Industrial real estate building gains on e-commerce growth

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Jason Tolliver and Bethany Bailey

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As 2015 drew to a close, the U.S. industrial real estate sector was on track to register another record-setting year in terms of demand. That’s no small feat, considering the current cycle is stronger in terms of net occupancy demand than anything we’ve seen since the mid-1990s. As we look ahead to another strong year of industrial demand, it’s clear the evolution of current trends and the emergence of others will have a profound impact on supply chains and industrial real estate demand.

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With 173.1 million square feet of positive net absorption gained through the first three quarters of 2015, the year already had placed among the top five for growth of leasing and occupancy gains.

Growth was greatest in the primary industrial markets and inland distribution hubs, with Chicago, Southern California’s Inland Empire, Philadelphia, Dallas, Atlanta, Los Angeles, Houston, Memphis, Seattle and Indianapolis posting the strongest net occupancy gains. As a result, the nationwide industrial vacancy rate through the third quarter stood at a 15-year low of 7.4 percent. This clearly reflects the fact that market-level supply pipelines, though growing, are still below the pace of leasing demand in most markets.

The dynamics of significant leasing demand, strong space absorption and low vacancies continue to put upward pressure on rents in most major industrial hubs, with the weighted average of industrial rental rates rising 4.8 percent year-over-year. In fact, of the 80 industrial markets tracked by Cushman & Wakefield, nearly half have posted year-over-year rent growth of more than 5 percent, with 14 markets registering double-digit gains.

With such strong underlying fundamentals, it isn’t surprising that the industrial sector garnered the attention of investors in 2015. U.S. commercial real estate has become the asset class of choice as investors search for yield in a global, low-interest rate environment, and the U.S. industrial sector has become a beacon for capital, evidenced by the $43.2 billion in sales through last year’s third quarter.

Strikingly, it took only nine months for 2015 transaction volume to surpass the year-end 2014 tally, ensuring a sixth consecutive year of improvement. While large-scale, multimarket portfolios drove sales activity in the first half of the year, the latter half of 2015 was more reflective of the norm as single-asset transactions comprised 81 percent of investment sales activity.

Meanwhile, supply-demand fundamentals for industrial real estate remain sound. Completions in the first nine months of the year totaled 124.8 million square feet. Of this, nearly 60 percent found tenants upon delivery, a clear indication that demand is keeping up with new development.

Net absorption has outpaced construction completions since 2010, and we expect this trend to continue in 2016, considering nearly 40 percent of the 182.3 million square feet of industrial product under construction is pre-leased. Another sign that bodes well for demand is the large number of active tenant requirements in the market that, on a square-foot basis, is nearly twice the amount of speculative construction underway.

Evolving trends

Although it’s promising to see that tenant requirements are increasingly broad-based in terms of size and industry — a sign of a healthy industrial market — it’s clear e-commerce fulfillment remains an evolving and transformative force. In the 21 years since the first reported online purchase, many aspects of e-commerce have progressed by leaps and bounds, not only changing but challenging the very nature of supply chains. As high-speed Internet access and constraints on consumers’ discretionary time become more ubiquitous, expect the next evolution in key trends impacting the logistics and the industrial real estate sectors.

The U.S. population continues to see a shift in where consumers want to work, live and shop. A return to the city center means urbanization of not only the millennials, but also of all generations. More than half of the world’s population lives in urban locations, and by 2050 that percentage is projected to increase to more than two-thirds, according to the U.N. The popularity of cities for U.S. millennials, empty-nest baby boomers and others suggests the population growth rates for large cities will continue to outpace those of suburbs in the U.S. Living in cities often means limited storage space in apartments, more consumer reliance on public transportation, a hurried consumer with immediate product needs, and a must-have-it-now sense of instant gratification.

With consumers shopping more frequently online, demand on shippers to provide faster, more diverse delivery options will only grow. Demand for same- or next-day delivery is increasing, although shippers will continue to grapple with shipping costs and whether offering free shipping can or should remain a competitive advantage for them.

Out of necessity and demand, many retailers and shippers are locating new distribution centers in infill locations. Available buildings and land closer to the urban core are often limited or nonexistent. Many shippers are locating smaller facilities near cities or opening smaller sortation facilities, where the only activity is the final sort on routes out to the consumer for last-mile delivery. No inventory is held in those locations. Rather, the orders originate from a regional facility, where they are picked and packed before moving onto the sortation center.

The intersection of these evolving trends also is causing many companies to re-examine their inventory deployment strategies. Fewer retailers are finding it practical or economical to keep and manage two merchandise inventories, one for their e-fulfillment and one for their stores. Although managing a single inventory in a DC presents more challenges in picking orders (bulk pack to the store and single picks direct to consumer), the benefits of managing and funding a single inventory for both channels can far outweigh the complexities. Having confidence in the SKU in-stock position across the supply chain offers many retailers far more flexibility and agility in filling online orders quickly and efficiently, using traditional fulfillment processes as well as emerging ones.

Emerging trends

A number of trends have emerged in the past few years, impacting not just e-commerce but all product categories as consumer behavior changes. Not only are shoppers finding convenience in all forms of online shopping (using desktop and mobile devices), but manufacturers and distributors also are finding innovative ways to leverage technology throughout their supply chains. It’s in these emerging trends that we see great opportunity, as well as challenges, for manufacturing, distribution and shipping.

While many U.S. cities experience population growth and consumers in all areas place greater demand on getting purchases faster, the methods and modes of last-mile delivery become more complex and diverse. Before e-commerce, most purchases (other than large appliances and furniture) were, in essence, self-delivered by the consumer by way of visiting a retail store. The rise of parcel carriers such as UPS, FedEx and even the U.S. Postal Service has meant convenience for consumers but an increasing landed cost, which is often borne by shippers, who are competing against one another to entice customers through free shipping offers.

“Free shipping” has been a known challenge to the economics of doing business, and future years will present some decision points for shippers to optimize their margins while managing customer expectations that have been instilled in consumers for years. Retailers and shippers are testing creative ways to leverage crowd-sourced carriers (such as Uber drivers delivering packages), incentivizing customers through discounts to take slower, three-to-five-day deliveries or to leverage inventory and shipping methods by offering “Buy Online, Pick Up in Store” options to the consumer.

That last option doesn’t necessarily require fulfilling the order from a DC and simply shipping it to a store near the customer for pickup. Several retailers also have developed, and continue to perfect, complex algorithms to evaluate the inventory position in the store or DC against the cost and time to ship the product from the DC or another store altogether to the store nearest the customer for pickup.

Technology will continue to assert itself in various ways to revolutionize, and in some ways, fundamentally change many aspects of supply chains. Robotics and automation in the DC are nothing new, but the demand for faster order fulfillment and the seemingly never-ending set of product configurations and dimensions, complexity of diverse orders and what gets packed into a single box for a customer mean new demands on that DC automation.

We will also see advances in the Internet of Things, helping supply chain leaders operate so-called smart buildings that will signal a preventive maintenance issue before it becomes a repair issue, and help consumers shop through “smart refrigerators” that will automatically send that weekly order for milk and bread directly to the grocery store, which will then magically appear at the customer’s door within the same day.

And, of course, 3D printing will find stronger roles in component manufacturing in various sectors.

Implications for industrial real estate

So what do these evolving and emerging trends mean for the industrial real estate sector and the role DCs, fulfillment centers, sortation centers, manufacturing plants and other facilities play in our critical supply chains?

Big-box DCs will still be key, but smaller infill and sortation centers will be in demand, providing opportunities for adaptive reuse, especially for infill locations.

Building design, especially for e-commerce facilities, will evolve as higher clear heights, automation in the DC, truck courts/queuing space, and employee parking introduce new challenges.

There will be greater complexity of inventory, fulfillment and value-added activities within the DC.

The labor force will be top of mind as transportation companies grapple with truck driver shortages, DC logisticians confront an evolving workforce requirements, and manufacturers strive to fill the skills gap.

Jason Tolliver is head of industrial research for the Americas at commercial real estate company Cushman & Wakefield. Contact him at jason.tolliver@cushwake.com. Bethany Bailey is Cushman’s managing director for strategy and operations, and logistics and industrial services in the Americas. Contact her at bethany.bailey@cushwake.com.