Warehouse Activity Cooling Down as Interest Rates Fire Up

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The view from industry experts and business

There is anticipation in the supply chain that logistics warehouse activity could reduce due to the rise in interest rates. This is because of the expectation that developers and investors may have second thoughts about any frenetic activity as they face the reality of higher capital costs. Data from the 2nd quarter of 2022 shows that the 12-year bullish market for US logistics warehousing will likely end soon. At the same time, there is the expectation of e-Commerce growth, meaning that businesses must raise and maintain inventory levels. 

Unprecedented price levels

During the 2nd quarter, the industrial construction pipeline reached an unprecedented 699 million square feet, a rise of 112% compared to pre-pandemic levels. Indeed, the latest reading is 177% larger than the 10-year average, as reported by Cushman & Wakefield (NYSE: CWK).  The real estate services firm released data indicating that new leasing activity for 2022 is likely to exceed 800 million square feet. This would be the second time such a statistic has been reached. 

The national vacancy rates fell during the 2nd quarter by 3.1%. This is 120 basis points below 2021. Virtually all canvassed regions in the US region reported under 4% vacancy rates for the 2nd consecutive quarter. Indeed, up to 20 markets reported vacancy rates of less than 2%. Chicago is a microcosm of these trends as the largest industrial market in the USA. Currently, Chicago reports 1.2 billion square feet of inventory. About 8.1 million square feet were developed, according to the latest statistics. 

This is the greatest 2nd quarter completion total in the entire history of the market, as reported by Colliers International Group Inc. (NASDAQ: CIGI). Furthermore, 20 projects total  8.1 million square feet. These commenced during the quarter for the Chicago market. Hence, there was an uptick in vacancy rates for speculative development. This means that certain projects are undertaken without any formal end-user commitment. Chicago also reported a reduction in leasing activity for the category. 

Is this market becoming tighter?

Some experts have questioned whether these indicators of a tight market are a trend or a mere blip. We are now a fortnight into the 3rd quarter of 2022. There is anecdotal evidence to make more confident predictions about the market. Investors had pumped a lot of money into the industrial market. Many were looking for higher yields in a low-interest context. Now, these investors have something akin to buyer’s remorse or food for thought. The key concern is how price real estate returns will pan out during a high-interest rate context. Others are thinking about the future direction of borrowing costs, given that the Federal Reserve has adopted an aggressive tightening mode.

According to Jack Rosenberg of Colliers in Chicago, cap rates are rising due to the higher cost. These cap rates determine the annual returns on property investment. This is achieved by dividing property values by net operating income. The industry should pay attention to his insights since Rosenberg is the national director of logistics and transportation, representing industrial tenants. Rising cap rates imply that any investment yields less than if interest rates were lower.  

The search for accurate data

There is a lack of clarity about the rate hikes’ extent, speed, and duration. Development rarely grows in such circumstances. If people do not know what cap rates will look like in the next year, it creates challenges when making decisions about leasing and reselling. Speaking on condition of anonymity, some developers and investors are beginning to pause their activities. For example, spring projects have been quietly moved to next spring. At the same time, sales prices in terms of per square foot quotations are falling. Indeed, some buyers routinely request modifications of contracts in their favor for projects already under contract. 

There has been widespread angst concerning the Fed’s decisions recently. Lisa DeNight of the Newmark Group (NASDAQ: NMRK) suggested that rising capital costs are leading to a halt in certain projects or complete abandonment of others. There are some reports of developers selling development sites. The slowing of new construction is expected in this climate. Nevertheless, it must be noted that new constructions remain historically elevated. 

Understanding a transformed business cycle

We seem to be facing a different cycle from the past. However, this is not the first rate-tightening cycle when one examines the records at least from 12 years ago. The current circle’s difference is the fact that it dovetails with construction cost inflation. Other factors include long lead times for materials and labor shortages. This is a direct consequence of the global supply chain disruptions that rage on today. 

Typically, commodity prices fall as bottlenecks ease. This reflects an expectation in the market that the higher rates curtail end supply. Hence, more supply will come into the market at lower prices; however, that pattern is not expected to hold true until the beginning of 2023 if the projections from Newmark are to be believed. 

Currently, the construction for new industrial projects is taking nearly half a year longer than it did in 2019. The average order lead time for a critical commodity like roofing materials ranges between 30-50 weeks. Understaffed local governments are processing building permits at a slow pace for understandable reasons. Two years of challenges have hampered virtually every stage of construction. No dramatic change in that situation is expected in the rest of 2022. 

Constructing despite an unfriendly rates market

The high interests notwithstanding, most projects that are in progress are likely to be complete, according to John Morris of CBRE Group Inc. (NYSE: CBRE). The predictions from the Americas president of industrial & logistics indicate the 12 to 18-month lead time for completions implies that it will take anywhere between 5 to 6 quarters for the full impact of the rate hikes to impact the industrial market dramatically. 

Currently, occupier demand is high even as e-Commerce stays high. Indeed, some tenants are anxious to occupy properties before the peak holiday season. According to some experts, overall occupier demand is 95% of what it was in 2021. That means that any slowdown is likely to emanate from the supply side instead of the demand side. 

Client responses to the market

According to industry insiders, few clients place their leasing needs on hold. However, others acknowledge that clients are sometimes behind the timeline of changes in the market, meaning they may eventually react to the interest rate hikes. Indeed, some projects may already be in the process of being shelved without informing industry experts. Therefore, the situation remains fluid. 

Nevertheless, Carolyn Salzer of Cushman (head of logistics and industrial research) argues that the supply-demand scales are currently weighted in favor of lessors. The space for occupiers is tight, and accommodations are being made to help tenants who want to join the market. This tends to happen in situations where tenants are advantaged by excess supply; however, that story is likely to occur in 2023, not 2022. 

Wrapping up

The key determinant is whether there is an expectation that the interest hikes will trigger a recession. That may lead to a noticeable drop in consumer demand. Where demand is falling, rents fall while vacancy rates increase. If the economy can avoid a contraction, then developments will continue. The competition for available space will hold, and prices or rents will rise. There are many crosscurrents that create some level of uncertainty. Stakeholders are usually accustomed to some level of predictability, which they are not getting currently. 

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