In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss the outlook for one of the relative bright spots in the commercial real estate economy – industrial real estate – with Senior Commercial Real Estate Economist Xander Snyder.

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Listen to the REconomy Podcast™ Episode 76:

“Vacancy rates reached all-time lows during the pandemic, industrial cap rates reached all-time lows during the pandemic, and the quantity of industrial space under construction hit all-time highs and remains high today. We're just not at the peak. So, in other words, nothing was normal about the industrial market during the pandemic. Some reversion to the mean, some normalization of these trends was, frankly, inevitable.” – Xander Snyder, senior commercial real estate economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 76 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American.

Mark Fleming - Hey Odeta. How are you?

Odeta Kushi - I'm doing well. Hey, Mark. We've also got Xander Snyder, senior commercial real estate economist at First American joining us on today's episode.

Xander Snyder - Hey, Odeta. Hey Mark, how are you both?

Mark Fleming - I guess three makes a party here. How's it going Xander?

Xander Snyder - Great. Golden down on the West Coast over here. Perfect.

Mark Fleming - We are excited to have you back on the show, if our listeners can't already tell that. Because today we get to talk about one of the brighter spots in the world of commercial real estate. And, yeah, those are hard to find at the moment. And that's industrial properties. For listeners who may not be familiar with the industrial asset class, it's a broad one that includes properties ranging from manufacturing facilities to warehouses, data centers and even cold storage facilities.

Xander Snyder - Yes, industrial real estate came to be considered a darling in quotes asset class during the pandemic. And, despite some softness compared to a year ago, industrial real estate remains more resilient today compared to other asset classes.

Odeta Kushi - And today, we'll get into why industrial properties have been more resilient than others. And what rising industrial cap rates say about broader market dynamics. But, first, let's just quickly recap what a cap rate even is. A cap rate is short for capitalization rate and is equal to the profit that a commercial property generates divided by the price of that building. We're just going to keep it to simple math today.

Xander Snyder - Yeah, right, exactly. Cap rates are just a type of yield, similar to the yield on a treasury bond, but on a commercial property. So it's the yield that you would get if you were to purchase the property without a mortgage. And during the pandemic, industrial cap rates declined to just over 5.1%, which is an all-time low. Now, however, they're increasing.

Mark Fleming - Yes, and in order to understand what's driving that increase, it's helpful to understand how industrial cap rates reached those all time, low levels in the first place. At the onset of the pandemic, ecommerce sales surged -- all those Amazon boxes that I was ordering -- which drove vacancy rates for industrial properties -- because the warehouses that store all of Amazon's goods are in that industrial class --  to all-time lows. Warehouses and logistics centers were in high demand because online, real-time retailers needed a way to store goods and get them to you quickly. All that online shopping we did drove industrial demand through the warehouse roof, get it?

Xander Snyder - Painfully so. That's right. And, since higher demand to lease industrial space drives demand to own industrial properties, which pushed prices up, cap rates declined.

Odeta Kushi - And if that seems unintuitive, at first, that greater demand to own industrial properties would drive cap rates down, try thinking about it this way, lower industrial cap rates effectively meant that investors were willing to pay more and accept lower rates of return in order to own industrial properties since they were in high demand.

Xander Snyder - That's exactly right. And now that trend has reversed. Industrial cap rates have increased from that low of about 5.1%, early in 2022, to about 5.9% by the third quarter of this year. So that means that the yield that you can get on industrial properties is about 80 basis points higher than it was a year-and-a-half ago.

Odeta Kushi - So what's driving this reversal of industrial cap rates? Is it due to the same sorts of pressure that we see in other asset classes, like office, where the need for office space may be permanently less than it was pre-pandemic? Or are these rising cap rates somehow different?

Mark Fleming - Hmm. Luckily, I believe we have just the tool to answer that question. Don't we Xander?

Xander Snyder - What a perfect setup. For those who missed it on First American's Econ Center, we recently released First American's Industrial Potential Cap Rate Model. Isn't that a mouthful? We refer to the Potential Cap Rate Model as the PCR to keep it to fewer syllables. Similar to our other Potential Cap Rate Models, the industrial PCR model is an estimated, or potential, cap rate based on the underlying market fundamentals for the industrial asset class.

Mark Fleming - And what are those market fundamentals used in the industrial PCR?

Xander Snyder - We use four inputs to the industrial PCR. The first is industrial vacancy rates. The second is ecommerce sales as a percent of total retail sales, which is really just the share of all retail sales made up by online sales. That's all that is. Third is industrial construction starts and fourth is commercial debt flows. And what's neat about building a model like this is once you estimate those cap rates using these market fundamentals, you can then decompose movements in the PCR, the estimated cap rate, and see which of these fundamentals is contributing more or less to movements in those cap rates.

Mark Fleming - I just have to point out that only geeky real estate economists like us would think building a model like this is quote, neat.

Odeta Kushi - Yeah, that's right. We're really revealing our true colors. Anyone want to invite us to their party?

Mark Fleming - Odds just went down.

Odeta Kushi - If you haven't read the blog post on this yet, be sure to check it out. Because there's a nifty chart that shows how much these individual market fundamentals are driving the industrial PCR, either up or down over time. We'll talk through some of that now. But the chart will certainly make some of these points clear.

Mark Fleming - Uh, nifty and neat. Oh my, our odds of being invited to the party have gone down even further.

Odeta Kushi - Probability is down.

Mark Fleming - Okay, so now we know we're not going to the party, that industrial cap rates troughed during the pandemic and are currently increasing, and that we've developed a model to help us understand those movements better. So, with that context, what have the primary drivers of change in the PCR been over the past year?

Xander Snyder - Right? Well, the increase in the industrial PCR is primarily being driven by rising vacancy rates for industrial properties, followed by a slowdown in construction starts. And these two are related. Vacancy rates are a measure of demand to lease space. Although, of course, the supply of available space also impacts vacancy. So rising industrial vacancy rates over the last year can be interpreted as a decline in the demand to lease space. And I said this a little earlier, but it bears repeating that demand to lease space drives demand to own properties, which means that as leasing demand for industrial space fell over the last year, demand to own industrial properties also fell. And demand to own is picked up in the industrial PCR model as declining construction starts.

Odeta Kushi - So you're saying that construction starts of industrial space is a measure of demand to own industrial properties? How does that work? Doesn't construction also impact the amount of supply that's available in the future?

Xander Snyder - Yes, that's right. I think this is one of those situations where distinguishing between the short term and maybe the intermediate term is helpful. In the short term, if there's strong demand to own industrial properties in some location, builders are incentivized to start new industrial developments since there's a good chance that they can sell their new development for a decent profit. So, in the short term, construction starts is a demand measure, in the intermediate term, say two-to-three years, which is roughly how long different types of industrial properties take to be built, the amount of construction underway becomes a leading indicator for supply, as you mentioned, Odeta. The industrial PCR model uses the short-term dynamic where construction starts are an indication of near-term demand to own industrial space.

Mark Fleming - So I know I teased this at the beginning of the episode. And, you know, sort of laughing, but industrial as an asset class was sort of the ugly duckling of commercial real estate classes for so long. But industrial real estate is seen by some now as a bright spot in an otherwise somewhat or, in many ways, gloomy commercial real estate market. Why is this? How do we know that this increase in industrial cap rates over the last year and a half isn't just a sign that the asset class is about to run into additional headwinds? And you know, that the status of being the darling child is going away all together?

Xander Snyder - It's a good question. And I think, like many other topics in commercial real estate today, the answer has to do with how industrial real estate performed during the pandemic. So, as you mentioned a little earlier, Mark, ecommerce sales surged during the pandemic. And this drove strong demand for industrial space, which in turn drove demand for industrial properties, which drove cap rates down. So vacancy rates reached all-time lows during the pandemic, industrial cap rates reached all-time lows during the pandemic, and the quantity of industrial space under construction hit all-time highs and remains high today. We're just not at the peak. So, in other words, nothing was normal about the industrial market during the pandemic. So some reversion to the mean, some normalization of these trends was, frankly, inevitable.

Odeta Kushi - So from this perspective a rise in vacancy rates and increase in cap rates seems more like a normalization than signs of trouble.

Xander Snyder - That's how I see it. Yes.

Odeta Kushi - But to drill into this a little bit more.

Mark Fleming - Nice construction metaphor there, Odeta. Touche, as they say.

Odeta Kushi - Nifty, right? Bringing back nifty. 

Mark Fleming - Goodness. 

Odeta Kushi - Okay. So, how do we know that more damage isn't coming? You mentioned that there's still a lot of industrial space under construction, and that will be delivered to market over the next year and change. How do we know that this additional supply, combined with lagging demand to both lease and own, won't cause distress or lead to a glut?

Xander Snyder - It's a great question. And I think a what-if analysis of the worst-case scenario can help answer that question. So, what if all industrial space currently under construction were to come to market tomorrow, completely vacant and unleased? What would the national industrial vacancy rate be at that point? Well, if that were to happen, the national industrial vacancy rate would increase from about 5.1%, where it is today, to about 7.8%.

Mark Fleming - So I'm sure I'm like many of our listeners, and I have no context for 7.8% on industrial cap rate history. Is 7.8% high, low, Goldilocks, just right? What other figures can we look at to help put that worst-case industrial vacancy rate scenario into context?

Xander Snyder - Well, the last time industrial vacancy rates were at 7.8%, was back in 2014. And that's not a particularly interesting time period for industrial commercial real estate, except to note that when vacancy rates were at 7.8%, you still had modest rent growth in the industrial asset class of between 2.5% to 4% in 2013 and 2014.

Odeta Kushi - I'm going to echo Mark's question here. Is 2.5% to 4% rent growth high, low, Goldilocks? What's the context for that range?

Xander Snyder - Well, over the last two years, rent growth for industrial property surged to double digits, another all-time record. But, if you look at pro formas, and pro formas are just projections of prospective investment returns. So if you look at these pro formas from before the pandemic, plenty of deals penciled out with low single-digit rent growth. Granted, interest rates were lower than too, but that implies that a 7.8% industrial vacancy rate supported a more normal level of rent growth compared to what we saw during the pandemic.

Mark Fleming - So maybe the worst-case vacancy rate scenario is more like, historically, just right. It also seems worth adding that ecommerce was far less prevalent in 2014 than it is today. eCommerce sales as a percent of all retail sales -- and I'm always fascinated by this statistic because I think it's surprising -- that is the share of goods that are purchased online, was only about 6% back in 2014. Yeah, we were just getting used to Amazon and things like that. And today, it's closer to 15%. And I know we're not talking about the retail asset class right now, but the death of retail due to ecommerce? Most stuff is still bought bought in stores. This would seem to imply that there is a stronger foundation of demand for industrial space now than there was then though.

Xander Snyder - That's exactly right. So, in fact, that near 8% vacancy rates that supported modest rent growth in 2014, that was a time when ecommerce sales were less than half of what they are today. And that means that the amount of new industrial space coming to market is unlikely to cause a glut on a national level because the demand is so much stronger than it was. And whenever I say, you know, it's unlikely to cause a glut on a national level, I always like to clarify that it will vary by location depending on where most construction is actually happening.

Mark Fleming - Economist forecast waffling right there.

Odeta Kushi - Caveat caveat caveat. To sum up, the industrial market does seem to be adjusting, but it seems to be more of a normalization than a cause for concern.

Xander Snyder - I'd say that's just about right. The industrial market is softening. But we would expect it to given how tight that market became during the pandemic.

Mark Fleming - Well, I'm glad we almost had you laughing so hard you could barely finish your sentence there, Xander. Victory in the podcast episode. Thanks for joining us today to talk about this bright spot in the commercial real estate landscape, Xander. 

Xander Snyder - My pleasure.

Odeta Kushi - Thanks, Xander. And that's it for today's episode. Thank you for joining us on this episode of The REconomy Podcast. As always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark and @XanderSnyderX for Xander. Until 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 2023 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.