Potential beyond the conventional: investment in IOS

Key messages

• Demand-side changes during the e-commerce boom prompted significant supply-side events affecting industrial real estate investment strategies. Challenged by a lack of supply and the need for more efficiency, location strategies and industrial real estate products themselves began to evolve with more urgency.
  
• Growing supply chain disruption prompted a shift toward alternative warehousing and storage, which distributors began to adopt more systematically, with cold storage, truck terminals, and industrial outdoor storage (IOS) becoming vital subsectors of the industrial real estate market.
  
• IOS has become more critical to the supply chain process by offering alternative storage for specific types of goods and enabling distributors to gain better access to ports and households through additional points of transfer to facilitate deliveries.
  
• E-commerce continues to be a primary driver of industrial and IOS demand, and its sector presence is expected to grow. Outsize growth and favorable occupancy point to key differentiators in IOS performance that make them increasingly attractive to industrial users.
  

Growing product innovation within industrial real estate

Supply chain management and the reconciliation of distribution channels became a key issue for the industrial real estate market during the pandemic, following the e-commerce boom that ignited massive structural demand-side change in the market nine years earlier. Shifts in demographic trends, consumption patterns, and procurement strategy, as well as urgent tactical decisioning to mitigate near-term supply chain risk, triggered fundamental supply-side events within the industrial real estate market. These included:

• Growth in emerging markets offering new industrial hubs
  
• Increased application of hub and spoke strategy
• Expansion of industrial subsectors or niche/alternative industrial real estate

Emerging industrial market growth reflected the pandemic’s net migration patterns. As population shifted to Sun Belt and Mountain markets, dispersing from denser urban environments to more suburban/exurban areas, additional industrial product was required. Moreover, record-level household growth translated to a spike in domestic e-commerce activity, on top of surging global e-commerce demands. This demand far outweighed the existing industrial stock in many port-proximate and high-growth markets, leading to the extension of spoke locations. Established industrial markets in strategic, water- and inland-port and central U.S. locations continued to serve as key hub locations. However, challenged by a lack of supply and the need to ensure more efficiency, users increasingly began to leverage spoke locations along main distribution channels to emerging population centers. Not only did location strategy for industrial users start to evolve with more urgency, but so did industrial real estate products themselves.

Supply chain pressures lead to innovative solutions

Initially, traditional industrial market product supply (i.e., warehouse and distribution space) ramped up to meet demand. However, growing supply chain disruption caused delays and warehouse users’ just-in-case approach in response to the pressure to deploy inventory began to stockpile in order to meet consumers’ expectations, which drove record levels of warehouse consumption and development. These increasing pressures on the supply chain were soon compounded by other factors, such as rising construction costs and labor shortages, which then affected the speed at which new warehouse space could be delivered. Organizations and stakeholders in supply chain management likewise pivoted to ensure efficiency in distribution and began to explore solutions more aggressively. One of the key shifts was in alternative warehousing and storage, which distributors began to increasingly leverage in a more programmatic way. 

New assets answer demand for efficiencies in supply chains

Industrial service properties are specialized assets or purpose-built areas that complement traditional industrial space by creating efficiencies in the supply chain. Beyond conventional warehouses and distribution space, cold storage, truck terminals, and IOS became critical subsectors of the industrial real estate market.

Already a niche area of industrial space, IOS began gaining attention as third-party logistics (3PLs) and distributors struggled to manage increasingly challenged supply chains during and after the pandemic.

IOS encompasses several types of uses, including:

• General short-term consumer product storage
  
• Truck/trailer/fleet parking
• Heavier machinery/construction material/container storage

To supplement limited warehouse availability, IOS became more critical to the supply chain process by offering alternative storage for specific types of goods and enabling distributors to gain more proximate access to ports and households through additional points of transfer that facilitate deliveries. IOS sites are typically located near water ports, intermodal/rail facilities, inland ports, and airports and often in supply-constrained, denser infill locations—location is paramount.

Industrial market trends and IOS dynamics

Because the IOS market is still considered somewhat alternative (although institutional exposure is growing), its market data history is relatively limited. Fundamentally, however, the demand and supply-side drivers of IOS are aligned with, or tangential to, those of the industrial market. Many of the same economic and demographic factors we consider from a market research perspective when analyzing industrial market trends are applicable to IOS (e.g., household formation, consumer spending, etc.).

Demand and supply-side drivers of IOS are aligned with, or tangential to, those of the industrial market.

The Industrial Employment Aggregate compiled by Oxford Economics is an indicator of hiring in the industrial market representing the jobs within the transportation, utilities, and manufacturing sectors, which is also a valid indicator of IOS activity.

Industrial employment growth, which ended 2023 up nearly 2.0% year over year, represents a pullback from 4.0% growth the prior year, but still eclipses its 1.4% 10-year average.¹ Payrolls are anticipated to expand at a significantly slower rate during the 5-year forecast period. This likely reflects a combination of labor efficiency measures, both in terms of labor costs as well as increased automation. 

Against a backdrop of reduced employment, there may be some risk of industrial fundamentals slowing slightly if this reflects business sentiment. However, household wealth looks positioned to continue driving product demand, which will benefit industrial and IOS markets. Wage growth averaged 2.3% during the last 10 years and was up more than 4.0% in 2023, with forecasts predicting an increase of 3.7% annually through 2028.¹

E-commerce continues to be a primary driver of industrial and IOS demand. While the rate of growth of e-commerce sales as a share of total retail sales has settled since the pandemic, its sector presence will continue to grow. Total retail sales for 2023 increased 2.1% with $1,118.7 billion (15.4%) being e-commerce sales, which increased by 7.6% last year and by 163.0% in the last decade.¹

We can likewise leverage a longer history of industrial operating fundamentals data (e.g., vacancy, rent, absorption) to analyze market and performance potential for IOS. Following an acceleration of the industrial market and subsectors seen during the pandemic, the industrial corporate real estate market is now entering a period of normalization:

• In the short term, we’ve seen a contraction in select markets materializing in lower rents, slower take-up, and increased vacancy reflecting macroeconomic trends. While the labor market remains in growth mode, hiring and wage growth are slowing, translating to more strategic business and consumer spending patterns as both businesses and households look to manage budgets.
  
• Meanwhile, traditional industrial hub markets continue to perform well, particularly infill locations where supply is constrained.
  
• High-growth industrial markets that emerged as a function of increased net migration, where developers quickly focused on taking advantage of more conditions and lower barriers to entry, are now faced with some oversupply risk, particularly big-box facilities.
  

Demand is now moderating from all-time high levels, and this is especially true for larger users. Record high supply is expected this year, but delivery momentum is projected to retreat. (The impact on IOS is also not as relevant as these big-box facilities are often located in distant locations and don't necessarily serve the same storage purpose as IOS, which is very much location driven.)

U.S. industrial vacancy increased to 5.7% at the end of Q4 2023 from 3.9% a year earlier, and from a trough of 3.8% seen in Q2 2023. Asking rents are rising by 6.4% annually, down from 2022’s midyear peak of 11.2%, but still 310 basis points above the long-term average. And across many markets, IOS rental growth appears to be outperforming overall industrial rent growth by approximately 2x on average. IOS rents have escalated by almost 30.0% over the last four years and vacancy has dropped from 2.0% to 3.0% nationally.

Reflecting its outsize rental growth and favorable occupancy, there are a few key differentiators benefiting IOS performance today compared with other industrial solutions:

Target market fundamentals are positive

From a geographical perspective, high-growth Sun Belt industrial markets were some of the best performers during and immediately following the pandemic. Many submarkets within these markets are now showing normalization, and in some cases, contraction; however, this is largely reflective of record development activity, and, again, very much concentrated within the big-box segment. In contrast, the high barriers to entry for IOS and limited supply—along with the differentiators highlighted previously—mean that this segment of those markets and micro-markets continues to perform well, particularly in more mature Sun Belt metros with well-developed infrastructure such as Atlanta, Dallas/Fort Worth, Nashville, and Jacksonville metros, which are strategically positioned to exhibit outsized performance. These industrial markets were outperforming even prior to the pandemic, each benefiting in different ways from the e-commerce boom. Here, IOS continues to appeal to industrial users as an alternative expansion mechanism within relatively tight industrial market conditions.

Key features driving industrial and IOS market growth, include:

• Strategic locations with access to major population hubs
  
• The combination of major interstate, water, inland port, and intermodal access
• Robust economic and demographic growth
• Favorable business climates and corporate relocations
• Plentiful, low-cost labor supply
• Lower barriers to entry (with the exception of IOS)

IOS continues to appeal to industrial users as an alternative expansion mechanism within relatively tight industrial market conditions.

Net migration and household growth are forecasted to boost IOS

We believe the IOS market is poised for further growth, particularly within major Sun Belt markets. Drivers of industrial market activity established before the pandemic and which gained steam during that period are anticipated to remain intact. Moreover, the net migration patterns that anchored the expansion of more tertiary, emerging industrial spoke markets during the pandemic are dissipating, likely benefiting better-established Sun Belt markets. There will be some divergence in trends reflecting supply pipeline variations by market, both in absolute and relative terms and in relation to the share of stock that will be added to inventory. The anticipated net migration flow and household growth that’s forecast to continue boosting employment and wage growth should underpin these industrial hubs and complementary IOS markets.