Industrial Real Estate: Threats and Opportunities Both Persist

This year, the North American real estate market is expected to reach a value of $133 trillion. While residential real estate should contribute $104 trillion, or 78%, of that amount…

The remaining 22% is filled with opportunities, including in the real estate investment trust space.

Looking at the chart below, the four largest U.S. REITs have outperformed the benchmark proxy Vanguard Real Estate Index Fund ETF Shares (VNQ) over the past 10 years.

• Rexford Industrial Realty (REXR): +305%

• Eastgroup Properties (EGP): +285%

• Prologis (PLD): +276%

• STAG Industrial (STAG): +191%

• VNQ: +79%

Since these top performers are all industrial REITs, it seems safe to say the sector stands out. It retains opportunities worth investigating –  even in this challenging market with all of its nagging threats.

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What Sets Industrial Real Estate Apart in a Challenging Market

Let’s face the negative facts first. Because the more informed we investors are, the better our portfolios can perform.

Generally speaking, commercial real estate (CRE) is in an increasingly tough spot, pressured by elevated rates and sticky inflation. On March 19, for example, Bloomberg highlighted the rise in delinquency rates for so-called “collateralized loan obligations.”

These CLOs bundle debt – the kind conventional mortgage-backed securities usually deem too speculative – into bonds of varying risks and returns. Bloomberg recently wrote how (emphasis added):

“In just the last seven months, the share of troubled assets held by these niche products has surged four-fold by one measure to more than 7.4%. For the hardest hit, delinquency rates are in the double digits. That’s left major players in the $80 billion market rushing to rework loans, while short sellers are ramping up attacks on publicly traded issuers they say may be so beset by missed payments that they have little to no equity value.”

Doesn’t sound good, does it?

Now, CLOs usually consist of short-term floating-rate loans for renovations or expansions. So they’re not necessarily the norm.

Even so, this could be a sign of broader weakness since it’s usually the first shoe to drop.

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Bloomberg adds that the Federal Reserve’s rate hikes had automatic results on developers with floating-rate loans who were hoping to quickly “flip” properties. And since we’re in a “higher for longer” environment, the issue has only grown worse.

The entire CRE field is indeed now under pressure.  

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Wells Fargo data shows vacancy rates have gained upside momentum. While office vacancy has increased since the initial pandemic damage was done…

Even stronger industries like apartments and industrials are now showing weakness.

Yet this chart doesn’t tell the full story. One of the sectors indicated is not like the others.

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A Healthy, More Stable, Industrial Image

While industrial demand has slowed, Wells Fargo concludes that it remains healthy. Its biggest weakness currently comes from:

1. Post-pandemic normalization as supply chains heal

2. A more certain economic outlook, which is typically bad for inventories (and therefore warehousing demand).

Yet larger secular trends remain strong. Last year, The Wall Street Journal agreed with Wells Fargo’s assessment, noting that long-term industrial demand is fueled by ongoing online sales growth.

This is a big deal since, according to Prologis – the world’s largest industrial REIT, whose properties move 2.8% of global GDP – e-commerce requires more than 3x as much space as brick-and-mortar sales.

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In addition:

• Companies are reevaluating their inventory strategies, often choosing to hold more goods closer to their customers to mitigate supply-chain disruptions.

• Geopolitical tensions are encouraging this trend even further.

That’s why asking rent growth reached 11% in 2022… after almost six years of annual increases that were closer to 6%.

While the chart might seem to indicate that demand has caved, there’s a very good reason for the downturn. Since real estate is a low-entry barrier industry, new entrants jumped on the opportunity and boosted new construction.

According to Cushman & Wakefield’s 1Q-24 report (emphasis added):

“The U.S. industrial sector continues to cool off after two years of unprecedented growth coming out of the pandemic. Tenant demand slowed in the first quarter of 2024 but remains positive.

New completions (supply) continue to exceed net absorption (demand), causing the overall vacancy rate to trend higher. Still, at 5.8% as of Q1 2024, vacancy remains below its historical average of 7%. Rent growth is also coming back down to earth. In Q1 2024, industrial rents grew 6% annually vs. 10% in 2023 and 20% in 2022.”

That mixed bag still indicates strong long-term prospects from here.

Construction Enthusiasm Is Waning

Now, you may know Prologis just reported its 1Q-24 earnings. In which case, you might have noticed its stock price dropped more than 7% in response.

That’s because it adjusted its guidance in expectation of lower occupancy rates. To quote the REIT:

“A volatile and persistently high-interest rate environment, together with mounting geopolitical concerns, contribute to this indecision and its short-term effect on net absorption.”

Yet this “short-term” news comes with opportunities. After all, elevated rates and sticky inflation are highly unfavorable for supply growth. That’s why Cushman & Wakefield noted that “the future construction pipeline is thinning out quickly.”

In fact, new construction is down 50% year-over-year.

Colliers’ data confirms this, showing a quickly narrowing gap between supply and demand, with net absorption expected to rise consistently through 2024.

Prologis and others believe this latest trend could mark the return to a much more favorable environment. Going into 2025, the REIT sees the absorption rate normalizing, with potential positive momentum through 2027.

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Prologis expects new buildings to remain subdued throughout this period regardless… which could translate to a lasting uptick in rent growth going into next year.

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Colliers also sees a peak in the industrial vacancy rate at 6.6% – well below the Great Financial Crisis height of 9.3%.

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Plus, Prologis’ in-house research found that vacancy rates below 7% are indicative of positive rent growth.

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Two Worthy Contenders in the Industrial REIT Sector

When looking for the sweet spot of industrial real estate, we want to find markets with both strong consumer demand and subdued supply growth.

That’s where Southern California comes in.

Generally speaking, SoCal benefits from:

• Geographic exclusions, with the ocean on one side and mountains on the other

• Very strict zoning laws

• The ports of Long Beach and Los Angeles

• A massive economy, with a whopping $1.57 trillion worth of goods and services produced in 2022.  

Rexford Industrial Realty is 100% focused on this area, which just so happens to be the largest industrial market in the United States… and the fourth-largest in the entire world.

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As shown, this market has low supply risk and a low vacancy rate. Which tremendously benefits pricing.

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This is why it’s grown its annual per-share funds from operations (FFO) by 15% over the past five years, outperforming its peers by four points. And remember that REXR was the best-performing industrial stock over the past 10 years.

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Then there’s the also-aforementioned Prologis, which operates in SoCal and similarly smart markets. Going into this year, it had 30% exposure to California…

An A-rated balance sheet…

And relationships with some of the world’s largest and most stable customers. This includes Amazon (AMZN), which accounted for 6.4% of its annual rent last year.

In general, Prologis has elevated exposure to areas with secular growth, defensive characteristics, and supply chain modernization needs. It offers advanced buildings and has connections that smaller peers just cannot compete with…

All reasons to appreciate it from an investment perspective.

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In Closing

Although the current operating environment is undoubtedly tough for most REITs, we’re upbeat about industrial real estate’s future. Going into 2025, we could see a mix of both supply and demand tailwinds, making current stock price weakness attractive.

Despite the headwinds of elevated interest rates and geopolitical uncertainties, the industrial real estate market in regions like Southern California remain particularly attractive. Strong consumer demand, favorable supply dynamics, and other strategic advantages should keep them healthy.

It may take 3-4 quarters until fundamentals improve. Then again, it could happen sooner. We simply don’t know.

Since we’re not market timers, we’ll keep our focus on companies like Rexford and Prologis that are in a good place to outperform in the long term.

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Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.