New York Industrial Innovation Spreads Nationwide
Despite the negative impact of the pandemic on many areas within commercial real estate, industrial assets continue to attract interest as a favored sector of many lenders and investors. The industrial market is outperforming others throughout this period of disruption.
E-commerce growth has resulted in growth in the industrial sector as the need for last-mile delivery and third-party logistics space increases. Similarly, urban infill demand has grown in supply-constrained markets. Finally, the supercharging the industrial sector has created a need for new construction in this asset class, and construction lenders are finding new opportunities to earn higher returns.
Industrial Market Trends
In major urban markets — New York City included — residents increasingly expect two-day delivery, next-day delivery and even same-day delivery. As a result of these shrinking delivery windows, the need for local distribution centers and last-mile facilities has increased significantly. The way people purchase and receive products has changed drastically, and the industrial sector must adjust to meet the demand.
The nation-wide stay-at-home orders implemented at the outset of the pandemic caused e-commerce to experience exponential growth. People who had never shopped online began adapting to this trend. This created the equivalent of 10 years of e-commerce growth in three months. The second quarter of 2020 marked the highest ever year-over-year growth for e-commerce sales nationally, increasing 44.4 percent from $138.96 billion in 2019 to $200.72 billion in 2020.
While the pandemic has solidified the need for industrial space, the industry has been gaining momentum for years thanks to the rising trend of e-commerce. Online sales are booming; meanwhile customers are bypassing brick and mortar retail.
E-commerce sales are growing by 16 percent annually and increased by $1 trillion from 2014 to 2017. These online sales will comprise 15 percent of all sales (up from 10 percent today) by 2022; plus, they are projected to rise 50 percent over the next three years to nearly $900 billion. E-commerce sales are generating three times the demand for warehouse space compared to store sales. These sales will generate a need for 300 million additional square feet of industrial warehouse space by 2022.
As we prepare for what will be the biggest e-commerce holiday season yet, retailers are working to meet consumer demand for fast delivery. This new era requires a rethinking of logistics. Retailers must move their warehouses closer to urban centers. Because of the increasing demand for last-mile distribution space, the industrial property sector is experiencing the emergence of urban infill, the redevelopment of existing properties or land in an urban environment, in supply-constrained markets across the country.
Retailers must also rethink the design of their spaces as well. Buildings are evolving to adapt: multi-story, high-ceiling, cutting-edge distribution space, among other last-mile building types, will continue to overtake heavy industrial, manufacturing or flex building types in urban centers.
Out with the Old, in with the New
In large cities and around the country, there is an undersupply of last-mile and third-party logistics space.
By way of example, in the early 2000s, industrial buildings in New York City were rezoned to a higher and better use, which at the time was residential. Areas, particularly along the waterfront, which were historically zoned for manufacturing, were repositioned to cater to high-rise multifamily towers. A massive amount of industrial building supply was therefore taken offline.
Twenty years later, with the growth of e-commerce, tenant and zoning needs have changed dramatically. Companies looking at existing industrial product are finding that they are no longer suitable for today’s needs. The undersupply of desired space, combined with the needs of tenants driven by e-commerce, has resulted in a massive imbalance of supply and demand.
As a result, new construction is necessary, and buildings need to evolve to accommodate the contemporary needs of large e-commerce tenants. Multi-story, high-ceiling, cutting-edge distribution space will continue to overtake heavy industrial, manufacturing or flex building types. In cities such as New York where space is limited, developers face challenges constructing industrial spaces large enough to meet tenant needs and produce ample revenue.
Out of this challenge, the trend of multi-story industrial developments has emerged – first seen in the dense urban infill of Asia, and now cropping up in cities across the United States. Building above grade on a piece of land maximizes the zoning and justifies the price, generating an appropriate yield on cost.
The Walker & Dunlop New York Capital Markets team is seeing multi-story industrial developments (a trend which New York City initiated domestically), in cities across the United States, including Seattle, Little Rock, Ark., and Dover, Del. The concept of having one, dedicated complex and distribution center is critical because last-mile space is all about outbound turns of delivery trucks from the facility to the customer. The more outbound turns, the larger the amount of distribution that can be done within a facility per day and the higher the lease rate the property can command. This is because transportation cost (including labor, tolls and fuel) is a significant component of logistics. If some of that overhead can be eliminated by creating more production and distribution out of these facilities, tenants can afford the higher rents required in supply-constrained markets.
A New Business Case for Industrial Product
Developers are designing and constructing warehouse developments tailored to accommodate the needs of large e-commerce tenants. Both lenders and investors are increasingly interested in properties that allow for higher returns, specifically for multifamily, industrial and life sciences industries. Lenders remain shielded from the effects of the pandemic as new product takes two or three years to complete.
There are proven benefits to constructing new industrial, build-to-suit product as opposed to using older existing space. Walker & Dunlop’s New York Capital Markets team did a study across the country that looked at rent premiums for new product delivered in traditional, single-story industrial markets. They discovered that there was a 40-45 percent increase in rent for creating new product that catered to active tenant needs, as opposed to product that already existed. From a rent perspective, if landlords were historically receiving $10 dollars rent per square foot, by simply building new products that spoke to all the physical requirements necessitated by tenant needs today, they could increase their charge to $14 rent.
Multi-story developments maximize the zoning floor area (ZFA), allowing for larger developments on smaller pieces of land. Those larger developments in turn create the ability to charge higher rents, receive tax benefits and do more business per day, increasing revenue.
Why Invest in Industrial?
The growth trajectory of e-commerce is directly correlated with industrial performance. The industrial market is expected to retain its resiliency, even during a recession. Stability during times of turmoil is a huge benefit, but why else should investors turn their sights to industrial?
First, this property type offers steady income and long-term cash flow. Industrial properties are expected to have lower long-term vacancy rates post pandemic compared to other asset classes. Longer lease terms also result in undisrupted cash flow.
The second consideration is lower maintenance: Expense ratios are typically lower, as industrial buildings require simpler construction compared to office or multifamily. This results in fewer and less intense maintenance issues, as compared to other asset classes.
Finally, with the secular shift and new need for warehouse buildings that are well-located, industrial buildings are in demand and absorption rates remain high.
Lenders and investors look for properties that will result in a favorable risk-return tradeoff. With the secular shifts in the marketplace, industrial properties are providing less risk and higher returns compared to other asset classes.
An Unprecedented Opportunity
We are living through the early stages of the most impactful secular shift in our lives, given the rise of e-commerce, and the benefits that has on the industrial sector. Last-mile product is often completely outdated or nonexistent, resulting in tremendous development or redevelopment opportunities that cater to new tenant needs. The limited supply of last-mile distribution space will continue to push industrial rent and revenue. This limited supply, complimented by the uptick in inventory lag, creates the perfect recipe for growth. The low interest rate environment combined with investor reallocations result in cap rate compression. Future growth is inevitable generating upward growth in yield on cost.
— Keith Kurland, senior managing director, New York City Capital Markets Debt and Equity, Walker & Dunlop and Mo Beler, senior managing director, New York City Capital Markets Debt and Equity, Walker & Dunlop.