viewpoint industrial sector, a continued industrial demand

Future Cities

Industrial Demand Remains Strong. Can Supply Catch Up?

VIEWPOINT

With demand surging in the industrial sector, a continued strong supply response is expected. However, some key risk factors could impede the pace of supply growth in upcoming years.

ECONOMETRIC ADVISORSOCTOBER 2021

2 © 2021 CBRE, INC.ECONOMETRIC ADVISORS

Future Cities Industrial Demand Remains Strong. Can Supply Catch Up?

Executive Summary– The rising share of e-commerce within retail has led to a prolonged

period of high demand in the sector.

– The resulting low availability and high rent growth should continue to drive a strong supply response.

– In the short term, materials shortages and rising construction costs have caused some temporary disruptions to supply growth.

– Over the long term, construction wages, limited land availability, and local and federal regulation remain risk areas for builders and developers.

Demand conditions and long-term tailwinds

The industrial sector continued to maintain its considerable momentum in the second half of 2021, as impressive demand for warehousing space propelled a near-record 120 million square feet (MSF) of net absorption in the third quarter. This far outpaced the rate of supply growth during the quarter and drove availability in the sector to a record low of 6.0%.

In many ways, the experience in the industrial sector over the past several quarters has been an enhanced version of trends that have been prevalent for over a decade. The shift in retail toward e-commerce and the associated push within e-commerce to increase delivery speed led to a general reevaluation of logistics and supply chains long before the pandemic forced new customers into online shopping. This, in turn, has provided a prolonged tailwind for the industrial sector, boosting demand for warehousing space to enhance e-commerce logistics.

The shift in retail toward e-commerce has provided a prolonged tailwind for the industrial sector.



The result has been an unprecedented cycle of expansion in the sector. Net absorption has been positive in every quarter since Q2 2010 and gained momentum in the five years before the pandemic. Industrial availability has followed a general downward trend as a result and has remained below the long-run average availability rate of 9.3% in every quarter since the end of 2014. (Figure 1)

CBRE Econometric Advisors’ (EA) view is that e-commerce sales are unlikely to grow as fast as they did prior to (and especially during) the pandemic but are still expected to gain share steadily in the retail space over the next decade. Because of this, the industrial sector should continue to experience a tailwind from e-commerce-based logistics demand, which should lead to above average absorption in upcoming years. It isn’t until the broader macroeconomy begins to slow significantly in 2024 and 2025 that the industrial demand begins to tail off.

Consecutive quarters of availability below historical average

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10-year projected CAGR for e-commerce retail sales 2021-31

7.7%

Figure 1: Industrial Availability Rate, Sum of Markets (%)

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Source: CBRE Econometric Advisors



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Rent Growth Long Run Rent

8 years of rapid rent growth

Rising rents and forecasting the supply response

The outlook for the industrial sector in part hinges on the interrelationship between the availability of space, rental growth, and the pace of new supply. When one of these fundamentals deviates from the norm in a market or the sector overall, the others adjust to return the market to normal long-run conditions. For example, a market that has seen availability rise above normal will tend to have weaker (or negative) rental growth relative to historic norms. This softer pace of rental growth tends to discourage builders from constructing new supply and entices prospective tenants to lease. This eventually leads to falling availability until conditions are returned to normal.

This process of mean reversion combined with professional economists’ analysis determining the long-term stability of economic relationships and causation forms the foundation of many of EA’s property forecasts. The duration of this adjustment process varies among markets and can be affected by external factors such as the state of the macroeconomy or the strength of e-commerce, but over time we assume that conditions eventually return to historic norms. The current environment for the industrial sector is essentially opposite of the one described above as availability has been below historic norms for several years.

This has led to strong rent growth with rents rising an average of 4.1% per year from 2014-2020, more than double the historic average of 1.7% growth (Figure 2).

Source: CBRE Econometric Advisors

Figure 2: Industrial Y-o-Y EA Asking Rent Growth, Sum of Markets (%)



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Completions (L) Availability Rate

Predictably, construction in the sector has responded by accelerating during this phase of the cycle and new supply has increased each year since 2012, reaching a near-record 295.MSF in 2020. Still, this has not been enough to keep up with demand, as a favorable macroeconomic environment and the continued tailwind from e-commerce have created an abnormally strong demand environment.

Going forward, macroeconomic conditions are likely to remain favorable for industrial demand for the next couple of years, as the U.S. economy is projected to grow at a fast clip while it continues to recover from the pandemic. As such, availability is expected to continue to trend near historic lows while rent growth and new construction remains strong through 2023. In the medium to long term, the U.S. economy is projected to slow noticeably, which will begin to slow the pace of industrial absorption and allow supply to catch up to demand and ease availability in the sector (Figure 3).

Average annual forecasted completions, 2022-2026

288.1 MSF

Figure 3: Industrial Availability Rate (%) and Completions (MSF), Sum of Markets

Source: CBRE Econometric Advisors Q2 2021

Forecast



Constraints to supply: wages and materials cost

Much of this forecast assumes that supply can respond in upcoming quarters similarly to how it has responded in the past. However, several issues that could slow the market response have emerged in the sector, both at the market level and for the sector overall.

- Rising construction costs and shortages of materials and labor- Land availability- Local legislation- Environmental, social and governance (ESG) regulation

There is already some evidence that these factors are influencing construction in the sector. The acceleration of the U.S. economy following the rollout of COVID-19 vaccines led to a surge in demand for commodities and manufacturing products, and over the past few quarters, producers have struggled to meet this sudden increase in demand. The result is that commodities and other key materials used in building construction have faced shortages and significant price increases during the first three quarters of the year.

The resulting sourcing delays and upward pressure on construction costs has posed a significant challenge for builders, leading to a record number of project delays among industrial projects during the first half of the year (Figure 4). This likely contributed to softer supply growth results in Q1 and Q2 despite a robust pipeline of new projects that were set to deliver.

Figure 4: Warehouse Under Construction Deferred Projects (# of projects)

Source: CBRE Econometric Advisors Supply Track

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Figure 5: Nominal wages index (2020 = 100)

The good news is that much of this is likely a temporary problem for the sector. EA expects that materials shortages and elevated materials costs will be resolved over the next several quarters as manufacturers ramp up production. In addition, completions rebounded nicely at the start of the second half of the year, registering the strongest third quarter on record.

Labor shortages and rising wages for construction workers are likely to put longer-term pressure on construction and supply, however. The market for construction workers is likely to remain tight given the appetite for building and wages for construction workers are expected to rise an average of 3.4% per year over the next five years, outpacing both historical average growth and the pace of wage growth in the

broader macroeconomy (Figure 5). This is likely to impact the desire to build new supply at the margins and puts additional pressure on rents to rise higher to justify higher labor costs.

Constraints to supply: land availability and local legislation

In addition to short-term materials shortages and expected long-term labor challenges, developers may also have difficulty finding favorable land to build new industrial space. This is not a new phenomenon in markets like Los Angeles and Northern New Jersey where low land availability for industrial construction has kept the supply of industrial space tight for years. However, this decade-long period of impressive demand and accelerating construction has made land availability an issue in many other markets that have previously never faced this issue.

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Total Construction Workers

Stronger forecasted wage growth in construction

Source: Oxford Economics



Theoretically, this problem can be resolved by zoning more land in these markets for industrial use to ease these land constraints. In practice, however, this is often easier said than done. During this period of rising e-commerce sales and retailers desiring warehouses and distribution centers close to population centers, what often gets overlooked is that residents generally don’t like warehouses close to where they live. Warehouses bring trucks, air and noise pollution, and traffic, and often face resistance from residents.

This resistance may manifest itself in the form of opposition in zoning committee meetings or in local legislative pushes to change air quality standards to discourage industrial construction or reduce emissions coming from warehouse operation and have had some impact on warehousing decisions over the past several quarters. For example, the South Coast Air Quality Management District, which regulates several Southern California markets like Los Angeles, Inland Empire and Orange County, passed a rule earlier this year requiring warehouse operators to earn points through investing in green technology to offset the effects of emissions coming from trucks.

In areas where available land is particularly scarce, developers can turn to alternative ways of adding supply to the sector. Creative solutions such as multi-story warehousing or conversions from other property types to industrial have emerged as a potential means of increasing the stock of industrial space. However, construction of multi-story warehousing space is costlier to build than traditional warehousing and requires significant rent premiums from tenants to justify the additional cost. Conversions from other property types such as retail have been occurring, but often face the same sorts of zoning issues and pushback from residents and businesses that traditional warehouses face. As such, these options represent niche solutions that do not add significant amounts of space into the market, and in many case add additional upward pressure to rents in the area.

Going forward, these types of local policy changes are likely to remain a threat in major industrial markets. Warehousing hubs have emerged in several areas across the country, including Atlanta, Chicago, Dallas and Northern New Jersey, and pushback against further industrial construction in these areas could be an

impediment to returning these markets to more normal levels of availability.

Constraints to supply: Federal policy and environmental regulations

Notably, issues of land availability and local legislative pushback are more important when looking at an individual market instead of the sector overall. That is, if available land is scarce or becoming too costly in one market, new construction will likely spill over into other markets where it is easier to build.

Broader federal regulation, however, could impose additional costs for the sector overall. The U.S. rejoined the Paris Agreement earlier this year, bringing climate change back to the forefront of federal policy. As part of rejoining this agreement, the U.S. has recommitted itself to reducing carbon emissions. While much of this effort will likely be focused on improving efficiency in passenger and freight transportation and reducing emissions from manufacturing processes, commercial real estate may find itself with new requirements for energy efficiency.

This is potentially an issue for developers in that new construction may prove to be more costly to meet these new standards. However, energy efficiency and other ESG issues have been a key theme in new construction already in recent years, becoming a selling point for owners to lure tenants with their own ESG goals. From a supply standpoint, the bigger issue comes from older existing buildings that now must be renovated to meet new standards. Again, these potential regulations would incur an additional cost on property owners and builders, putting additional upward pressure on rents to justify the expenditure.



© Copyright 2021. All rights reserved. This report has been prepared in good faith, based on CBRE’s current anecdotal and evidence based views of the commercial real estate market. Although CBREbelieves its views reflect market conditions on the date of this presentation, they are subject to significant uncertainties and contingencies, many of which are beyond CBRE’s control. In addition, manyof CBRE’s views are opinion and/or projections based on CBRE’s subjective analyses of current market circumstances. Other firms may have different opinions, projections and analyses, and actualmarket conditions in the future may cause CBRE’s current views to later be incorrect. CBRE has no obligation to update its views herein if its opinions, projections, analyses or market circumstanceslater change.

Nothing in this report should be construed as an indicator of the future performance of CBRE’s securities or of the performance of any other company’s securities. You should not purchase or sellsecurities—of CBRE or any other company—based on the views herein. CBRE disclaims all liability for securities purchased or sold based on information herein, and by viewing this report, you waive allclaims against CBRE as well as against CBRE’s affiliates, officers, directors, employees, agents, advisers and representatives arising out of the accuracy, completeness, adequacy or your use of theinformation herein.

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Conclusion

The long-term trend toward online shopping away from traditional retail has ushered in an unprecedented boom in demand in the industrial sector, and current conditions suggest that leasing should remain strong in upcoming years. Current forecasts call for a strong supply response to loosen availability in the sector and bring sector performance closer to long-run averages. However, a number of potential factors, ranging from construction costs to land availability and legislation, could make this transition to normal conditions more difficult than theory would predict.

It is worth noting that none of these risk factors to supply are certain to have a noticeable effect on supply growth in the sector overall. Materials shortages are unlikely to persist over the long term, technological advances toward electric freight transportation are likely to help logistics companies meet emissions standards, and future regulation may not require any additional effort beyond the steps that developers and property owners are already taking to improve energy efficiency in warehouses and manufacturing properties. Still, these factors present a significant downside risk to the pace of supply in outer years. Ultimately, if demand is strong enough developers will continue to build additional space, but faster rent growth may be necessary to justify the necessary pace of supply growth in the sector.

Ibrahiim BayaanIndustrial EconomistCBRE Econometric [email protected]

viewpoint industrial sector, a continued industrial demand

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