Demand for industrial product remains high throughout the Twin Cities market. The challenge? Rising interest rates are already scuttling several planned industrial developments, something that will make it that much more challenging for end users to find space in this market.
And the brokers working in the Minneapolis-St. Paul industrial market say that the imbalance between demand for and availability of industrial product won’t be evening out anytime soon.
But while rising interest rates might slow new construction, vacancy rates and industrial rents continue to rise in the Twin Cities market as 2022 nears a close. That’s evidence of just how strong the industrial market has been here.
Chris Hickok, managing director and industrial lead with the Minneapolis office of JLL, said that more than 180 companies are looking for industrial space throughout the Twin Cities market. And these companies are looking for roughly 14 million square feet between them.
To put that into perspective? Before the COVID-19 pandemic, Hickok said, industrial users were looking for about 5 million to 7 million square feet of industrial space in the Twin Cities market in a typical year.
Craig Patterson, senior vice president with Bloomington, Minnesota-based NAI Legacy, said that demand for industrial space in the Twin Cities has been even higher in the past. He said that nine months to a year ago, active users were searching for an unprecedented 12 million square feet of industrial space here.
“Even with interest rates and inflation, this is still a robust market,” Patterson said. “Even before the pandemic, the online ordering of goods and services was escalating. It’s getting to the point now where consumers want to order their products and have them delivered on the same day. It’s forced retailers and third-party logistics companies to be more efficient with their supply chain and logistcs, and that means they need more industrial space.”
An attractive market
What’s behind the soaring demand for industrial space here? Hickok pointed to the strength of the workforce in the Twin Cities and the diverse array of businesses that have set up shop here.
“The strength of our market is driven by a very desirable and educated workforce that companies want to tap into,” Hickok said. “Finding good workers is on the top of all companies’ minds right now. Attracting employees and retaining them, getting the right employees, is challenging today.”
Peter Kroner, Central region lead, innovation and insight, for the Minneapolis office of Avison Young, said that the demographics of the Twin Cities make it an attractive market, too, for end users.
“The demographic story is very strong for Minneapolis-St. Paul,” Kroner said. “People here have disposable income. We have a highly educated workforce. The demographics hit all the marks that anyone looks for when they are looking for e-fulfillment space. Minneapolis checks all the boxes for a lot of occupiers. A lot of occupiers are planting roots here to make sure they can better serve the Minneapolis-St. Paul area.”
Jeff Swanson, senior associate for sales and leasing with the Minneapolis office of Avison Young, said that industrial vacancy rates in the Twin Cities market today are the lowest he’s seen during his decade-long career.
“There is still so much demand. The new construction in the pipeline will not fill the void we have,” Swanson said. “We still have tenants who can’t find the right space. It doesn’t exist in the geographic area and size that they want.”
Dan Swartz, senior vice president with the Minneapolis office of CBRE, said that the rise of onshoring is also increasing demand in the Twin Cities industrial market.
During the early days of the pandemic, companies struggled to get their products to consumers. That’s partly because so many were manufacturing their products overseas and following the just-in-time model, sending these products to consumers as they were ordered.
As supply chains constricted during the pandemic, the flaws of this model were exposed. Today, more companies are moving more of their manufacturing processes back to the United States.
“End users realized that they couldn’t rely on that just-in-time approach,” Swartz said. “The Twin Cities has a diversified product base. We don’t rely on just one industry. There are lot of different companies in this area with a lot of different needs. Suppliers want to be close to them. They want to be able to get their products to them quickly.”
At the same time, the Twin Cities industrial market doesn’t rely as heavily on ecommerce as do some other Midwest markets. Financial companies and medical device technology providers have carved out a solid foothold in the Minneapolis-St. Paul market, for instance. And while ecommerce is important to the Twin Cities industrial market, the growth of these other businesses is providing it a boost, too.
This diverse industry base has protected the Minneapolis-St. Paul industrial market from big drops even when certain industries are struggling, Hickok said.
“In the last four cycles or periods of market disruption, our market has not dropped as low,” Hickok said. “It hasn’t gotten as high as other markets, either, though. We are a steady, reliable market from an industrial standpoint.”
These advantages are important to the Twin Cities. Unlike many Midwest markets, Minneapolis and St. Paul aren’t located in the dead center of the country. That inherently makes it a less essential location for distribution centers.
But Hickok says that the Twin Cities’ other benefits to end users have kept demand high for industrial space here. At the same time, companies do look at this market when they are searching for a hub to distribute products throughout the upper regions of the country.
“Companies aren’t dropping one of their main distribution hubs in the Twin Cities to feed the rest of the country. Logistically, that doesn’t make sense,” Hickok said. “But putting spurs of networks into the Twin Cities that feed the greater Minnesota area, the Dakotas and into Iowa and Wisconsin, that does make sense. A lot of the demand for industrial space here is driven by the quality of companies that we have here, companies like Target, General Mills and United Healthcare. Those big letterhead names bring other companies here that support them. That keeps our diverse economy going.”
Patterson said that the Twins Cities historically has not been much of a distribution market. The region was always considered to be too close to Chicago, the Midwest’s big distribution hub. That began changing as ecommerce sales grew, Patterson said. The growth in ecommerce has resulted in a decentralization of distribution channels, opening new opportunities for Minneapolis and St. Paul.
Today, Minneapolis and St. Paul can rely on their strong highway access, which allows end users to quickly ship goods throughout the Midwest and down south to Texas. The Twin Cities also rests along the Mississippi River, which allows companies to transport their goods on barges.
“We are a good-sized metro market that can distribute to a 500-mile radius pretty easily,” Patterson said. “That makes us a good location for much of the country as well as our own market.”
Worries over rising interest rates
As strong as demand is for industrial space, economic uncertainty is impacting the sector. Rising interest rates, for instance, are slowing new construction in the industrial market and giving investors who would otherwise purchase these properties a reason to pause. Hickok says that the number of industrial property sales in the Twin Cities is down considerably since interest rates began their steep rise.
“Interest rates have had a dramatic effect on the capital markets side of the business,” Hickok said. “The majority of buyers and sellers are on the sidelines until rates stabilize and they have a clear vision of where rates are going to end up. We are seeing some properties trade. Part of that is because there is still some capital that is looking to get placed.”
Swanson said that while demand for industrial isn’t slowing, aggressive capital is being sidelined.
“There is a longer runway for deals to get done today,” Swanson said. “There isn’t a drop in demand. It’s more like a plateau. We are back to reality from the feeding frenzy we were experiencing before. Things are settling into more of a normal market.”
What is providing a boost for sales, even in this environment of rising interest rates, is the steady rent growth industrial properties here are seeing, Hickok said.
Investors, though, are hesitant to commit to any real estate today, even the still-in-demand industrial sector.
“The interest rates have thrown a wrench into how buyers and sellers are looking at the values of properties and what their returns might be,” Hickok said. “The debt markets are up in the air right now. Raising equity is becoming a problem. Until the interest rate environment settles down, this will continue.”
Hickok said that some new industrial projects in the Twin Cities market have been put on hold. That will keep the local industrial market tight from a vacancy standpoint, he said. The market’s vacancy rates are already quite low. But as interest rates keep new construction activity lower, expect industrial occupancy rates to only increase.
Patterson said that it is difficult to underwrite an industrial project today.
“The numbers don’t work,” he said. “The cost factors have escalated 20% to 30% thanks to rising construction costs. Rents have kept up, which is good. But you can’t even figure out today when you go to a lender what your interest rate will be. If you don’t know what the interest rate will be, you don’t what the cap rate is going to be. New projects just don’t pencil out today. People are entering a wait-and-see mode to see where inflation and interest rates go.”
This can make life more difficult for end users who are looking for industrial space in the Minneapolis-St. Paul area.
“Right now it can be very challenging to find industrial space,” Hickok said. “It can be very difficult to get into the exact submarket you are looking for with the right type of space.”
Two weeks before this interview, Hickok said, JLL leased out a 200,000-square-foot industrial building that won’t be delivered until June of 2023.
“That’s a good sign of the activity levels,” Hickok said. “It is a challenge for companies to find the space they are looking for.”
Swartz said that expects developers to continue to add new industrial product to the Twin Cities market in 2023. That’s because many of these developments have already been financed. Swartz, though, said that he expects a slowdown in deliveries in 2024. Those are the new products most likely to be scuttled by today’s rising interest rates.
Swartz said that while investment activity in industrial product might slow in the coming months, he doesn’t expect it to peter out completely.
“There is still demand for industrial space on the part of investors,” Swartz said. “But it comes down to understanding where pricing is today and where it will be in the future. The key for new developments lies in discovering where the price is going to be when you deliver the product in two years.”
Swanson said that it was challenging even in a healthy market during the last 10 years for companies to find the right industrial space in the Twin Cities market. Today, with interest rates and the rising costs of materials slowing new construction, end users are finding it even more frustrating to find that perfect space.
“What is the answer to it? I don’t know,” Swanson said. “Developers aren’t confident in the interest rates. I don’t know when that will change.”
Kroner said that many investors will remain quiet until the movement of interest rates settles into a more predictable pattern.
“A lot of funds that were fully committed the last two years to deploying capital into industrial assets are not doing that right now,” Kroner said. “That dry powder is sitting on the sidelines until we have more clarity on how aggressive or soft the Federal Reserve’s future policies will be. Everyone is in pause mode. The capital is not going anywhere. It is staying on the sidelines.”
An unprecedented industrial market
Hickok has been working in the Twin Cities market since 1989. He says he’s never seen demand for industrial space so high.
He points to the shift in how consumers buy goods, turning to the Internet to find just about anything and then expecting it to show up on their doorsteps in one or two days.
That has resulted in a greater need for warehouse and distribution space. But Hickok said that the growth of other industries is boosting demand for local industrial space, too. The medical device industry continues to take up a larger footprint in the Twin Cities market, he said. As that industry continues to grow, it just adds to the need for industrial space here.
Max Nolan, insight analyst with the Minneapolis office of Avison Young, said that there’s been a change when it comes to who is buying industrial buildings in the local market. During the past year, about 70% of all industrial sales in the market were made by out-of-state capital, Nolan said.
Nolan added that the share of industrial properties in the Twin Cities market held by owners with 30 properties or more has also doubled.
“Owners see Minneapolis as a good investment opportunity,” Nolan said.
Patterson said that the Minneapolis-St. Paul industrial market does face a supply issue. And it doesn’t look like that issue is going to resolve itself anytime soon.
“Once the pandemic hit and the demand for industrial space escalated to an even greater point, it created a supply issue,” he said. “Couple that with the fact that you aren’t able to get product and buildings up as quickly as you used to, and you’re seeing even more pressure on the market.”
Patterson said that the industrial market in the Twin Cities region had a vacancy rate of 3% as of early December. That’s low, especially considering that a stable market will have a vacancy rate of 6% to 7%.
The good news is that there is a solid amount of new construction taking place now, with 5 million square feet of industrial product under construction as of early December. The challenge? The market as of the end of 2022 was demanding 11 million to 12 million new square feet of industrial space, Patterson said.
“We are still going to be short of industrial space,” Patterson said. “Anyone looking for 200,000 square feet or greater is going to have very limited options.”
Companies face other challenges when looking for space in the Twin Cities market, Swartz said. It’s not too difficult for developers to find enough labor to build new industrial space. But end users often struggle to find enough workers to staff these facilities, he said.
“Companies are 100% making decisions based on the availability of labor,” Swartz said. “That can be a challenge here. Our unemployment rate remains low, so it can be a struggle to find enough workers.”
And a prediction for next year? Swartz offers this:
“I would expect 2023 to have solid demand, limited availability of space and a continued increase in net rental rates,” Swartz said. “We have seen unprecedented growth in industrial rental rates. I expect that to continue.”