Canada’s industrial real estate market was performing well for owners and managers before COVID-19 hit and it’s been cranked up to another level since the onset of the pandemic.
Panattoni Development Company research manager for strategy and market intelligence John Scioli moderated a four-person panel on how the industrial market has outperformed all other sectors and what to expect in the future at the June 7 Land & Development conference at the Metro Toronto Convention Centre.
The session was led off by a short presentation by MSCI executive director Bryan Reid.
The rolling 12-month total return on the MSCI/REALPAC Canada Annual Property Index was well over 30 per cent in December 2021, which Reid said eclipses anything historically seen in institutional investment markets — and the gap between industrial performance and other asset classes is widening.
MSCI tracks approximately 90 global metropolitan areas and Toronto’s 22.7 per cent, five-year annualized total return for industrial properties (as of December 2021) ranked second only to Riverside, Calif.’s 23.7 per cent. Edmonton’s four per cent return during that same period was among the weakest in the world, but was still positive.
Due to this strong performance, investment allocations are shifting and industrial’s share is increasing domestically and around the world. From December 2011 to December 2021, industrial’s allocation rose from 10.3 per cent to 20.7 per cent in Canada.
“Some of that is the organic component that values are rising faster for industrial,” said Reid. “So what’s in the portfolio is increasing proportionally, but then also we are just seeing a huge amount of net inflows into the asset class.”
The share of industrial transaction volumes in Canada has also increased and is now at more than 30 per cent.
Industrial rents are increasing by eight to 10 per cent year-over-year, according to Reid, but recent transaction activity suggests potential 20 per cent-plus increases in some markets.
Industrial development moving farther out of GTA
Fengate senior vice-president of development Andrew Konev said his company will look at land outside the core Greater Toronto Area (GTA) market based on its performance projections and benefits such as access to labour and transportation, sensible development approval timelines and reasonable construction costs.
When looking for spaces of 100,000 to 300,000 square feet, there are often few options so National Logistics Services director of supply chain solutions and engineering Nick Gaganiaras said his company might be forced to look elsewhere.
He said this might only offer a short-term solution of less than five years because another market might be sub-optimal from labour and transportation perspectives. However, if it meets immediate needs, the decision can be re-evaluated later.
Labour remains critical, according to Gaganiaras, who pointed out that large, fully automated Amazon facilities in Brampton, Ont., still employ 1,000 people per shift.
“We need the technical capabilities, the maintenance, the computer and the local knowledge to keep the systems running, so labour is still a very critical component of decision-making.”
Avison Young real estate broker, associate and principal Ben Sykes said some companies have no option but to move outside of the GTA because most land, aside from some infill sites, has been built out.
While there are a large amount of large industrial facilities in the pipeline in the GTA, Sykes said there is very little small and mid-bay space available. Yet, there’s a large market because few developers are servicing that segment.
Konev said there are price discounts outside of the GTA, but they’re not significant.
Sykes reminded attendees that, despite skyrocketing rents, they only account for five per cent of overall supply-chain costs. A 20 per cent increase should therefore be looked at from that perspective.
Supply chain issues
Gaganiaras said the supply chain is moving from a just-in-time to a just-in-case model, which presents challenges.
“Now you’re paying more for space to store product that you’re hoping to sell, but then we move further upstream and we have huge disruptions in ocean and air schedules. So the inventory that you’re bringing in that you’ve planned for is missing the season. And so we’re now building up inventory that’s off-season.”
Konev said Fengate sees plenty of demand for short-term storage.
“When you want to put up a building, you need a building to store a lot of your equipment. If you’re building condominium building, you need to store your appliances. A lot of demand is coming from that segment of the market, so we’re trying to figure out how to cater to that short-term piece.”
Forecasting is another challenge, according to Gaganiaras, who said e-commerce was growing very rapidly two years ago but has now flattened out. E-commerce facilities typically require four to five times the amount of space as a traditional retail fulfillment operation, he added.
“When you’re forecasting inventory and you’re trying to build-out systems and facilities and supply chain strategies, there’s really a lot of potential outcomes where you could be at 200,000 square feet or you might be at 150,000 square feet,” said Gaganiaras.
“And there’s a huge difference as it grows and compounds. It becomes a long-term impact. So the idea of short-term storage or short-term solutions is very attractive to the end-users and the occupiers because it allows us to manage more discrete challenges.”
“Users are trying to figure this out on the fly and at the same time they’re being forced into signing long-term leases,” said Sykes. “We have clients that are literally at the start of a project in some cases and don’t exactly know the specific business operation or how they’re going to operationalize the building.”
Seventy million square feet of industrial space is in the GTA development pipeline, said Sykes.
Gaganiaras said delivery of automated systems for new industrial buildings takes at least a year and often longer, so they don’t coincide with the building fit-up. The systems also take two months to commission.
“There are a lot of challenges in marrying up all these different components, where historically you could order racking. You knew what the lead time was and you knew exactly how long it took to take it up. And as soon as it’s up, you could start using it.”
In a rising rental rate environment, developers often want to wait as long as possible to lease a new building to maximize leasing rates. Sykes said 90 per cent of the industrial space being delivered this year is already leased and much of the space coming in 2023 has also been committed, so tenants are looking into late 2023 or 2024 to secure space.
Everyone is building in aggressive inflation rates into their costs and Fengate errs on the conservative side and builds in bumps on interest rates when considering land purchases.
“You have to believe in the growth to really make sense of any land purchase these days,” said Konev.
Multi-storey industrial and automation
Fengate hasn’t built multi-storey industrial buildings because of the high cost and lack of tenant demand, but said it could make sense once land hits $6 million to $8 million per acre.
Sykes said multi-storey industrial is being driven by developers – due to high land costs and constrained land availability – more than by end-users which can face higher fit-out costs for taller buildings.
Spec-built, single-storey facilities in Canada are topping out at 40-foot clear heights while many European industrial buildings are up to 60 feet.
Gaganiaras said most traditional equipment caps out at 40 feet and the costs of adding automation and going higher are significant. Such buildings also reduce the potential tenant pool as most users can’t take advantage of 55-foot clear heights, he added.
Sykes pointed out that moving products up and down also takes more time, adds to costs and may not be appropriate for items that churn quickly. Operating heavier equipment that can go higher also requires wider aisles, which may somewhat negate any benefits, Gaganiaras added.
Konev said municipalities are often willing to push fully automated industrial facilities through the approvals process faster because of the promise of high-paying jobs for the area.
Gaganiaras said tenants are making their automation systems work in whatever space is available. In a market with more equilibrium, users would be seeking buildings with higher power availability and clear heights, and sufficient structural strength to manage conveyances at ground level and connected to the ceiling.
Sykes said automation is very expensive and users have to consider payback periods before making such investments.
“The challenge for a lot of these users on the automation side is their business could be quadruple or half, or they could be bought by somebody.
“So how do they go and invest in a 20-year payback automation system, not knowing that in five years they may need twice the amount of space? And then all of a sudden all that infrastructure’s just out the window.
“Automation is great, but it’s not the cure for even e-commerce.”
Scioli said many tenants are seeking three- to five-year leases and thus aren’t willing to invest in automation systems.
Traditional racking solutions offer flexibility via adding or subtracting staff to manage inventories, Gaganiaras noted, while automation is expensive fixed infrastructure but can continuously run at full speed.
Konev said tenants planning sophisticated automation will seek a design-built facility to incorporate it and offer built-in expansion capabilities. They’ll also lock in to 30-year leases.
Impact of ESG considerations
Fengate is a speculative developer focused on keeping costs down but still delivering quality and Konev said many tenants aren’t willing to pay a premium for LEED-certified buildings. Sykes agreed, saying tenants are primarily focused on rents and when they can move in.
“If you truly want to future-proof your building and you’re OK to take a small return today, then work some of these things into your model,” said Sykes of LEED and other ESG initiatives.
“If it’s all about ‘What are my returns from Day One and will the tenants pay?’ I don’t think the tenants now will pay.”
Reid said all major institutional investors have ESG mandates for assets that will be held a long time.
Scioli said green buildings trade at a premium in Europe and he’s starting to see some demand for LEED-certified buildings by both tenants and some municipalities in Canada. He noted Panattoni is building class-A industrial buildings that are close to LEED status.