It’s no secret that the U.S. industrial property market has been on fire—especially over the last few years. And with vacancy reaching new record lows of 3.1% at mid-year 2022, rent growth has accelerated at a rate never seen before. Although many assume that inflation is the main culprit of this accelerated rent growth, a recent Cushman & Wakefield occupier inflation article illustrates that rental rate growth is tied to vacancy rates, not to inflation.
To put into perspective just how tight the current market is, look at the current vacancy rate in comparison to the industrial construction pipeline. As of Q2 2022, there was almost 700 million square feet (msf) of space under construction with just under 26% of that space pre-leased, leaving well over 500 msf of product currently without tenant commitments to be delivered over the next couple of years. Based on preleasing rates, even if all speculative products were to hit the market immediately as vacant, the national vacancy rate would only tick up by 320 bps to 6.3%. The probability that rents will decline is extremely low, with little risk that overall vacancy rates will rise that rapidly or to concerning levels next year. Not every industrial-logistics occupier has a lease rolling this year or next, but eventually all occupiers who rent real estate will face these conditions.
Ongoing tight market conditions and aggressive competition for space resulted in 16.4% year-over-year (YoY) asking rent growth in Q2 2022. At $7.47 per square foot (psf), this is the second quarter in a row that national overall net asking rents for warehouse/distribution space have surpassed the $7.00 psf mark. In fact, 44 of the 81 markets tracked by Cushman & Wakefield saw warehouse/distribution asking rents exceed $7.00 psf and 35 markets surpassed 20% YoY growth in Q2 2022. Warehouse/distribution overall net asking rents will continue to grow but national headline trends only reveal so much about the market.
Differences between asking rents (defined as the annual cost per square foot offered by the landlord or sub-landlord for leasing space) and taking rents (defined as the agreed upon rent to be paid at the start of the lease signed between the occupant and the landlord) and trends in those rents, can cause unexpected outcomes for occupiers and are important to investors’ returns. Just how different have asking versus achieved lease rental rates trended over time? Do these vary in level and/or growth terms, and, if so, what are the implications?
How high are rents, really?
On a national level, there has been a consistent trend over the past twelve years (2010-2021) of both asking and taking rents for warehouse/distribution space mostly increasing. And while both see periods of deceleration, asking and taking rent decreases tend to occur at different times. There are a few reasons this is inclined to happen. Asking rents can remain sticky because owners are still listing at "hopeful rates" vs. taking rents which adjust quicker to real market conditions. Or asking rents may stay elevated slightly longer even as the market slows because owners aren’t willing to drop the asking price, but they are willing to offer more concessions which are captured in “taking rent." As time has passed, the divergence between the rates has begun to grow. As seen in Figure 1 below, both average net asking rents and average net lease rates have grown, but the growth rate in taking rents has exceeded that of asking rents, especially in 2021. The difference between net taking rates and net asking rates was 28.2% at year-end 2021, up from a 12.8% spread in 2011. As the market has tightened over the years, landlords have gained additional leverage. Although asking rents have appreciated, taking rents have outpaced due to occupiers competing aggressively for more limited space options. Thus, this widening was not due solely to 2021 rent growth.
While national relative spreads have grown from 12.8% to 28.2% over a 10-year period, this varies significantly across market type, class and other property types. For primary markets, the spread increased from 7.9% in 2011 to 37.5% in 2021 while its share of leasing activity largely held steady (38% in 2011 and 36% in 2021).
This spread could be even more severe for markets in the 75th percentile (i.e., higher cost markets) for net asking rents. In contrast to the prior figure’s data where the relative spread has remained somewhat bounded—the top quartile’s (high-cost markets) relative spread continues to widen. As you can see in the figure below (see figure 2), rents in the upper quartile saw a widening delta between asking and actual taking rates over time. It was, in fact, the largest delta between the quartiles. This is intuitive, of course, that the markets with higher asking rents will pay more than the median, but by how much of a difference can markets with the highest asking rents see compared to taking lease rates? By 2021, the taking rates for transactions signed in the top quartile were 63% higher than average asking rents. The dispersion of rents is growing over time, demonstrating that the variance of rent payments is growing between markets and product type. The most significant increase in the spread was in 2021. Markets where we see these higher rates are traditionally primary markets as well as coastal proximate markets like Los Angeles, Inland Empire, New Jersey, the New York Outer Boroughs, Long Island, San Francisco and San Diego.
How does this impact tenants?
Occupiers need to be aware of the relationship between asking and taking rents, lest they get an unpleasant surprise in terms of rent spend. Limited availability of stock has ceded control to landlords when it comes to negotiating rents. Unfortunately, this can put potential occupiers at a disadvantage as some landlords will just mark an available building “subject-to-offer” or “negotiable,” instead of quoting an asking rent. This can leave the door open for a landlord to ask whatever rate they choose without proposing an asking rent. The omission of asking rents on availabilities can also distort market statistics.
Let’s use an illustrative example to show what the impact of differences can have on rental/cost planning. In this example, there is an active occupier in the market looking to expand and lease five new 100,000 square foot (sf) buildings across the country. Based on the current asking rent for the markets, plus a 3% annual escalation, we can estimate what the total rent spend would be over a relative five-year and seven-year period. (Most lease lengths have historically been in this range.) Factoring the 2021 year-end spread of 28.2% between asking and taking rents, we can calculate the actual rent spend for said occupier on these five new 100,000 sf properties they plan to lease (see Figure 3). On the five-year lease, said occupier could be under-estimating rent payments by nearly $5.0 million and on the seven-year lease by nearly $7.2 million. For most companies, that amounts to a significant increase in rent spend that they hadn’t planned on. For example, if your firm has an annual operating expense budget of $50 million versus $250 million, then these impacts are dramatically different. In these market conditions, it is clearly more important than ever to carefully consider the difference between asking and taking rents when entering a new market and leasing a new space.
Less obvious than the prior example would be one in which an occupier is planning to enter the market in the next year or two, especially in segments of the market where there is structural pressure on the spread between asking and achieved rents (such as in the 75th percentile which is 63%). In this case, using today’s spread is not very useful since it will likely continue to grow. So, assuming two or three years from now the overall asking rent versus lease rate spread grows by the current CAGR (Compound Annual Growth Rate) trend of 6.3% (an additional 18.8% over that three-year period), the applied example would then result in millions of dollars more in rent spend. This lack of transparency is a major risk for occupiers.
Investors also need to pay attention to the differences
The aforementioned example is also of particular importance to investors because it can impact expected total returns via income growth. This, in turn, can support different valuations and exit cap rate assumptions. What matters here is the relative spread, or variance of growth, of asking rents versus taking rents. For example, in the figure below (see figure 4), the spread between the Class A asking rates versus the Class A lease rates for warehouse/distribution space grew even faster than overall, which means there is more growth potential to NOI (Net Operating Income). Class A lease rates started to climb incrementally over the past ten years but saw the largest delta in 2021 with a $2.72 psf or 53% percent difference over average asking rates. Over the last decade, Class A asking rents only increased 1.6% annually on average while actual lease rates increased 7.2% annually on average, or a 550-basis point difference. This higher NOI growth potential (assuming a fully occupied building throughout the five to seven-year lease from the previous example) by holding these buildings could result in a higher value and therefore a higher sale price, even if cap rates remain the same or even rise somewhat.
Now, let’s use the data from Figure 3 as an example but with taking rents. If estimating the purchase price of the five-year value of taking rents with a 5.0% cap rate and we assume the NOI is $20.7 million (excluding operating expenses for the sake of the example), the purchase price of the portfolio of buildings would be $414.4 million. If we apply the same to the actual lease rates assuming NOI is $26.6 million with a 5.0% cap rate, the purchase price would be $531.5 million. That is a difference of roughly $117 million (or a 28% increase). Even if adjusted to a higher exit cap rate of 7%, the difference between pricing is $83.6 million, still a significant difference in pricing.
What happens next?
With inflation adding to nearly every operating expense occupiers incur, and rising interest rates top of mind for investors, having a deep understanding of rent dynamics has never been more important. National asking rents are expected to grow—effective rents even faster—as market conditions remain tight despite some upward movement in vacancy rates. This analysis has revealed that the incredible nuance to rent planning necessitates vigilance and thought when looking for real estate. Recession notwithstanding, industrial rental rates will continue to climb for the next couple of years, albeit at a slightly slower pace. Based on Cushman & Wakefield forecasts, even the most severe downside stagflation would still see 18% taking rent growth through 2026—still around 3.6% growth annually on average. It will be critical to keep an eye on all leasing fundamentals to help predict where rents will trend.