Investor activity has slowed in the third quarter as dynamics change
Following five quarters of strong activity, the industrial sector saw its first investment sales volume decline since early 2021. The rapidly changing economic picture fueled by rising interest rates, stifling consumer inflation and persistent supply chain shocks are having slight impacts on some leasing demand. However investment activity has curtailed immensely. While the pullback was somewhat anticipated given signals from the Fed, it points to the acute reality of our current economic situation. We believe that the current short-term Fed policy driving-up interest rates does not overshadow the long-term health, and most importantly, investor resilience, within the industrial sector.
Principal
Head of Industrial Capital Markets
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Interest rates pushing back against strong investor demand
The recent rapid boost in interest rates is prompting many investors and lenders to pull back from commercial real estate and re-evaluate their market positioning, underwriting projections and tolerance for near-term risk. While other market sectors have seen more significant sales declines, the industrial sector is now seeing its first recent sales decline, following five quarters of year-over-year increases ranging from 15% to 166%. In Q3 2022, industrial sales declined by 30.7%, a sign that investors are retrenching to re-examine their go-forward strategies amidst significant economic volatility.
The leasing fundamentals that drive the industrial sector remain very solid, with low vacancies and rising rent growth consistently the norm in many markets. The jolt from the increased cost of capital has added layers of uncertainty, but the slowdown in industrial sales is expected to be short lived. Positive industrial asset fundamentals continue to benefit owners, therefore, as lending liquidly becomes more prevalent in the coming months, we believe that investors (and sellers) will learn to comply with the new realities of the price of the debt as transaction volumes increase in the future.
According to Q3 2022 research from Real Capital Analytics, U.S. industrial real estate sales dipped 30.7% year-over-year to nearly $23 billion. There were 1,215 properties totaling 175.3 million square feet sold during the third quarter, with an average price-per-square-foot of $132. The average cap rate was 5.4%, up 11 basis points year-over-year, but still lower than rates seen before the pandemic.
The Q3 2022 sales figures follow five quarters when year-over-year sales volume increased, with a few quarters showing robust increases as investment rebounded from the early days of the pandemic. Q2 2021, for example, had a 150.7% increase year-over-year, followed by a 166.61% increase in Q3 2021.
The decline from Q2 2022 to Q3 2022 was seen across markets ranging from large metros to notable growth markets, including: Los Angeles, $17.7 billion to $16.8 billion; New York City, $9.5 billion to $9.1 billion; Chicago, $8.5 billion to $7.9 billion; Dallas, $7.3 billion to $6.5 billion and Atlanta, $6.2 billion to $5.1 billion.
A look at the first few weeks of the fourth quarter shows total industrial property sales volume recorded or pending was $14.7 billion across 620 properties totaling 170 million square feet. The sales volume is about 65% of the total for the third quarter, a sign that fourth quarter sales may rebound and finish ahead of the prior period. So far, the average price per square foot has increased to $181 from $132 in the third quarter. The average cap rate is edging up to 5.5%.
Exeter fund secures $3 Billion
One recent sign of confidence in the market is the closing of the EQT Exeter Industrial Core-Plus Fund IV at an oversubscribed level of $3 billion in equity commitments, which exceeded the initial $2.5 billion goal. The pool of investors includes entities from North America, Europe, Asia, and the Middle East, according to GlobeSt. The focus is on Class A, single-tenant big box distribution and fulfillment centers, along with last mile logistics properties and other facilities. The firm has closed 900 industrial investments totaling nearly $30 billion in gross asset value over the last 15 years.
Debt financing stains as interest rate caps rise
Rising interest rates are also pushing up pricing on interest rate caps and putting a strain on debt financing. With three 75 basis point interest rate increases since June, the Federal Reserve pushed up the benchmark federal funds rate to between 3% and 3.25%, a dramatic change from its 0.25% to 0.50% range taking place in May.
This spate of rapid rate increases have prompted many large lenders to pull back on commercial real estate lending and are pushing some companies to seek alternative financing options, such as using fixed-rate debt or hedging their variable debt.
Low vacancy, strong rental rates still the norm
Despite volatility in capital markets activity, the fundamentals driving industrial activity remain solid. A review of third quarter reporting shows that key gateway and port markets remain highly competitive, with super low vacancy rates and increasing rental rates. Avison Young Q3 2022 research shows average sales pricing for industrial assets in Los Angeles at $343.31 per-square-foot, a new all-time high for that market. With a market-wide vacancy rate of 2% for the quarter, rents are up nearly 34% from the previous year, reaching record highs. Rent growth is expected to continue to reach 10% to 15%.
In the Inland Empire, the vacancy rate is 1.3%, holding steady from the second quarter, as robust demand continues to shape market dynamics. The average sales price for the quarter was nearly $300 per square foot, an increase of 60.3% from the prior year. The average cap rate was 3.6%. Leasing velocity was also strong, with more than 10.4 million square feet leased in the third quarter, a 78% increase from the prior quarter.
Sources: GlobeSt, Propmodo, Real Capital Analytics, Wall Street Journal