It’s true: These are challenging times for all commercial real estate sectors, including that long-time darling of investors, industrial. High interest rates, an uncertain economy rocked by the failures of three large banks and continued supply chain delays have made selling and building industrial properties more difficult.
But industrial remains one of the strongest commercial real estate sectors even with these challenges. And the industrial sector is still healthy in the Twin Cities region, thanks to demand that still outpaces the supply of industrial space.
And the best news? Two local industrial experts told Minnesota Real Estate Journal that they expect the industrial market to weather the challenges of higher rates and economic certainty. That bodes well for the sector.
“The rapid rise in interest rates over the last half of 2022 and into 2023 has had a dramatic effect on real estate investors and their appetite to develop new speculative buildings or buy existing buildings,” said Paul Hyde, co-founder of Minneapolis-based Hyde Development.
This shouldn’t be a surprise. As Hyde says, the cost to borrow money to buy or develop industrial space has risen, with interest rates jumping from 3.5% to about 7%. Because of this, the owners of industrial space have to increase rental rates for tenants to make up for their higher mortgage payments.
“That has had a chilling effect on new developments,” Hyde said.
The higher rates have also slowed the sales of industrial buildings. But Hyde said that this isn’t an entirely negative development.
Hyde said that the industrial market, though not a bubble, was overheated before interest rates began rising. As he says, investors were buying new buildings that were empty just so they could find a place in which to invest their money. They weren’t concerned that there weren’t tenants in the space yet to pay rent.
“That is not healthy in the long-term,” Hyde said. “There were prices being paid for existing building that were higher than we’d ever seen. I think this slowdown in sales is setting our market up for a strong and sustainable next cycle.”
What the higher rates haven’t impacted yet, Hyde said, is leasing activity. It seems logical that higher rates would have already slowed the appetites of tenants to grow or expand their industrial footprint. But that hasn’t happened yet.
The demand among tenants for industrial space remains high, Hyde said. Owners with vacancies in existing buildings or those building new industrial space will find plenty of tenants to fill those empty slots.
Why? Consumers still want the products that they order to show up on their doorsteps quickly. Companies, then, need to populate warehouse and distribution space that allows them to ship their products across the country in less time.
“It’s not just Amazon, either. Everything is now being held to that overnight delivery model,” Hyde said. “That consumer and business demand is driving the need for more industrial product. That’s one of the reasons why there hasn’t been a slowdown in industrial product. It’s one of the reasons why there hasn’t been a slowdown in demand.”
Mark Kolsrud, vice chair with the St. Louis Park, Minnesota, office of Colliers, said that the steady demand from tenants has been encouraging.
But Kolsrud did say that the amount of new industrial construction has slowed in the Twin Cities market.
“Speculative development has largely come to a stop,” Kolsrud said. “Now it is better to have a tenant in tow. With that, we are also seeing fewer industrial sales.”
At the same time, industrial rents throughout the Minneapolis-St. Paul market have grown during the last five years, Kolsrud said. This has helped keep vacancy rates low in industrial space throughout the region, he said.
Industrial landlords want to earn market-rate rents. When it is time for their tenants to renew, they propose a higher rent. Tenants then explore the market to see if they can find the same quality of industrial space at a lower cost.
The challenge? Industrial rents have risen throughout the market, Kolsrud said.
“Tenants often find that they can’t save any money even if they move,” he said. “So they negotiate a renewal at their current locations. The rent growth in some ways is keeping tenants in their current locations for a longer time.”
Looking for certainty
While tenant demand remains high, the rising interest rates have made investors skittish, even it comes to the hot industrial sector.
As Hyde says, investors hate uncertainty. And there is nothing certain about today’s economy. Throw in the three bank failures earlier this year, and it’s little wonder that investors are cautious today.
“Investors are desperate to know where the market is,” Hyde said. “There isn’t a lot of data on where the market is for new construction pricing or for buying existing buildings. That uncertainty causes investors to wait.”
Kolsrud said that this is still a good time for investors to buy industrial product in the Minneapolis-St. Paul market. But obtaining financing for all commercial real estate deals has become more difficult and expensive, he said.
At the same time, sellers are holding onto their industrial assets, waiting for the right sales price before closing deals.
“There are more investors out there than sellers,” Kolsrud said. “The sellers remember what prices they could get in the market 18 months ago. They don’t want to sell at today’s new market price. The sellers are hopeful that the market will improve and go back to where it was. I don’t know if that will happen. But sellers today are waiting to see what happens.”
But if investors see that the increase in interest rates is slowing or that the Federal Reserve Board might be ready to stop boosting its benchmark interest rate? The certainty that comes with that will increase investor activity.
Investors don’t even need to see rates fall back to the historic lows they recently enjoyed. As Hyde says, that’s unrealistic. Investors just need to know where rates will settle, he said.
“I’ve done this for 25 years and have never seen rates that low in my career,” Hyde said. “I think it’s likely that we might never see those rates again. That was the result of the pandemic and economic policy that was focused on recovering from COVID. We might get back to the interest rates we saw in the mid-2000s when we were borrowing at 4.5%. That is reasonable. And that would be perfectly fine.”
A focus on green
Hyde said that Hyde Development today is working to add solar to all its industrial projects. This is a smart move, he said: Industrial buildings feature large roofs. They can generate plenty of energy from solar panels.
“If I talked to tenants about this five years ago, they would have rolled their eyes at me. They wouldn’t have been interested,” Hyde said. “Now they are excited about this. Every single one of our tenants talks about this. They are either trying to meet corporate efficiency goals or they like the idea of the certainty of costs that we can provide with solar power.”
Hyde Development will also continue to focus on infill sites when developing new industrial projects, Hyde said.
“The last-mile space is important,” Hyde said. “Speed and service is a huge part of what tenants are looking for. If you can provide that, it can be a real difference maker. The challenge is that it is harder to find these sites. And when you find one, you’ll pay more. We have seen this in Denver, and we are seeing it now in Minneapolis.”
Kolsrud describes today’s industrial market as being in a “quiet period.” As he says, there is little product for sale, estimating that there is only 1/10th of what was on the market just two years ago.
But Kolsrud said that there are signs that buyers and sellers are getting closer to transacting again in the industrial space. “Right now, investors want to be rewarded for the changes in the economy and the higher interest rates,” Kolsrud said. “The sellers haven’t been willing to adjust their pricing expectations. There hasn’t been an equilibrium yet. But we are getting closer all the time.”