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Beat Goes On: E-Commerce, Strong Returns Fuel Bullish Outlook for US Logistics Investment

Capital From Every Direction Flowing Into Non-Traditional US Distribution Hubs as Land Costs, Pricing Rise
February 7, 2018

IDI Logistics recently sold a 2.2 million-SF portfolio in Ohio and Mississippi to Granite REIT for $122.8 million. Owners are starting to list industrial portfolios in a broad array of US markets.

The industrial real estate market's remarkable growth run is continuing into 2018 as internet commerce demand prompts investors and developers to pour more and more capital into logistics portfolios across a growing array of second- and even third-tier U.S. markets.

The push by Amazon and other e-commerce sellers to invest in the "last mile" of their distribution networks to support next- and same-day delivery is driving a burst of development and investment activity into smaller warehouse and distribution properties, even as building and land prices continue to appreciate in traditional coastal U.S. logistics hubs.

Despite the boom in warehouse and logistics construction, the U.S. industrial vacancy rate decreased in the fourth quarter of 2017 to 5.1% -- lower than in any quarter leading into the Great Recession, according to data presented at CoStar's recent fourth-quarter 2017 State of the U.S. Industrial Market webcast. In total, warehouse and distribution tenants absorbed roughly 70 million square in the U.S. in the final three months of the year, with one-third of that total occurring in the major distribution hubs of Dallas, Atlanta, Chicago and Memphis.

While the pace of rent growth is beginning to ease as new supply comes online, e-commerce demand shows no sign of abating. Amazon has signed major leases recently in the Inland Empire, CA; Denver, Dallas, Portland and Salem, OR; Philadelphia, Trenton, NJ and Phoenix.

The e-commerce giant's activity is pressuring brick-and-mortar retailers with online stores to compete with Amazon’s quick delivery, with Target, Walmart, JCPenney and Macy’s retooling their omni-channel offerings, either by expanding their distribution footprint or with third-party logistics providers.

"There is an increasing appetite for 'right now' shipping options, meaning e-commerce retailers will need to invest in more industrial spaces to meet the demand," noted Richard Kalvoda, senior executive vice president with Altus Group Ltd, which recently released findings from its recent Real Confidence Executive Survey. Asked where they expected to see the best returns for real estate investment in 2018, respondents gave industrial the highest allocation for the second year in a row.

Private-equity capital and investors from around the globe are crowding into the unconventionally sexy warehouse sector. Industrial was the only major commercial property type to post annual sales growth in 2017, with total volume edging up 2% from the prior year to $75 billion, even as activity has decelerated since reaching record-shattering levels in 2015 and 2016, according to CoStar data.

Many investors have expanded their horizons after being priced out of primary markets. Long gone are the days when San Jose and Phoenix were considered secondary markets.

"As third-party logistics firms and retailers have built out their supply chains to minimize the threat of disruptions and reach online shoppers more quickly, demand has increased for industrial buildings of all shapes and sizes," said CoStar senior managing consultant Shaw Lupton, who co-presented the State of the U.S. Industrial Market report with Rene Circ, director of U.S. industrial research at CoStar Portfolio Strategy.

Such facilities include highly functional logistics buildings where online orders are initially fulfilled, midsized sortation centers through which regional shipments pass and last-mile delivery centers positioned to serve local populations in the same day.

"Investors are consequently finding opportunities to purchase buildings leased to credit tenants in places that would not traditionally be considered tier-one distribution markets," Lupton added.

With demand still chasing supply in many markets, prices of warehouse and other industrial properties keep appreciating, despite the moderating sales growth, Circ said.

Industrial repeat sales grew by an annual 12% in the fourth quarter, nearly double the 6.3% growth of the multifamily sector and nearly three times the growth of the office sector index, according to the value-weighted CoStar Commercial Repeat Sales Index (CCRSI) for the last three months of 2017.

Logistics and other industrial property was the only major property type to show growth in annual sales volume, climbing 2% in 2017 from the prior year to $75 billion. While down from the record trading volume in 2015 and 2016, the large logistics portfolios that drive sales are have resumed trading in recent quarters as Blackstone, investors from China and other buyers have poured into the market to scoop up the shrinking supply of for-sale properties.

"Very few institutions are over-allocated to industrial," Circ said. "Until a couple of year ago, most investors were under allocated."

In the largest deal of the fourth quarter, Blackstone, which re-entered the industrial market last year, acquired a 38-property portfolio totaling 4.4 million square feet in the Southern California cities of Chino, City of Industry, La Mirada and Ontario. The giant private equity company, which bought the portfolio from Principle Real Estate Investors for approximately $500 million, or $113.44/SF, will be an even larger factor in the first quarter of 2018.

Blackstone in January agreed to buy Canada-based Pure Industrial Real Estate Trust, which owns and operates industrial properties across North America, in an all-cash deal valued at about $2 billion. In another large end of the year deal, IDI Logistics sold a 2.2 million-square-foot portfolio in Ohio and Mississippi to Granite REIT for $122.8 million.

"Some large portfolios have already hit the market and others will entering the market this year, so I would not be surprised if 2018 is as strong as last year for the industrial segment, amid slight declines in the other property types," Lupton said. "We see very strong interest from our institutional investment clients - both the traditional investors with a track record, as well as clients that would like more exposure to industrial. Along with very strong rents and income growth, it continues to drive pricing up," Lupton said.

There are a few yellow flags because of the heavy construction in certain markets. Speculative projects account for a greater proportion of recent deliveries and projects under construction last year and while leasing velocity has been impressive, the waters will be tested in 2018 when record levels of new inventory enter the market.

That said, core logistics property capitalization rates were at an all-time low of 4.4% at end of 2017, compared to 4.7% at the peak of the last cycle, Circ said. However, the spread between industrial cap rates and the U.S. Treasury rate is nearly 200 basis points, compared with just 70 bps 10 years ago.

"There's definitely plenty of cushion in the spreads, which is why we believe industrial prices can continue to rise, even in this somewhat scary part of the cycle," Circ said.

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