A slowing macroeconomy and elevated interest rate environment underscore the importance of investing in sectors and markets supported by structural forces that can provide growth. Industrial real estate, the major beneficiary of the e-commerce megatrend of the last decade, is positioned to again benefit from the next megatrend: the overhaul of global supply chains. While investors have had their pick of any product (bulk warehouses to support large-scale distribution, or small last-mile facilities to support same day delivery) and generate strong returns, the locations, product types and asset specifications required to support supply chain shifts are much more nuanced.

The e-commerce penetration rate increased from 11% in 2015 to 17% in 2019, and rents for industrial properties increased by 35% (8% per annum) in major markets over those four years. Since COVID-19, e-commerce penetration has accelerated to 23%, and rents jumped 45% (10% per annum)¹. While Morgan Stanley Research predicts that e-commerce sales growth will decelerate from 20% (2017-‘22) to a still healthy 8% per annum (2023-’27) due in part to a revival in brick-and-mortar retail, growing e-commerce penetration (expected to reach 27% by 2027) will continue to drive significant industrial demand, as each point of e-commerce penetration roughly equates to 100 mm square feet of incremental demand.

For decades, the U.S. has enjoyed a smooth global supply chain, the disinflationary benefits of globalization and products at our front doors when we want them. At the same time, companies have optimized their operations focusing on efficiency and cost, resulting in fewer manufacturing nodes, few ports of entry and lower inventory levels. This premise has been fundamentally challenged in recent years due to geopolitics and event-driven supply shocks, which are heightening companies’ focus on supply chain resilience and optionality to respond quickly to a disruption anywhere in the world. In turn, companies are changing or expanding where they manufacture their goods and how they distribute them to their end customers.

Geopolitics and the shift to de-globalization is contributing to a re-allocation of global manufacturing. Morgan Stanley Research estimates that around $850 billion of China’s $4.9 trillion of manufacturing will shift to other countries with major beneficiaries: the U.S. and Europe ($200 billion each); Japan and Southeast Asia ($100 billion each); and Mexico and India ($50 billion each).

Supply Chain Optionality
Besides the geopolitical crosscurrents, event-driven supply shocks such as the recent tragic collapse of the Francis Scott Key Bridge in Baltimore, the drought in the Panama Canal, conflict in the Suez Canal, and labor disputes on the East and West Coast of the U.S. have significantly disrupted shipping routes resulting in logistical chokepoints, delivery delays, higher costs, and product shortages. These bottlenecks have been a chronic issue since COVID-19, when the fragility of the global supply chain first became obvious. The increasing frequency and magnitude of these events has laid bare the need for retailers and consumer goods-oriented companies to hold more inventory and build greater optionality into their supply chains to minimize these risks and preserve revenue streams. This has required them to diversify into a five-corner distribution strategy that includes key ports in the Southwest, Pacific Northwest, Northeast, Southeast and the Gulf of Mexico. Given most companies have a West Coast presence due to their long-standing relationship with China, we believe this additional diversification should disproportionately benefit East Coast ports over time.

Implications for Industrial Real Estate
We believe that supply chain reconfiguration is additive to overall industrial demand and can contribute an incremental 75 mm square feet of new annual demand over the next five years, in addition to the extra 100 mm square feet of demand generated by rising e-commerce penetration levels (off a base of around 250 mm square feet of demand in 2023). This incremental demand will feed different markets and product types, ranging from manufacturing/light industrial facilities for onshoring to distribution centers for nearshoring and port-adjacent friendshoring demand. While near term events such as the U.S. and Mexico elections might slow nearshoring and onshoring decisions given uncertainties around trade and immigration policies, MSREI maintains conviction in the longer-term trend of supply chain diversification and its positive impact on industrial demand.

Additionally, supply is not expected to keep up with this increased demand in the near term due to elevated construction costs and expensive construction financing. Speculative under construction levels are down 50% or more from peak levels in the fourth quarter 2022 in major markets, such as Dallas down 65% (38 mm square feet), Atlanta down 63% (24 mm square feet), and Pennsylvania down 77% (14 mm square feet). Growing demand and reduced supply should bode well for industrial fundamentals in the medium term.

Conclusion
While remaining constructive on investing in the industrial sector, we believe that investors need to adopt a more nuanced strategy accounting for the impacts of supply chain reconfiguration which is shifting demand within U.S. markets and product types. Moreover, rather than thinking about industrial real estate as warehouse and distribution only, we believe investors need to build a diversified portfolio that includes bulk distribution centers tied to e-commerce and global trade, manufacturing/light industrial assets to support advanced manufacturing, and smaller, multi-tenant infill assets to support every-day consumption needs.

¹ Source: Costar, as of first quarter 2024.