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The Impact Of Interest And Inflation On Industrial Real Estate

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The Good News

Industrial leasing fundamentals are still positive after a banner 2021. Despite a hearty influx of new deliveries, national vacancy rates fell for the sixth straight quarter to 3.4 percent as occupiers absorbed 110.8 million square feet in first quarter 2022.

As such, the average national asking rent climbed to $7.62 per square foot, marking a 7 percent increase over fourth quarter 2021 and becoming the largest quarter-over-quarter increase since at least 2000.

In addition, investor transaction volume for the first quarter 2022 was strong, reaching $33.2 billion, the second-highest total ever for a first quarter showing and a notable achievement following a year that saw a record amount of capital pour into the industrial sector. There is still record levels of liquidity in the domestic markets, and overseas capital has an even longer runway.

In first quarter 2022, developers delivered 90 million square feet of new inventory, effectively equal to first quarter 2021. While strong by historical standards, this influx of new space barely moved the needle on vacancy for most markets. According to JLL research, the pipeline of under-construction space grew to 531 million square feet, of which more than a quarter is in the mega-box size category of 1 million square feet and larger.

There appears to be a bifurcating of markets between the coastal/port markets and non-port markets. Port markets have seen year-over-year rent growth eclipse 23 percent, compared to 16 percent in non-port markets. Further, despite a near 40-basis-point pricing premium, these coastal cities represent an attractive opportunity for investors looking to secure long-term net operating income growth.

The (Less) Good News

While projects continue to be mired in delays due to materials and labor shortages, the volatility in material pricing itself has started to calm. However, prices are still going up for these materials, thanks to inflationary pressures. Tight labor and housing markets, supply chain constraints, growing production and energy costs, and surging consumer demand are all key contributing factors to our rising inflation, which in May reached the highest levels since 1981 at 8.6 percent.

Real concerns surrounding inflation and rising interest rates are causing investors to assess their underwriting. Negative leverage is beginning to be the primary driver of capitalization rates due to the cost of capital. It’s possible to mitigate some of this negative leverage with the exponential rent growth that is still occurring in many markets. However, if and when rent growth moderates, there will likely be some downward pressure on values.

The Overall Outlook

JLL anticipates that vacancy will continue to decline for industrial product, likely bottoming out at sub-3.0 percent. From a landlord perspective, any shifts in rates have not impacted the need for space. The supply chain is still not right-sided, which means that tenants are not at pre-pandemic supply levels in their warehouses. Even if there were to be a pull-back in consumer spending, there would still be a significant shortage of warehouse space throughout the country.

Businesses are also still shell-shocked from the massive disruption to their supply chains that occurred during the pandemic and are re-thinking their distribution models. “Just in time” delivery used to drive decisions. There’s since been a pivot to “just in case”, both in terms of product and in terms of space-banking due to rental rates increasing quickly.

Workforce considerations are also driving these locational decisions, as are rising fuel costs due to inflation. Tenants are approaching expansions, especially to non-gateway markets more carefully, as the rent savings from moving to tertiary locations is likely offset by higher transportation costs.

However, real estate is only a fractional part of overall cost for these businesses (estimated at 3 to 6 percent). The inflationary pressures in terms of real estate costs likely pale in comparison to the inflationary and interest rate impacts on the rest of their business.

Given these factors, it is anticipated that market rents will continue to increase across the industrial sector. Most investors are underwriting 7.0 percent or higher in most markets and anticipate rising rents through 2023.

Speculative development will likely continue, though will be impacted by supply chain and regulatory restrictions. Capital is virtually non-existent for non-permitted and phased development (two to three years until completion). Upfront due diligence for construction debt is becoming far more robust, with more focus on appraisals and underwriting assumptions.

Capital markets underwriting has changed significantly in second quarter 2022. There has been re-pricing of many assets, which was initially driven by changes to the debt market but are now more driven by overall risk assessment. The most attractive type of industrial property has become value-add product with near-term roll or vacancy.

The buyer pool has also decreased for industrial assets, as investors are pivoting away from asset classes that aren’t near the peak of pricing (ie. retail). Most investors are now underwriting slightly higher investment rates, particularly at the end of their projected holding period.

Overall, the entire real estate class could benefit from this period of economic volatility and continue to outperform the broader equity markets. Some market participants are assuming that this volatility is short term. Others believe that a slowdown in the economy could create arbitrage opportunities. Investors are stress testing for an inflationary environment, rate increases and a potential recession. It’s likely that this will continue for the second half of 2022 until the direction of the economy becomes clearer.

 

Source:  CPE

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Here Come The Multifamily Headwinds

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There are usually multiple ways to look at anything. In the case of the Yardi Matrix National Multifamily Report for March 2022, you could emulate the late lyricist Johnny Mercer: accentuate the positive, eliminate the negative, and don’t mess with Mister In-Between.

But what works for an upbeat song isn’t necessarily good for business planning. There is ample good news of increased asking rents and occupancy rates, but in a sense, that’s all in the past. The question investors and operators must ask is what might be coming.

One big consideration is rent growth. “Asking rents increased by $34 nationally, up 2.1%, in the first three months of 2022, which is record growth for a first quarter,” the report said. However, that’s unlikely to continue for a few reasons. One is slowing economic growth as inflation continues to take a toll on activity. Slower growth will affect incomes, meaning the likelihood of fewer gains to cover costs of higher rents. The war in Ukraine is also an issue, according to Yardi because that could help sustain inflation, especially with the effect on energy prices.

Inflation means higher interest rates as the Fed tries to cool the economy. But multifamily acquisition yields are low, at a 4.5% average and down into the threes for prime locations. “Low cap rates caused little concern when the risk-free rate was 1% and the typical mortgage coupon was 2.5% to 3.5%, but when the cost of capital gets more expensive, low yields can complicate transactions and refinancings,” the report says.

Then there’s household formation.

“Although official numbers for 2021 have not been released, some estimates put the number of new households formed in 2021 in the two million range, which makes sense given record multifamily absorption of nearly 500,000,” the report says. “Household growth and absorption are likely to slow to more normal levels in 2022, to about half of last year. That would presage healthy—albeit more moderate—gains in multifamily fundamentals.”

Also, rent growth is not at all nationally even. Migrations to the southeast and west are a big force in rent growth, presumably because there’s a lot of new construction happening, which means higher costs given rising building materials and labor expenses and a steady stream of asking rents not tied to previous occupancy.

Occupancy is cooling in some high-growth metros—that is, the very west and southeast that has led growth because of demographic migration.

“Occupancy rates in several markets have decreased over the last year as demand hasn’t kept pace with deliveries,” the report says. “Phoenix showed the largest decrease in occupancy (-0.5%) in March, followed by the Inland Empire and Las Vegas (-0.4%) and Sacramento (-0.3%).”

 

Source:  GlobeSt.

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These Are The Asset Classes Most Resistant To Inflation

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Inflation is the risk factor investors are watching the most closely this year—but each property type has unique nuances in terms of how it interacts with inflation.

That’s according to John Chang, senior vice president and director of research services at Marcus & Millichap. He says office properties have general inflation resistance because their values tend to align with replacement costs and they mark to market upon tenant turnover. Some properties may also have inflation escalators built into lease agreements.  On a scale of 1 to 10, with one meaning little to no inflationary risk, Chang ranks the office sector risk at a three to a five.

Multi-tenant retail falls in the same category, he says, thanks to long-term lease agreements that could have escalators tied to sales. Single-tenant properties typically don’t have such escalators, but the risk depends on the tenant he says; Chang ranks them in the three to five range as well.

Seniors housing market-rate units can recalibrate on turnover, and government programs like Medicare or Medicaid also typically adjust to inflation. The sector has the ability to mark to market so the inflation risk rating is in the three to four range.

Medical office inflation risk is low, Chang says, in the two to four range. Meanwhile, the multifamily and self-storage sectors have tremendous inflation resistance since their rents mark to market frequently.

The most inflation resistant CRE property type—with the ability to change rates every day—is hotels, at the one to two range.

“Periods of high inflation tend to be relatively short—a few years or less,” Chang says. “This shouldn’t be a primary commercial real estate investment driver but it could nudge investor decisions a bit. Real estate is generally a long term investment with multi-year hold periods, so while you factor in inflation and other short term risk, investors need to keep their eyes on the horizon.” 

 

Source:  GlobeSt.

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Higher Inflation Means More Competition For CRE Assets

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Supply chain problems, labor shortages, and the housing shortage are all fueling inflation to eye-popping levels – and for CRE investors, that will mean greater competition for assets.

Headline inflation is up 7.1% from last year, the biggest uptick since 1982. And that rising inflationary pressure is forcing the Fed to switch gears and tighten policy. This will in turn put upward pressure on interest rates, raising the cost of capital for CRE investors, says Marcus & Millichap’s John Chang.

Supply chain is the first contributing factor to inflationary pressures: “It’s hard to move products from the manufacturers to the customers,” he says, pointing to shortages in raw materials, limitations on foreign port capacity, shipping container shortages, backlogs at domestic ports like those in Los Angeles and Long Beach, and a shortage of trucks.

“Basically, people want to buy more stuff than our supply chain can handle right now, so there are shortages and that means prices go up,” he says.

Retail sales are up 16% over 2019 numbers, while the amount of product moved by trucks in the US is down 5.1% over the same period.

The second issue? Labor shortages, which continue to stoke inflation.

Quite simply, “the US has never experienced a labor shortage like this,” Chang says, “at least not in the last 22 years, when records have been kept. As a result, companies are competing for personnel, and that’s driving up wages.”

Average hourly earnings are up 5% over last year, and sectors like accommodations and food services have seen labor cost increases of more than 15%. And “rising wages create broad-based long-term inflation,” Chang says.

The third challenge is the housing shortage: there are not enough houses to buy or apartments to rent right now, and the problem will likely continue at least in the near term. There are currently about 1 million houses for sale in the US right now, about two months’ worth of supply; typically, four to six months’ worth of supply is required to maintain stability in the market.  Housing prices shot up 14.9% last year in response to the shortage.

In addition, there are only about 480,000 apartments available for rent, a vacancy rate of 2.6%, the lowest on record. Rents rose 15.5% last year.

“The Fed will be taking action to curtail the rising costs,” Chang says.

He notes that Fed Chairman Jerome Powell has already announced plans to accelerate the end of quantitative easing that was put in place during the pandemic, and says this will likely put upward pressure on long-term interest rates. The overnight rate is also on track to increase three times or more this year, which will put upward pressure on short term interest rates.

As a result, Chang says, interest rates are likely to continue to rise. The ten-year Treasury rate is already up about 30 basis points from the beginning of December to a little over 1.7%.

For investors, this will equate to more competition.

“Commercial real estate is viewed as one of the best places to invest money during periods of high inflation, especially properties that can increase rents with the market, like apartments, hotels, and self-storage properties,” Chang says. “Rising interest rates, and increased investor demand, implies that levered yields will compress this year. Basically, more commercial real estate buyer competition will push cap rates lower while the cost of capital, or interest rates, rise. That means CRE levered returns may tighten.”

But several property types still offer higher yields, like well-positioned office assets, retail assets, medical office buildings and some hotels, he says – and properties in softer markets harder-hit by COVID restrictions could also offer higher yields and stronger multi-year returns.

 

Source:  GlobeSt.

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