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Warehouse Slowdown Is Coming, Says Prologis

Oct. 9, 2023
Conflicting forces set the stage for slowing industrial real estate development.

In recent months those involved in industrial real estate (IRE) development have taken a hard look at recent industry trends and what the future holds. Warehousing and distribution services have boomed in recent years, and investors rode that boom. But changes taking shape are resulting in a slowdown in new construction, rising costs and increased technology requirements.

Regardless of whether the economy will slide toward recessionary territory or continue to enjoy steady if not robust growth, Prologis Research (the research arm of IRE global giant Prologis) recently took a more detailed look at where the industry is headed

The researchers argue that future logistics real estate cycles will be less volatile because of the multiplier effect on demand and structural discipline in supply. “For every dollar of U.S. gross domestic product, at least 20% more logistics space is needed than before the COVID-19 pandemic,” they say.

However, they add that an institutionalized developer and investor base—coupled with rising geographic and regulatory barriers to supply—will limit capacity growth throughout the cycle stages.

Service levels are fueling demand again for logistics space. Customer network expansion needs are rooted in offering the speed and choice demanded by the end consumer to compete for revenue. E-commerce is reaccelerating and on pace to reach more than 23% of U.S. retail goods sold in 2023, up 100 basis points (bps) year-over-year.

At the same time, product variety is on the rise. The top consumer goods companies have increased their product mix by 16% from 2018 to 2023, the researchers point out.

Customers also are still building in resilience to manage persistent disruption following the national and worldwide supply chain disruptions that became highly visible during the COVID pandemic.

“The shift from just-in-time to just-in-case is on-going,” the Prologis researchers observe. “The surge of demand to accommodate inventory growth generated 65%+ higher net absorption than typical from 2020-1H 2023, and inventory-to-sales and inventories/household ratios recovered to +3% more than pre-pandemic levels,” they said. “We expect +5% long-term, but economic uncertainty may push some demand into 2024.

When the U.S. inventory to sales (I/S) ratio fell to 10% below pre-pandemic levels, Prologis Research called for cumulative inventory growth of 15-20%, driving a surge of demand. Subsequently, real inventories increased by 15% and both the I/S ratio and inflation-adjusted inventories per household recovered to 3% above pre-pandemic levels.

From 2020 to the first half of 2023, logistics real estate demand totaled 1.2 billion square feet or 330 MSF (thousand square feet) per year vs. historical expansionary average of 175 to 200 MSF in the top 30 U.S. markets, showcasing this incremental demand.

More growth is needed to reach “just-in-case” inventory levels that are 5% or more above pre-pandemic, although economic uncertainty may push some demand into 2024. Historical patterns suggest inventories could decline by approximately 2% before sales slow, a quantification of the uncertainty. Going forward, resilient inventories are part of the 20% higher demand

Diversified sourcing and ports of entry will reshape supply chains for years to come, driving incremental demand along trade routes and near newly established production facilities, they predict. At the same time, the Prologis researchers believe the extraordinary period of growth for IRE construction activity is heading for a brick wall, which will bolster occupation levels and likely rents as well.

“New building deliveries will contract by 35% or more in the U.S. and Europe in 2024, creating a window for positive demand to take market vacancies further below historic norms in late 2024 and into 2025. Replacement costs remain elevated, driven by higher financing costs and competition for construction materials and labor from infrastructure, manufacturing and housing.”

Financing Costs Rising

Inflation is no one’s friend in the end. Replacement costs remain elevated, driven by higher financing costs and competition for labor and materials from infrastructure, manufacturing and housing.

“Construction loans are expensive and difficult to secure. With most banks tightening lending standards and interest rates doubling during the past 18 months, the era of ample, low-cost financing ended abruptly in 2022,” the researchers note. “Financial market volatility has translated to a greater than 200 bps increase in required returns that are needed to warrant new development. At the same time, repricing and tighter lending standards in the debt markets limit financing for development.”

The evolution of supply chain needs and availability of advanced technological solutions means the warehouse and distribution systems of tomorrow will look vastly different and require changes that will drive new strategic approaches, the researchers believe.

Flexibility and creativity will turn out to be the keys to future success, they say. “The future of the supply chain is resilience. Customers are evolving their global supply chains to manage persistent disruption.”

They point out that economic activity has shifted toward more logistics real estate-intensive uses over time. In addition, the researchers figure that each unit of growth will require more than 20% of additional logistics space than was needed pre-pandemic for three reasons:

• Higher inventory carry (5% or more) for each unit of sale to build in supply chain resilience to disruption.

• Increased product variety will drive the need for more storage space to service each unit of consumption.

• Goods’ share of consumption is poised to remain higher for longer due to demographic trends. They estimate goods will make up approximately 38% of U.S. consumption going forward as Millennials enter peak spending years, down from a pandemic high of 40% but above the pre-pandemic share of 36%.

“Online share of goods spending will continue to increase (from 15% in 2019 to 25% by 2025), which will continue to drive the need for more space because e-commerce requires three times the logistics space compared to brick-and-mortar retail,” the researchers forecast. “Outside of these share shifts, we see signs of increasing logistics real estate intensity, even in traditional retailing models.”

In the end, it is retail that is driving IRE demand. With greater predictability in supply chains in the absence of the previous pandemic-era disruptions, they believe that companies are again turning to improvements in service to win consumer dollars.

Another big factor that will continue to drive IRE growth is the fact that e-commerce is gaining share. Prologis Research expects over 100 basis points growth in U.S. e-commerce share of goods sales in 2023 measured year-over-year, equal to more than 50 million square feet of demand.

“Around the world, delivery timelines are falling again as the ability to consistently deliver goods in one day or less produces a competitive advantage,” the researchers say. Investments in larger, decentralized distribution networks are being made to facilitate fast delivery and reduce transportation costs. As a result, they expect increased demand for logistics real estate concentrated near centers of consumption.

An additional change driving warehouse and distribution network growth is the fact that product variety is on the rise. Another avenue to revenue growth is the retailers’ expansion of consumer choices to stay on top of rapidly evolving preferences and the public’s growing desire for customized offerings.

In fact, the top global consumer goods companies increased product mix by 16% between 2018 and the first half of 2023. This broadened product mix requires additional storage space and complicates fulfillment, which adds to logistics real estate demand. Among the factors limiting supply is that less land is available near centers of consumption, and new projects face increased government resistance and regulatory costs.

The outlook for decreasing vacancy adds upside to market rental growth in 2025 and beyond, Prologis Research concludes. “Taken together, positive demand drivers and a rapid fall in starts could push the U.S. vacancy rate from a peak in the mid-4% range at the beginning of 2024 back to the mid-3% range by the end of 2024.”

For users of mission-critical logistics facilities, the researchers believe that structural shifts in demand, like evolving consumer preferences and the need for supply chain flexibility in an increasingly uncertain world, are more likely to be met with chronic undersupply and higher barriers to new development in the future.

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