Warehouse Rents on the Rise Despite Dropping Demand

Despite decreased leasing activity, industrial rents in the U.S. surged to an all-time high in the last quarter. Here’s why.

Record high: U.S. warehouse rents reached a record high in Q2, averaging $9.59 per sq ft, a 16.1% year-on-year increase. This rise extends a four-year trend, which has seen a 50% price increase since spring 2020 due to pandemic-induced consumer demand. Some regions, like Tampa Bay, FL, experienced an even steeper climb, with rents surging 32.2% in the same period.

Slowdown in demand: However, alongside rising prices, vacancy rates for industrial real estate also increased to 4.1% in Q2, up from nearly 3% in late 2022. The demand for storage sites has significantly dropped with newly-leased space falling by almost 36% in Q2, as consumer spending shifted from goods to services and large retailers aimed to eliminate excess inventories.

Tight market conditions: This seeming paradox of falling demand and rising prices can be attributed to the unique dynamics of the industrial real estate market, where leasing decisions are typically based on long-term projections instead of short-term market conditions. Despite the rise in vacancy rates, the broader market for warehouse space remains historically tight, with availability still substantially below pre-pandemic levels.

Construction trends: Leasing dynamics are also impacted by changing consumer behavior and fluctuating interest rates. Companies, particularly suppliers to manufacturers opening U.S. facilities, are still competing for space, thereby driving up rents. Newly constructed facilities, better designed for modern logistics strategies, are replacing older ones and adding to the average rental rate, albeit tenants now have more options due to this new construction.

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Why it matters: Developers have begun to pull back on projects due to decreased leasing activity and rising interest rates. This may cause a shortfall in logistics space and increase pressure on rents. Construction starts by Prologis, the world's largest builder of logistics properties, fell about 40% in Q2. Analysts expect rents to continue rising, though at a slower pace than during the peak pandemic period, with no projections for a downward trend.

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Starwood 'Foaming at the Mouth' to Deplpoy Capital Despite Market Uncertainty

Starwood Property Trust's Q2 earnings fell by 20%, even as revenues rose. CEO and billionaire Barry Sternlicht criticized the Fed, predicting a potential recession due to climbing rates and a challenging real estate landscape.

Market view: Sternlicht criticizes the Federal Reserve's actions, suggesting they have fostered a disincentive for stakeholders to sell real estate properties unless absolutely necessary. Furthermore, he highlights the unintended consequence of swift interest rate hikes, which, despite reducing inflation significantly, have entrapped the Federal Government, burdened with $32 trillion debt, in a detrimental cycle of escalating payments.

Economic impact: Despite a recent decline in inflation, Sternlicht equated the economy to an “icy lake with visible cracks.” These cracks represent maturing loans in private equity, technology, and real estate. Sternlicht predicts a downturn across all asset classes due to the Fed's policies, with real estate bearing the brunt of the impact.

Q2 earnings: Starwood reported a decrease in second-quarter earnings, down by 20% compared to the same period last year. However, its revenue saw a substantial increase of 58%. The company has worked to bolster its liquidity through initiatives like issuing $381M in convertible notes and receiving $1.3B of commercial and infrastructure loan repayments.

Acquisitions plans: Starwood has also made headway with its loan recoveries and real estate acquisitions. In particular, the firm foreclosed on a $42 million loan for a retail building in downtown Chicago. Additionally, the company aims to be fully reimbursed for other real estate-owned properties it has acquired through foreclosure.

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Zoom out: Starwood's conservative market approach provides it with an edge over competitors, with Sternlicht suggesting that the company's special servicing platform, LNR, is their "secret sauce". Despite the market uncertainties, the firm is keen to deploy capital and is confident about its non-income producing assets. This strategy could unlock further earnings power for the company, reinforcing Sternlicht's belief in navigating the challenging economic environment in a safe yet beneficial manner.

Demolishing Office Buildings for the Dirt Underneath Is Latest Property Bet

Vincent Chiara's firm, Groupe Mach, has spent over C$1 billion since 2020 on underpriced Canadian office buildings, betting on their land value for potential redevelopment.

Banking on the dirt: Chiara's investment strategy capitalizes on the current price disparity between office properties and their underlying land. Chiara believes this difference can cover the demolition costs, making way for more in-demand residential constructions. Should office values continue to decline, he envisions converting these structures into lucrative residential projects, a tactic he dubs "land banking."

Housing crisis: The strategy is backed by a housing shortage across Canada's major cities and worldwide, enhancing the value of land that can accommodate new homes. This is exemplified by Mach's recent acquisition of a suburban Toronto property from the 1980s. The land's potential residential worth, pegged at C$250 million, significantly overshadows the C$165 million acquisition cost, thereby providing room to offset demolition expenses and permit residential redevelopment.

Leading the way: This unique approach has propelled Mach to be the second-largest buyer of Canadian office buildings since the pandemic's onset. If adopted by more developers, it could stabilize the commercial property market. Beyond Canada, Chiara's strategy could have global real estate market implications in similar situations.

The role of lenders: Chiara’s strategy has attracted the attention of major Canadian banks, which have extended loans to Mach at moderate interest rates. This suggests that lenders view these ventures as low-risk. Despite the office space market's uncertainties, Chiara sees signs of leasing recovery in his properties. However, if occupancy rates decline dramatically, he anticipates city officials will quickly grant rezoning permissions due to housing needs and the financial implications of vacant office buildings.

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Investing against the grain: Despite office buildings facing a downturn, Chiara's counter-cyclical strategy offers a unique perspective on the situation. It takes advantage of the decreased prices of office buildings, the potential value of the underlying land, and the ongoing housing shortage. Additionally, the stable lending environment and stringent loan covenants in Canada have resulted in fewer defaults. This less distressed landscape suggests that the market might be bottoming out, creating opportunities for buyers like Chiara, who provide an exit strategy for owners looking to sell their properties.

Data centers is the strongest performing sector in North America and Asia with respective returns of 19.4% and 23.9%.

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