CSCMP's Supply Chain Quarterly
December 18, 2017
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U.S. industrial property market to extend roll deep into 2018, firm says

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JLL says demand for e-commerce fulfillment is just getting started.

The U.S. industrial property market is on track for another record year in 2016, and the market could expand well into 2018 despite the possibility of higher interest rates that would increase the costs of carrying inventory, according to a leading industrial real estate and logistics firm.

JLL Inc.'s optimistic longer-term outlook for industrial demand and pricing goes beyond earlier projections by other real estate and logistics consultancies, which said the market would cool in 2017 as abundant new supply comes online to satisfy what has been a multiyear surge in demand. Richard H. Thompson, JLL's international director, supply chain and logistics solutions, said demand will be powered by the dramatic growth of e-commerce and the fulfillment networks developed and expanded to support it. E-commerce accounts for only 8 percent of all U.S. retail sales, according to JLL estimates. (Other estimates are somewhat higher than that.) That figure will undoubtedly rise as traditional retailers begin shifting massive resources that were once reserved for brick-and-mortar investments to the digital world.

Through the end of the third quarter, the national vacancy rate stood near all-time lows, at 5.8 percent, despite additional supply being delivered to the market, JLL estimated. Net absorption, which measures the amount of space occupied at the beginning and end of a reporting period, has been in solidly positive territory for the past few years, signaling that strong demand continues to absorb available square footage.

As of the end of the third quarter, JLL said that all of the top 50 industrial markets it surveys were experiencing either "peaking" or "rising" conditions.

Capitalization rates, which represent the ratio of an industrial property's value to the operating income it generates, will compress at a modest rate, meaning buyers will continue to pay more for space that generates the same amount of income, JLL said. For top-rated "Class A" properties, the widening spread between the so-called cap rate and yields on long-term Treasury bonds will allow for ongoing cap-rate compression, the firm said.

In virtually every market except for southern California and Seattle, where demand has been nearly off the charts and vacancies are in the low single digits, industrial portfolios can be acquired at cap rates of between 5 and 6.5 percent, according to JLL figures. As of Friday, the yield on the 30-year Treasury bond stood at 2.46 percent.

In addition, an absence of portfolio acquisition activity so far this year has left large amounts of capital on the sidelines that could potentially be committed to industrial property, JLL said. The sector's record performance in 2015 was capped by more than $20.5 billion in transactional activity in the fourth quarter, the best quarter for total closing volumes in history, according to the firm

In a presentation made late last month at the Council of Supply Chain Management Professionals' (CSCMP) annual meeting in Orlando, Kris Bjorson, JLL's international director retail/e-commerce distribution, said the strongest relative growth for 2016 will be in markets like Denver, Salt Lake City, and San Antonio. Those areas are not normally considered first-tier industrial property centers like southern California's Inland Empire east of Los Angeles, eastern Pennsylvania, and Indianapolis. This reflects the desire of traditional retailers and e-tailers to build fulfillment centers nearer to end markets so product fulfillment and delivery can be executed more rapidly, Bjorson said.

In May, Chicago-based real estate services giant Cushman and Wakefield projected a 5.9-percent industrial vacancy rate by year's end, on par with levels not seen in 30 years, and well below the 10-year average. The firm said at the time that an uptick in construction activity in 2017 would help to alleviate some of the space shortages.

The industrial market collapsed along with the rest of the U.S. economy during the Great Recession, but began recovering around 2011 and has been gaining steam ever since.

The market's current growth cycle will dovetail with what will likely be a period of rising interest rates. The Federal Reserve dropped the rates on federal funds—the interest on overnight loans between member banks—to near zero during the 2007-08 financial crisis that precipitated the recession. Since that time, the Fed has raised rates just once, a quarter-percentage-point increase last December. However, there is an emerging consensus it will be do so again this December, and many market participants believe more rate increases are in the offing. That's because the Fed is looking to normalize rate conditions as the U.S. economy improves in an effort to stop inflation before it can take root.

Businesses in 2015 experienced, on average, a 5.1-percent rise in inventory-carrying costs due to higher capital costs, according to the most recent annual "State of Logistics Report," which was written by the consulting firm A.T. Kearney for CSCMP and was presented by Penske Logistics. At the same time, the report found that business inventories—which had grown steadily at approximately 5 percent per year between 2009 and 2014—flattened out in 2015 due to sluggish domestic demand and a slowdown in exports, a byproduct of a strengthening U.S. dollar.

Businesses today have costlier inventory loads to finance than at any time in years, the report found. In 2009, inventory value stood at $1.93 trillion. At the end of 2015, it stood at $2.51 trillion, according to the report's data. However, the Kearney analysts said the data point to an inventory correction, not a more widespread problem such as a recession.

"Rents have been rising faster than interest rates and are at a level that justif(ies) new construction in most markets, so the concern of rising rates hasn't been an issue," said Jeffrey Havsy, chief economist in the Americas for Los Angeles-based real estate services giant CBRE Inc. "Rising rates are lower on the list of concerns for industrial developers."

Mark Solomon is executive editor—news at DC Velocity, a sister publication of CSCMP's Supply Chain Quarterly.

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