The Future of the Industrial Sector: Key Insights for Investors

By Eli Randel, COO of Crexi

Industrial property proved essential in the COVID and post-COVID world, and while the property type’s popularity and rising valuation were already on the rise years before the pandemic, interest in the sector has grown exponentially. Increasing adoption of e-commerce and a demand for immediate consumer deliveries have pushed retailers and delivery operators to acquire more industrial space, particularly warehouses and last-mile logistics centers. At the same time, U.S. regulators have incentivized the transition to domestic factory operations, further driving demand for the sector.

Despite this, uncertain local and macro-market changes have somewhat paused industrial activity yielding mild signs of correction. Our Q3 trends report noted a slight dip in industrial valuations, with prices contracting alongside a slight vacancy rise. However, as the cost of construction reaches unprecedented levels, supply remains in check even as asking prices are overshooting adjusted buyer valuations resulting from increased interest rates and costs of capital.

Additionally, as warehouse operations become increasingly expensive, businesses are pausing on expansion to evaluate where the economic chips may fall headed into 2023. Some e-commerce businesses have faced challenges in online sales due to general consumer response to inflation and rising rates. However, spending still increased by 0.6% in September, per a recent Reuters report.

Looking ahead, strong fundamentals are unlikely to allow a pause to the market for long, and the corrections that have bubbled up are more a sign of decreased growth velocity than turbulence in the industrial sector. We’re unlikely to see a long-term impact on the need for distribution and fulfillment space. Additionally, the continued incentivization of domestic manufacturing will drive the demand for factory and storage space.

Here are three considerations for the savvy industrial investor and what to keep in mind when evaluating deals in today’s market.

1. Constricted development and market headwinds may lead to a small and likely temporary correction.

For nearly every month in the last two years, industrial properties have enjoyed rising valuations according to Crexi data. It’s only in this last quarter that we’ve observed any pause in asking prices, primarily due to increasing interest rates and the resulting increased costs of capital and alternative yield options. Deals are now being underwritten with today’s projections and cost of capital, and the growing bid-ask gap between owners and buyers requires longer negotiation times and a slower transaction velocity.

Plentiful development is still occurring in central markets such as Omaha, Chicago, and the Inland Empire, which surged full-steam-ahead in the last few years despite increased construction materials and labor costs. While materials have leveled in price, labor costs are still well above pre-pandemic levels, forcing developers to accommodate these costs with higher valuations.

Cap rates, however, have stayed chiefly steady in the same period, with a median 7% closed cap rate from Q3 2021 to Q3 2022. Investor appetite has yet to disappear for industrial properties; instead, they’re more closely scrutinizing what deals come across their desk and mitigating risk by shelling out capital on the most promising assets. As market conditions return to more favorable skies, capital will likely return in droves to the sector after some mild potential correction. But this temporary pause offers potentially lucrative opportunities for the discerning investor with cash-in-hand.

1. Return to U.S. manufacturing incentives, continued interest in e-commerce points to long-term demand.

Regulations such as The Inflation Reduction Act of 2022 (IRA) have already spurred the onshoring of U.S. businesses, with a score of other bills already moving through Congress and local state governments. These, other job-creation incentives, and Environmental, Social, and Governance (ESG) protocols are (right or wrong) increasingly being applied by investors to their strategic analyses.

The onshoring of businesses, backed by government-driven encouragement, is unlikely to disappear any time soon despite the higher costs of doing business on American soil. As such, we anticipate a flight to quality with newer Class A or retrofitted developments that meet these standards. With limited Class A supply, we’ll likely see ambitious developers retrofitting and updating Class B and C buildings, particularly those in central and last-mile markets.

At the same time, the growth of e-commerce will continue to be a major tailwind for the warehouse and distribution sector. In 2022, a Shopify report anticipates global e-commerce spending to account for 19.7% of retail sales, up from 18.8% in 2021. As more consumers choose to shop online, retailers are acquiring ever larger distribution and storage spaces and last-mile hubs closer to suburban and smaller metros. Despite a promising return to brick-and-mortar retail, consumers are unlikely to shake their online shopping habits. They expect the immediate gratification of fast delivery – and the prognosis for e-commerce-driven industrial property remains strong.

1. Keep an eye out for emerging markets with strong industrial fundamentals.

Demand for industrial property will likely stay robust in markets with well-built transportation inroads and developed sea, air, and land logistical ports. A recent CBRE report noted that companies are acquiring distribution hubs closer to air cargo ports to counter various challenges in trucking/train transportation operations which account for between 45-70% of total supply chain costs. The cost savings in transportation make these businesses more than willing to eat the 3-6% rise in occupancy costs. They will likely spur continued demand for these markets in the coming years, even as transportation costs temper.

Key performance indicators such as population growth, GDP growth, infrastructure development, absorption, deliveries, and corporate movements have highlighted several emerging markets to watch for industrial investment. Cincinnati, Cleveland, and Denver reported among such markets in our Q3 white paper, offering generous yields for these growing industrial markets. At the same time, we’ve observed other metros like Phoenix and Salt Lake City experiencing high demand via search and buyer activity.

Despite economic headwinds and skyrocketing interest rates, the industrial sector’s strong staying power and solid fundamentals point to continued success. As the saying goes, the best time to invest in commercial real estate was 20 years ago, and the second best time is today. Industrial commercial property may falter in the economic interim, but these blips are unlikely to last long.