Changes are happening in the industrial real estate market

Full Warehouse shelves

We have all been affected one way or another by the unprecedented demand for warehouse space since COVID began… But I see that quickly coming to a halt & here’s why:

1. Retail inventory levels are out of control.. for now

“Just-in-time” manufacturing was totally thrown off course with the complete shutdowns across the globe due to COVID & the government pumped out billions of dollars in stimulus checks to keep the economy going… Which essentially over-stimulated consumer demand. This has obviously been the main driver for all of this demand for warehouse space. How did we get here? Well, a lot of reasons, but these are the main factors in my opinion.

  1. The double-edged challenges of more demand and supply chain limitations resulted in retailers quickly running out of inventory & not being able to replace it fast enough. This caused them to place massive purchase orders to replenish the normal inventory levels… with the addition of some “just-in-case” inventory increasing demand for warehouse space.
  2. What was the domino effect of this? The major jam up at the ports & insane price increases to get containers from China to the US ($1,500 per container pre-Covid went up to over $20,000 per container!). Remember that in the news? A record of over 100 ships waiting for berth off the West Coast alone. All of that inventory flooded into warehouses across the US & created the wildest frenzy for space that we have ever seen, especially in coastal markets. Vacancy rates are still below 1% (healthy VR is 5-7%) in some major markets across the US which has pushed rents to more than triple in some cases (For context, some warehousing companies operating a 250,000 square-foot warehouse in the Los Angeles area saw their rent go from $100,000 per month up to $315,000 per month).
  3.  Freight costs have skyrocketed due to high demand, increased costs for staffing transportation jobs, & the price of diesel… So, when your supply chain costs pop like this, you have to raise prices to maintain target margin.
  4. Apple made some changes in the new iOS update that completely changed the game for the digital marketing world. This caused the customer acquisition costs of retailers who are marketing online to more than double, if not triple, in some cases… again resulting in increased prices/lower margins & a major negative impact on sales volume.

2. Hyperinflation is slowing demand

You may be thinking… Why isn’t all this inventory moving as they anticipated? Well, because of hyperinflation. When people have less money to spend they are forced to only focus on necessities like food, gas, and rent/mortgage payments because those costs are also going through the roof & fast. This caused the anticipated consumer demand to really slow down leaving retail companies sitting & paying on way too much inventory.

3. How do we stop it…? By raising interest rates.

The Federal Reserve is raising interest rates faster than they ever have… More than twice as fast as what we saw back in ’88-’89. This is quickly causing a domino effect and contracting the economy… which is the whole point. Here are just a couple of the effects we are seeing right now:

  1. In the capital markets of the industrial real estate world, cap rates are climbing fast due to the increase in the cost of capital… So investors are not able to pay as much for buildings if they want to achieve the same yield, even if they could get the same rent growth we have seen since all this began… Which they are struggling to get. (More on this below)
  2. Most of these retailers use a revolving line of credit to purchase all this excess inventory, so they are getting crushed every time they raise rates because their debt service payment moves higher as interest rates move up.

4. So now what do the retailers do?

Retailers have to get rid of all this stuff and fast. Their customer acquisition costs have doubled, their supply chain costs have doubled (if not tripled), their debt service is skyrocketing… & now they have to get rid of all this inventory at a major discount because consumer demand has really fallen off…

How do they get rid of it? Sales on sales on sales. Get ready for a WILD Q4 2022 full of long and extreme sales across the board. The best way to liquidate inventory is simply to cut prices, cross your fingers & hope consumers still buy what you are selling.  (A whole different topic could be around what a 3PL or Landlord has to do if the actual owner of the inventory goes bankrupt?)

5. What happens to the industrial real estate world when all this inventory moves out… & interest rates have jumped so fast?

Sublease. Wave. & a pop in vacancy rates… & a major opportunity for users to BUY.

We are likely going to see a mixture of subleases, defaults on leases & a ton of new construction deliveries open up a large chunk of available warehouse space across the US pushing vacancy rates back up to normal (if not higher) levels.

The result should be a few things:

  • Softening of lease rates & terms because landlords will shift their focus to occupancy. I think most Landlords will do whatever they can to restructure leases or work out a blend & extend to keep existing tenants in business & remove subleases that are competing with their direct vacancies. They will also be more open to shorter term leases & demising larger buildings that they had originally been focused on the single user.
  • Merchant developers (companies that typically build, lease, and sell to institutional capital) will look to exit their developments that they built on a speculative basis & haven’t leased, creating a strong market for industrial real estate users to buy
    • Merchant developers tend to plan for 20-24 months from breaking ground to lease up & then their exit… But with supply chain slowdowns and overall high demand for materials, their delivery date was delayed from the estimated 10-12 months to a year and a half in many cases & the leasing activity is stuck in quicksand… With debt service payments coming due around the 20th month or so, they need to either lease or sell the building to avoid any major losses. This will give some layup opportunities for users to buy brand new class A warehouses to have and to hold… or sell on a sale lease back when the capital markets come back in full force 1-2 years later (Let us help you evaluate your lease and purchase options across North America.)

What should you do to prepare?

Well first off, your real estate broker will be your strongest ally through whatever comes, & you need to be certain that they are on your team. As a 100% Tenant Representation brokerage firm, we ( are going to be all hands on deck to help our clients through the process of negotiating the restructuring of leases, acquisitions of buildings, or (if you are a retailer) sourcing 3PL partners to provide flexibility in your supply chain.

Secondly, you need to have your financials in order & a solid relationship with a bank. If the opportunity to buy a building presents itself, you need to be ready to move fast. We can help you with this, just ask.

Please feel free to reach out to me or anyone on our team to discuss your thoughts on these topics or if you need help navigating any situations relating to your real estate, we are here to help.

Thank you,

Summitt Hogue

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