As the economic recovery and the evolution of e-commerce continue to fuel the business of moving and storing goods, they also are generating incredible resiliency in the nation's industrial real estate sector. In fact, shifting demand and service paradigms and demographic market forces are supporting favorable supply-and-demand trends in warehousing and logistics space across all major markets in the U.S.
Brick-and-mortar retail locations historically served as main benefactors of robust economic fundamentals, with the warehouse market largely providing inventory storage and staging. Now, e-commerce is transforming warehouse/distribution facilities into the retail stores of the future as more and more consumers purchase merchandise online. Forrester Research estimates that the online share of the retail sector will reach the mid-teens during the coming decade, up from less than 10% today.
Amazon is clearly making the largest e-commerce impact, currently occupying approximately 66 million square feet of distribution space nationwide. In a move to compete with Amazon, Walmart is now investing heavily in the build-out of its e-commerce fulfillment network. This includes 1 million-square-foot projects under development or already operating in six major markets. Home Depot, Target and Kohl's are also making major investments in e-commerce-related facilities throughout the U.S. With projected occupancy gains of 380 million square feet in warehouse/distribution space from 2014-2017, this demand will remain strong.
Construction Heats Up, Rents Rise as Space Tightens
The U.S. industrial vacancy rate continues to trend down. At mid-year 2015, it reached 6.6%—60 basis points lower than one year ago and the lowest level since first quarter 2001. New inventory is quickly being added to meet strong market demand for high-quality Class A space, with an anticipated 290 million square feet expected to be completed over the next three years. Still, we will likely see the vacancy rate tighten even further.
Markets with land available to develop—including Atlanta, Chicago, Dallas, California's Inland Empire, Houston, New Jersey, the Pennsylvania I-81/I-78 corridor and Phoenix—are well positioned to satisfy demand with new warehouse product. Mature markets including Los Angeles, Orange County and Silicon Valley, with diminished land to develop, will continue to tighten.
Low supply is also driving strong rent growth in most major industrial hubs. U.S. warehouse rents, at a weighted average of $5.17 per square foot per year as of mid-year 2015, were up 3.7% year-over-year. They are projected to grow 5% by year-end and by more than 10% over the next three years.
Logically, the largest gains will be seen in the most supply-constrained regions. Asking rents for warehouse space in Los Angeles Metro will finish 2017 at $8.12 per square foot, significantly higher than the projected U.S. average of $5.79 per square foot. Strong rent growth in Silicon Valley will make that market the most expensive for warehouse space in the country by 2017, with an asking rate of $9.03 per square foot.
As the Gulf and East Coast port regions continue to capture modest market share from West Coast port markets, Houston has been a stand-out, and chalked up one of its best years on record in 2014. In response, rental rates have increased by more than 9% in the last year and are projected to reach $6.17 per square foot in 2017. However, the recent drop in oil prices—while largely positive for the U.S. economy—is a concern as the outlook for Houston remains highly contingent on energy pricing.
Newly added port customers and shifting cargo from U.S. West to East Coast are all fueling the growing cargo volumes at Georgia's ports. In addition to Savannah, Atlanta has also benefitted significantly from the increased trade volume with a 4.3% rental rate increase, to $3.64 per square foot at mid-year 2015.
Markets with significant construction activity, including the Inland Empire, PA I-81/I-78 corridor, Chicago and Dallas, offer the most affordable rates, which are projected to remain below the national average for the next three years. New supply will keep landlords from significantly raising asking rates.
What Do the New Facilities Look Like?
Today's e-commerce facilities house operations that require design elements and fit-outs not found in many existing facilities. So beyond the sheer need for additional square footage, the mandate to accommodate a more sophisticated usage is a significant driver of new construction and, more recently, the redevelopment of older stock in infill locations.
For example, large, "big box" properties remain dominant. These massive structures are generally state-of-the-art distribution facilities equipped with larger bays, more surrounding land for additional parking, and better temperature control and more power as required for fulfillment equipment. Ceiling heights are rising to the 36- to 40-foot range to accommodate modern conveyor systems and mezzanines that support high-velocity order picking.
Increasingly, however, we are observing growing demand for smaller- and mid-size buildings. Heightened service expectations, elevated transportation costs and the need to access labor are leading e-commerce and logistics companies to establish smaller infill locations around major population centers. Not only do companies covet the closeness to FedEx/UPS ground shipping centers these locations often bring, proximity also enables them to fill and deliver orders to a large number of customers quickly.
A Word on Last Mile
The latest buzz in e-commerce involves the race to develop effective last-mile delivery strategies—much of which will depend on the retailer's view of the future trade-offs between shipping cost and speed. As a key part of this, close-in development of smaller distribution facilities is guaranteed by two major factors. The first is certainly urbanization and the gradual net movement of population towards the dense core of the city. The other major factor is the rising service level expectations from e-commerce buyers.
The huge investment Amazon is making to expand its Prime Now service is predicated precisely on getting more customers accustomed to near-instant gratification. This requires deep penetration into urban centers, and Amazon is quickly establishing 10,000- to 70,000-square-foot last-mile terminals to accommodate two-hour (or less) deliveries. The company is aggressively building out this network.
Growth in Amazon Prime customers is testimony to the power of a membership model paired with fast delivery and low or no incremental shipping cost. Walmart and Target, among others, have launched similar offerings. The growing group of new last-mile providers is all chasing the fast delivery proposition. It remains to be seen who will be able to build enough scale to avoid losing money on each fast-moving package delivered. Those that can deliver both compellingly low-cost shipping and fast delivery will come out on top.
E-commerce retail is still a relatively new business, overall, and we can expect it will continue to evolve. Given how heavily it relies on technology, and appeals to a younger group of consumers, we can expect it to evolve even more rapidly.
Labor will be a challenge. As the e-commerce landscape continues to take shape, the cost and availability of labor will play important roles in the ability of retailers to keep up with demand and control costs. We expect to see wage and benefit expenditures rise across the board. At the same time, a continued and worsening shortage of labor is a serious challenge that likely will be addressed by companies introducing new benefits—such as flexible hours and tuition assistance—in an effort to recruit younger workers into e-commerce fulfillment. Additionally, companies will need to maximize automation in their fulfillment facilities, resulting in more capital expenditure.
What else may change? Branded companies and traditional wholesalers are beginning to make major investments in positioning themselves to sell and ship directly to customers, which could really shake things up. They, too, will need distribution space.
Undoubtedly, this evolving sector will look quite different five years from now. Perhaps the only guarantee is that the future of retail and the struggle for control of the customer will remain among the most interesting topics affecting industrial real estate in the interim.
John Morris is executive managing director, logistics & industrial services lead, Americas, with Cushman & Wakefield (www.cushmanwakefield.com), a commercial real estate services firm.