2023 stood out as a significant year for the sector, and while things are constantly changing, enthusiasm for what’s in store remains undiminished.
Recently, we turned to experts from three leading firms to explore investment trends and discuss the anticipated outlook for the coming year.
Chicago Industrial Properties: Looking ahead to 2024, what are your expectations for rental rate trends in the Chicago industrial market? How do these predictions compare to recent years, and what factors are driving these expectations?
Robert Smietana, CEO and President, HSA Commercial Real Estate: We’re still seeing healthy increases in rental rates, and we don’t think that’s going to change in 2024. For most renewals, the new rent is minimally 20% higher than the current rent. While a number of speculative projects have delivered this year, increasing vacancy, construction starts have slowed, which will drive demand for space in 2024 and 2025. This should shift the market back in landlords’ favor.
Tyler Ziebel, Vice President, Colliers: Chicago user markets, along with nearly all industrial markets throughout the U.S., were supercharged in the months following the initial COVID-19 breakout. Consumer and business trends during that time, (onshoring, work from home, e-commerce, home delivery, etc.) combined with all-time low interest rates, all lent to a frenzied leasing environment from industrial users in virtually every submarket across the Chicago MSA. 2021 and 2022 saw record amounts of new supply come to market and even higher net absorption as vacancy plummeted to the lowest levels on record and market rents shot upward, particularly in core submarkets. As rates began to rise at an unprecedented pace in 2Q 2022, and continued in 2023, we have seen a notable slowdown from both users and developers. Market wide absorption sits at roughly half of what it was this time last year as tenants contemplate the possibility of a recession and battle increased lending costs. We generally expect that trend to continue, as it appears rates will remain at elevated levels for the foreseeable future. This will be somewhat offset by the complete disruption of the construction pipeline as construction starts have halted across the market which will have a significant impact on the supply going forward in the next three years.
Chicago Industrial Properties: In terms of vacancy rates, what trends are you anticipating for industrial properties in the area in 2024, and how might these trends be influenced by market dynamics and economic conditions?
Smietana: In the near term, vacancy rates are going to increase and that’s showing up right now. Third-quarter vacancy rates were around 5%, according to Colliers’ most recent Chicago Industrial Report. Next year, vacancy may climb to 6.5% or 7%. Historically, that’s not high, but it’s a reversal of the downward trend we’ve seen in recent years. The Fed policy on interest rates not only affected real estate developers, but it also has impacted tenants and their suppliers. So, there’s going to be more prudent expansions even by the tenants because their bottom line has been hit by increased labor and borrowing costs.
Ziebel: We expect vacancy to tick up nominally, largely due to new construction deliveries. For the time being, tenant demand seems stable on existing space and virtually all of the core submarkets continue to benefit from near record low vacancy rates. While we don’t expect to see anything near the frenzied leasing activity of the post-COVID period, user fundamentals remain positive across the market.
Chicago Industrial Properties: Are there any noteworthy policy changes or regulatory developments on the horizon that could impact industrial investments in the region in the coming year?
Ziebel: The most significant policy change across our market is Chicago Mayor Brandon Johnson’s “Mansion Tax” that was recently approved on November 7 and will be voted on this coming March. The proposed bill would quadruple the transfer tax on the sale of real estate over $1 million from .75% to 3%. The increase will have a meaningful impact on the sale of virtually all Chicago commercial properties and have a direct effect on the underwriting of city properties.
Chicago Industrial Properties: Given recent economic shifts and potential uncertainties, how do you assess the overall risk and return profile for industrial investments in the coming year, and what strategies should be implemented to manage these risks effectively?
Smietana: Most completed developments have locked in low interest rates, but when the term expires, many loans will be going from 3.5% to around 7%. That clearly impacts viability for projects that have not yet broken ground and profitability in the case of existing assets. It’s another factor that is increasing rental rates. As interest rates have increased, cap rates have also increased, putting downward pressure on property values for most stabilized assets—at least temporarily.
Ziebel: Risk mitigation has largely come in the form of a nationwide pricing reset across the board for industrial (and other) real estate assets. Put simply, the rising rate environment and persistent volatility has had a tremendous impact on investor underwriting in the form of increased lending costs today and the threat of even higher interest rates tomorrow. Investors have responded with more conservative underwriting both on debt and market assumptions. We expect that to continue until the capital markets find stable footing.
Chicago Industrial Properties: What key factors are contributing to the continued enthusiasm for industrial real estate investment in 2024? Are there specific drivers or market conditions that make this sector particularly attractive?
Smietana: Enthusiasm for industrial continues for a lot of the same reasons we saw prior to the pandemic. While consumers have returned to brick-and-mortar shops, e-commerce is still forecasted to constitute 41% of global retail sales by 2027, a significant increase from its share of just 18% in 2017, according to new research from Boston Consulting Group (BCG). So, despite headwinds, the demand for goods bought online that need to be delivered on increasingly shorter time frames will continue fueling demand for industrial in the years to come. The scars of the pandemic are also driving activity. Because of resulting supply chain disruptions, a lot of businesses and manufacturers no longer want to source all their raw materials or goods from overseas. The onshoring or nearshoring of supply chains is also increasing the need for modern manufacturing and warehouse space.
Ziebel: While today’s investment numbers for 2023 will look somewhat dismal, there are a number of very positive undercurrents persistent throughout the market. COVID put a spotlight on the industrial sector for investors as the user markets exploded upwards across the country. While those fundamentals have slowed from the frenzied pace of 2021 and 2022, the development pipeline and new starts on projects have followed suit (albeit for different reasons). The net effect of this is that Chicago has largely remained in balance from a leasing perspective. Vacancy remains near record lows. Square footage currently under construction continues to drop. Asking rates remain at record highs.
Chicago Industrial Properties: How do you see the overall investment landscape evolving for industrial properties in the Chicago market? Are there any emerging trends or strategies that investors should consider as they plan for the new year?
Smietana: The investment market has stalled, and there’s a lot of price discovery underway. No one really knows the current value of an asset because there haven’t been many comparable sales. Most investment brokers I talk to say their business is down 50% or more. It could even go lower as core investors and institutional money stay on the sidelines because they’re afraid of what’s going on in the overall commercial real estate industry. I don’t see conditions changing quickly. It doesn’t mean properties won’t get sold. It just won’t be as common or happen as quickly as in recent years.
Ziebel: With construction starts at their lowest level in decades for much of 2022 and all of 2023, it will be interesting to see the whip effect the lack of upcoming supply will have in the next two to three years. Chicago’s construction pipeline is already 30% lower than it was just last year as those buildings started in 2020/2021 are brought to market. That pipeline will continue to drop as space is delivered and new projects stay on hold. The net effect of this, even with modest demand from users, will be a total lack of supply in the next two to three years across the Chicago market and particularly in Chicago’s best, most desirable submarkets.
Chicago Industrial Properties: With 2023 being a significant year for the sector, what lessons or insights from the past year do you believe will be most valuable for investors as they navigate the opportunities and challenges of 2024?
Smietana: We’ve all had a dose of almost zero interest rates for many years. Now we’ve been reminded that rates do go up. Having a low-leveraged investment is always better than a high-leveraged one. Higher-leveraged buyers and owners will have an awakening when their loan comes due. For an 80% loan, it’s shocking, but for a 50% loan, it isn’t as terrible.
Ziebel: 2023 largely saw a “back-to-basics” approach to Chicago industrial underwriting. Outrageous market assumptions tempered. Building basis became a focus. Debt underwriting and sources of capital became incredibly important. For all intents and purposes, 2023 felt like a bit of a reset from the frenzied (and frankly, unsustainable) buying environment of the previous two years and a transition back to the stable pricing environment seen in the years immediately preceding the pandemic.