US Industrial REITs Benefit From Rising Warehouse Demand

Warehouse space is likely to remain in steady demand, supported by favorable fundamentals and the rapid growth of e-commerce sales, notes Moody's Investors Service Analyst Alice Chung.

Alice ChungIn Moody’s view, US industrial REITs are well-positioned to capitalize on the robust demand for distribution space amid rising e-commerce sales. Sector fundamentals continue to be healthy, with positive levels of net absorption and record-low vacancy levels. While there is new supply coming, rent growth for industrial real estate should continue to strengthen, particularly in core distribution markets. 

E-commerce is a key driving force for industrial real estate, with U.S. industrial REITs being one of the biggest benefactors of the ongoing trend because they generally own the larger, more modern facilities that e-retailers seek. The rapid growth of e-commerce sales is fueled by retailers who are expanding their online presence. In second-quarter 2017, retail e-commerce sales increased 15.7 percent from second-quarter 2016, to $111.5 billion. Online retail sales have posted gains in 34 consecutive quarters, and Moody’s expects that within seven years, they will account for 23 percent of total U.S. retail sales. As consumers increasingly look to the internet for their shopping needs and expect fast delivery times, warehouse space is likely to remain in steady demand.

Favorable supply-demand characteristics

The strength in industrial operating fundamentals is also supported by still-favorable supply and demand characteristics. Net absorption in the quarter totaled 60 million square feet, up 44 percent from first-quarter 2017, marking the 29th consecutive quarter of positive absorption. Low vacancy rates also drove the demand for space. As of the end of second-quarter 2017, only 4.6 percent of U.S. industrial space was vacant, the lowest rate on record for the industrial sector, according to CBRE Economectric Advisors. In the tightest markets, vacancy levels for Class A warehouse space closed in near 1 percent. As vacancy continues to drop, occupancy rates have risen. In second-quarter 2017, rated U.S. industrial REITs averaged 95.6 percent in same-store occupancy rates.

U.S. industrial REITs with a majority of assets in markets with high annual rent growth and low vacancy rates are the best positioned to outperform in Moody’s view. These markets include the Inland Empire (Los Angeles and Riverside), Northern California/Bay Area, New Jersey/Newark and the Seattle sub-markets. All four markets have had solid annual rent growth rates, in addition to low vacancy rates. San Francisco’s net asking rent increased about 25 percent in 2016, and the reported vacancy level was 2.6 percent for second-quarter 2017. The rent and vacancy trends give landlords tremendous pricing power because tenants seeking to lease in these markets have limited options.

Tightening market fundamentals have led to stronger rental growth, with net asking rents up 6.6 percent in second-quarter 2017 from second-quarter 2016, and occupancy levels approaching 96 percent, on average. With in-place rents 10 to 15 percent below market rent, on average, U.S. industrial REITs will have the opportunity to drive rent growth, with expected same-store growth in the 3 to 5 percent range.

While industrial REITs continue on the path of improved profitability and higher revenue, there are risks to their operating performance. These risks include:  rising interest rates, with the magnitude of the impact largely dependent on how fast rates rise; uncertainty with regard to international trade policy; and the amount of supply built on a speculative basis in select markets where tenant demand is slowing.

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