Key challenges and opportunities for industrial at mid-year

Industrial remains resilient but headwinds persist

A review of U.S. industrial market activity over the first half of the year provides some guidance as to what’s ahead. There are many signs of strength in the industrial sector as it continues to recalibrate after the robust growth spurt during the pandemic. Tenant demand is strong, but is moderating as businesses rethink their space needs during these uncertain economic times. We continue to watch these indicators, along with the impact of new construction coming into many markets as leasing demand softens. Here’s a look at what this all means for the rest of the year.

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A review of industrial fundamentals for the first half of 2023 shows continued strength and resilience, as well as the lingering impact of higher interest rates and concerns over a recession. Some tenants are pulling back on space usage or waiting for economic conditions to improve before committing. And, sublease space continues to gain momentum, although it remains a small portion of the overall inventory.

The national vacancy rate moved up to 4.9%, but remains historically low despite large amounts of new construction delivered across the country.

Gross leasing volume declined in the first half of 2023, despite the first quarter falling in line with historical averages, according to Avison Young research. Several users have been delaying location decision-making to gauge whether the economy would enter a recession, including halting leasing activity by over three quarters. As the economy continues to showcase resiliency, more users have been actively entering the pre- leasing process, indicating that strong leasing activity may occur in the second half of 2023.

Net absorption for the first half of the year remained positive on a national level, but declined when compared to the robust levels recorded in 2021 and 2022. One significant shift is in the Inland Empire. For the first time in over a decade, that market recorded negative net absorption, reaching negative 3.6 million square feet in the second quarter. The market is expected to record positive annual net absorption by the fourth quarter of 2023, however, due to several large pre-leasing projects delivering by the end of the year. 

When viewed on a longer time horizon, national net absorption reached negative 38.6% for the first half of the year when compared against the five-year average. If net absorption remains positive over the next three to six months, despite new supply coming online, there could be a supply imbalance in favor of developers. A significant factor is the slowdown in the industrial pipeline. New industrial groundbreakings topped out in the third quarter of 2022 and have slowed since then due to rising borrowing costs and a pullback in construction lending.

Rental rates are climbing nationally (to $9.27 at Q2 2023) and in many markets, reaching $8.41 psf in Atlanta during Q2 2023, for example, up from around $7 psf in 2022 and $5 psf in 2020. In Houston, direct asking rents for the first quarter were $8.14, up from $6.82 at the beginning of 2020. Rates in Chicago have increased 14.6% year-over-year to $7.74.

While fundamentals have been softening in the industrial markets across the country, the shift is not enough to change the landlord-tenant dynamics, according to Prologis. The global industrial REIT recently told GlobeSt. it expects the competition for industrial space to increase next year. Low vacancy rates and strong demand is expected to keep the pendulum tilted toward landlords and spur additional increases in lease rates.

Overview of Top U.S. Industrial Markets

Here’s a look at how top U.S. industrial markets were faring at the end of the second quarter.

In addition to the negative net absorption noted earlier, the Inland Empire is seeing a correlating rise in total availability, which has nearly doubled since 2021, reaching 8.7%. This is due to substantial increases in the amount of vacant space returned to the market. The market is also seeing a significant increase in sublease space, as occupiers shed excess space during this challenging economic environment. Vacancy rates have edged up to 2.9%, a low rate, but one that is significantly above the 1% seen over the last two years.

Chicago’s industrial market recorded 10.6 msf of year-to-date net absorption, which outpaced construction activity and, along with the 4.2% vacancy rate, serves as a strong indicator of the overall health of the market. A look at pre-pandemic levels from 2015 to 2019 show net absorption averaging 19.7 msf. Among Chicago’s 20 industrial submarkets, 14 have vacancy rates below 5%.

A total of 20.3 msf was leased in Chicago during the first half of 2023, as strong tenant demand continues to drive activity. The market is experiencing a slowdown in leasing in bulk product over 500,000 square feet. The average yearly leasing from 2015 to 2019 was 53.4 msf.

The Houston market gained 9.4 msf of positive net absorption during the first half of 2023 and is returning to typical pre-pandemic levels. The market’s vacancy rate increased by 60 bps quarter-over-quarter to 6% due to 14.8 msf of construction deliveries that outpaced demand. The vacancy rate remains near its 20-year historical average, however.

Construction activity is slowing in Houston in response to easing occupier demand and current financing conditions. The industrial pipeline declined by 12.8% in the second quarter of 2023 and has fallen by 18.1% since peaking at 36.2 msf at the end of last year. There is nearly 30 msf of new space underway, with nearly 25 msf expected to deliver by year-end 2023.

Atlanta is experiencing steady demand, but more tenants are searching for smaller square footage compared to previous years. In the first half of 2023, for example, 56% of leasing activity fell into the 50,000 square feet or less category, compared with 38% for the first half of 2021. The market recorded 4.1 msf of positive net absorption in the first half of 2023, a significant falloff from previous years.

This Southeast market has experienced an influx of development deliveries in the last couple of years, totaling 32.7 msf in 2022 alone. Much of that space has been absorbed by tenants with large space needs, leaving smaller tenants without many viable options.

Atlanta has also seen a 167% year-over-year increase in sublease space, but only .30% of that space is truly vacant. The rest is space that companies leased with plans to expand over the next few years. They have since marketed that space to optimize their footprint or until they are ready to expand. 

Across these key markets -- and nationally -- the industrial sector is headed for a strong finish to the year by historical standards. The pandemic-era exuberance has clearly diminished, leaving new challenges and opportunities for the near term.

Sources: Avison Young research, CoStar, GlobeSt., Prologis