Industrial REITs show solid performance as supply headwinds emerge

Despite challenging economic conditions, industrial REITs were off to a solid start in the first quarter, recording strong revenue growth and high occupancy levels. Short-term returns were down due to the impact of rising interest rates and an upcoming spike in supply has sparked concern. Let’s examine what lies ahead as the industrial market navigates through yet another period of uncertainty and transition.

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REIT performance strong, but headwinds persist

Industrial REITs were off to a solid start in the first quarter of 2023, with many companies recording strong revenue and occupancy levels. First quarter earnings reports note occupancy levels near 100% for Prologis, First Industrial Realty Trust, Rexford Industrial Realty and others, according to Bisnow. Prologis, the largest REIT, reached $1.77 billion in revenue in Q1 2023, a 45.1% yearly increase and a level that beat analysts’ expectations.

Despite strong financial health and an average occupancy level of 98% across the firm’s 1.2 billion-square-foot portfolio, Prologis executives cautioned about the impact of macroeconomic issues on leasing demand for the balance of 2023. Prologis also reported a 60% decline in its net earnings compared to Q1 2022.

As landlords brace for a wave of new construction scheduled to deliver in 2023, they are predicting several quarters of shifting supply-demand variables. Ongoing economic uncertainty and the lingering impact of rising interest rates continue to shape market sentiment. This is occurring as the industrial sector moves from a period of robust pandemic-era demand to a more moderated flow of activity. There is concern that current economic conditions might prompt some occupiers to retrench or push decision-making into 2024. An expected drop in deliveries in 2024 could even out the supply equation, however.

First Industrial Realty Trust, which reported a 98.7% occupancy level for the first quarter of 2023 and a 58.3% increase in rental rates YOY, expects 400 msf to 450 msf of new product to come online this year in the 18 markets they are active in. The company focuses on supply-constrained markets, such as Southern California, New Jersey and the Lehigh Valley.

That influx of new space may be a short-term issue, however. First Industrial expects construction activity for 2024 to moderate, bringing vacancies back to current levels or even lower by the end of 2024. With many REITs focusing on supply-constrained markets such as Southern California, they could be insulated from any long-term fallout from an uptick in vacancy rates.

Prologis’ projections call for the average U.S. industrial vacancy rate to be in the mid-3% to lower 4% range over the next 18 months due to strong demand as well as a lack of supply coming online in 2024.The company remains bullish on markets such as Los Angeles County and the Inland Empire, given the strong market conditions keeping vacancy rates between 1% and 2%. Company executives are watching some markets, such as South Dallas and Atlanta, due to the potential for softening demand and overbuilding.

Long-term REIT returns

An Avison Young research review of U.S. NCREIF NPI quarterly returns shows yearly declines over the last year for all property sectors except hotels, which posted a 3.27% return. The data is based on lagging data available through Q4 2022. The declines were attributed to rising interest rates and other factors that have slowed investment deal velocity. The industrial return was - 3.56% in Q4 2022, compared with -4.80% for office, -3.21% for multifamily and -1.61% for retail.

A review of FTSE Nareit Equity REITs as of late April 2023 showed all sectors with negative performance over a one-year period. The return for industrial was -20.5%, versus -29.4% for multifamily and -48.3% for office. Free-standing retail fared the best, recording an -8.4% return compared with shopping center retail (-16.9%) and hotel properties (-21.2%).

When viewed over a three or five-year horizon, however, the returns are more positive for all sectors except office, which continues to record rising vacancies due to work-from-home shifts and other factors. Over a three-year period, the industrial sector posted a 13.7% return, but was surpassed by all other sectors except multifamily (7.7%) and office (-11.2%). Shopping center retail recorded the highest return (27.9%), followed by hotel (18.7%) and free-standing retail (16.6%).

Industrial showed higher returns over a five-year period and had the highest return (15%). Free standing retail (9.0%) was next, followed by multifamily (6.3%), shopping center retail (5.6%), hotel (-4.4%) and office (-9.0%).

The industrial sector continues to show its resilience and ability to outperform many other asset classes, but there are headwinds on the horizon. The next 12 to 18 months will be yet another test of this sector’s ability to persevere in light of macro-economic conditions and shifting market dynamics.

Sources: AVANT by Avison Young, Bisnow, FTSE, Factset, NAREIT