Investors jump in early in industrial sector

The already hot industrial real estate sector is burning up with demand that's so fierce investors increasingly are competing to buy warehouses before they are built or leased.

Traditionally, investors were loath to take on development and leasing risk, preferring to buy warehouses when completed and with tenants in place. But industrial rents are rising quickly — with first-year comparable rents up 10.8% in 2021 from a year earlier, according to CBRE research — and consistent growth in leasing rates is causing investors to be less concerned with those risks.

According to MSCI Inc.'s RCA Commercial Property Price Indices, industrial prices rose a record 28.1% in the 12 months ended Jan. 31. That's faster than the growth in any other property sector in the period, besting apartments' 22.5% increase.

Real estate executives say the industrial properties segment still has room to grow.

"If you take any kind of view of the world that there could be reversion to the mean, it points to a peak," said Richard Kleinman, Chicago-based head of LaSalle Investment Management's U.S. research and strategy group and co-CIO for the Americas. But investors expect rents to continue to rise and, so far, they have been right because supply has lagged demand, Mr. Kleinman said.

LaSalle has $76.6 billion in assets under management.

While the industrial real estate market is certainly heated, "it doesn't scream to us that it is overheated," he said.

Still, there are caution signs on the horizon, including uncertainty around whether rising interest rates will slow transaction activity and impact pricing across real estate sectors. What's more, rising costs of building materials, fuel and labor as well as slower delivery times of needed construction materials could also cut into returns.

Industrial by far was the top-performing domestic property sector in 2021, returning 43.3%, the NCREIF Property index shows. By comparison, the total NCREIF Property index returned 17.7%.

Looking ahead, investors do expect industrial returns to fall to 8.2% in 2024 from 14.8% in 2022, according to the Pension Real Estate Association's first quarter consensus forecast survey. But that's still better than many expect to get in other asset classes and real estate property types, sources said. Even with falling returns, industrial is still expected to the top-performing property type in 2024, PREA's consensus survey shows.

Industrial "looks pretty good" after analyzing factors such as capitalization rates — a calculation estimating investors' expected return on a real estate investment — and capital needed by the sector, and if the property type will continue to produce the returns LaSalle investors require, Mr. Kleinman said.

This is especially the case since rents are expected to continue rising, judging by low vacancy rates of industrial properties in many real estate markets, among other indicators. To take advantage of rising rents, owners of industrial assets are holding off from preleasing the property, expecting rents to increase while the real estate is being developed, Mr. Kleinman said.

The use of these so-called forward purchases is not altogether new, but the number of "players that are utilizing that structure and the aggressiveness they are being employed is a new phenomenon," representing a new competitive dynamic, said Jonathan Van Gorp, a San Francisco-based managing director at real estate management and outsourced CIO firm Makena Capital Management LLC, which has about $20 billion in assets under management.

Some asset owners are entering into their own deals called "build-to-hold" investing before the warehouses are built, agreeing to own the warehouses for about a decade, said Michael Levy, Dallas-based CEO of Crow Holdings, a real estate investment and development firm. While not new, interest in these deals has grown rapidly over the past year, Mr. Levy said.

Crow has $24 billion in assets under management.

For example, in August, Crow entered into a joint venture with Mubadala Investment Co., the $243.4 billion Abu Dhabi-based sovereign wealth fund, to develop $1 billion of Class A industrial properties in the U.S. Mubadala is taking development and leasing risk as both the co-developer and capital source for the joint venture, Mr. Levy said. Mubadala is also expected to buy some of the completed developments to hold for the long term, he said.

Crow is currently working on about 25 development projects slated for various build-to-hold strategies, Mr. Levy said.

One of the challenges for institutional investors is finding big enough deals to put their money to work because individual industrial property purchases alone don't require that much capital, said Pamela Boneham, Chicago-based senior adviser for real estate investment trust Ventas Inc. and an independent investment committee member for CBRE Investment Management and City of Hope, Duarte, Calif.

To make a large enough investment that will "move the needle," institutional investors are seeking to buy portfolios rather than invest in industrial properties one at a time, she said.

Asset owners and real estate managers are looking to establish relationships with strong developers where they can get access to multiple deals through the same development partner, Ms. Boneham said.

Some investors will take the development risk and the leasing risk. Other investors will wait to invest until after the property has been developed but before it is rented, she said.

Other factors driving the trend are an increasing amount of capital available for the asset class and the expected lower potential return for stabilized industrial properties compared with the expected return for real estate that has not yet been developed, said Jon Pharris, Newport Beach, Calif.-based co-founder and president of industrial real estate manager CapRock Partners, which had $2.6 billion in gross asset value as of Dec. 31.

Mr. Pharris said this is not the first time he has seen a plethora of investors willing to take market risk on industrial properties. The first time was just prior to the 2008-2009 global financial crisis, when the overall real estate market was similarly frothy, he said.

Indeed in 2021, there were an "unprecedented" number of industrial properties leased or sold before they were built, said Mary Lang, New York-based head of Americas direct logistics strategies at CBRE Investment Management, which has $141.9 billion in assets under management. Last year, 80% of all newly constructed industrial real estate was leased or sold before the properties were built, according to CBRE's research group.

"A significant supply-demand mismatch" is giving investors more confidence that the industrial sector will continue to expand, Ms. Lang said. The U.S. needs to construct another 330 million square feet just for e-commerce tenants and another 1.2 billion square feet for new modern logistics properties for all other types of industrial tenants, according to CBRE research.

"What is really driving the sector today isn't really e-commerce," which makes up 12% of industrial and logistics tenants, Ms. Lang said. "The story today is that the inventory model has shifted. It has moved away from just-in-time to a just-in-case inventory model."

The COVID-19 pandemic sped up people's expectations on when they can get the goods they desire, Ms. Lang said. "For years and years, we talked about last mile ... for me it is not a function of distance, it is a function of time" to get goods to the end user or consumer. Industrial properties also have to be close to where warehouse workers live and have easy access to public transportation, Ms. Lang said.

The most desirable industrial properties are scarce and it is difficult to build more because there is limited land available in some locations such as near ports and airports, and "people don't want to see trucks rolling through their neighborhoods," Ms. Lang said.

Since there is a finite supply of industrial properties to invest in today, buyers worry that if they don't embrace the risks and buy warehouses before they are developed, they may not be able to buy the assets, Makena's Mr. Van Gorp said.

At Blackstone Inc., logistics including industrial assets have grown from 9% of its real estate portfolio in 2017, representing its smallest major real estate sector, to 40% in 2022, said David Levine, New York-based co-head of Americas acquisitions for Blackstone's real estate business, in an email.

Blackstone managed $881 billion as of Dec. 31, of which $280 billion was in real estate.

"Tailwinds supporting the sector accelerated over the past 24 months with even greater e-commerce growth and adoption," he said.

Blackstone executives are concentrating on last-mile properties, "given the available supply in these areas and that these locations are likely to benefit the most from e-commerce growth," Mr. Levine said.

While nobody expects industrial property sectors' growth engine to sputter to a halt anytime soon, there could be a few bumps ahead. Many existing warehouses don't have enough parking for trucks and heavy equipment, said Leo Addimando, a Philadelphia-based managing partner and co-founder of industrial and multifamily real estate manager Alterra Property Group LLC, with $1 billion in assets under management. This could potentially make these properties less attractive investments for some buyers

The Russia-Ukraine war also is causing gas prices to rise, impacting industrial tenants' biggest cost — transportation — making so-called infill properties, mostly located near urban areas, even more attractive, said Matthew Pfeiffer, managing partner and CIO of Alterra. Developers are buying lots used for truck and heavy equipment storage to build warehouses, exacerbating the problem, Mr. Pfeiffer said.

Industrial developers also are not immune from supply chain issues, making materials more expensive and taking longer to arrive, cutting into returns, Mr. Pfeiffer said.

But so far, "rental growth and related value creation has outstripped higher costs in materials and labor to build," Crow's Mr. Levy said.

"The biggest challenge as a developer is the cost to build and supply chain delays, and that can have a negative impact on overall investor returns," Mr. Levy said. Crow is managing its rising costs of materials by buying in advance and storing the building materials in warehouses, he said.

"I know at some point the real estate industry will create enough supply to meet this unprecedented demand and it will become a more normalized market," Mr. Levy said. "I just can't see it happening soon from where we are now."