Trepp LLC

07/24/2020 | News release | Distributed by Public on 07/24/2020 08:40

Increasing Inventory Levels, E-Commerce Demand Fueling Industrial Market

In the late 1980s, companies in the United States began adopting the so-called 'just-in-time' supply chain strategy that was popularized in Japan. The goal was to reduce costs by decreasing the amount of inventory carried.

Just-in-time also was known as the Toyota Production System as it was adopted by Toyota Motor Corp. Initially, it was relied upon by manufacturers to reduce inventory carrying costs. It's also been adopted widely by retailers through drop-shipping, where third parties deliver items directly to customers who placed their orders online. It has allowed retailers to sell items that they haven't even purchased and placed into inventory.The strategy promises to reduce inventory fees by more than any increase in transportation costs. But it's not necessarily sure-fire as it relies on an efficient transportation network to succeed.

The coronavirus pandemic has shown other drawbacks to the strategy. Companies first began experiencing issues in January and February when manufacturing in China closed as a result of the virus' outbreak, delaying the shipment of goods to the U.S.

In March, when the pandemic started having a major impact domestically, supply chain issues were magnified. Companies were unable to fulfill orders from customers for items ranging from household products to medical supplies, including ventilators and personal protective equipment (PPE).

As such, industrial property owners and brokers predict companies will decide to carry more inventory, or so-called 'safety stock,' to deal with any supply chain issues that may arise in the coming years. They also noted that the state and federal government would be looking to carry more supplies in case another pandemic occurs.

For instance, Prologis Inc., a San Francisco industrial REIT that owns 528.1 million square feet of space in the U.S., projects that inventory levels could increase by 5 to 10%, leading to an additional 285 million sf to 570 million sf of industrial space demand in the next two to three years.

'Just-in-time is not looking so good right now with this disruption,' said Dwight Merriman, the head of industrial real estate for Black Creek Group of Denver, which owns 35.3 million sf of space in that sector. 'That's going to be re-thought. Companies don't want to get stuck short again like they have during this crisis.'

The pandemic, in particular, contributed to disruptions for e-commerce retailers that saw a surge in demand, as stay-at-home orders designed to stem the spread of the coronavirus forced nonessential retailers to temporarily close. But even before the pandemic, e-commerce already had been growing at a healthy pace in recent years.

During the first quarter, e-commerce retail sales increased by 14.8% from a year earlier to $160.3 billion, according to data from the U.S. Census Bureau. Total retail sales, meanwhile, increased by 2.1% to $1.36 trillion during that same period. E-commerce accounted for 11.8% of retail sales in the first quarter, up from 10.5% a year earlier and 9.6% in the first quarter of 2018.

The Census Bureau noted that non-store retail sales, which include e-commerce as well as orders through call centers, catalogs and television infomercials, increased by 21.6% in April compared with a year ago and by 8.4% compared with March. Total retail sales in April, meanwhile, declined by 21.6% compared with a year earlier and by 16.4% from March.

The Census Bureau data underestimates the impact of e-commerce because it factors in total sales categories such as automobiles and gasoline that are usually not sold online. PGIM Real Estate estimates that if those categories are excluded, e-commerce accounts for 17% of retail sales. The Newark, N.J., affiliate of Prudential Financial expects that e-commerce could increase to 20%of sales within the next year.

'E-commerce was already doing well and continuing to grow at a pretty unbelievable pace,' said Steve Schnur, chief operating officer at Duke Realty Corp., an Indianapolis REIT that owns 156 million sf of industrial space. 'And then you throw in a pandemic and a shelter-in-place order, and all of a sudden you've got a huge tailwind.'

Since the pandemic began, large e-commerce companies such as Amazon.com Inc. have been actively leasing space, as have traditional brick-and-mortar retailers like Target and Walmart, which are increasingly selling goods online, while expanding their industrial space to meet customer demand and shore up their inventory levels.

Amazon already was a dominant player in the industrial sector, including being the largest tenant as of the end of the first quarter for such REITs as Prologis, with 25.3 million sf; Duke Realty, with 9.7 million sf; and First Industrial Realty Trust of Chicago, with 1.9 million sf.

Since April, Amazon has completed leases with property owners throughout the country, including inking a deal for 749,600 sf in the Chicago suburb of Channahon, Ill.; a 1 million-sf warehouse in University Park, Ill., also a Chicago suburb; more than 1 million sf in the Crossroads Business Center in Atlanta; and 1 million sf in the Dallas suburb of Forney, Texas.

'We saw Amazon's demand models change' as a result of the pandemic, said Michael Yocco, managing director at Elion Partners, a Miami investment manager that specializes in industrial investments. 'They had an immediate need for more square footage in almost every major market.'

While large e-commerce companies have continued to expand, some smaller tenants have vacated or taken less space as their businesses suffered due to the pandemic. That could lead to an increase in the vacancy rate, which stood at 5.2% at the end of the first quarter, the same as a year earlier and near an all-time low, according to JLL. Five markets had vacancies below 3.5%: New York City, with 2%; New Jersey, with 2.3%; Orange County, Calif., with 2.7%; Long Island, N.Y., with 3.3%; and Nashville, Tenn., with 3.4%.

With property tours limited during March, April and May due to social distancing protocols, industrial property owners looking to fill vacancies were more willing to lease space on a short-term basis, primarily to retailers that typically house most of their inventory in their stores. With stores temporary closed due to government mandates, retailers needed to house the inventory they had ordered before the pandemic hit. Most of those leases are for three to 12 months.

'Before the pandemic started, it was very tough to find that type of short-term space,' said Kyle Eaton, a managing director specializing in the industrial sector at NKF. 'Now, some landlords are considering shorter-term deals whereas before they wouldn't do that whatsoever.'

Property owners also are more willing to work with tenants who are having trouble paying their rent. Kris Bjorson, a managing director at JLL specializing in the industrial sector, estimated that industrial landlords collected on average 90% of their rents in April and May. He added that about 5 to 10% of tenants he works with have received rent deferrals, most of which are for three months. Tenants are expected to pay back the rent within six to 24 months, Bjorson noted.

Collection rates have been better for most large REITs. Prologis, for example, collected 97.6% of its April rent and 95% of its May rent; Duke Realty collected 98.3% in April and 95.4% in May; and First Industrial collected 97% in April and 96% in May.

Schnur noted that collection rates in the industrial sector have been higher than in other property types, except for apartments. But he said that the investment-sales market has been slow since the pandemic began as lenders have become cautious as they assess economic conditions and collection rates. In addition, the owners that have offered properties for sale have valued them much higher than what buyers are willing to pay.

Still, Schnur said that the industrial market would benefit in the long-term from the growth of e-commerce, companies looking to produce more goods in the U.S. and tenants with more inventory.

'All that points to future demand in the industrial sector,' he said. 'I think people are going to realize there's still a lot of runway left here. There's a significant amount of money that would like to get into this sector.'

This article was originally published in The Mid-Year 2020 magazine, which contains additional research from Trepp and Commercial Real Estate Direct analysts. Download your complimentary copy of the magazine here.

Disclaimer: The information provided is based on information generally available to the public from sources believed to be reliable.