With all the recent worries about defaults and higher interest rates leading to lower valuations in commercial real estate, investors may wonder if it is worth considering the asset class in the current environment. However, commercial real estate is a broad definition with many asset classes including office, multifamily, industrial, retail, healthcare, hospitality, etc.
We believe active management is important with any asset class, especially when it comes to security selection. That is why we’ve avoided most commercial real estate asset classes–with the exception of industrials, where we are overweight. For example, we made the case back in November 2022, asking is Mexico the next China?
To help understand our investment logic, here are some tailwinds and headwinds facing owners of industrial real estate:
Short Term Tailwinds
- New supply is constrained due to tight development financing & increased labor costs.
- Inventory rebuild across industries (especially with change from just-in-time to just-in-case inventory).
- Net absorption is skewed towards Class-A space, which is still capacity-constrained.
Short Term Headwinds
- US vacancies are below long-term averages. Reversion to the mean suggests there may be some short-term normalization of trends. (3.4% vs. 6.8%, respectively)
- Rationalization of overcapacity brought on by higher levels of demand related to COVID.
- Near-term valuations facing the impact of lower appraisals due to higher discount rates to value new, longer leases, despite steady cash flows.
- Refinancing risk at higher rates impairs profitability.
Long Term Tailwinds
- Continued consumer spending to drive increased warehousing needs. (eCommerce)
- Global movement to onshore manufacturing locally.
- Approximately 28% of available US warehouse space is almost 50 years old, considered technologically obsolete, and likely to be replaced.
- Supply chain diversification.
Long-Term Headwinds
- Local and environmental opposition to new projects.
- Other competing real asset classes become more attractive over time as issues resolve.
- Move to longer leases (5 Yr. vs. 3 Yr.) to decrease the frequency of rent increases in the industrial space.
To summarize, we believe supply will continue to be constrained, movement to Class-A space will require new building, demand will persist due to manufacturing onshoring and eCommerce, and the supply chain diversification will continue to drive long-term demand in industrial real estate.
There may be short term headwinds, but overall, the space should continue to grow and presents a potential benefit to an investor’s portfolio.
