Industrial real estate plays a crucial role in the supply chain. It may not have the glamor of other real estate sectors, but its importance cannot be overstated. From the clothes we wear to the food in our refrigerators, almost every product we use has passed through an industrial facility.
The surge in e-commerce, accelerated by the COVID-19 pandemic, has drastically increased the demand for fulfillment centers and last-mile delivery hubs. At the same time, economic factors such as tariffs, shipping costs and the political climate have influenced where and how companies choose to manufacture and distribute their products. Understanding these demand drivers and their impact is essential for navigating the current landscape.
Understanding E-Commerce And Current Demand Drivers
E-commerce has emerged as a major driver of industrial real estate demand. Depending on the source, e-commerce is reported to constitute between 15% and 25% of all retail sales. E-commerce is currently just over $1.1 trillion in sales. In 2019, the net absorption of ecommerce in the industrial sector was just below 15%. That number shot to 31% during the pandemic, showcasing the power of demand drivers. Recent research by Boston Consulting Group shows that e-commerce is projected to capture 41% of all retail sales by 2027.
The growth of e-commerce has led to an increased need for fulfillment centers and last-mile delivery hubs. These facilities are crucial for managing the logistics of online orders, from the moment a customer clicks “buy” to the delivery of the product at their door. The last-mile delivery process has increased competition for strategically located industrial real estate, driving up demand and prices in prime locations. Last-mile fulfillment is 52% of transportation costs, so if you aren’t next to the customer then you’re not profiting. This is a key reason why growth in rents over the past 5 years has been so substantial.
Supply Chain Interruptions
The COVID-19 pandemic brought supply chain vulnerabilities to e-commerce, highlighting the need for strategically located manufacturing bases. Companies that relied heavily on a single source or region for their goods faced significant disruptions when those areas were affected by lockdowns and other pandemic-related measures. This disruption led many companies to a reevaluation of their supply chain strategies, with many companies seeking to mitigate risks by changing their manufacturing locations.
For example, the automotive industry faced significant delays due to a shortage of semiconductor chips, which are primarily produced in a few key locations worldwide. This shortage halted production and highlighted the need for more resilient and flexible supply chains. Companies across various sectors began to adjust their strategies, exploring options to nearshore or onshore manufacturing to reduce dependence on distant and potentially unstable regions. Onshoring manufacturing is expected to have a “multiplier effect” on industrial real estate as vendors/suppliers will need to occupy last-mile industrial space to support these manufacturers.
Nearshoring And Onshoring Trends
There has been a noticeable shift towards nearshoring and onshoring since the COVID-19 pandemic. Nearshoring involves relocating manufacturing closer to the home market, while onshoring brings production back to the company’s home country. These strategies aim to reduce the risks associated with long supply chains and dependence on foreign manufacturing. Mexico in particular has become an attractive option for U.S. companies to nearshore manufacturing as a means of diversifying their supply chains as opposed to being solely dependent on Asia. The imposition of tariffs on imports from certain countries has further incentivized companies to consider nearshoring and onshoring to avoid additional costs.
The benefits of nearshoring and onshoring include reduced shipping costs, shorter delivery times and increased control over the production process. However, these strategies also present challenges, such as higher labor costs and the need to invest in competitively priced industrial real estate. Still, the trend is gaining momentum as companies strive to build more resilient supply chains and mitigate future risks.
Challenges Facing Industrial Real Estate
One of the most pressing challenges facing the industrial real estate sector today is the tightening of capital markets. As interest rates have risen, the landscape for lending has dramatically shifted, creating significant hurdles for developers and investors alike.
1. Capital Market Constraints
The bulk of lending for commercial real estate comes from big banks and regional banks. However, in recent times, banks have significantly pulled back on their lending activities. This contraction is primarily due to their existing exposure to commercial real estate, which has become problematic as loans come due and refinancing becomes difficult or impossible. Many banks find themselves with a substantial number of loans on their books that are either delinquent or significantly devalued. I’ve observed this leading to write-downs of 50 to 75 percent in some cases.
2. The Role Of Regional Banks
Some sources say regional banks have a significant portion of their balance sheets tied up in commercial real estate loans—44% according to Reuters. There are estimates that up to 75% of all office loans in underwriting, meaning the properties are worth less than the loans. If you bought an office building and you financed it with a regional lender, your property may be worth less than their loan. As these loans come under pressure and defaults increase, regional banks are finding it difficult to extend new credit. This reduction in lending capacity is a significant constraint on the overall availability of capital in the market.
3. Rising Interest Rates
The increase in interest rates has also had a direct impact on the cost of financing new projects. Where once a developer could secure a loan at 3%, they now face rates upwards of 8%. This spike in financing costs makes many new projects financially unfeasible, slowing down the rate of new industrial development at a time when demand remains robust. The financial strain has led to a notable reduction in the pace of new construction, tightening the available industrial space even as demand continues to rise. According to information provided to us by Costar, net supply additions across the 87 markets that Costar tracks peaked at 147 million square feet during the second half of 2023. That figure fell by 30% during the first quarter of 2024 and it’s anticipated that it will continue falling through 2025.
Navigating the current landscape requires a deep understanding of the capital market constraints and an ability to adapt to the changing lending environment. Developers and investors must be prepared to explore alternative financing options and potentially adjust their investment strategies to align with the new reality. While challenges are present, those who can effectively manage their capital needs will be well-positioned to take advantage of the ongoing demand for industrial real estate.