In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Senior Commercial Real Estate Economist Xander Snyder discuss the outlook for industrial properties and why industrial remains a relative bright spot in the broader commercial real estate market. 

Don’t miss a single REconomy episode, subscribe today.

Listen to the REconomy Podcast™ Episode 85:

“The long-term demand determinants for industrial are fairly strong. For example, the rise of eCommerce over the last decade or so has greatly increased the need for warehouse and distribution facilities. Though eCommerce sales temporarily spiked during the pandemic quarantine, they were gradually rising for many years before then. The need for this space has resulted in a lot of new industrial construction since the shift from brick-and-mortar retail to online shopping isn't over.” – Xander Snyder, senior commercial real estate economist at First American

Transcript:

Xander Snyder - Hello, and welcome to episode 85 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing, and affordability. I'm Xander Snyder, senior commercial real estate economist at First American. And here with me is Mark Fleming, chief economist at First American. Hi, Mark.

Mark Fleming -  Hey Xander. And then there were two.

Xander Snyder - Indeed, for our regular listeners, you'll notice Odeta won't be joining us today. She's on the road sharing her expertise on the wide world of residential real estate.

Mark Fleming - So that means today will be another CRE-focused episode, because these days, that's where all the action is. Xander, it's hard to miss that there's been concern lately about commercial real estate because of the impact of higher rates, work-from-home dynamics, and that many CRE loans are coming due this year and next. But, what often gets missed in that coverage is that commercial real estate isn't uniform.

Xander Snyder - Right? Economists would refer to commercial real estate as a highly heterogeneous good, which is just kind of a wonky way of saying most commercial properties are different from one another.

Mark Fleming - I really like heterogeneous and homogeneous, big words are helpful, sometimes. Different shapes, different locations, and, of course, different commercial purposes all drive the heterogeneity of commercial real estate.

Xander Snyder - That's right. In fact, different types of commercial properties are typically categorized by the type of business that's conducted in them. Most people associate commercial real estate with office buildings, but there are also retail centers, malls, hotels, and what we're going to talk about today, industrial properties. These are all types of commercial real estate, or different types of asset classes. And not all of them face the same sort of demand reduction that the office market is going through right now as a consequence of remote work. 

Mark Fleming -  And chances are, unless you work in an industrial business, you're not very familiar with this type of property. A lot of people have worked in offices, so they're more familiar with those. And everyone's gone shopping, so they're familiar with the different types of retail, or stayed in a hotel. But typically aren't many reasons for someone to visit an industrial property, unless they work there or manage it. And these days, a lot of industrial properties run the cloud and our favorite AI chat bots. More on that in a minute.

Xander Snyder - That's right. And I think the lack of familiarity among the general public of industrial properties is part of why media coverage of commercial real estate lately has focused predominantly on office buildings. It's what we're familiar with. That, and of course, there are real concerns about long-term demand for office space. So office has dominated the CRE news of late.

Mark Fleming -  Right, but one interesting aspect of commercial real estate's heterogeneity is that each asset class has unique fundamentals, which means that certain economic trends impacting one type may differently impact others. And there are a lot of long term determinants of demand for industrial space, which we'll get into in a minute. But first, what exactly do we even mean when we say industrial property? What types of buildings are we talking about?

Xander Snyder - So, industrial as an asset class is a pretty varied category in its own right. There are a lot of different types of industrial properties. For example, factories are industrial properties, but so are warehouses and data centers. Cold storage for food distribution, and logistic facilities are also types of industrial properties.

Mark Fleming -  So, as you said at the beginning, it's often classified based upon the business purpose distinguishing industrial properties from other types, but are there other reasons why they can distinguish them?

Xander Snyder - Well, again, to draw a distinction between industrial and office, specifically. One major difference is the lease structure. So office leases are typically what's called gross leases, and industrial leases are almost always net leases. And don't get too caught up in the terminology here, the only difference between the two is who pays for what, the tenant or the landlord. In a gross lease, the landlord pays for all or most of the operating expenses in a building, such as utilities, repairs and maintenance, insurance premiums and property taxes. By contrast, with a net lease, the tenant pays for some or all of these operating expenses. And there are different types of net leases, but one of the most common is called a triple-net lease. And this is where the tenant covers all common area expenses and the landlord only pays for the large capital expenditures. So say for equipment that will remain fixed to the building over the course of multiple lease periods. Well, the main reason is that it's difficult to parse out costs in a big office building with lots of different tenants. Imagine a high-rise building. And in a high-rise building, for example, you could have dozens of tenants or more. And it's often difficult to know exactly how much water or electricity each one is using. Unless the building is extensively sub-metered, and most aren't. Plus, in office buildings, you know, there's often a lobby that serves all the tenants, there may be a security desk there or a gym. And these are offered by the landlord as an amenity to attract tenants. Typically, industrial properties have fewer tenants and a lot are actually single-tenant properties. And that makes it easier to calculate a tenant's share of building costs and pass them through.

Mark Fleming -  Okay, so that means with industrial properties, landlords aren't exposed to the risk of rising operating expenses, which is one thing that has been a concern for some of the other asset classes, specifically office buildings. But why would any landlord ever choose a gross lease? In other words, why isn't everything net-lease structured? That makes a lot of sense. And so, as we hinted at the top of the show, the industrial story right now is actually not as bad as many other asset classes, in fact, generally one of resilience. But why is that the case right now?

Xander Snyder - Yeah, that's right. And so when we talk about an asset class' fundamentals, we genuinely mean how supply and demand forces interact with each other, both for owning the properties and for leasing the space in the properties. And you know, no surprise, these two are related. So let's touch on that demand side first. The long-term demand determinants for industrial are fairly strong. For example, the rise of eCommerce over the last decade or so has greatly increased the need for warehouse and distribution facilities. Though eCommerce sales temporarily spiked during the pandemic quarantine, they were gradually rising for many years before then. The need for this space has resulted in a lot of new industrial construction. Since the shift from brick-and-mortar retail to online shopping isn't over.

Mark Fleming -  And sadly, there's one stat that I continue to find particularly revealing about this dynamic of brick-and-mortar retail versus eCommerce. And that is that only about 15% of all retail sales come from eCommerce, even though we sort of maybe think of it as a much bigger share. In other words, there's a ton of room for eCommerce to continue to grow. If retail sales continue to move online, which is the expectation, there will presumably be even greater demand for warehouse and logistics space in the near future.

Xander Snyder - Exactly. And, in addition to that, it's not just online retailers that need warehouse space, brick-and-mortar retailers also need advanced logistics capabilities to ensure that they have the products in stock when their customers do visit their stores or can at least get them quickly. Heading into tjhe pandemic, there simply wasn't enough industrial space out there to cater to the surge in demand to purchase goods online that occurred. And that contributed to record-low vacancy rates, rapid growth in industrial property prices, and a surge in new industrial construction in order to meet that demand.

Mark Fleming -  It's almost like retail, immediate gratification requirements driving demand for industrial space. And that's just warehouses. Beyond that, data centers are a niche sub-set class of industrial that's getting a lot more attention now, given the rising need for computing power for AI and, more generally, everything moving to the cloud. Fun fact, I live in the Virginia suburbs of Washington, D.C., near the single largest concentration of data centers in the world, based on megawatts of electricity consumption. Dare I say my head is practically in the clouds?

Xander Snyder - Hmm, that might explain some things.

Mark Fleming -  Oh and wait. And then there's Electric Avenue nearby. 1982? Eddy Grant? No? I'm really resisting trying to sing it here. Too much, too much. I'm pretty sure the listeners don't want to hear me do that. So we've talked a bit about the demand side, let's hop over to the supply side of the equation, that is deliveries of new industrial space. Due to all these pandemic dynamics, a record amount of industrial construction started during the pandemic, with under construction space peaking at over 700 million square feet in the third quarter of 2022. That new construction is being delivered to the market now and will continue throughout the year. Which raises the question, is there still enough demand to absorb it all?

Xander Snyder - It's a good consideration. But I think the short answer is, yes, there is sufficient demand with the caveat that, of course, it will vary by geography.

Mark Fleming - Yes, all real estate, even this asset class is local after all.

Xander Snyder - Indeed, so when thinking about the risks to rents and prices from the new supply from all this new construction that you were talking about, I sometimes like to perform a worst-case scenario sort-of analysis. And the idea here is, if the worst situation you could possibly think of came to pass, what would the impact be on some measure of performance? So, in the case of industrial properties, we can look at the roughly 415 million square feet currently under construction, and say, what would happen if all of this space were delivered fully vacant and unleased? Of course, this won't actually happen since industrial space is in demand. But, if it were to happen as a worst case scenario, the national industrial vacancy rate would increase to about 8% from 6%, which is where it is right now.

Mark Fleming - That doesn't seem so bad, at least in the amount of change. I mean, that's only two percentage points, but is 8% even a lot, or a little? How do we put that figure into context?

Xander Snyder - Well, one way is to look at history and ask, what's the last time an 8% vacancy rate occurred? And how did the industrial market respond? So, late 2013 was the last time that the national industrial vacancy rate reached 8%. And back then, annual industrial rent growth was about 3.5%. In other words, moderate positive rent growth is entirely possible with an 8% vacancy rate. And again, this is the worst-case scenario. And I doubt that the vacancy rate will reach a percent nationally based on the current supply pipeline.

Mark Fleming - So, the real takeaway here is, it seems that there is a lot of new industrial space coming to market. But it's unlikely to lead to a glut of new space, because there is still lots of demand for space to run the cloud to send me my music and store my future Amazon purchases.

Xander Snyder - Yeah, that's how I read the numbers. And that doesn't mean that industrial isn't facing a slowdown compared to the pandemic-era market. But, arguably, the pandemic-era industrial market ran extremely hot for a couple of years, and both slow and overheated, markets can be unhealthy. All of the new supply of industrial space coming to market is, therefore, more of a normalization and a reversion to a well-balanced market then, say the beginning of widespread distress for industrial.

Mark Fleming - You know, we talk in so many aspects these days about not too hot, not too cold, just right, this seems to be another one trying to get to just right, which is definitely good perspective to have. One interesting aspect of this conversation on construction is that it can act both as a supply measure -- new deliveries coming to market -- and a demand measure -- new construction starts due to increased demand to own properties. And, while we didn't have time today to get into a deeper discussion about industrial cap rates, Xander, you did just publish an update of First American's proprietary Potential Cap Rate Model, which uses this front-end and back-end aspect of construction to model industrial cap rates.

Xander Snyder - Yes, indeed. And we've included a link to that blog post in the show notes for this episode. In it, I go into a little greater detail on how construction can act as this dual measure of supply and demand. If you're interested in what's happening to industrial cap rates, be sure to check it out.

Mark Fleming - While economists might also be known as dismal scientists, it was good chatting with you about an underreported bright spot in the world of commercial real estate, Xander.

Xander Snyder - Thanks, Mark. Good chatting with you as well. Well, that's it for today. Thank you for joining us on this episode of The REconomy Podcast. And, as always, if you can't wait for the next episode, you can follow us on X. It's @XanderSnyderX for me and @MFlemingEcon for Mark. See you next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.