2019 outlook: Real estate

As e-commerce grows, industrial REITs are benefiting from strong demand for warehouse properties in supply constrained areas.

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As the retail industry increases its emphasis on online sales, we've seen an equally big shift in the logistics business—obtaining, storing, and transporting products from source to destination. As real estate portfolio managers, we see industrial real estate investment trusts (REITs) as a potential opportunity to capitalize on this global theme. Industrial REITs own, operate, and develop warehouses for providers of manufacturing and, especially, logistics services.

Demand for high-quality logistics space has been surging, and the supply has fallen short. According to real estate services provider CBRE, demand for warehouses has exceeded supply every year since 2010, while occupancy rates have gone from just over 90% to greater than 97% today. Meanwhile, leasing spreads—the gap between new lease rates and what a tenant previously paid for the same space—have risen at a mid-teens percentage rate.

Growth in e-commerce is a big reason behind this demand. According to CoStar Group, an information provider for the commercial real estate industry, e-commerce sales volume has been growing at an annualized rate of greater than 10% per decade and recently saw its fifth straight quarter of annualized growth exceeding 15%. According to CoStar’s analysis, e-commerce sales volume is closely linked to logistics facility absorption—meaning how much the demand for space has "absorbed" new supply of logistics real estate. So, with the expansion in e-commerce sales, we’re seeing equally robust growth in demand for warehouse and logistics facilities that has, so far, shown no sign of abating.

To meet the demand, industrial REITs increasingly must locate warehouses where they can serve the needs of online shoppers, whose expectations for delivery times have changed dramatically. As two-day, next-day, or even same-day deliveries have become the norm, warehouse operators often now choose to locate closer to consumers, including in geographically constrained and more expensive areas such as coastal cities.

As the retail landscape shifts, businesses are scrambling to figure out how to move product from manufacturers to consumers in a cost-effective manner. Surprisingly, locating warehouses in higher-cost areas has helped: Although tenants ultimately pay higher rents, they still represent less than 5% of supply chain costs, according to Prologis Research (see chart above). That makes it a lesser consideration relative to the savings from reduced transportation costs—along with labor, the other main expense—by locating closer to customers.

We also see other factors supporting our overweighting of industrial REITs. One is that both equity and debt capital have become more affordable for REITs. This has fueled external growth via acquisitions and new development, which in turn has driven earnings growth beyond what any other REIT sector is experiencing.

Industrial REITs also appear well suited to the current economic environment. Since 1994, this segment has been the strongest performer in the REIT market during periods of either rising rates or flattening yield curves—both of which we’ve seen in recent years.

As we look to individual investment opportunities within the industrial REIT category, our preference is for companies that: (1) focus on well-located, unique properties in highly desirable locations and that can facilitate "last-mile" delivery; (2) can potentially provide strong organic earnings growth; (3) offer a strong balance sheet, which facilitates external growth; and (4) can take advantage of new technologies to offer a competitive advantage to tenants.

Next steps to consider

Research the Fidelity® Real Estate Investment Portfolio (FRESX).

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