The Next “Industrial Revolution”

March 7, 2015 • By Courtney C. McKay, CAE

The U.S. industrial sector, long considered the hottest in the commercial real estate industry, even in the midst of a slow economic recovery, isn't showing any signs of cooling just yet. According to industry experts, no matter what criteria you use to measure its success—vacancy rates, rental rates, new construction—industrial is booming.

“We're beyond bullish on the future of industrial.” So says John Morris, Cushman & Wakefield’s leader of Industrial Services for the Americas. “In fact, we believe that we're in the midst of what we're calling the second ‘Industrial Revolution.’” Why such strong optimism? First, there is the national vacancy rate, which, according to Cushman & Wakefield’s latest research, dropped to 6.8 percent at the end of 2014—its lowest level in nearly 14 years. “2014 was such a strong year on the occupancy side, with leasing reaching its highest level since 2005, and there's no reason for that to soften in 2015,” says Morris. “In fact, 2015 is likely to be another record year in this area.”

Rising rental rates also make the industrial sector attractive. “Rents are spiking nationwide,” says Chris Caton, global head of research for industrial giant Prologis. “They were up about 9.0 percent in 2013, up another 8.0 percent last year, and I think we will continue to see growth well in excess of inflation this year and next,” he explains. Morris agrees that rental rates will continue to rise faster than inflation, especially now as demand catches up to supply.

That’s not to say industrial construction has slowed. Dallas, for example, brought online 20 million square feet of industrial distribution space in 2014, making it the country’s strongest industrial construction market. While most major industrial markets are now land constrained, that’s not the case for Dallas, which, according to Morris, is one of the few markets in the U.S. with an excess of supply right now. Another reason for a lack of surplus property? “Investors are being cautious in the wake of the Great Recession,” explains Morris. At the end of 2007, approximately 165 million square feet (msf) of industrial space was under construction, while, at the end of 2014, this number was closer to 100 msf. “I think these numbers are a good indicator of the approach that the majority of developers are taking right now,” says Morris, “so I wouldn’t say we’re in danger of a bubble any time in the next three years either.”

When accessing the relative strength of markets across the U.S., Caton says there really aren't any sluggish industrial markets, only ones expanding at a less rapid rate than others. “Markets that are performing particularly well are major ports of entry for Asian trade, but one place to keep an eye on in particular is Central and Eastern Pennsylvania,” he reveals. “We saw some of the biggest growth there last year, since it’s a point of entry for distribution to the whole Northeast region.” For his part, Morris considers the 1.5 billion-square-foot Southern California industrial market the strongest by far. “It’s the biggest market, it’s the most active market, it has the most development and occupancy, and the rental rates are huge,” explains Morris. Area population growth is a contributing factor, but so, too, are its ports, with their close proximity to Asia, which house a significant percentage of the nation’s industrial import volume. “If you’re a developer and can find land to build an industrial property in Southern California, users will be interested before you even clear the dirt,” says Morris. “If you’re an investor, you’ll find a solid market with bond-type returns in the area of 4.0 percent.”

What’s driving this growth? Experts say a big factor is the economy, which has improved thanks to lessening uncertainty surrounding fiscal policy. Domestic manufacturing also has seen a resurgence, especially in the automotive industry. Hand-in-hand with an improving economy and increased manufacturing, though, is the explosive rise of e-commerce. “We’ve been talking about e-commerce for years, and it continues to grow at three times the rate of regular retail,” says Morris. “In fact, retail square feet are slowly converting into industrial square feet because you shop from your home in your pajamas now, and that’s only going to continue.” Caton agrees. “Today, e-commerce makes up more than 10 percent of our new leases, up from 5 percent just four years ago, and I think we’ll see that number grow quite a bit,” he says. “What’s at work is a standard evolution of the e-commerce industry: there was a time when key players were figuring out if e-commerce even was a viable business, but now e-commerce is about 7.0 to 8.0 percent of total retail sales, and that, too, will continue to grow.”

The biggest X factor for the continued expansion of the sector is, no surprise, also e-commerce. This is because the economics of e-commerce haven't been entirely sorted out just yet. “Where consumer preferences for delivery are going will define a lot for industrial because the infrastructure to support an increase in rapid shipping costs money," says Morris. Caton believes it all comes down to one question: “What will become the standard delivery time for online purchases in the U.S.?” In some places, like Toyko or London, e-commerce is more mature, so same-day or next-day shipping is much more commonplace, but the supply chains are organized differently in smaller island countries. “In the U.S., we have a pretty fragmented, spread out consumer base, so challenges are far greater for e-commerce distribution here,” explains Caton. Morris thinks delivery speed expectations will moderate, which also may moderate industrial space demand: “I can see a world in the near future where, if two or three days is good enough for the average customer, there will be discounts associated with waiting a bit for delivery,” he says.

Industrial’s success also has implications for the rest of the commercial real estate industry. “If you are a retail real estate services provider, you might be concerned that some major branded companies that normally sell through brick-and-mortar stores might begin shipping to clients directly, which would hit big box suburban retail the hardest,” says Morris. “However, one thing I think that's possible in the next few years is that we will see a convergence of property types,” he predicts. “Thanks to Millennials who are comfortable with spaces that have multiple functions, we may soon see offices, restaurants and processing or manufacturing all in the same building in high-density markets.” Some future modelling, he says, shows buildings in urban cores that have industrial space at the ground level, and office buildings on top.

So, what does the future hold for the industrial sector? According to the experts, the answer is continued expansion. Right now, roughly speaking, industrial is 14.0 to 15.0 percent of real estate by value, but industrial's piece of the commercial real estate pie has been growing, especially as more and more companies strategically sell off office properties and place more money into industrial. “By the end of 2017,” predicts Morris, “I believe the percentage of industrial in the industry will be approaching 20 percent.” That’s quite an industrial revolution indeed.