By Tyler Ziebel, Colliers
Following one of the most active and aggressive periods in Chicago’s industrial capital markets history, 2022 ended as a year most market participants would rather forget. As the buying community returned to their desks and fastened their seatbelts for another year of fun in 2023, industrial sales brokers across the country are starting the year posed with a question from investors that hasn’t been asked in some time: “What are we going to be able to buy this year?”
It’s easy to assume that investors will remain content to sit out of the turbulent market, but the answer to where we are, and aren’t, seeing liquidity requires a nuanced answer.
In order to do that, we must take a quick look at 2022 and what set this uncertain market in motion. After several record-setting years for industrial leasing and sales in 2020 and 2021, accelerated by the COVID pandemic and a historically low interest rate environment, 2022 opened with the same frenzied pace and enthusiasm of 2021.
But as the Federal Reserve pivoted its focus from keeping the economy stable to taming the resulting inflation, rapidly rising interest rates grounded institutional industrial transactions and development deals to an abrupt halt.
Nationally, the numbers speak for themselves: industrial transaction volume ended 2022 down 15 percent from the year prior — that after outperforming 2021 for the first seven months of the year. The month of December alone saw a 76 percent decrease in transaction volume year-over-year. Chicago followed suit, with an approximate 25 percent year-over-year drop in investment sales volume. But is that drop a true reflection of market activity? And where, then, are deals getting done today?
To the surprise of absolutely no one active in Chicago industrial capital markets over the last nine months, deals for Chicago’s best located “core” facilities dropped off a cliff in 2022 as the 10-year Treasury skyrocketed nearly 200 basis points over the course of 90 days beginning in March.
The Chicago market recorded 24 core transactions with an average cap rate around 4.4 percent in 2021. Heavily concentrated (over 80 percent) in the second half of the year, the majority of these transactions had greater than seven years of remaining lease term.
The second half of 2022 had four such deals — with only one closing after the month of August. The reason why isn’t particularly hard to figure out: as the spread between long-term borrowing rates and current cap rates quickly eroded and went negative, institutional buyers had zero appetite to pursue deals with negative leverage and sellers countered with an unwillingness to adjust pricing expectations. The old math on long-duration core assets simply no longer penciled out and that continues to be the case in 2023.
On the surface, those deals make the market. Market reports, research forecasts and Real Capital Analytics data from the second half of last year suggest that everything is on pause and the market is at an impasse. But that’s not the whole story. Deals are getting done. They are smaller and perhaps not as impactful, certainly not on the data, but they are getting done in a variety of non-core asset classes that don’t translate as cleanly to the quarterly statistics.
These transactions have generally been smaller bets driven by variables other than cap rate (short-term expirations, mark-to-market opportunities, unique building layouts, flexible lease structures, etc.) and they dominated the latter half of 2022 with continued demand from capital today.
Mark-to-market opportunities have generated particular interest as user fundamentals have remained extremely favorable. Given the extreme lack of space in primary submarkets, nearly all five- or seven-year leases approaching expiration are substantially below current market levels almost by definition. The favorable risk/reward on trending market rents and potential for outsized returns upon lease expiration has emerged as one of 2023’s most liquid deal profiles, with five offerings totaling approximately $240 million currently on the market to start the year.
There continues to be an active market for net-lease/sale-leaseback transactions (particularly shorter-term sale-leaseback transactions in favorable locations), value-add, multi-tenant and near completion/completed shell sales. The underlying theme across these deal profiles (save for long-term net-lease deals) is that buyers need to be able to take advantage of the continued health and projected growth of the user market to get deals to underwrite effectively.
So where does 2023 go from here? Research tells us that anyone who claims to have a concrete answer to where the economy is going is probably wrong. Few are optimistic much will improve from an interest rate perspective in the early half of the year, and further rate increases by the Fed are certainly still in play if not likely. That said, the worst of the interest rate volatility appears to be behind us. As the dust continues to settle, it appears that the immediate future is going to look a lot more like the second half of last year than the first.
Leasing fundamentals continue to be a bright spot throughout the market despite increased recession fears: 20 of Chicago’s 22 submarkets ended last year with a lower vacancy rate than the year prior. Not surprisingly, every single submarket boasted higher asking rents, a 13 percent increase across the entire market. These figures were notably higher in institutional submarkets, punctuating a truly unprecedented environment whereby the user market and sale market are so completely divergent.
Given that, the market should continue to find liquidity where it can as we await some interest rate stability. In the meantime, opportunistic investors seem perfectly content with the shorter bid lists, higher cap rates and decreased competition as the rest of us continue to pray to the interest rate gods.
Tyler Ziebel is a vice president, industrial investment sales with Colliers. This article originally appeared in the March 2023 issue of Heartland Real Estate Business magazine.