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Real estate

Investors weighing if industrial real estate’s hot streak to continue

Industrial real estate is benefiting from the popularity of e-commerce. This warehouse in Brooklyn is viewed as a possible location for Amazon, which is looking to establish a second U.S. headquarters.

Updated with correction.

Many investors and managers believe the rise in popularity of online shopping has been a boon for the industrial real estate sector, though some insiders now are starting to wonder if too much capital is moving into the space.

For the near term, the industrial sector still has a sunny outlook, according to a recent review by real estate research firm Green Street Advisors LLC. Demand for industrial properties should exceed supply in 2017 and 2018, and property values are up 9% over the past year.

In response to the growing surge in online shopping, demand for warehouse space to accommodate shippers' need for inventory storage has pushed up industrial valuations as well as rents in the past few years.

Industrial assets have earned better returns than most other property types over the past two years, said Eric Frankel, lead analyst for the industrial and tech sectors at Green Street in Newport Beach, Calif.

But there are signs that rosy picture might be changing.

"It (industrial) is seen as safer than other property types because it is benefiting from e-commerce," Mr. Frankel said.

However, supply might edge past demand. Green Street recently increased its forecast for the growth of industrial property supply in 2018 to just more than 1.9% as of Nov. 27 from 1.8% as of Aug. 22.

In its latest report, real estate consultant The Townsend Group noted that while e-commerce and imports are driving demand for industrial properties in the U.S., "supply is rising in hotbeds, requiring focus on quality assets in neglected markets."

Even so, managers are still bullish on the sector.

"Industrial is clearly at the head of the class across the five main food groups," said Indraneel Karlekar, Los Angeles-based managing director at Principal Real Estate Investors.

"There's a lot of very active capital looking to be placed in this property type," Mr. Karlekar said.

Principal manages a multibillion-dollar separate account for a large pension fund that is investing a portion of the portfolio in what Principal executives call build-to-core industrial. Mr. Karlekar declined to identify the investor.

Prices are higher for core, stabilized industrial assets because there is too much capital investing in those properties, Mr. Karlekar said.

That is why build-to-core — new buildings erected in good locations that are then sold into the hot market — works, Mr. Karlekar said.

It is a riskier strategy than core industrial because it has lease-up risk — the risk that is there will be insufficient tenant demand when the project is finished, he said. This risk is mitigated by building in markets with strong tenant demand, he noted.

Despite healthy market fundamentals, nearly 65% of the tracked industrial markets are in a contraction phase, as new supply in the near term is projected to place downward pressure on rental rates. On the positive side, however, no tracked markets were in the recession phase, according to FTI Consulting Inc.'s third quarter Economic & Real Estate Report, which was released Dec. 6.

Within the core commercial sectors, pricing within suburban office assets increased 1.8% during the third quarter, eclipsing gains of 1.5% within the central business district office and industrial property types, the FTI report showed. Pricing within retail properties gained 0.3%.

Even so, returns in industrial are the second highest among the main real estate property types. Industrial properties earned 8.2% for the year, an annualized 57.1% for the five years and an annualized 10.4% for the 10 years ended Sept. 30, the FTI report noted. The industrial sector was only outpaced by apartments, which earned 10% for the year, 75.7% for the five years and 53.8% for the 10 years ended Sept. 30, FTI report showed.

Investors are gravitating toward industrial as retail continues to evolve.

"Retail has changed so much that we are finding better opportunities in industrial," said Paul Chapman, director of real estate for the $23 billion New Mexico State Investment Council, Santa Fe.

"Industrial is the new proxy for retail. Last-mile and general distribution and fulfillment centers are very important to retail these days."

Industrial is "the easiest sector to raise money," said Scott Crowe, Philadelphia-based chief investment strategist at real assets manager CenterSquare Investment Management.

There are barriers to new industrial buildings, including large truck clearances and amenities for workers such as parking, he said. And the rent growth of warehouses in places away from population centers and amenities will disappoint

A better opportunity is to redevelop properties, he said.

For example, CenterSquare is redeveloping a Quaker Oats facility in Harrisburg, Pa.

CenterSquare is knocking down the walls of a building that was both warehouse and office space, and turning it into a modern warehouse.

Tenants these days are looking for large "last-mile" distribution facilities so consumers can receive their goods in hours or a day. "The time to delivery is very important," he said. The Quaker Oats facility is in an area that can access 10% of the U.S. population in one day, he noted.

There is a chance those close-to-town fulfillment centers are being overbought, creating expensive prices. But "there is still room to run," Mr. Crowe said.

In the next 12 months, industrial properties should continue to appreciate.

Joseph Sumberg, New York-based managing director and co-head of Goldman Sachs Asset Management's private real estate business, said the best industrial investments are located in zones where retailers and third-party logistics firms can get access to significant populations in a short drive.

Industrial rents are "less expensive than retail properties and that's a factor pushing growth (in industrial), Mr. Sumberg said.

"If you are in a dense infill location … like New York, Los Angeles, Atlanta, you can occupy an industrial property and reach consumers in the same drive time as a retail property. But the rents you pay are much less than an equivalent basis for retail," he explained.

Said Robert Perry, Los Angeles-based portfolio manager for CBRE Strategic Partners U.S. Value 8: "I do like infill, last-mile distribution facilities." Industrial assets provide cash flow and diversity, but they will never make up the majority of the fund, he added.

"It's highly priced," Mr. Perry said. "It (industrial) is very, very much in demand today."

Fund 8, CBRE Global Investors' latest domestic value-added fund, closed last month at $1.34 billion.