Philly Industrial Tenant Demand Still Strong — If Developers Can Figure Out How To Finance Construction

Spiking interest rates are proving powerful enough to slow the industrial real estate market in Greater Philadelphia, even though many retailer tenants are still on the hunt for space to house their swollen inventories.

Industrial property values have dropped by 30% or so in the region as investment transaction activity has slowed dramatically, panelists said during Bisnow’s Philadelphia Industrial & Logistics Summit at 355 Maple Ave. in Harleysville, Pennsylvania, on Nov. 17.

Even tenant demand has calmed down, though not enough to leave desirable buildings unoccupied.

Across the Philadelphia region, including the Lehigh Valley, leasing activity averaged 17M SF per quarter before the pandemic, before leaping up to 28M SF per quarter from late 2020 through the beginning of this year, JLL Northeast Industrial Region Senior Vice President Larry Maister said at the event. In the third quarter, about 20M SF of leases were signed in the region.

“The tenant demand is there,” Maister said. “We might not have eight proposals on a space. But if we have three or four, that's still pretty good.”

The retreat in demand could be in response to a previous overcorrection for pandemic trends, like Amazon is experiencing, or to how consumers are being affected by inflation. But despite real estate being a fraction of the logistics bottom line, the high cost of capital has driven some tenants out of the leasing market for now, Bridge Logistics Properties Managing Director Greg Boler said.

“I mean, tenants have debt as well, right?” Boler said.

The logic of geography and population density plays in favor of the Philadelphia region, with many national tenants making South Jersey or the Lehigh Valley a priority if they are no longer in full expansion mode, Endurance Real Estate Group co-founder and principal Ben Cohen said. That has kept the leasing market moving, even if the occupier class is less aggressive on the whole than it had been last year.

“What we're seeing is a return to normalcy, where you don't start a project and all of a sudden, you have a [requirement] for 1M SF or 500K SF kind of drop out of the sky,” Colliers Executive Vice President Michael Golarz said. “There actually may have to be a tour.”

If leasing is still chugging along, though, the real pain has been felt on the supply side.

The financial environment has throttled the rate of construction loan origination, panelists said. Lenders are changing terms so often during the due diligence phase, developers feel as if they can’t close deals.

“[Lenders] issue term sheets, the interest rates rise and the debt service coverage ratio that you thought you had no longer works for their underwriting,” J.G. Petrucci Executive Vice President Peter Polt said. “And so it's really hard to get term sheets at all. I think that's going to drive — especially in our market, but even nationwide — it's going to drive a decline in construction starts next year.”

With financing often a final piece of the puzzle for construction to begin, plenty of developers are faced with projects that have gone through pre-development but without the capital to start building. In the past few months, companies in that position in the region have either pushed groundbreaking dates to next year or pivoted to selling entitled development sites before construction, Lee & Associates of Eastern Pennsylvania principal Kim Jacobsen said.

“I do think we’ll see supply impacted,” Jacobsen said. “My guess is that we will eventually run out of space for certain size requirements.”

Construction prices are no longer climbing higher every day, but they are still elevated and affected by long lead times obtaining materials. And with financing costs double what they were at the start of the year, the construction pipeline could narrow enough to keep upward pressure on rents, Jacobsen and Boler said.

Panelists disagreed about when conditions would improve enough for the capital markets to thaw out, with the earliest projections pegging the turning point at late 2023.

“For putting financing together, the dramatic slowdown has already started, obviously,” BG Capital President Joseph Byrne said. “And I don’t think it’s going to come back to even pre-pandemic levels until 2024. But tenant demand is still definitely there, so if you can figure out how to finance projects, leasing is still not going to be a challenge.”