Assessing industrial real estate demand drivers

You likely have heard a variety of what might seem to be conflicting insights when discussing the state of the industrial real estate market. Decision making has slowed down, leasing has cooled off, yields have softened and speculative development has slowed as well. However, lease rates are still strong, vacancy rates are still relatively tight and occupier demand is focused on “flight-to-quality” space.

Big banks watching the commercial real estate sector are always evaluating a number of economic indicators to assess the macroeconomic environment. Understanding the demand side of the industrial real estate market is essential.

We’ve been tracking various macroeconomic indicators as well to gain a better understanding of what might be happening with industrial real estate demand. Seven of those indicators are as follows:

1. Industrial Production—Industrial production measures the output of the industrial sector, including manufacturing, mining and utilities. Industrial production has been growing steadily over the past five years, although it experienced a significant decline during the pandemic due to disruptions in global supply chains and reduced consumer demand.
2. Retail Sales—Retail sales are a measure of the total amount of merchandise and services sold in the retail sector. Despite fluctuations due to events like the pandemic when online spending surged, retail sales have grown steadily over the past five years.
3. Consumer Price Index (CPI)—The CPI measures the average change in prices of a basket of goods and services over time. The CPI has been relatively stable the past five years, with an average annual increase of around 2%. However, some sectors have seen fluctuations due to supply and demand imbalances.
4. National Federation of Independent Business (NFIB)—The NFIB index is a measure of small business sentiment and economic optimism. The NFIB index has been trending upward over the past five years, reflecting the overall optimism of small business owners about the economy’s direction.
5. Employment—Employment measures the number of people employed in the economy. The past five years has shown employment as steadily increasing, with unemployment rates dropping to record lows before the pandemic caused a temporary surge in joblessness. The economy has since recovered, with employment rates returning to pre-pandemic levels.
6. Institute for Supply Management (ISM)—The ISM measures the health of the manufacturing sector. The ISM has been expanding in the last five years, reflecting the steady growth of the economy and of the manufacturing sector.
7. Logistics Managers Index (LMI)—The LMI is a logistics-industry-specific metric. This index was developed seven years ago by academics in supply chain and evaluates the three largest operating buckets within logistics: transportation rates, warehousing capacity and inventory levels.

Global supply chains are smoothing out

Most of the seven macroeconomic indicators listed above are showing signs of our current economic slowdown. Industrial production is slightly down, e-commerce growth rates are down from record pandemic highs, prices are trending slightly down, small business optimism has dipped, logistics employment has slowed, and freight costs are down from record highs.

Retailers bought so much “stuff” during the pandemic due to supply chain uncertainties that freight costs skyrocketed and inventory levels swelled, bringing warehouse capacity to record lows. As supply chains have begun to smooth out again, retailers have been jettisoning unneeded inventories.

Global supply chains are finally getting back to “normal” after experiencing a once-in-a-lifetime shock, creating a tremendous “bull whip” effect on corporate supply chains.

Supply chain fundamentals remain positive

Focusing on macroeconomic indicators can be insightful, but you can’t drive a car looking through the rearview mirror. In addition to evaluating economic metrics and real estate industry-specific data (vacancy rates, leasing transaction volume and occupier demand by market), it’s important to understand and consider some of the less quantifiable, but critically influential, supply chain fundamentals. Those trends drive change to corporate occupier supply chains and have a significant impact on industrial real estate demand.

Our supply chain experts and industrial researchers evaluated six of those catalysts: 1) e-commerce growth; 2) freight costs and global complexities associated with shipping; 3) changing customer service expectations; 4) the growing importance of sustainability; 5) the impact e-commerce (B2C) is having on business-to-business (B2B) supply chains; and 6) the growth of North American manufacturing.

Our summary of each is captured in the graphic below:

The theory of relativity

Everything is relative. Putting the last three years in perspective, the pandemic accelerated a number of trends and industrial real estate demand spiked as companies sought to meet growing on-line consumer demand.

Hamid Moghadam, chairman and CEO of Prologis, the world’s largest owner and developer of industrial real estate, said the market was on “steroids” in reaction to the pandemic and that we are now returning to a more normal pace of leasing. In 2023 and heading into 2024, the industrial real estate market is coming back down to earth. Online purchasing has dropped to around 15% of all sales, down from a peak of around 20%, with the potential to reach 30% by 2030.

Despite the current uncertainties associated with the global economy and geopolitical concerns, there is always going to be “something” that will be disruptive to global supply chains. That said, supply chain fundamentals are still strong, and there’s little doubt long-term demand for industrial real estate will continue.