Industrial Continues Its Wild Streak But Inflation Threatens Deal Flow

The US industrial market saw vacancy tighten to 4.7% nationwide last quarter, while the Inland Empire hit a record 0.6%—but while price gains continue to march on, inflation and rising interest may begin to weigh on the sector in the near term. 

“Inflation and rising interest rates will reshape the transaction market in a variety of ways,” analysts from CommercialEdge write in a new report breaking down Q1 sector data. “Some investors may be faced with the untenable proposition of purchasing a building with negative leverage, assuming that rent increases will continue and produce positive leverage in the future. Properties with vacancies or leases set to expire will command the highest price, as investors will be looking to quickly capture the rent growth that has occurred in the last two years. Many investors will be using this period to reevaluate their underwriting assumptions or even withdraw from the acquisition market for the time being.”

But while some reporting suggests the buyer pool for industrial assets is shrinking, it’s unlikely to impact pricing until rent growth cools and buyers cease including big rent gains in underwriting, those analysts say.

National in-place rents for industrial space averaged $6.53 per foot in May, up an increase of 4.7% year over year. Rents are growing fastest in Southern California (Los Angeles and the Inland Empire) and in Boston, while the markets with the largest spread between average rents and new leases were ports, led again by those in Southern California.

“Tenants are paying a hefty premium for new space, with the average price of a lease signed in the last 12 months costing $1.17 per square foot more than the overall average,” the report notes. “Spreads between average in-place rents and new leases should continue to grow in the near future, fueled by robust demand for industrial space and inflation.”

Nearly 656 million square feet of new industrial space is currently under construction, with the Inland Empire again leading the charge. But there’s a catch, according to CommercialEdge: residents, elected officials and environmental groups are increasingly opposing new projects. Several municipalities in the region have passed moratoria on new industrial development, with at least a dozen more under consideration.  And at the state level, Assembly Bill 2840 would ban localities from approving industrial facilities 100,000 square feet and larger that are within 1,000 feet of homes, schools and community centers. That legislation has passed the California State Assembly and is now under consideration by the Senate.

Analysts say that a development slowdown would “squeeze already tight markets,” particularly since nearby Los Angeles and Orange County are themselves grappling with record-low vacancies and have two of the country’s lowest rates of under-construction square footage as a percentage of stock to a lack of developable land.

Some of the tightest industrial markets are likely to see relief, however, in the wake of Amazon’s reported pullback of its massive industrial presence, which will see the company sublease at least 10 million square feet and allow some leases to expire to shrink its footprint.  In late May, Bloomberg reported that the recent slowdown in e-commerce sales back to pre-COVID levels left the company with a glut of industrial space, including warehouses in New York, New Jersey, Southern California, and Atlanta. Anonymous sources told Bloomberg at the time that the surfeit of space could be up to 30 million square feet. 

Bloomberg’s report suggests that the subleases will be primarily in Southern California, New Jersey, New York and Atlanta—all cities with some of the lowest vacancy rates on record in the US. The Inland Empire has a vacancy rate of just 0.6%, Los Angeles 2.1%, Orange County 3.3%, New Jersey 2.9% and Atlanta 3.0%. 

“Any space that Amazon offers for sublease will likely be absorbed very quickly,” CommercialEdge analysts say.