Industrial Real Estate Fundamentals and Investment Outperformance
By: Chris Caton, senior vice president and global head of research, and Melinda McLaughlin, director of research, Prologis
Winter 2016 2017
Why is industrial real estate so attractive to the capital markets, and why is it outperforming other types of real estate investments?
INDUSTRIAL REAL estate is basking in the sun. Average annual returns have been 12.8 percent during the last five years on an unleveraged basis, according to data from the National Council of Real Estate Investment Fiduciaries (NCREIF), above the broader real estate industry average of 11.5 and above historical norms of about 10 percent for industrial properties. Returns for industrial real estate have been the highest or second highest of the main property types (including office, retail and apartments) in each quarter for more than three years.
Operating fundamentals are at their best in more than a generation. Vacancy rates have fallen to all-time lows in many markets and stood at 5.2 percent nationally in September 2016, according to CBRE. Rental rates have risen rapidly. Rents rose 9 percent in 2016 and are up 30 percent cumulatively in the last four years.
Nevertheless, there is more room to grow. In-place rents are farther below market than ever before, creating an opportunity for solid growth in net operating income (NOI) as leases are renewed at higher rates. Much of this positive momentum has occurred in an environment of subpar growth in GDP. Two new structural drivers have been critical in moving the industrial real estate markets forward despite modest economic growth.
The Supply Side
The recovery in industrial development has been gradual. Data back to 1950 illustrate that this recovery has been the slowest on record. The global financial crisis was one factor, but it hides structural changes that have occurred among the key players in the development landscape, including developers, banks and municipalities.
Among real estate developers, activity has become more institutionalized, with large entities comprising a greater share of development activity than ever before. Industrial projects are bigger and more complex. Institutional developers are more thoughtful about the types of projects and total risk they are willing to take, and they have real-time information at their fingertips to help them make investment decisions.
The financial community has also become more institutionalized. Banks are larger than ever. They place a greater focus on sponsor quality and are more discerning about the clients to whom they lend. New bank regulations, capital ratio requirements and notably higher equity commitments also factor into the availability of capital for industrial development.
With respect to local communities, the uses encompassed by this asset class can pose challenges. Today’s industrial projects are bigger than ever, and they attract more attention. Municipalities have become increasingly stringent with permitting, approvals and mitigation requirements.
On the demand side, e-commerce has contributed to the industrial sector’s outperformance. First, e-commerce continues to enjoy double-digit growth, comprising approximately 20 percent of new leasing, up from less than 5 percent five years ago. Additional catalysts such as the maturing of the millennial generation and advances in virtual reality technology continue to drive e-commerce growth, which in turn will drive industrial growth.
Second, e-commerce fulfillment operations are intensive users of logistics real estate. Research on e-commerce and store-focused supply chains indicates that online retailers need three times more logistics space to fulfill e-commerce orders than to supply store shelves for the same level of sales. Compared with rapid throughput distribution to stores, e-commerce fulfilment operations keep higher levels of inventories, stock a wider range of products, support direct-to-consumer shipping and accept returns. The recent growth of “last mile” delivery facilities is another avenue in which e-commerce is propelling industry demand.
Investor expectations concerning financial returns have declined over the past two decades. This is a critical context for understanding the current valuation environment. Beyond real estate, 10-year government bond yields have fallen from 8 percent in the early 1990s to less than 2 percent today.
This shift in financial market pricing has also translated to shifts in real estate pricing for all property types, but particularly for industrial real estate. Cap rates, which were above 10 percent in the 1990s, are below 6 percent today. Development yields have followed suit. Looking forward, interest rates are expected to rise. However, today’s real estate pricing does not fully reflect the current low interest rate environment; the spread between cap rates and the 10-year government bond yield is approximately 350 basis points, high by historical standards, leaving room for rising interest rates.
What do these trends mean for the near-term investment outlook? According to a second quarter 2016 survey of investment management companies conducted by the Pension Real Estate Association, investment returns are expected to increase. The survey reveals that returns are expected to average 7.2 percent during the next five years, a level near current underwriting assumptions and consistent with historical averages. Just as important, the survey reveals that investors still expect industrial real estate to outperform all other property types.