Goodwin Insights August 26, 2020

Envisioning the New Normal: Real Estate + Technology: Part 7: Industrial

Summary

This article is the seventh of a multi-part series examining the impact of the COVID-19 pandemic on select real estate sectors and the considerations around how technologies will shape future operations and accelerate means to re-entry of physical space.

INTRODUCTION

As the COVID-19 pandemic has sent shockwaves through market operations of most real estate asset classes, the industrial sector has remained largely unscathed – and  has even seen growth accelerated by the impacts of the pandemic. While hotel, retail and office property owners and managers are grappling with the financial challenges associated with the virus outbreak and its effects, participants in the industrial market are in the midst of a robust continuation of pre-pandemic activity. Despite appearing to be insulated from the effects of the pandemic on the operational viability and marketability, every owner and operator of industrial properties faces a unique set of human health and safety-based considerations that must be addressed. Growing demand for fulfilment and distribution centers provides a unique opportunity for real estate investors and operators in the industrial sector to embrace supply chain logistics technology and implement strategies for investing in and operating in the industrial market in the new state of the world.

STATE OF THE MARKET

Increased consumer e-commerce spending, which has been trending upwards in recent years and has undoubtedly been aided by the pandemic, has sparked demand for warehousing space and distribution centers, especially in and around major metropolitan areas and population centers. As a result, the industrial market has been perhaps the only commercial real estate asset class where property values are rising.

A primary driver of the strength of the industrial market is the fast-tracked rise of e-commerce. Jones Lang LaSalle (“JLL”), a professional services firm specializing in real estate and investment management, predicted in a June 2020 article that total e-commerce sales could hit $1.5 trillion by 2025, requiring a projected increase in demand of an additional one billion square feet of industrial real estate in the United States or globally. COVID-19-related government regulations, general consumer safety tendencies, and convenience have amplified the shift from brick and mortar retail to online shopping, which was already well on its way prior to the COVID-19 pandemic. This is not limited to the U.S. markets, as European markets are similarly seeing increased investment and demand in logistics.

THE ”AMAZON EFFECT”

The “Amazon Effect” is centerstage when it comes to the state of leasing activity in the industrial sector. Amazon’s demand is so robust that it was recently reported that the company is looking to repurpose big-box retail space previously leased (or, in some cases, still currently leased) by mall anchor tenants J.C. Penny and Sears as fulfilment centers in locations across the U.S..  While Amazon continues to be in a class of its own when it comes to leasing fulfilment and distribution centers, the general move away from brick and mortar retail has resulted in strong demand for leasing industrial properties across the country. Traditional big-box retailers like Walmart and Target are also more active in the e-commerce market, now offering same or next-day shipping options to large numbers of Americans in an attempt to draw business from Amazon. Moreover, generally bolstered by this Amazon Effect, landlords have found that they have additional leverage when re-negotiating and/or releasing industrial space even to smaller tenants to push for higher “market” rental rates.     

While proximity to major metropolitan areas is obviously attractive for this (or any) asset class, industry leaders are also seeing increased demand for sites that can accommodate fleet-vehicle parking and ingress and egress solutions, and access to intermodal facilities as sites providing those specifications are viewed as more attractive by the big last-mile distribution players. The Amazon Effect can also be seen in less populated and rural areas where demand for last-mile distribution remains comparatively high, however there are fewer of the most attractive e-commerce tenants currently willing to lease space in those markets, making these investments more risky.  Even some of the big-box tenants have tended to remain closer to metropolitan and more heavily populated suburban areas.  Investors have found that in pursuing industrial sites in the less populated areas, the results to leasing can be quite binary. That is, either, landlords are able to sign one of the few biggest e-commerce players as tenants for fulfillment and distribution centers, or they are left to market the site to less creditworthy local industrial businesses where it may be difficult to negotiate anticipated rents. This “boom-or-bust” scenario is one to track in coming months. 

Most commercial real estate owners have faced challenges filling vacant space, collecting rent and responding to rent abatement and restructuring requests in the wake of the pandemic. This is no different in the industrial sector. However, in comparison to other asset classes, owners of industrial properties are seeing lower vacancies and more economically resilient tenants –obviously aided by consumer demand, but also “essential business exemptions” that allowed industrial tenants to remain open for business throughout the pandemic. Unlike other asset classes and as a result of the market factors described above, rental rates in the industrial space are also in an “up” market. As such, landlords have been faced with balancing the fact that many tenants who request economic flexibility resulting from the pandemic based on leases that have been in effect for some time may well already have below-market rent terms. This places landlords in a difficult situation of determining how to balance general tenant relations and assisting tenants with understandable pandemic-related business obstacles with maximizing property value – which  in certain instances might incentivize landlords to enforce rights and to push for tenant vacancy so that the space can be relet at market rents.  

HOW REAL ESTATE IS PARTNERING WITH TECH TO MEET CONSUMER DEMAND

E-commerce giants often develop – or work with third parties to develop – customized technology to meet their supply chain logistics needs. Companies not only need nationwide distribution networks, but also fulfillment centers and “last mile” delivery solutions that get goods to consumers’ front doors as fast and efficient as possible. As a result, e-commerce players are increasingly requiring customized build-out of space to implement and incorporate their supply chain technology and logistical solutions.

The result is that owners of industrial real estate looking to cater to e-commerce tenants are facing tougher leasing negotiations as a result of the desire for “smart” warehousing – distribution and fulfilment spaces that  are customized to tenant needs. Also, the biggest e-commerce players each have a separate proprietary technological approach to preparing their respective warehousing, distribution and fulfillment centers. As such, landlords are generally finding it difficult and of diminishing value to incorporate specifications into an industrial facility prior to marketing the space that would be attractive to a number of the most attractive tenants. Industry leaders have responded by favoring investments that follow this blank-slate approach to maximize flexibility for interested tenants. Landlords and prospective buyers of industrial real estate are looking for certain important infrastructural aspects to a property (such as ample parking, ingress and egress solutions, and large spaces providing ability to incorporate applicable intermodal facilities).

Technology has had a profound effect on lease negotiations in the industrial space. When negotiating tenant improvement allowances for industrial space prior to the e-commerce boom, landlords in the U.S. could often set market at or below approx. $4.00/square foot. Now, to bring in some of the most attractive e-commerce tenants, that number can be as high as $7.00/square foot in the most attractive markets.  Real estate owners in the industrial space are showing more flexibility – both in their willingness to foot some of the bill required to build out intelligent spaces, but also in their willingness to invest in property that would have previously been considered outdated or substandard with the understanding that significant tenant improvements will be required.

SAFELY OPERATING AND RETURNING TO WORK IN THE COVID-19 ERA

Undoubtedly aiding the resilience of the industrial sector (specifically, e-commerce) during the pandemic is continued investment in automation. The 2020 Honeywell Intelligrated Technology Study, published in early July 2020, found that e-commerce and logistics were two of the three industries most willing to invest in the automation of their operations.  

In some respects, certain inherent characteristics of industrial property that existed prior to the COVID-19 pandemic have created an easier path to “return to work” or to a “new normal” for landlords and tenants of industrial properties. Industrial properties are generally expansive spaces that allow for social distancing. The nature of occupying a warehouse is such that employees do not need to be together in confined spaces. Given that industrial uses often involve a certain level of hazardous materials, operators are familiar with implementing and administering health and safety protocols. This is particularly true with cleaning and sanitizing needs which now will be emphasized more than ever before.

Increased spending on tenant improvements also presents an opportunity for landlords and tenants moving forward. In addition to building out space that incorporates the technology required to meet supply chain needs, landlords and tenants can intelligently design cleaner, safer and COVID-19-resilient workspaces.

LOOKING FORWARD

An e-commerce boom aided by the advent and expectation of “next day delivery” and accelerated by COVID-19 “stay at home orders” has resulted in unprecedented demand for warehouse and distribution space across the United States and Europe. As industrial tenants work to rapidly expand their businesses to meet demand – while continuing to refine and develop the technological advancements that allow for the supply chain to meet consumer demand –landlords, e-commerce tenants and prospective purchasers of industrial real estate are responding to a lack of supply available with the associated necessary infrastructure to satisfy such demands. As such, many landlords and prospective buyers have begun to look to distribution centers with out-of-date technology and infrastructure, understanding that through negotiations with potential tenants, significant tenant improvement costs will need to be shared between the parties to get these sites ready for tenant use. Despite the increased improvement costs, industrial assets remain not only a viable investment strategy but also an even more attractive asset during the pandemic because companies are able to implement social distancing protocols and additional employee safety precautions as they work to prepare the sites for occupancy. As e-commerce becomes the new normal in the COVID-19 age and companies strive to develop and implement the technology and infrastructure required to efficiently distribute, fulfill and deliver products, industrial real estate owners and investors must similarly be willing to adapt and embrace technology.  

PART 8 PREVIEW: Cross-over

The next and final article in our Envisioning the New Normal: Real Estate + Technology series will summarize the core themes across real estate sectors, highlighted in the series. A variety of technological demands on real estate operations have been surfaced by the health crisis – building safety, data, privacy, network efficiencies, supply chain disruption, and space utilization, among others. Adoption of responsive technologies is providing resilience to real estate businesses during the pandemic and will also position real estate companies for sustainable long-term growth beyond the recovery period.