Amazon, Ambivalence and The Future of Industrial Real Estate

As the economic uncertainty associated with COVID-19 continues to escalate, transactional volume for commercial real estate has screeched to a halt. Whilst the impact of social distancing and nationwide lockdowns has become increasingly apparent in an already struggling retail real estate industry, buyers and sellers of industrial real estate are recalibrating their expectations amidst an increasingly volatile macroeconomic environment. As the outlook for industrial real estate remains in a state of relative flux, two competing yet parallel narratives about the future of the industrial real estate industry have emerged. Buyers, keenly aware of the fact that we are entering into uncharted economic territory, are readjusting their valuation to account for the heightened economic instability. Sellers, motivated by maximizing the value of their respective properties, will insist on a rosier outlook for industrial real estate. Since the world rarely exists in bifurcated states of black and white, slivers of truth can likely be found in both the bullish and bearish outlooks for the industry. The purpose of this article is to briefly explore the events that precipitated prior to COVID-19 outbreak, understand the implications of said events on the current state of the industrial real estate market, and make reasonable projections about the future of the industrial real estate industry using both a bullish and bearish lens.

Riding the wave of extraordinary economic growth in the United States and the blistering pace of e-commerce expansion, industrial real estate became an increasingly sought-after asset class this past business cycle. While much of the attention has been directed towards the ascent of Amazon onto corporate America’s Mt. Rushmore, the stodgy ‘steady eddies’ such as Best Buy and Walmart have also invested substantial amounts of capital into enhancing their e-commerce infrastructure and digital experience for their customers. Aside from investing tremendous amounts of money into improving their online presence, both companies have practically metamorphosized into sophisticated omnichannel retailers that are increasingly reliant on industrial real estate to meet the demands of their customers. Keenly aware of the shifts in consumer demand, pension funds, and private equity groups alike have invested heavily in the asset class this past cycle. These institutional players, along with the REITs, find tremendous solace in the asset class given its compelling fundamentals and relative stability.

In addition to the increasing presence of institutional capital in this sector, the presence of foreign investors cannot be understated either. Frustrated by low and in some cases negative interest rates, foreign investors highlight the stability and cash flow of American commercial real estate in a yield-starved environment. As the American economic engine hummed along and as low-interest rates persisted, a tsunami of capital washed ashore into several Tier 1 cities. This foreign influx of capital combined with the staggering amounts of capital already invested in the market by domestic institutional investors led to the materialization of cap rate compression for industrial real estate in several major metropolitan areas. Cap rate compression across Tier 1 cities can be partially attributed to the lower return of profile of foreign investors combined with the low (read: non-existent) costs of capital for REITs and large institutions. As per CBRE, stabilized, Class-A industrial properties in prime markets such as Orange County and San Francisco were trading at cap rates as low as 3.75% in 2019. Secondary and tertiary markets were not spared either, as investors flocked to these markets after being priced out of Tier 1 metropolitan areas. Cleveland, a city that been experiencing consistent population decline for decades, had cap rates as low as 6.25% for Class A industrial properties and 7% for Class B industrial real estate in 2019. What was once a humdrum, sleepy asset class in commercial real estate had transformed into a fiercely competitive market.

Developers looking to cash in on this bonanza started speculatively building newer facilities. Holding on tight to the mantra of ‘if you built it, they will come’, developers across the nation constructed several million square feet of new product with the hopes of being able to attract a big-name tenant and convince them to sign the dotted line to a long term, triple net lease. The Atlanta metropolitan area alone has well over 19,000,000 SF of industrial under construction right now, 60% of which is speculative in nature. As Sam Zell so eloquently put it ‘the beverage that everybody is excited about is distribution…my guess is that it’s getting too exciting and we’re building too much industrial space.”

Despite its recession resilient characteristics and ‘defensive’ nature as an asset class, the industrial real estate sector, like any other business, is not immune to the basic principles of supply and demand. Before the outbreak of COVID-19, the industrial real estate sector experienced unprecedented average annual rent growth as the demand for space outstripped supply by a wide margin. This resulted in average rents for industrial properties in the US to increase annually at a startling rate of 7.5%. Whether or not rents will continue to rise at such a torrid pace is in question as there is a multitude of factors that indicate a slowdown.

The COVID-19 pandemic along with the ongoing energy crisis, travel restrictions, and skyrocketing unemployment will all have a material impact on both the asking rents and the sales prices for industrial property across several markets. The normalization of social distancing and reduced density in public spaces is already impacting low-margin businesses that are predicated on volume – i.e. hotels, bars, theme parks, bars. As a result of international travel restrictions, metropolitan regions with large tourism sectors, such as Las Vegas and Orlando, have transformed from bustling cities into ghost towns. The lack of air travel, along with the widespread adoption of remote work has contributed to a 30% reduction in global oil demand and the near-collapse of the oil and gas industry. Houston, the energy capital of the world, will likely experience increased vacancies due to oversupply across several submarkets and reduced demand for industrial space in the wake of the most recent energy crisis. Port cities will not be immune to this downturn either. One of the leading logistics indicators in the United States is inbound port traffic. Declining cargo traffic and the ongoing US-China trade tension, will likely impact the demand for industrial space across several West Coast markets including San Francisco, Los Angeles, and Seattle. These constrained markets, however, are likely to fare better than inland counterparts due to their high barriers to entry.

Although industrial real estate has fared well in previous economic downturns compared to its commercial real estate counterparts, rents and sales prices have experienced declines in the past two recessions. Following the dotcom bust, rents for industrial space experienced a slight decline at only 5%. In contrast, the sales prices for industrial real estate declined 25% following the dotcom crash. On the other hand, industrial rents following the Great Recession slid 18% from peak to trough while sales prices fell 35%. For many, the Great Recession was commonly conceptualized as ‘the worst case’ scenario for commercial real estate in the United States. However, given the severity and global reach of the current crisis, there is no frame of reference for being able to accurately forecast COVID-19’s impact on the economy, our way of life, and the future commercial real estate in the United States. The figures following the Great Recession of 2008 may indeed represent the best-case scenario.

Although the prospects of a bleak economy, staggering job losses, and oversupply in several major markets support a bearish outlook for commercial real estate, there are several cues in the news to suggest that industrial real estate will emerge from this crisis as a long-term favorite in the commercial real estate space. The shift from ‘Just-in-Time’ to ‘Just-In-Case’ inventory strategies, the closing down of several of brick-and-mortar stores, and insatiable demand of basic consumer goods (read: toilet paper) has not only disrupted global supply chains but will also likely lead to an increase for warehouse space to house excess inventory. As coronavirus protocols restrict people to the confines of their homes, consumers across the nation are increasingly dependent on e-commerce for more than just discretionary purchases. Although e-commerce currently represents a mere 3% of US grocery sales, the market for online groceries will expand significantly over the coming decade according to CBRE. Walmart Inc alone generated nearly $900 million in online grocery sales in March 2020. 62.6% of consumers said that they purchased groceries from Amazon in the past 12 months. Industrial giant, Prologis, anticipates that e-commerce growth will boost demand in the long run as there is now a wider range of consumers shopping online for an even wider range of products – including both food and medicine. Average website traffic for e-commerce websites has on average increased 115% over last year, with daily platform traffic consistently eclipsing the previous record set on Black Friday in 2019.

While the short-term outlook for the US economy and commercial real estate industry continues to deteriorate significantly, industrial real estate is poised to rise out of the ashes of this pandemic-induced recession faster than its commercial real estate counterparts (retail, multifamily, office), and may emerge as the premier asset class for savvy investors. Shifts in consumer behavior and the growing market for purchasing durable goods online will drive demand for fulfillment centers, warehouses, and cold storage facilities across the United States. Increased inventory holdings for durable goods may also drive demand for warehouses as retailers look to loosen ‘lean’ inventory strategies. Whilst the long-term fundamentals remain strong, short term uncertainty brought about by the current recessionary environment will likely lead to an adjustment of both rental rates and sales prices for industrial real estate. Secondary markets will see greater corrections in valuations as a result of overbuilding and speculative development. Despite the short-term hiccup in valuations, well-built industrial property located in secondary markets characterized by pro-business leadership, temperate climate, and affordable housing will prosper as the Southernization of the US population continues. For some investors, secondary markets with significant overbuilding may be an attractive starting point in this environment. On the other hand, investors looking for ‘fire sale’ deals may be better served by directing their attention towards hospitality and retail real estate sectors – the real victims of the COVID-19 outbreak.