This spring, Duke Realty bumped up its forecast for development starts in 2018 from a range of $500 million to $700 million to a range of $650 million to $850 million.
Capitalizing on intense demand for industrial space, Duke Realty Corp. is on a development roll.
As it stands now, the Indianapolis-based industrial REIT owns and operates about 149 million rentable sq. ft. of industrial properties in 20 major U.S. markets. The portfolio is ballooning quickly, though.
This spring, Duke Realty bumped up its forecast for development starts in 2018 from a range of $500 million to $700 million to a range of $650 million to $850 million. As of early April, $337 million in development projects totaling 4.5 million sq. ft. were already underway.
“As a general rule, we’ve got development going in most all of our markets right now—some more than others,” says Jim Connor, chairman and CEO of Duke Realty.
Connor cites Southern California, South Florida, New Jersey, Atlanta, Chicago and Dallas as some of the top-tier markets where Duke Realty is adding the most space. However, he points out that the REIT has developed more than 2 million sq. ft. of industrial space this year in one second-tier market—Columbus, Ohio.
Across the company’s 20 markets, e-commerce players drive anywhere from 25 percent to 40 percent of development and leasing activity for what Connor likes to call “modern logistics buildings.” Those buildings serve customers such as Amazon, Home Depot, Target, UPS, Walmart and Wayfair.
In a Q&A with NREI, Connor delves into his outlook for the industrial sector, including the role played by e-commerce, and discusses Duke Realty’s development and leasing forecast.
This Q&A has been edited for length, style and clarity.
NREI: How are you feeling about the industrial sector these days?
Jim Connor: I’m feeling pretty good. Business is really, really good. Some of my peers jinx us when they say, “It’s as good as it gets” or “It’s never been better” or anything like that.
NREI: What underlies that “pretty good” feeling?
Jim Connor: You’ve got 4.5 percent vacancy nationwide. It’s the lowest it’s been as long as anybody can remember, and they’ve been keeping records 25-plus years. We keep predicting every year that supply is finally going to catch up with demand, and it still hasn’t happened yet. Based on activity, I don’t see that trend changing. When you’ve got that low of a vacancy rate, it allows us to keep the occupancy rate in our portfolios ridiculously high. Our in-service portfolio is 97.5 percent leased [as of the first quarter of 2018], and with that you get great, strong rent growth numbers.
The challenge for us—and there’s always a downside with the upside—is we’re really in favor right now, so there’s a ton of capital chasing industrial. Even though interest rates have gone up 50 to 60 basis points in the last eight or nine months, we’ve seen cap rates on industrial compress 25 basis points, and maybe more in some cases. So, there’s a lot of competition out there.
NREI: The industrial sector has been really hot lately. How long is that streak going to last?
Jim Connor: Absent some global event that obviously nobody anticipates, I would tell you the market dynamics we’re seeing look really good for the next 18 to 24 months. That’s with the supply-and-demand equation staying in balance; even if we reach equilibrium with supply and demand, equilibrium is not a bad place, particularly when you reach equilibrium with 4.5 percent vacancy. That’s still a landlord’s market.
Nobody’s slowing down at all. E-commerce continues to be a big, big driver in our business. Those guys are not slowing down. Our traditional customers—retail and consumer products companies—are investing in their supply chains to get products to their customers more quickly and more efficiently. You’re seeing a tremendous amount of investment and modernization in that sector to help them compete with the e-commerce business.
NREI: How much more industrial activity can be supported by e-commerce?
Jim Connor: I believe, as do most of the industry experts, that e-commerce is in the very, very early innings—arguably the second or third inning. E-commerce today represents about 9.0 or 9.5 percent of total bricks-and-mortar retail sales. Most experts will tell you that’s heading to 20 percent.
So, if it heads to 20 percent, that would tell you there’s a lot of runway for industrial. It doesn’t mean that all of the e-commerce deals that we’ve done in the last 10 years, we’re going to double that square footage. But it means there’s a lot more demand for e-commerce facilities, whether it’s for pure e-commerce companies like Amazon or Wayfair, or whether it’s this new generation of e-commerce food companies like Blue Apron, or whether it’s existing retailers and consumer products companies that are investing in the supply chain to better support their e-commerce efforts. The logistics sector looks very, very bright for the next several years.
NREI: In light of the demand you’re foreseeing, are you leaning more toward development or acquisitions? How does that play out in terms of adding supply to meet demand?
Jim Connor: We’re kind of blessed. We can do either/or, or in some years we do both. The vast majority of our capital and our time and energy today is going toward new development, both build-to-suits and speculative, because it’s much more lucrative for us. We’re developing projects that are probably 200 to 250 basis points higher in sustained yields than on the acquisition front. We’re very, very focused on the development side.
NREI: What are you projecting for leasing?
Jim Connor: In 2017, we did about 23.7 million sq. ft. of leasing, which was a phenomenal year for us, one of our best ever. In the first quarter of 2018, we did just under 7 million sq. ft. Ours is not a perfectly linear business, but based on first-quarter activity, our expectation is to meet or exceed last year’s leasing volume, which would put us in the mid-20 million-sq.-ft. range and would be another phenomenal year. With occupancies so high across all of the markets, until you create some softening in some of the markets—either a pretty dramatic fall-off in demand or a bunch of oversupply—I think you’re going to continue to see very, very strong numbers in terms of leasing and rent growth that industrial owners are going to put up.
Pressures within the sector are already being felt.
Nearly one year after Amazon’s acquisition of organic grocer Whole Foods, the grocery-anchored shopping center sector, typically viewed as more “Internet-proof” than other segments of retail, has taken greater strides to boost its omni-channel offerings.
So far, the acquisition has not been overtly disruptive to the grocery industry, experts say. However, some grocers are still working to hedge any long-term effects of the deal, particularly as smaller chains struggle to keep up with technological pressures and price competition intensifies. These factors could lead to continued consolidation of smaller grocers and increased investor scrutiny of grocer tenants, according to those in the industry.
“There’s been a limited short-term impact on existing brick-and-mortar grocers,” says Joseph McKeska, president and co-founder of Elkhorn Real Estate Partners, which provides advisory and investment services for those in the retail real estate sector.
There still could be a greater impact should Amazon look to expand its brick-and-mortar food footprint, McKeska says. That’s what’s triggered some grocers to improve now, even if it hurts their bottom lines in the near future, “in anticipation that Amazon is going to become more aggressive over time,” he says.
But to start, it appears the union of the online retail giant and Whole Foods, which has some 480 stores in North America and the U.K. and is known for its focus on organic fare and higher-than-average prices, was to improve Amazon as a retailer by giving it more of a physical foothold, says Theresa Johnson, senior vice president of retail investment sales at Avison Young, a real estate services firm. The move comes as there has been increasing competition between Amazon and Walmart. Walmart operates more than 4,100 stores in the U.S. and acquired e-retailer Jet.com in 2016 for $3.3 billion.
The acquisition of Whole Foods also allowed Amazon to tie discounts related to its Prime customer loyalty program to the grocer. “The Amazon acquisition was more of a play to get people more embedded into the Amazon model,” Johnson says.
Other grocers have taken notice. Prior to the transaction, many brick-and-mortar chains were already working on improving their omni-channel services. But the partnerships and services offered only seemed to escalate in the months since the deal’s announcement.
Kroger, for example, which operates some 2,400 stores across the U.S., introduced a partnership with online grocery service Ocado and expanded its partnership with Instacart, a customer delivery service. In its first quarter earnings release, Kroger reported it grew its digital sales by 66 percent during the quarter. Meanwhile, Walmart, which has announced partnerships with delivery companies Postmates and DoorDash, reported that its e-commerce sales grew by 33 percent in the first quarter of 2018.
Indeed, it appears there is growing consumer demand for these types of services. A report from analytics firm Nielsen found that 23 percent of shoppers in the U.S. purchased groceries online in 2016, which is 20 percent more than two years prior. The firm estimates that between 2021 and 2023 total online grocery spending in the U.S. will hit $100 billion. And according to a survey Nielsen conducted, 69 percent of households said home delivery models appeal to them.
Grocers have also started to reinvest more into their physical stores and some have pulled back on expansions. A report from real estate research firm JLL found that grocery store openings were down 28.8 percent from 2016. Investment sales in the grocery-anchored shopping sector remains strong, however, as in 2017 the sector saw sales growth of 5.3 percent, the report stated. That may be because property fundamentals are still strong. While the retail sector overall has struggled, the occupancy rate for neighborhood centers was close to 93 percent in the second quarter, up from 92.4 percent year-over-year, according to research firm CoStar. Rents for the sector grew by 1.9 percent year-over-year.
Nevertheless, the grocery market is oversaturated with stores—whether its non-traditional grocers like Walmart expanding or traditional players overtaking existing chains—and that could trigger more chains to concede market share, wrote Suzanne Mulvee, director of research at CoStar, in an email. “There is not enough room for all of these players to succeed, and chains will continue to be displaced by those with a better business model. A bigger shift to e-commerce in this sector will lead to even more consolidation,” she wrote. Most at risk from these pressures are middle-market grocers, or those that favor trade areas with $50,000 to $70,000 in median household income (think Aldi and Kroger).
“It was a warning shot across the bow, as they say, and each of the stores has reacted in their own ways,” says Joel Murphy, CEO of New Market Properties LLC, of the Amazon deal. New Market, an Atlanta-based owner and operator of 41 grocery-anchored shopping centers in seven Sun Belt states, has been working with its grocers to modify its centers’ common areas if needed to help grocers facilitate these offerings, for example with expanded refrigerated sections, Murphy says.
Meanwhile, some of the smaller grocers who may have already been struggling may not have the capital resources to implement the costly infrastructure needed to be competitive in the online world, Murphy says.
And pressures within the sector are already being felt. The Fresh Market Inc., a grocery chain based in North Carolina that was acquired by private equity firm Apollo Global Management for about $1.36 billion, announced recently that it is closing 15 underperforming stores across the country. Southeastern Grocers, the parent of Winn-Dixie, announced in March that it was closing 94 stores in the U.S. and filing for bankruptcy. And Tops Markets LLC, a regional player, said it to was filing for bankruptcy amid increasing price pressures from Amazon and debt, Reuters reported.
With Amazon now playing in the grocery sector, consolidation in the space, particularly as smaller, regional grocers are pushed out of some markets, may only continue. The deal not only intensified a price war that had been long felt throughout the industry, but also introduced a technology war, says Jeffrey Edison, CEO of Phillips Edison & Company, which operates hundreds of shopping centers across the country. Now investors will have to be more selective about the grocers they have in their tenant mix; the grocers who are not investing in technology will have a good chance of being left behind, Edison says. “It’s going to make it increasingly important on who you bet on for your anchors,” he notes.
Aside from watching grocers adapt to these new pressures, Edison says his firm is also avoiding tenants that are backed by private equity firms. News has abounded in recent years of retailers in other sectors that have been acquired by private equity, taken on a lot of debt and subsequently closed many stores or filed for bankruptcy—Toys ‘R’ Us being a prime example. “We don’t believe leverage in the retail business works over a long period of time,” Edison says, as it deprives retailers of the ability to reinvest in their stores. “It’s very destructive,” he adds.
Phillips Edison & Company, Inc. (PECO), a public non-listed REIT (PNLR), said July 18 that it has agreed to merge with Phillips Edison Grocery Center REIT II, Inc., a PNLR it currently sponsors and manages, creating a $6.3 billion REIT focused exclusively on grocery-anchored shopping centers.
The stock-for-stock merger will create a national portfolio of 323 grocery-anchored shopping centers encompassing approximately 36.7 million square feet, located across 33 states.
Glenn Rufrano, CEO of VEREIT, Inc. (NYSE: VER), participated in a video interview at Nareit’s REITweek: 2018 Investor Conference in New York.
Rufrano said VEREIT’s portfolio diversification is moving in a positive direction after standards were set for it more than two years ago. While there is still work to do, he said, protecting the downside of the company is key.