Industrial Is On The Brink Of Overbuilding

Industrial developers are unleashing nearly 700M SF of warehouses across the nation following two years of record absorption as Amazon and other retail companies expanded their distribution networks.

But experts say a likely recession and quickly decelerating online sales growth could mean developers are in danger of overshooting demand.

Commercial real estate analytics firm Green Street predicts that developers in the U.S. will likely build 90M SF more a year than will be leased by companies, decreasing occupancy a full point to 94% over the next three years.

“Our new supply forecast indicates that we think supply will outpace demand going forward,” Vince Tibone, a retail and industrial senior analyst with Green Street, said during a July 14 webinar. “In certain markets, we're seeing some of the best demand and rent growth for the newer big-box space, but that's also where most of the supply is coming.”

One major developer told Bisnow the prospect of overbuilding is real.

“We are concerned about the overall supply,” said Stan Conway, executive vice president for Majestic Realty Co., a family-owned commercial real estate firm with more than 80M SF in projects under its belt and one of the most active private industrial developers in the U.S.

“Just being in the business over the years, there appears to me to be too much product on the way relative even to historic demands,” said Conway, whose firm has 11M SF of distribution space under development throughout the country. “We're certainly keeping a close eye on new starts.”

So far, concerns of industrial oversupply aren't being borne out in the fundamental data.

In the first half of 2022, developers delivered 194M SF, according to a Q2 Cushman & Wakefield report. But 236M SF were absorbed in that time, and leasing has outpaced construction for seven consecutive quarters. Last year was a record one for warehouse landlords, who saw companies gobble up more than 490M SF throughout the U.S., an 81% increase from 2020, according to JLL. That helped push vacancies at warehouses down to a historic low of 3.8%. Landlords also have reaped the benefit in rents, with the rate rising to $8.36 per SF in the second quarter, the first time the average warehouse rent eclipsed $8 per SF in the more the 20 years that Cushman & Wakefield has tracked that data.

These fundamentals have fueled a development boom in the sector. In the second quarter of this year, the construction pipeline of warehouses and distribution centers reached 699M SF, up 112% over pre-pandemic levels and 177% above the 10-year average, according to Cushman & Wakefield.

But cracks are beginning to show in what had been robust online shopping demand and the overall economy, which has some analysts predicting a slowdown.

Green Street has cut its expectation on how much e-commerce-based industrial leasing will be done from 30% to 40% of total absorption per year to 15% to 20%, Tibone said.

“What we're forecasting for e-commerce-related demand is a lot lower than what we saw even before the pandemic,” he said.

And David Rodgers, a senior REIT research analyst for Robert W. Baird & Co., said he expects absorption to fall back to historical norms of around 200M SF a year, especially with what he expects will be a “sharp recession” this year, resulting in slowing consumer demand.

“If we continue to build 600M SF to 700M SF, yeah, we're building too much,” he said. 

The pandemic caused online sales to skyrocket, but growth is tapering. E-commerce sales grew 50% from 2019 to 2020 and 14% from 2020 to 2021. That has ebbed further so far this year, with online sales hitting $231B in the first three months of 2022, a 6.7% increase from the same period in 2021, Digital Commerce 360 reported, citing U.S. Department of Commerce data. 

In April, Americans spent $5.28B less online than in March.

In May, Amazon pulled the rug out from under what appeared to be an insatiable demand for global distribution space when Bloomberg reported it planned to scale back new warehouse leasing and attempt to sublease upward of 30M SF across the U.S. At its leasing peak in 2020, Amazon accounted for 30% of net industrial absorption in the U.S., according to data from Green Street. That number was down but still significant last year when the online retail giant accounted for 15% of net absorption.

The news had a seemingly chilling effect on industrial REIT stocks, with returns shrinking more than 20% since May compared to a 9% fall in returns with the S&P 500 as a whole, according to Green Street.

Many economists contend that the Federal Reserve raising interest rates in an effort to combat inflation will push the U.S. into recession this year. Consumers have remained resilient in spending, but some of the increase in e-commerce sales this past quarter can be attributed to higher prices because of inflation, Digital Commerce 360 reported.

Even if e-commerce companies do slow their pace of industrial leasing, some experts say these accumulating clouds won’t lead to a storm.

Activity among prospective tenants is broad-based beyond just e-commerce uses, including food distributors and home improvement companies, said Greg Boler, managing director of Bridge Logistics Properties' Eastern region. Plus, a chunk of the space that is underway in the U.S. is already being claimed by companies, he said.

Cushman & Wakefield analysts said 26% of space underway is pre-leased.

“Given how tight the industrial market is, it is difficult to get too worked up about an overbuilding scenario,” Cushman & Wakefield's Carolyn Salzer and Jason Price wrote in a report. “Even if all speculative product were to hit the market immediately as vacant, the national vacancy rate would rise to 6.3% — a chip shot away from its historical average of 6%.”

Companies inked more than 408M SF of leases during the first half of 2022, which puts that metric on track to exceed 800M SF by the end of the year, the second time leasing would hit that level, according to Cushman & Wakefield. Though Amazon pulled back, companies like Lowe's, Target, the U.S. Postal Service and Wayfair, as well as third-party logistical companies, continued to enter into new leases, with more than 15 deals signed in the second quarter across the country exceeding 1M SF, according to the report.

“We should expect for e-commerce to slow down a bit. Obviously, we're getting back to something that's a new norm and we're getting back in person. We're not just ordering online,” said Boler, whose firm has a 11.7M SF pipeline of new industrial development across the country this year.

Manufacturers also are picking up leasing activity, converting warehouses into plants and other facilities, Cresa Senior Vice President Adam Burgess said. When speed to market matters, manufacturers will take an existing warehouse and convert it to fit their needs versus building from scratch.

“I sit in Detroit, and this is the first time in my career that we've seen a shift of institutional money moving into the market,” Burgess said. “If you look at the mix of tenancy, I would bet a greater percent of manufacturers are moving into those buildings than distributors.”

Rodgers also said that despite new deliveries of warehouses so far, the vacancy rate continued to drop, which is indicative of pent-up demand.

“When you look back, the data looks pretty supportive. In a shorter period of time, we've seen a big acceleration in the need for warehouse space. The reality is we don't really know [if there is overbuilding]. We know we're in a great spot with respect to vacancy,” he said.

CORRECTION, JULY 19, 1 P.M. ET: A previous version of this story misstated the square footage under development with Bridge Industrial Properties across the country.