Industrial real estate is one of the hottest property types these days. Demand for warehouse space is rising steadily, driven by the accelerated adoption of e-commerce and supply chain issues, forcing companies to keep more inventory on hand. Because of that, industrial REITs (real estate investment trusts) are leasing space at breakneck speed, driving up rental rates.
For the most part, the industry has kept up with demand by steadily adding new supply. However, it's getting harder to develop warehouse space, suggesting the market will remain tight. That's another reason why investors should consider adding industrial REITs to their portfolios.
The supply conundrum
Industry leader Prologis (NYSE: PLD) released a white paper last month detailing the issues the industry is facing as it races to meet demand by developing additional warehouse space. The company noted several issues it believes would cause completions to fall short of demand in most key logistics markets over the next decade. These problems included:
- There are significant barriers to new supply.
- Building requirements are increasing.
- Differentiation among properties is widening.
Prologis pointed out that land suitable to accommodate the development of future-proof logistics facilities is growing increasingly scarce, especially in large metro areas. Many cities are converting industrial-zoned land to other uses, like residential. Meanwhile, logistics buildings have gotten large, thus requiring more land.
Further, replacement costs are surging, including the price of land. According to Prologis, replacement costs have risen 60% over the last five years, including 15% already in 2021. Making matters worse, the permitting and entitlement process has gotten increasingly difficult, expensive, and time-consuming, as communities don't want these buildings in their backyard.
Also driving up development costs are additional features that tenants desire because they support improved productivity. Likewise, sustainability features such as increased energy efficiency also add to development costs. These factors also differentiate properties, making older buildings obsolete, as they can't meet the needs of many e-commerce customers.
No easy solution
Location is a crucial factor for many companies seeking last-mile distribution space. They need to be close to their customers in urban areas to deliver goods as quickly as possible. Unfortunately, that space comes at a premium.
One potential solution is to convert underutilized retail space into distribution facilities. However, Prologis doesn't view this as a viable option for many reasons. For example, this space would have a higher and better use for multifamily development to help address affordable housing issues than being used as logistics space. Further, politicians are less likely to approve rezoning retail space to industrial due to the loss in sales tax revenue. Meanwhile, most retail locations are too small for logistics uses.
Because of that, Prologis estimates that the industry will only be able to convert 50 million to 100 million square feet of retail space to logistics space in the U.S. over the next 10 years. For perspective, that's only 3% of the industry's total requirement in a typical year.
Increasingly valuable real estate
Development becoming harder to complete means existing logistics buildings are even more valuable, because they should capture steady rental rate increases. For example, Prologis noted that its current in-place rents are 16.9% below market rates. As the company brings them up to market rental rates when existing leases expire, it will drive significant income growth. The current spread alone represents $700 million of incremental NOI, or $0.90 per share, a substantial uplift for a company that generates $3.2 billion in annual NOI.
Because of this factor, Prologis noted that the value of its assets rose by 8% in the second quarter, the strongest quarterly increase in its history. That number should continue expanding as Prologis benefits from low vacancy rates and continued rental rate growth.
A great industry for real estate investors
Prologis will be a big beneficiary of the industry's supply crunch. Not only does it already own the largest portfolio, but it also has a leg up on the competition when it comes to expansion because it controls enough land to support $18 billion of future developments.
However, it's not the only industrial REIT that will benefit from tightening supply. That trend will drive down industry vacancy rates and push up rental prices, making the sector's existing properties more valuable. Because of that, investors should consider adding some exposure to industrial real estate to their portfolio, with these leading REITs a great place to start.