Size Matters Not: The Promise of Shallow Bay Industrial Real Estate

COVID-19 has fueled the e-commerce flame that has all but scorched the traditional retail business model. As consumers, seeking convenience and flexibility, continue to embrace e-commerce, m-commerce (mobile commerce) and s-commerce (social media commerce) in droves, this shift from physical to virtual storefronts, coupled with the globalization of the world economy, has exponentially complexified a once, simple highly localized retail supply chain. Incognizance and inability to adapt to this new retail landscape have forced several retailers into the halls of bankruptcy courts, including Sears, Toys R Us, and most recently, J.C Penney. In stark contrast, retailers that have ridden the e-commerce wave have not only survived but also poised to thrive amidst an increasingly unpredictable macroeconomic environment. Unlike traditional retailers, successful contemporary retailers have remolded themselves to become omnichannel supply chain management companies competing in a highly, competitive globalized marketplace. Under this new paradigm, speed is not only an essential feature but a crucial competitive advantage that has radically reconfigured the commercial real estate industry. As inventories to economic output declines and customer expectations for same-day delivery become the industry standard, high-throughput fulfillment centers, particularly infill shallow bay industrial, have become the pulse of the modern industrial real estate sector. This article will briefly outline the evolution of the supply chain and how it has driven demand for shallow bay industrial properties. Furthermore, this article will also provide a concise overview of the current market and analyze both current and future demand drivers for shallow bay industrial real estate in the United States.

Before the advent of e-commerce and the globalization of the world economy, the retail supply chain was a simple, localized series of events with only one point of purchase for the customer – i.e. the physical retail store. Local suppliers provided the parts for domestic manufacturers who would then box and ship their respective products to small distribution centers. From there, these items would be delivered to a retail store where customers would come in and purchase their desired products. In this simple supply chain, the primary demand drivers for industrial real estate were local manufacturing, bulk storage for materials and goods, and the need for distribution centers that delivered products to physical retail stores. As the central point of contact between businesses and their respective customers, a well-located physical storefront was indeed an asset for any business.

Fast forward several decades later, and this once simple chain of events has spiraled into a complex international ecosystem spanning several thousands of kilometers. Cheaper material and labor costs abroad resulted in several firms relocating their factories abroad in an attempt to achieve lower production costs on a per-unit basis. Once products have been manufactured abroad, they then arrive on shopping containers via ports and border crossings, where they are subject to time-intensive security protocols. Upon receiving clearance from border personal, these products are then moved into regional distribution centers on pallets. Unlike the previous supply chain model which had only one point of purchase for the customer (the physical store), customers can now purchase items from the comfort of their living room and expect to have it delivered the same day. As a result, items are now moving from distribution centers to fulfillment centers that process bulk shipments into smaller batches. When packages move from distribution centers to fulfillment centers, items arrive in bulk, which results in a lower shipping cost on a per-item basis. However, once items leave a fulfillment center, items are shipped individually and dropped off on a door-to-door basis. This final sequence of the modern retail supply chain is known as the ‘last mile’ and accounts for a high very high percentage of overall shipping costs for any individual item. Estimates for last-mile delivery as a percentage of total shipping costs range from 28% to as high as 51%. In this modern supply chain, the breakneck speed of e-commerce, the shift from physical storefronts to virtual storefronts, and high costs of last-mile delivery have propelled the demand for high throughput fulfilments centers located near major population centers.

While colossal distribution centers leased by big-name tenants like Amazon have grabbed headline, shallow bay industrial (aka light industrial) spaces between 50,000 – 120,000 square feet have disproportionately benefited from this supply chain reconfiguration. To reach and retain customers, firms need to shift their attention to providing consistent, speedy delivery in dense population clusters where last mile issues are particularly acute. As e-commerce continues to expand and as expectations for same-day and one-day shipping becomes the new industry standard, online retailers and logistics companies alike are streamlining their distribution strategy by utilizing infill light industrial facilities as part of ‘hub and spoke’ delivery network. Modeled after the aviation industry’s network of domestic and international flights, hub and spoke distribution networks entail a system in which retailers utilize one big box facility that is one hour away from a city (i.e. the hub) and have several smaller light industrial facilities (i.e. the spoke) closer to major populations. These ‘spokes’ are high-throughput light industrial facilities that are designed for quick inventory turns as opposed to storage. For several businesses, the utilization of this strategy is that it solves issues related to rising costs associated with last-mile delivery – i.e. the movement of products to the final destination. Moving forward, several firms may choose to lease multiple 50,000 square foot spaces across a dense metropolitan cluster as it may be more advantageous to do so in comparison to leasing one big 300,000 square foot distribution center located on the outskirts of town.

Given its proximity to customers and compelling supply & demand dynamics, light industrial facilities utilized as ‘spokes’ in dense infill locations have significantly outperformed their larger counterparts this past business cycle. Accounting for half of the total warehouse inventory in the United States, light industrial facilities under 70,000 square feet in size have experienced rent growth of 33% between 2015 and 2020. In contrast, warehouses larger 250,000 square feet have had rent growth of only 16% over the same period. Properties smaller than 70,000 SF are also experiencing availability rates that are more than 300 basis points lower than their larger (250,000+ square feet) counterparts. In densely populated urban areas where land is scarce, prospective light industrial facilities compete with other higher and better uses that generate higher taxes and rents – i.e. office or multifamily. As a result, development has been very constrained and new light industrial completions only make up 1% of total light industrial inventory since 1990. As retailers and logistics operators push for greater proximity to population clusters, rents for well-located light industrial facilities in highly populated, growing markets will continue to outpace larger warehouses located in peripheral regions for several reasons.

Following the Great Recession of 2008, asking rents for light industrial facilities across the United States experienced a 10% decrease, falling from $4.30 per square foot to $3.80 per square foot. During the Great Recession, the average price per square foot for an industrial facility had experienced a steep decline from roughly $45 per square foot to nearly $30 per square foot. However, valuations on a strict price per square foot basis deviate significantly based on the age of a property. Properties built post-2000 have experienced tremendous increases in valuation on a price per square foot basis. In 2016, the average price per square for a small bay industrial facility was well over $75, eclipsing the all previous all-time high set in 2007. Properties built in the 1990s, like their modern counterparts, also experience tremendous fluctuations on a price per square foot basis. In contrast, properties built in the 1980s, and pre-1980 have stayed relatively consistent on a price per pound basis, generally moving in lockstep with the overall economy. While the price per square foot is indeed an important pillar for making informed investment decisions, industrial properties are primarily valued for the income they produce.

During the Great Recession, cap rates for small bay industrial properties had risen roughly 150 basis points between 2007 and 2010. Vacancy rates during this period had risen to close to 13%, as absorption rates dipped into negative territory in 2009. Aside from the general risks associated with economic cyclicality, there is heightened risk in this particular niche given the fact that landlords are more likely to lease their property to smaller, non-credit tenants who are more susceptible to macroeconomic shifts. Aside from being especially vulnerable to macroeconomic shocks, these companies tend to be on short-term leases, which poses an additional risk for landlords. Following the Great Recession, however, the small bay industrial market rebounded as completions lagged net absorption for five consecutive years, creating a supply-demand imbalance that has driven rents across the nation – especially in supply-constrained West Coast markets.

Given COVID-19’s devastating impact on the global economy, it appears that there may be a correction in the form of cap rate expansion, increased vacancy, and decreases in rental rates in the US small bay industrial market in the United States. Based on their historical volatility on a price per square foot basis, shallow bay industrial properties built in the 1990s and 2000s may see more acute corrections in valuations in comparison to their older counterparts. Landlords who purchased properties late in the cycle are more vulnerable to lease defaults and shocks in cash flow. This may result in some distress but nothing in comparison near the levels of distress seen in the hotel and retail real estate markets. As economic uncertainty continues to escalate, a cap rate expansion of 150 basis points may be within the horizon for the small bay industrial market as prospective buyers adjust their expectations based on the increased risk associated with being a landlord in today’s macro-economic environment. Several industries, especially ‘non-essential’ industries like apparel, have been adversely affected by statewide lockdown protocols and may choose to either downsize their retail footprint, non-renew their lease, or move their products into bulk storage to stay afloat. While this is good news for warehouse owners, small bay industrial facilities will not benefit from the increase in inventory holdings as its small size and high-throughput construction make it less than ideal for bulk storage. As a result, it seems that decreased demand may dampen the rental rates for the next 18-24 months.

While there is a multitude of factors to suggest that a pricing correction is on its way in the small bay industrial market, there are several reasons to believe that the small bay industrial market will not be as adversely affected as it was during the Great Recession. As lockdown orders and statewide shutdowns confine the average citizen to the confines of their home, the torrid pace of e-commerce continues. According to Visa Inc, face-to-face transactions have fallen 45% during April, while several million consumers, out of necessity, have been making e-commerce purchases for the first time. As a result, US e-commerce sales have jumped 49% in April. While e-commerce sales are not expected to make up for the loss of in-store purchases, several sectors have seen an increase in sales. Online electronic sales, for example, have jumped 58% in April, while online grocery shopping grew by 110%.

As the pandemic continues to overwhelm global supply chains, several retailers, unable to keep up with the surging demand, have decided to prioritize ‘essential’ items like medicine and food much to the dismay of the consumer. This may create opportunities for smaller, niche firms to capitalize on consumer’s growing frustrations with large retailers, namely Amazon, and provide supply chain solutions for the last mile delivery of ‘non-essential’ items. This may be a significant demand driver for small bay industrial facilities in the short term. Another factor that could potentially drive demand would be traditional retailers reconfiguring their commercial real estate strategy to include more industrial space at the expense of their retail footprint. As retail foot traffic and car-counts dwindle across the nation, and as e-commerce sites are experiencing record levels of web traffic, the value proposition of a well-located distribution and/or fulfillment center becomes increasingly clear. This shift from bricks to clicks may mitigate any decrease in demand for small bay facilities in the near-term future.

Lastly, the prospect of onshoring and nearshoring of American businesses may also serve as long term demand drivers for light industrial facilities. As COVID-19 exposes the fragility of global supply chains, the repatriation of American manufacturing may resonate with senior business leaders. In a recent survey of 1,000 North American manufacturers, 64% indicated that they are interested in nearshoring or onshoring their business. Frustrated by the increasing costs of labor and materials in developing countries and the amplified supply chain risk associated with manufacturing in East Asia, several manufacturers have begun to rethink their supply chain strategies. In addition to the challenges of manufacturing in Asia, the rise of automation and new technologies such as 3D printing reduces the need for inexpensive labor, which was an important factor in why several US firms decided to relocate abroad, to begin with. In addition to the economics of offshoring, several geopolitical trends indicate that we are moving towards a more localized, protectionist world economy. Ongoing US-China trade tensions, the rise of right-wing nationalism in Europe, and Britain’s departure from the European Union highlight a growing backlash against the globalization of the world economy. While it would be naïve to assume that all global manufacturing will somehow return to the United States within a span of a few months, several economic and political trends indicate that we will likely see some kind of increase in reshoring and a corresponding increase in demand for light industrial properties in the United States.

In summary, the combination of globalization and e-commerce has not only reconfigured supply chains for American businesses but has also significantly impacted how firms utilize commercial real estate to maximize profitability and retain customers. Physical storefronts, once a necessity, have become increasingly obsolete as customers continue to flock towards e-commerce given its convenience, efficiency, and reliability. Supply chains, once localized and domestic, have morphed into a globalized web of perpetual movement. This rapid flow of goods across borders has triggered a demand for several types of industrial real estate, namely high throughput distribution centers. Despite the clamor and hype associated with behemoth distribution centers, shallow bay (aka light industrial) properties have outperformed their larger counterparts by a wide margin. The scarcity of these shallow bay industrial facilities in urban areas combined with the developmental barriers to new supply has led to both lower availabilities and strong rent growth across several major markets. As firms continue to adopt same-day and one-day delivery, the strategic importance of the last mile cannot be understated. To meet high consumer expectations, firms have adopted the hub and spoke distribution model, in which the nimbleness and decentralization of light industrial properties become competitive advantages in the age of speed. This distribution model, especially in dense urban areas, has been the key driver for demand for light industrial real estate and will likely continue to drive demand as more firms embrace e-commerce. Despite its stellar performance this past business cycle, light industrial properties are not immune to downturns in the economy. Newer product is especially vulnerable to shifts in valuation on price per square foot basis. Furthermore, light industrial properties are more likely to be leased to non-credit tenants on a short-term lease, which significantly increases the risk for landlords. Despite the short-term challenges associated with the COVID-19 pandemic, several demand drivers will boost the need for light industrial facilities in the foreseeable future. E-commerce’s torrid takeover the total retail market will lead to several retailers configuring their commercial real estate strategy to include less retail and more industrial space. Furthermore, the onshoring and nearshoring of North American businesses to the US and/or Mexico will likely push demand for light industrial properties for states that share a border with Mexico – i.e. Texas, California, New Mexico & Arizona. Ultimately, while the near term forecast for shallow bay industrial properties calls for overcast skies and corrections in valuations, the long-term outlook promises extended periods of sunshine, as e-commerce growth, corporate onshoring and barriers to new supply in dense populations centers will drive demand and create attractive buying opportunities for investors seeking outsized returns.