Red-Hot Warehouse Market Faces a Reality Test

Since the beginning of the pandemic, warehouse owners have been able to expand their footprint and raise their rates, thanks to soaring e-commerce demand and a dearth of warehouse space in many U.S. markets.

But that growth is facing headwinds, including a slowdown in consumer spending and rapid inflation, which could test the resiliency of the business, industry watchers say.

“If the consumer stops spending because of high gas and food prices, that reduction in demand means that there are going to be less goods coming into warehouses,” said Joseph Ori, executive managing director of Paramount Capital, a real estate investment, finance and advisory firm in Walnut Creek, Calif. “It may not lead to a crash, but we’re not going to see the big rent increases that we’ve seen recently.”

The slowdown in demand is compounded by an uptick in warehouse construction that may spoil the favorable conditions. But others argue that a crash is far away, if it comes at all.

“In terms of vacancies and rental growth, we are in unprecedented times,” said Hamid R. Moghadam, chief executive and chairman of Prologis, a real estate investment trust that owns one billion square feet of warehouses and other industrial space globally.

In California, New Jersey, New York and other states where Prologis operates, market rates are about 55 percent higher than what Prologis is charging its tenants, he said. Consequently, the company can negotiate higher rates when those tenants renew leases or vacate space.

“Consumption is pretty resilient to economic cycles,” Mr. Moghadam said, “and almost everything that goes through our warehouses would be considered a basic necessity.”

Prologis, which says it has less than 4 percent of its space available, recently announced that it would acquire Duke Realty, an industrial real estate investment trust, for $26 billion in an effort to expand.

Warehouse rent has grown an average of nearly 3 percent a quarter nationally since mid-2020, reaching $9.56 per square foot in the second quarter of 2022, according to Newmark, a commercial real estate brokerage firm. In a handful of markets, including Silicon Valley, Los Angeles and Long Island, N.Y., rents exceed $15 per square foot.

Surging online purchases at retailers have fueled a good part of that growth. E-commerce sales expanded 30 percent in 2020 to $782 billion, and they rose an additional 23 percent in 2021‌‌ to $960 billion, according to the Census Bureau.

But consumer spending has slowed this year, growing a mere 0.3 percent in the second quarter. And e-commerce sales as a percentage of all retail purchases slipped to 13.9 percent in the second quarter this year, according to the Census Bureau. That was down from a high of 16.4 percent in the second quarter of 2020, according to Green Street, a commercial real estate research firm.

The most recent reading on online shopping was only 3 percentage points higher than before the pandemic and suggest that e-commerce penetration is closer to maturity than originally thought, said Cedrik Lachance, director of research for Green Street. The firm recently forecast that e-commerce would grow around 7 percent per year, down from an estimate of nearly 13 percent it made in the fall of 2020.

In addition to lowering its e-commerce growth expectations, Green Street also tempered its outlook for growth in warehouse rent, Mr. Lachance said.

“The industrial business has risen very far and very fast in recent years, and it clearly benefited from the pandemic as we all became addicts of online shopping,” he said. “But as normalcy returned and consumer behavior changed again over the last 12 months or so, you can tell that e-commerce growth is just not going to be at the same pace as what we would have expected.”

Prologis has a more optimistic outlook. In May, the company cited convenience for consumers, improving supply chains and closures of physical stores to support its prediction that e-commerce would grab 25 percent or more of all retail sales by 2025.

Other industry observers also remain encouraged by the long-term trends buoying warehouses, especially in coastal markets, like Southern California, that are substantially built-out; highly populated, inland transit hubs such as Chicago; and growing markets like Las Vegas. Despite the recent slowdown, e-commerce sales will keep growing as younger people who were weaned on a mobile device become a greater percentage of the population, they say.

Plus, warehouse leasing continues to be driven in large part by light assembly companies, midsize firms, and manufacturers of household products, construction materials and other merchandise, said Peter C. Lewis, president and chairman of Wharton Equity Partners, an investment firm in New York that focuses on real estate.

“We’re clearly bullish about industrial real estate over the next three to 10 years,” he said. But he added that he expected choppiness in the market over the next six months. “We’ve seen rents go up 50 cents a day in a world where for 50 years they went up a penny a year, and as an owner, that’s just unrealistic.”

Even now, experts say, retailers and other tenants are hunting for scarce space after abandoning “just in time” methods that kept inventories slim. Now they’re pursuing a “just in case” strategy to significantly fatten inventories and avoid the type of shortages experienced during the pandemic.

But in some cases, that newer strategy has backfired, and retailers now have too much stuff. In the spring, Target reported excess apparel, kitchen appliances, televisions and outdoor furniture after it failed to anticipate the extent of slowing demand for certain goods once federal stimulus spending stopped. Stumbles at Target and other retailers have been a boon for liquidation warehouses.

This overcorrection is known as the “bullwhip effect,” and it tends to happen in reaction to supply-and-demand disruptions, said Craig Fuller, founder and chief executive of FreightWaves, which provides supply chain markets with data analysis. As a result, freight traffic is down substantially, he said.

“Everybody expected inventories to remain quite low, and it wasn’t until April, May and June that people became aware that inventories were in fact bloated,” he said. “It’s going to take a while for this excess inventory to burn off.”

Warehouses are benefiting from the glut of goods, but a jump in construction and softer leasing could lead to oversupply of warehouses, especially in markets where speculative development equals 1.25 percent or more of total warehouse stock, said Kyle S. Roberts, an executive managing director in Newmark’s Salt Lake City office.

Wagering on continuing demand for warehouses, developers were building a record 613 million square feet of space in the second quarter, almost double the construction pipeline in 2019, according to Newmark.

“Warehouse users can’t just flippantly lease large amounts of space in anticipation that people are going to keep spending the way they have been these past couple of years,” he said. “Based on the data available, I think consumption has peaked for this cycle.”