Industrial is only getting hotter.
Chicago’s record numbers bode well for many in the industry, but navigating the numerous economic headwinds and resulting competitive climate has proven to be quite the challenge. Demand for space is far outweighing supply, and this can only mean one thing:
The Space Race is on, and this one looks a little different than the last. That was just one takeaway from Chicago’s 2022 Industrial Event, hosted by Chicago Industrial Properties.
Panel I: State of Chicagoland Industrial Market
What goes up, must come down. Robust growth is being seen across Chicago, but 2022 has come with its own set of concerns. Inflation, rising interest rates, geopolitical uncertainty and political disfunction have all been seen before, however not at the same time.
Interest rates are predicted to increase yet again. Rising rates impact underwriting development deals as capitalization rates begin to change. And as exemplified over the last few months, these rates fluctuate consistently depending on product type, term, and buyer. Buyers who need debt and leverage must solve for a return higher than their cost of capital, and developers must solve for a higher yield. Land and construction process are high, leaving companies to navigate how best to bridge the gap. The only moveable factor is the increasing of rent, which is a concern for occupiers.
When interest rates reach 6-7%, Joyce said it is better to lease than to own, considering the effect these rates have on monthly payments.
Smaller investment deals are also affected by this. Rising rates force the pushing of yields lower with capitalization rates and competition, causing deals to become too thin. Lenders are therefore looking at stress testing to see if the deals work, according to NAI Hiffman.
Other looming challenges include inflation and supply chain disruptions, both impacting costs.
Construction materials cause some of the more significant impacts on pricing relative to or because of supply chain issues. Steel prices increased two and a half times from January to September of 2021, which has had a major effect on project development. Spec has been about 60% of development, leaving build-to-suits around 40%. The gap is expected to widen even further in the coming months.
These increases are tapering slightly due to softened demand, but because of the strong backfill of demand for continued development, this might not have much of an impact.
Lease Negotiations: Trends & Tenants
Companies are seeing massive rent growth, especially for REITs. Duke Realty expects to see some normalcy around 3.5%. Buyers are also preferring short-term leases over long-term to bump rent prices.
It’s competitive. Tenants who are now coming out of long-term leases are seeing rates that have increased 25-30% in the last two years. There are new, large blocks of product on the market, but extremely limited inventory, especially near O’Hare. The I-55 Corridor, for example, is experiencing a less-than-2% vacancy rate.
Companies brave enough to roll the dice on spec builds are having success because of users need for space. Businesses are threatened by losing market share or closing completely if they don’t make the right decisions.
Current economic conditions are trusted to continue to fuel the boom in Chicagoland. Looming threats aren’t stopping anyone from continuing to gamble despite the risks. In fact, NAI Hiffman said that many don’t have a choice. Users are relied on by their customers to grow and fulfill new contracts, only adding to the continued demand for space.
Chicago has received its fair share of bad press in recent years, but its industrial market has remained one of the strongest across the U.S. It’s over-land transportation network, intermodal system, and air freight business, to name a few factors, make it especially attractive to those both inside and outside the city. Twelve million people inhabit Chicagoland, and it will always be in favor due to its central location.
The markets that don’t have any buildings or vacancy are the places where you can push rents. Duke Realty, for instance, is building in Cicero and Geneva. Duke can push rents higher in Cicero due to the lack of competition. Infill markets will continue to see rent growth as long as demand stays high.
Demand will start to plateau at some point, though, and a problem will arise when one underwrites a deal at rents they can’t hit. Companies will continue to aggressively chase until that happens, while remaining cautious and methodical in non-infill locations.
SVN Chicago Commercial highlighted the growth of I-65, I-90 West, Hoffman Estates and Shamburg, all relatively new to the action.
Panel II: Industrial Development, Leasing Trends and Construction Challenges in Today’s Market
Chicago Industrial Properties heard from Alba Colavitti, CRG; Andrew Maletich, Cawley Chicago; Chris Moore, FCL Builders; Melissa Roman, Prologis; and Patrick Clay, ARCO/Murray, regarding the impact of inflationary prices and emerging technology.
Cost Increases and Projections
Steel was the crisis of last year. Today’s concerns, moreover, lie with tilt and concrete. Chicagoland has seen an increase of around $6/square foot, and there are many contributing factors. There are few suppliers within the region, for one. Lead time for precast is close to a year and a half, and it’s not economically feasible to have precast shipped from elsewhere in the U.S, especially after considering recent fuel surcharges.
Roofing prices are another concern. Escalations are being carried at 15%, and some buildings are having to make do with temporary roofs until the materials are available. Melissa Roman received pricing updates as recent as a few weeks ago that confirmed prices would rise again on June 1.
It’s an issue of supply and demand, largely due to inventory and labor constraints, and both factors have the potential to impact the market long term. Alba Colavitti placed a big emphasis on the need for campaigns to attract more trade employees to lessen the shortage.
Demand type has also widened the gap between supply and demand. Roofs are a good example. Many made the switch to TPO last year due to steel prices, which caused a shortness in availability of materials.
To combat the issues of long lead times and supply chain issues, Chris Moore and Patrick Clay highlighted the importance of force majeure clauses within contracts. When you’re dealing with unpredictable commodity fluctuations, buying and designing early is the only way to beat the game.
Clay believes what may happen is a continued receding from economic centers, like Chicago’s CBD, to places outside of that sphere. Only 4% of the U.S. is industrialized, which is a lot of land available for construction opportunities, and things are not expected to slow down.
Technology and Other Trends
Prologis is considering smart technology to allow for easier self-management of its buildings. There’s also a push toward sustainability and net zero — ARCO/Murray is utilizing solar panels and solar farming on top of assets. This will eventually become standard, and experts are exploring new ways to incorporate environmentally friendly elements into their projects. Tenants have been especially interested reducing their carbon footprint. These changes aren’t easy, though, in today’s constrained market. They require much more involvement, especially when reworking an existing building.
Multi-level builds are yet another trend being seen across the U.S. And in Chicago? It’s coming. The asset class is flexible, and the mixed-use configurations are endless. The multi-level shift makes sense for monetization of land, but Clay confirmed it will have to fall in line with the economics of the deal.
Looking to the future, Chicago is showing no signs of cooling off. The area has shown incredible growth — Q1 of 2022 has only been beaten by Q4 of 2021. Recessions are inevitable due to the cyclical nature of the industry, but experts are poised to handle whatever comes their way due to today’s climate and ceaseless demand for e-commerce and related industries.