Industrial properties likely to feel a bit of turbulence

Industrial properties have been a top-performing real estate sector for institutional investors, and while the COVID-19 crisis is expected to pressure returns, the property type still is expected to outperform.

Warehouses in the U.S. earned 13.4% in 2019, the only sector to produce double-digit returns in the NCREIF Property index, according to NCREIF data. The second highest-performing sector of NCREIF Property index was office, with 6.6%.

While hotels have been the hard hit by the coronavirus, the industrial sector recently is beginning to see "chinks in the armor" in industrial properties, especially those in the shipping port market, Taylor Mammen, a Los Angeles-based senior managing director and director of institutional adviser services at RCLCO Real Estate Advisors, told CalSTRS' investment committee on March 4.

The $252.4 billion California State Teachers' Retirement System, West Sacramento, has a 13% target real estate allocation, with $34.2 billion invested as of Sept. 30, according to its latest semi-annual real estate report.

A combination of factors, including new warehouse construction and "drastically increasing rents" have added to problems warehouse tenants are facing with reduced cargo from China. That's prompting warehouse users to question whether they need more space, Mr. Mammen said.

Buyers, too, are seeing the effect of the coronavirus, with prices they are willing to pay starting to fall, he said.

Overall, investors should expect "less than ideal investment outcomes" near term, with distress for every property type in all locations as a result of the coronavirus, said Christy Gahr, principal and real estate consultant at Meketa Investment Group.

The hospitality sector has already been hurt by travel restrictions, including business and event cancellations and a drop in demand for leisure travel. She said she expects the hospitality sector to post negative returns in the next quarter. Other real estate sectors, including industrial, could post lower returns in the next six to 12 months.

Within the industrial sector, e-commerce historically has boosted warehouses supporting "last-mile" logistics, Ms. Gahr said.

"We expect an increase in demand but that will be at the expense of large logistics centers that were already fractured," she said. Warehouses that are outside of city centers and hubs for manufacturing would suffer further. There are already disruptions to supply chains and there will be more, Ms. Gahr added.

The coronavirus will only further impede logistics centers, Ms. Gahr said.

CalSTRS is underallocated to industrial, which has been a drag on returns over the last couple of years, but that may turn out to be a positive, Mr. Mammen said.

Some 13% of CalSTRS core portfolio is invested in industrial properties, which is 5 percentage points less than the NCREIF Fund Index–Open End Diversified Core Equity. Core real estate accounted for 67% of CalSTRS real estate portfolio as of Sept. 30.

The issue for warehouse owners is whether supply-chain disruptions causes credit quality to deteriorate so tenants can't pay rent, said W. Todd Henderson, New York-based head of real estate for the Americas at DWS Group GmbH & Co.

Port activity is down but the sector is not dead, despite an interruption in the supply chain, which historically has not lasted long, Mr. Henderson said.

COVID-19 will cause a pause in demand and impact the pace of expansion and new leasing, he said. "But I expect that it (demand) will regain momentum as fears over coronavirus pass."

What's more, rental rates for most industrial tenants is minimal, making it easier for tenants to hold on, even in light of continued supply chain disruptions, Meketa's Ms. Gahr said.

"It's not like an office building where rent has a meaningful impact on the cost of doing business," Ms. Gahr said. "It will take longer to get leases done. ... Those in charge of real estate management will be likely to hesitate in making any long-term commitments."

Indeed, across real estate property types, Meketa executives expect leasing to new tenants to be slow, she said. Landlords will dive even deeper into the financial health of prospective tenants.

Ms. Gahr said she expects increased vacancies as well as delays or cancellations of new investments as money managers forgo travel to inspect properties during the coronavirus crisis.

While real estate returns are expected to fall across property types, industrial is expected to continue outperforming other sectors, the Q1 2020 PREA Consensus Forecast Survey shows.

"Everyone is in learning mode right now," said Gunnar Branson, Washington-based CEO of AFIRE, the association for international real estate investors.

AFIRE's house view is that for the industrial sector, it is too soon to tell if foreign investors in U.S. real estate are changing their views. "Industrial has been one of the two favorite property types for global investors for some time," Mr. Branson said.

Industrial is a little more global by nature than other property types and it has benefited from the expansion of online procurement, he said. "There will be a recessionary period and we will see repricing," Mr. Branson said. "There will be some winners and some losers."

So far, tenant demand for industrial hasn't slowed, said Jon Pharris, Newport Beach, Calif.-based president of industrial real estate manager and developer CapRock Partners Management.

"No one is stopping in their tracks, similar to after 9/11 or during the (financial crisis)," said Mr. Pharris, whose firm builds new warehouses and makes value-added investments in the Western U.S.

However, there are reasons to be cautious, he said.

At "the ports of Los Angeles and Long Beach, the heartbeat of the U.S. economy, imports were down a little more than 15% year-over-year as of Feb. 28," according to information released by the ports, Mr. Pharris said.

Between 2008 and 2009, the imports increased or decreased 2% to 5%, he said.

Mr. Pharris expects another decline in March because it takes less than three weeks for goods to get from China to the ports of Los Angeles and Long Beach, so the March data will be impacted by the February slowdown. He anticipates a slight rebound in April.

For the industrial sector, the flip side to the coronavirus crisis is that industrial could emerge even stronger, Mr. Pharris said.

"People are being forced to go online more than they are used to doing," Mr. Pharris said.

Amazon leases 14 million square feet in the Inland Empire metropolitan area of Southern California and is looking for more space, he said.

"We expect there to be a slowdown but don't expect as deep or severe from industrial perspective than after 9/11" or the financial crisis, Mr. Pharris said.