Throughout the current industrial expansion, which began in 2012, the pipeline has often struggled to keep pace with demand throughout the market. In fact, between 2012 and 2022, new supply has only surpassed demand three times on an annual basis. There are several reasons for this, including the restraint shown on the development side compared to the previous expansion. At the height of the previous industrial cycle (2002-2007), the speculative pipeline made up roughly 90% of all space under construction while the nationwide vacancy rate stood at 7.9%. Once the Great Financial Crisis (GFC) struck the nation, the impacts of this amount of supply pushed annual net absorption into negative territory during 2009. With strong demand and some of the lowest vacancy rates recorded since 2001, the mentality for development before the GFC was “build it and they will come.” Taking from lessons learned, the current expansion saw stronger build-to-suit (BTS) ratios (averaging 38% from 2012-2022) and it wasn’t until the fourth quarter of 2013 in which the under-construction pipeline exceeded 100 million square feet (msf).
After boasting two years of unprecedented, accelerated demand due to the pandemic, we have now started to enter a cyclical reset to the market—with the space under construction nearly four times the size the pipeline was at year-end 2007. As of Q1 2023, 63% of available logistics space was built before 2000 and over half has clear heights below 28 feet. For many tenant purposes, however, a 32-foot clear height is a necessary minimum which limits options for tenants seeking modern fulfillment space. Due to this change in requirements, the amount of quality space in the market needed to increase. But as demand has pulled back to more historically average levels, the space under development has sustained. The robust pipeline is now sitting at 663.3 msf as of Q1 2023 with 84% of that space being built as speculative space, bringing the possibility of overbuilding up for the first time in recent memory.
The main questions we are addressing:
- Is there a risk of oversupplying the market again?
- Which markets are in more danger of doing this than others?
- Will we see negative demand?
We examine our Q1 2023 numbers on a market level* and submarket level to determine if markets could be in jeopardy and why.
Before diving into the details, it is important to note that we are not in the same position we were in before the GFC—much tighter market conditions are persisting now compared to the last expansion cycle. As of the first quarter of 2023, the overall vacancy rate was 3.6% for the nation. Though this was a 40-basis point (bps) bump quarter-over-quarter (QoQ), it still sits well below the 10-year historical average of 5.3% and 430 bps below the 7.9% recorded at Q1 2007. On a regional basis, the South posted the highest vacancy rate at just 4.2%, the only region over 3%. This is as expected with the South region making up 48% of the Q1 pipeline and 46% of the deliveries so far this year. The West remains the only region with a sub-3% overall vacancy rate at 2.9%. All that to say, the near-record low vacancy rate puts the market in a very different position, despite the elevated pipeline. In fact, hypothetically, let’s say that the entire speculative pipeline were to deliver right now (assuming no preleasing for the sake of this scenario). That would mean 557.1 msf of space would hit the market vacant. Even if that space were to hit, it would push vacancy upward to 6.9%. This is still 100 bps below Q1 2007 and 10 bps below the 10-year pre-pandemic average of 7% (2010-2019), widely considered a healthy market rate.
The Devil is in the Details
Unsurprisingly, the South region contains the majority of markets that boast some of the largest pipelines in the country. With plenty of land to build upon, strong population growth and net migration to warmer clients during the pandemic, cheaper labor, and two of the strongest primary markets for demand (Dallas/Fort Worth and Atlanta), the South has been a logical choice for new development. According to the U.S. Census Bureau, Texas had six of the top 10 counties for numeric growth from April 2020 to July 2022. Based on annual percent growth, nine of the top 10 counties were in the South including Texas, Georgia, North Carolina and Florida. Economic growth in these areas has also contributed to the large jump in under construction activity, causing it to jump 115% since before the pandemic (Q4 2019). The Northeast, Midwest and West regions have seen large increases as well, climbing 78%, 48% and 133% respectively. The South also boasts the lowest employer costs per employee at $35.52, including benefits while the national average sits at $40.23 in total compensation according to the Bureau of Labor Statistics.
As of Q1 2023, three of the top five largest construction pipelines reside in the South with the Dallas/Fort Worth market containing a pipeline of nearly 75 msf, 11.3% of the total U.S. space under construction. It makes it a market that may be in danger of overbuilding for several reasons. The sheer size of the pipeline, the BTS to speculative ratio being skewed to 90% speculative, and vacancy rate reaching 6% in Q1 2023 all make it one to watch. When it comes to overbuilding, the composition of space at this point in the cycles matters, alongside the markets’ vacancy rates. Some markets with robust pipelines that are speculative heavy may seem dangerous, however, if they have a low vacancy rate, this puts them in a better position to mitigate oversupply risks. A few examples of these markets include Atlanta, Chicago, and the Inland Empire. All three of these markets have pipelines greater than 25 msf with speculative percentages above 80%--looking at those numbers alone might put them in a “risky” category. However, Atlanta is currently sitting 150 bps below its five-year historical vacancy average at 4.1%, while the Chicago market is at 4% vacancy—50 bps below the five-year average and the Inland Empire stands at a mere 1.9% vacant. And while that’s only 30 bps below the five-year historical average, they have remained sub-2% for the past two years. So really, these markets are in a good place to bring some balance back to the market without serious threat of overbuilding as of today.
Another factor to consider with the current space under construction is what it is as a percent of market inventory. We see markets like Charleston, Boise or Phoenix with pipelines that are 11% or more of total inventory. While this sounds like a lot, the story behind the numbers can help put it into perspective. Charleston, for example, is a smaller market with an inventory of approximately 85 msf and a vacancy rate of just 1.9%. Due in part to its close proximity to the Port of Charleston which boasts the deepest east coast port at 52 feet deep, it has become an attractive industrial market. Though it seems like a large percentage, the total amount under construction is only around 10 msf. Boise has a similar story in terms of market size, with under 50 msf of total inventory and the space under construction only amounting to 6.2 msf—minimal compared to most markets. Phoenix is a little bit different. Phoenix has the second largest pipeline next to Dallas/Fort Worth and is considered a larger/growing market with 375 msf of inventory. Phoenix’s growth has accelerated during the pandemic due to population growth/migration and because it is seen as a cheaper alternative to some of the more expensive west coast markets while maintaining proximity to the consumers. While Phoenix has a large speculative ratio, it is sitting at a 4.4% vacancy rate, 360 bps below its 10-year average. It is a market that has registered strong demand in recent years, providing a cushion on the supply risk side.
Under the Microscope
Diving even deeper than at the market level for potential signs of danger, we can examine some of the submarkets with larger pipelines that may be approaching a threat level. From a construction perspective, nine of the top 20 submarkets for space under construction sit in the South region, the South Dallas submarket in the Dallas/Fort Worth market claiming the top spot at 16.9 msf. The West has six submarkets in the top 20, three of which are in the top five. Two of those submarkets, North Goodyear and Phoenix-Mesa Gateway lie in the Phoenix market. The remaining five submarkets sit in the Midwest (three) and Northeast (two) regions.
In terms of individual submarkets at risk, it’s important to note the vacancy rate of those submarkets as well as their demand activity. When getting down to the submarket level, vacancy can get a bit more volatile due to smaller inventories. Even just a few million square feet can send the rate up several hundred bps depending on the existing inventory. For example, the North Goodyear market has a vacancy rate of 12.7% and has the second most space under construction as of Q1 2023. However, the inventory of the submarket is only 27.9 msf. This means there is just 3.5 msf of vacant space. This submarket also absorbed 2.4 msf in the first quarter, 53% of the entire Phoenix market’s net absorption. In contrast to a high vacancy market, the Jurupa Valley/Eastvale submarket in the Inland Empire (ranked 20th for largest submarket pipeline) has a pipeline of 5.4 msf and a vacancy rate of 1.2%. The total market rate for the Inland Empire is 1.9% so the submarket with the most construction activity has less vacancy than the other areas of the market. With just 517,346 sf vacant and available, the space coming online is extremely important to bring balance back to the market and provide options for occupiers.
As its stands, there are nine markets in the top 20 largest pipelines that have 20% or more of total inventory under construction. Vacancy rates for these markets range from 2.4%-13.3% and inventories range from 1.0 msf – 81.2 msf. There is such a wide range of variability and volatility between these submarkets, it makes it difficult to predict much of the risk. One thing is for sure, all markets and submarkets will need to be monitored as we enter a time of even more economic uncertainty.
Where Do We Go From Here
Overall, the pipeline is not as daunting as it may appear by just the headline numbers. Outside of record low vacancies and stable demand, another promising stat to combat the risk of overbuilding is the slowdown of construction starts. Construction starts have slowed significantly over the past two quarters due to factors such as lack of financing, economic uncertainty, and lessened demand in the market. Though Q1 2023 deliveries are up 40% from this time last year with 129 msf coming online, starts were down 60% from Q1 2022 levels and fell 34% from Q4 2022. First quarter 2023 starts in the South and West regions, the two regions with the largest pipelines, are down 65% and 66% respectively from Q1 2022 and all regions lagged at least 32% from the five-year historical start average (2018-2022). It looks as though most developers and owners have started to read the signs and pulled back on launching new projects as to not make some of the same mistakes made in past expansionary periods. While the moderating of starts is a good thing, that doesn’t mean the threat for oversupply in some markets and submarkets isn’t there. It will bear watching over the next several quarters.
The 2023-2024 outlook will play into the pipeline as well. Demand is forecasted to lose speed and register totals closer to those realized at the beginning of the expansion amid economic headwinds. Nevertheless, growth will continue to be positive with 350-400 msf of absorption anticipated in 2023 and 2024 combined. To help bring balance back to the market, construction completions will persist and new supply will outpace demand by roughly 1.9x, leading to higher vacancy rates across many markets. Although the national vacancy rate is projected to reach around 5.3% by year-end 2024, the market will remain historically healthy with vacancy, matching the 10-year historical average. Due to the scaling back of construction mentioned previously, vacancy is not expected to top out higher than 5.3%.
As we approach a time of economic uncertainty, the outlook for the industrial market is still a healthy one.
*Select markets used for the purposes of this study