programs to attract companies. One such program is the Foreign Trade Zone (FTZ) program. FTZs are governed and administered by the Customs Border Protection (CBP). FTZs allow businesses located within an FTZ to store commercial products without paying customs duties and help reduce the administrative burden of customs entry procedures. Warehouses within FTZ’s that store international trade merchandise can benefit from potential duty-deferral or exemption. FTZ-located properties are also eligible for reductions on property taxes.

Investing in Industrial Real Estate in 2021

As Charles Kurz, Associate Director of Investments, discussed in our recent Investor Relations webinar, 2021 was a record-setting year for the industrial market. Strong U.S. industrial market fundamentals led to historic performance levels across all major metrics¹:

1. Sales Volume: Q4 2021’s investment sales volume of $67.1B was the strongest quarter ever, topping previous highs set during the prior quarter. We believe this demonstrates there is demand, as well as liquidity in the market, which can help investors exit opportunities.¹
2. Pre-Leasing Activity: Per JLL, pre-leasing rates rose to historic highs last year. This is another indication of a competitive market, as potential tenants feel the need to secure space even before buildings have been completed.²
3. Properties Under Construction: On the supply side, a record-setting 448.9 msf of space was under construction as of Q3 2021.³
4. Vacancy Rates: 2021 industrial vacancy rates fell to 3.8%, the first annual total to dip below 4%.⁴

Over the past year, absorption has also grown to 507.3 million square feet (msf).⁴ Despite the strong development pipeline across the U.S., leasing velocity outpaced supply in various categories of industrial property. Given this supply and demand imbalance, commercial real estate professionals expect further rent growth.

In fact, in Q4 2021, the national industry rents averaged $7.11 psf, up 11.3% since Q4 2020 (JLL).²  According to Cushman & Wakefield’s recent forecast, asking rents may even reach $8.72 psf by the end of 2023.⁴

Industrial Demand Drivers for 2022

Continued E-commerce Growth

An important leading economic indicator that drives demand in this particular asset class is consumer spending. E-commerce sales increased at the onset of COVID-19, rising to 21.6% of total retail sales in Q2 2020, up from 16.2% in the previous quarter.³ Online purchases are still above pre-pandemic levels at around 20% as of Q3 2021, according to CBRE Research.³

We expect this trend will continue in 2022, as consumers are now well-accustomed to the convenience of purchasing goods online. Companies will then naturally have an even greater need for warehouses and fulfillment centers to support this growth.

Ongoing Supply Chain Volatility

You might think that supply chain disruptions would have a negative impact on the industrial asset class. However, in reality, companies tend to hold a larger supply of goods onsite due to shipping delays–a potential benefit for industrial property owners.

In addition, CBRE notes transportation costs will remain at high levels in 2022 (40-70% of total logistics spend on average).³ In 2021, ocean freight costs rose by 200%, and domestic freight costs rose by 40%.³ U.S. gas prices also increased by 18% between December 2021 and January 2022 alone.⁵ We expect ongoing increases will likely continue due to the recent unrest in Ukraine.

To meet quick delivery demands and minimize transportation costs, we think the need for warehouse space should then increase accordingly.

The Bottom Line

If you have not already invested in the industrial real estate sector, it may be worth considering as part of your 2022 investment strategy. Note: EquityMultiple believes diversification across asset classes can help reduce risk in your investment portfolio. That said, while we believe industrial real estate is likely a strong bet given current market fundamentals, we encourage you to do your own due diligence prior to investing.

Want to learn more about industrial real estate investing opportunities? Schedule a call with our Investor Relations team today.

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¹Source: Colliers Q4 2021 US Industrial Outlook Report (as of March 1, 2022)

²Source: JLL United States Industrial Outlook (as of February 15, 2022)

³Source: CBRE U.S. Real Estate Market Outlook 2022 (as of December 8, 2021)

⁴Source: Cushman & Wakefield North American Industrial Outlook (as of December 2, 2021)

⁵Source: Money.com (as of January 27, 2022)

This document is for informational purposes only and is not an offer or solicitation to purchase or sell securities. Investing involves risks, including the potential for principal loss. There is no guarantee that the strategies and services will be successful or outperform other strategies and services. Certain assumptions may have been made in connection with the analysis presented herein, and changes to the assumptions may have a material impact on the analysis or results.

¹Past performance is no guarantee of future results. The investments discussed herein may be unsuitable for investors depending on their specific investment objectives and financial position. Investors should independently evaluate each investment discussed in the context of their own objectives, risk profile and circumstances.

All opinions expressed herein constitute the author’s judgement as of the date of this article and are subject to change without notice. Statements made are not facts, including statements regarding trends, market conditions and the experience or expertise of author are based on current expectations, estimates, opinions and/or beliefs. Such statements are not facts and involve known and unknown risks, uncertainties and other factors. Past events and trends do not predict or guarantee or indicate future events or results.