Posted on September 27, 2022 · Posted in Industrial / Flex, Investments, Land, Retail

As the pandemic wanes, businesses large and small—and the logistics networks that move their goods—are dealing with earthquake-sized aftershocks that will take years rather than months to sort out.

Logistics networks that are the backbone of the US economy are struggling to adapt to disruptive shocks including the explosive growth of e-commerce and the near-collapse of the global supply chain, which at one point threatened to paralyze the movement of goods from ports to warehouses to consumers.

Nowhere is the strain more evident in a system pushed to the precipice of its breaking point than in the industrial warehouse sector. At the same time that demand for industrial space has been lifted into orbit by e-commerce growth during the pandemic—pushing logistics networks and 3PLs to rush to establish last-mile distribution centers that offer same-day delivery—the existing inventory of leasable industrial warehouse space has been filled to capacity in major markets including New York, New Jersey and Southern California’s Inland Empire.

In the busiest markets in the US, industrial warehouse vacancies are hovering around 1%. In a sector in which tenants now are leasing space before they need it—and before it’s been built—just to secure it, this means the inventory is sold out. Industrial warehouse space also is running out in emerging markets, with the vacancy average dipping below 4 percent in markets with the highest growth rates.

This is the new normal, a tightness that most likely will last for several years. Most of the nearly 400 million square feet of new warehouse space in the pipeline rapidly is being leased out. When the new supply arrives in coming months, at least another 400 million square feet—perhaps even double that amount—will be needed by the end of 2025 to meet demand at current growth rates.

Relentless rent increases also are the new normal, with the national average now approaching $7 per square foot. In the tightest markets, like Southern California, rents have surged to nearly $12 per square feet, a 7 percent increase compared to a year earlier. Incremental rent “bumps” now are standard features of long-term leases, including triple net lease deals.

Footprints are being adjusted depending on the availability of space, with many 100,000-square-foot occupiers leasing two 50,000-square-foot spaces in different locations if that’s the only space available. Tenants now must decide whether to lease smaller footprints in emerging networks of last-mile facilities, or to take space in warehouses much further out from their markets.

Rents, which typically consume only 5 to 7 percent of operating costs, are almost irrelevant to these decisions: the deciding factors include the skyrocketing cost of transportation and the availability and cost of labor.

A Lease-Negotiation Frenzy

Tenants, owners and landlords are busy improvising new leasing strategies for allocating industrial space during the warehouse crunch. One industry veteran calls the lease-negotiation frenzy driven by the scarcity of available industrial space “insane.”

“This is unprecedented,” Rob Kossar, a vice chairman at JLL who oversees the company’s industrial division in the Northeast, said. “The supply and demand curve is completely out of whack.”

In order to secure leases for industrial warehouse space, Kossar said some tenants are negotiating leases with multiple landlords on spaces that aren’t available yet.

“Tenants are thinking that, if they don’t actively negotiate on two spaces and acquire the leases, they’ll get left at the altar. They don’t want that to happen because they need the space,” Kossar said.

Asked if this strategy is similar to dinner guests making reservations at several restaurants when they only plan to eat one meal, Kossar replied: “Not when there are 10 people standing in line to take your seat.” He added that landlords also are playing the field in tight markets to get the best deals.

“What happens if a tenant goes on a tour, picks a space, negotiates on it and then maybe a stronger tenant comes in?” Kossar said. “The landlord turns around and gives a lease to the stronger tenant. Some tenants are getting left at the altar.”

Kossar suggested that large tenants who are reserving more space due to the unprecedented demand for industrial warehouses aren’t exacerbating the warehouse supply crunch.

“I don’t think the bigger tenants are operating in a way that they need to take more space than they need,” Kossar said. “The smart tenant will always prepare for growth. If they don’t factor growth into the long-term leases they sign, they’re not being prudent.”

Industrial occupiers who are starting negotiations earlier and planning to be more flexible in meeting their logistics needs are faring better in the intense competition for industrial space in sold-out markets like the Inland Empire.

“Space has effectively been sold out in Southern California for the last year,” Kim Snyder, president of Prologis’ West Region, said. “Customers who can afford to plan ahead and be more creative with their operational needs are the ones who are able to secure the little space that is available.”

Large tenants are factoring in the likelihood that demand will outstrip the supply of industrial space for the foreseeable future into their leasing decisions, Snyder said, by choosing to occupy extra space today and by pre-leasing new supply that’s in the pipeline.

“Of the 390 million square feet of construction now in the pipeline in the US, most will be spoken for upon delivery given current pre-leasing volumes, which have pre-leased about 70% of the new supply,” said Snyder, who is the incoming chair of the executive committee of NAIOP.

A recent report from NAIOP said industrial space is so scarce that occupiers are leasing empty retail properties like box stores in malls, supermarkets and drugstores and converting them into temporary storage facilities.

Chunker, a national online marketplace for short-term, on-demand warehouse space—the platform bills itself as “the Airbnb of temporary warehouses”—is busy adding retail properties, including 10 empty Sears stores and several former Walgreens outlets, to the 30 million square feet of short-term warehouse listings it’s offering on the rapidly growing platform, which debuted in 2019.

The platform doesn’t do any conversion work on the retail properties to expand the number of doors or loading docks, so occupiers of this temporary warehouse space typically are using the facilities for “overflow” storage needs during their leases, which run for four or five months. The minimum footprint Chunker leases is 5,000 square feet.

CEO Brad Wright told GlobeSt.com that Chunker estimates the total market for short-term warehouse space to be at least 3 billion square feet.

Shorter Leases Keep Pace With Rent Hikes

As the demand for short-term warehouse space grows, more owners and landlords of industrial warehouses are offering shorter lease terms than traditional 5-year lease renewals, according to John Morris, CBRE executive managing director, Americas Industrial & Logistics leader.

“On average, we’re seeing some shorter-term durations being offered by owners and landlords,” Morris said. “With pricing and rental rates in the asset continuing to rise, a shorter lease term now has the potential to offer an owner the opportunity to align even sooner with market dynamics that are beneficial to them.”

According to Lisa DeNight, national industrial research director at Newmark, the “velocity” of rent growth in tight markets is inducing owners and landlords to offer shorter lease terms so they can keep riding the crest of the wave.

“Industrial landlords hold all the cards in an environment of such space scarcity, and most adjustments made to new lease terms are to keep up with the momentum of the market,” DeNight said. “In the tightest markets, shorter lease terms are acceptable to landlords since many deals are ‘under market’ the moment a lease signs, such is the velocity of rent growth.”

Large tenants—those who need 750,000 square feet or more—usually ask for a 10-year deal with options to go to 15 or 20, Kossar said, but a growing number of landlords don’t want to offer these long-term leases unless rent increases that track the rate of inflation are factored into the deals.

“There’s a trend with some landlords who are seeing rapid rent growth and (strong) fundamentals, they’re very reluctant to sign longer leases right now, unless leases have bumps to accommodate rental and inflation rates,” Kossar said.

A new analysis of 101 metros by Moody’s Analytics said the proportion of new warehouse leases from 25 to 60 months in duration declined by 24% during the last three quarters of 2021, while the share of properties with lease terms of two years or less saw a 22% increase.

DeNight confirmed that tenants are preleasing space that’s not yet available in order to secure space in tight markets. She cited a recent Newmark study which found that in 2021, for buildings that have reached stabilization, the average length of time between a speculative warehouse’s delivery and full lease-up was less than a quarter, with many preleasing well before delivery.

Most warehouses currently are fully leased no later than two months after delivery, she said, a duration that has dropped from an average of nearly a year that was the rule of thumb five years ago.

Morris said CBRE is seeing occupiers search for space in secondary or smaller markets, only to encounter low vacancy in alternative markets.

“Some may also be delaying their requirements, or downsizing them, by leveraging various forms of temporary storage, though this strategy can be more complicated,” Morris said.

Morris suggested that the best strategy for occupiers to deal with the scarcity of vacancies is “to be aggressive and creative when leasing space” including considering whether to build the storage space they need.

“One way they can be creative is to partner with a developer for a build-to-suit project. Industrial is seen as the most stable asset class right now and there’s an ample amount of capital chasing it,” Morris said. “If an occupier can partner with a developer, they can initiate a bidding process for new sites and fund development from investor sources. This way, they can acquire new space while leveraging incremental sources of capital.”

Pop-Up Yards Are Rushed Into Service

The shortage of industrial warehouse space is exacerbating the backlog at congested ports, DeNight continued, because some firms are waiting weeks to claim containers from ports.

“The shipping containers act as impromptu storage when a firm’s warehouse has no space to spare,” DeNight said.

To help alleviate the gridlock at ports, Chunker is growing a bricks-and-mortar business model that Wright calls “a perfect fit” with its platform for on-demand warehouse space: temporary “pop-up” container yards.

Chunker recently inked a 1-year deal with California to lease 150 acres from the state to equip and operate six new temporary pop-up logistics facilities—at three armories, two fairgrounds and a former prison—that will temporarily store containers from ports in Los Angeles and San Francisco.

In addition to these sites, Chunker operates five smaller pop-ups in Los Angeles, where a continuing backlog of containers at the ports is forcing ships to anchor further out at sea to avoid adding to pollution.

Wright said the company is considering inquiries to establish pop-up operations near ports in other states. Georgia Ports recently announced it will set up a network of short-term container storage facilities to service the Port of Savannah, one of the nation’s busiest.

IOS Emerges As Next Frontier

Every conceivable mode of storage is being deployed to meet the tsunami of demand for industrial warehouse space.

With available property for new industrial space in urban centers limited to infill sites, demand is skyrocketing for a limited inventory of industrial outdoor storage (IOS) properties clustered around cities.

IOS lots are being used as storage facilities supporting e-commerce, infrastructure, construction and logistics businesses, storing everything from equipment and vehicles to stacks of containers. They’re typically zoned to restrict any building from covering more than 25% of the property. Rental prices are set by the acre, instead of the square foot.

JLL’s Kossar believes that the IOS market, currently valued at about $200 billion but still highly fragmented and largely devoid of institutional ownership, is on the cusp of becoming a major asset class for institutional investors.

“They’re not creating more land for outside storage. In most cities, nobody wants to see more outside storage,” Kossar said. “It’s zoned out everywhere, so wherever it exists, it’s super-valuable. That’s why institutional investors have suddenly woken up (to IOS).”

Kossar added that investors who in the past five years focused on newer, more “pristine” industrial storage space now are more inclined to invest in older and “dirtier” urban IOS lots in extremely tight industrial markets.

We asked him to predict how long it will take for the supply and demand curve in industrial markets to come back into balance.

“Ultimately, we’ll be able to satisfy the demand over a 10-year period,” Kossar said. “But right now, with the vacancy rate in core markets hovering around 1 percent or zero, it’s very difficult for tenants.”

If the current frenzy in industrial lease negotiations is the shape of things to come, a decade sounds like a conservative estimate.

 

Source: GlobeSt.

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