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Today we present a guest column from Goran Brelih, a Senior Vice President for Cushman & Wakefield ULC. He has been servicing investors and occupiers of industrial buildings in the Greater Toronto Area for the last 27 years, and has been involved in the lease or sale of approximately 25.7 million square feet of industrial space, valued in excess of $1.6 billion dollars.
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Present - Are We in a Landlord’s Market?
A few recent Toronto newspaper articles have described our commercial and industrial markets as such:
“Toronto Is Running Out Of Commercial Real Estate And Has Record High Rents”
“Toronto is the Most Constrained Industrial Market in North America”
“Availability in Canada’s Major Industrial Markets Continues to Plummet; Putting Pressure on Tenants.”
Can the 'new normal' rents be explained entirely by a lack of supply?
Or are there other factors at play here?
And, can we look elsewhere to model and predict what may be in store for the GTA in the near- and long-term future?
Well, the truth is, the supply of industrial space in the Greater Toronto Area reached a historic low in Q1 2019, with predictions that it will become even more constrained, while industrial net rent has reached its highest level ever.
But to get an even clearer picture of what is going on, let’s first take a look at GTA Industrial Market as it relates to other centres in North America…
The Greater Toronto Area Industrial Market is one of the top three industrial markets in North America and continues to grow…
In addition, the Greater Toronto Area is one of five supply-constrained markets in North America; where demand outstrips supply by a large margin. When trying to examine what is actually happening and driving changes in our market, this is an indicator to watch closely, something that can have effects for years to come…
Right now, though, this imbalance of supply and demand has pushed vacancy rates to a historically low rate of 1.5%.
Worse, when looking at properties of a medium- to small-size, vacancy rates dip even further to below 1%; with 0.9 % for properties between 20,000 - 50,000 SF and 0.3% for properties smaller than 20,000 SF.
For smaller operations, this means finding space is downright impossible unless you can find an off-market opportunity and are willing to outbid competitors (or just get lucky).
For users looking for big-box spaces, this may mean pre-leasing a couple of years in advance or developing your own space.
So, why is that? Well, nobody is building small bays anymore; it is too expensive, plus developers are focused on delivering new ‘big-box’ warehouses suitable for e-commerce….
Such an imbalance of supply and demand, coupled with low vacancy rates has caused net rental rates to increase 42.5% over the last four years…
In the past year alone (Q1 2018 to Q1 2019), there was an increase of 21.3%, suggesting that this trend will continue to accelerate, especially if supply continues to stagnate.
Now, when looking at the movement of rents by building size, this pressure has hit smaller tenants the hardest, with a 57.1% increase in the small bay market (below 20,000 SF), while the large bay market (200,000 SF plus) has (only) gone up 34.6%.
This makes sense given our previous point regarding non-existent vacancies and developers’ lack of motivation to construct new product of this size.
And while there is some inventory coming to the market in the 100,000-200,000 SF and 200,000 SF plus range, much of it is already pre-leased, and thus, demand is pushing rents in those ranges higher, as is clearly shown in the upward curvature of rents.
Overall, there is still room to grow for the Average Net Rental Rates (in USD) in the Greater Toronto Area Industrial Market, given they are still way below other North American centers.
However, based on the increase in the last twelve months it appears that we will be catching up with Vancouver and Los Angeles very soon…. way sooner than expected…
Past - What's Driving the Market Forward?
The growth in the GTA Industrial Market is driven by the relentless expansion of e-commerce.
People are changing their shopping habits; everybody is ordering more and more “stuff” online and retailers are adopting, not only to capture this audience but to keep up with their competitors.
We can see that online retail sales in Canada are predicted to grow by $18.8 billion USD between 2017 and 2023. For each $1 billion USD of sales volume, we require approximately 1.2 million SF of industrial space. Older and functionally obsolete properties don’t count here…. We need new buildings that are both designed and built for E-commerce. So, keeping with these assumptions, just to keep up with and satisfy the growth of online retail sales, we will require 22.56 million SF of new distribution space…..
Now, the scary part about this is that we aren’t even considering the full potential of e-commerce. This is purely looking at core e-commerce and online retail for mainstream products such as clothing, books, supplies, and other small goods. In addition to large e-retailers broadening their product selection, we will see additional verticals moving towards online sales, as well as market penetration within each vertical.
We are already seeing this next huge wave of change; driven by the food sector, which is adopting offerings such as home-delivery grocery and pre-made meal services. In the GTA alone, a number of major retailers are building modern cold-storage distribution centers to deal with this demand.
And when I say modern, I mean modern.
Fully automated warehouses with 90 feet clearance.
Racking systems and robotic automation. The full package.
This growth in online retail sales and surge in demand for space has created an average annual absorption of 9 Million SF; more than three times greater than that from pre e-commerce…
When juxtaposed as such, it’s unmistakable the effect that e-commerce is having on the industrial market as a whole.
The only question is, how will it continue to evolve from here?
Understandably, when a business expands and invests in their real estate and operational infrastructure, they need people to then operate the day-to-day activities. In the context of e-commerce, the workforce required is for:
• bringing product in,
• re-organizing it, and
• getting it out and delivered to end consumers.
It’s no surprise that, therefore, we see this surge in demand for labor in Trucking, Warehousing, & Support Activities; with the Warehouse & Storage Sector leading the way with an explosive 73.5% demand growth between 2015 and 2018…
To further solidify our observations and argument that e-commerce is the engine driving the Industrial World right now, it would make sense to see 3PL companies growing alongside them.
Looking at the numbers, 3PL Companies leased almost 30% of all industrial buildings in the last 5 years, compared to leasing only 4.8% between 2004 - 2008; a period that we classified as the pre e-commerce era…
Lastly, diving deeper into the changes in demand for skilled workers, we see how strong the job market is for Trucking, Warehouse & Storage, and Supporting Activities across the Greater Toronto Area.
As any system expands and grows, its potential is always capped by the limiting agents; basically, which resources get used up first. In this case, it may very well end up being the labor pool.
The unemployment rate in Canada fell to 5.4 percent in May of 2019 from 5.7 percent in the previous month and below market expectations of 5.7 percent. It was the lowest since comparable data became available in 1976.
Given the fact that unemployment is at 5.4% (its lowest level since 1976), labor has become an extremely important factor in the site selection process.
Availability of skilled or unskilled labor will be a challenge for any companies leasing or looking to occupy these brand-new, shiny warehouses out in West Milton or Caledon-North; so far from where people are commuting from.
Firms such as Amazon or Wall-Mart have unlimited resources, however, they are playing in an arena with finite space and limited access to both people and transportation routes; which are both extremely costly.
The implications of this are that the firms looking to find space - whether it be to lease, purchase, or build - should look to find the best location possible. The premiums to occupy or purchase space are negligible compared to other line items, and thus, as long as the supply of product is slow to come on board, there is no reason for rental rates and valuations to stop going up.
Future - So What’s Next For the GTA Industrial Market in 2019 and Beyond?
As we have previously stated, we anticipate the supply of available industrial product to continue to be constrained while demand continues to increase, leading to further increases in rental rates…
This phenomenon will continue to create a ‘pressure cooker’ in the region.
So how do we anticipate things to change moving forward?
In a normal economic scenario where demand outstrips supply, we would expect to see price increases signal other producers and suppliers to either enter the market or produce higher quantities.
This is because rising rents and leverage in negotiating due to lack of availability would create higher profits. In the context of commercial real estate, that means we should see a boom in supply… but that is not what has happened.
Developers stepped on the gas but can only deliver so much; constrained with the amount of serviced industrial land. Further, everybody is building large distribution centres and moving away from (or allocating fewer resources to) small- and mid-size-bay buildings (aside from a few successful industrial condominium projects and conversions from rental to condos).
Compared to the last economic cycle, supply has tapered off this time around, suggesting that there may be other factors limiting new construction.
• The GTA is limited in its size, however, there is still more than enough land to build on, if that is what you really want to do (that land is located in Caledon and Milton, where we will have issues with labour.. and that still needs to be serviced).
• Taxes and development charges can be substantial depending on which municipality you build in, yet, those shouldn’t be that much of a deterrent.
• Finally, accessing the labor pool is becoming more and more difficult as the city sprawl expands and traffic arteries clog further, yet again, it’s still feasible.
• Whatever the reason may be, we expect the market to remain tight until at least 2022.
But what if there was another explanation?
An explanation that, if true, would change our view of this ‘pressure cooker’ demand and explain the not-so-robust rebound in supply since the last recession?
See, if we view demand through the lens of multiple tiers, then the rest of the indicators and symptoms make a lot more sense. Said another way, demand for certain types and sizes of product, in certain areas, will be greater compared to others.
Looking anecdotally, it’s obvious that location has become the most important factor for users requiring logistics, cold-storage, warehousing, or distribution facilities. Being in close proximity to major highways and population centres is the most cost-effective way to grow their operations.
The biggest firms such as Amazon, Tesla, Walmart, Purolator, etc. are all looking to create hubs or headquarters that will last for decades or even generations. They are building assets that fit into their overall strategic plan for connecting with their consumer base, not just finding ‘space’ to ‘put stuff.’ They are moving fast yet also planning for the super long-term.
If these users are willing to pay premiums, build or pre-lease, and wait years before occupying, then demand is focused on product in top-quality locations with particular specifications; which are naturally in short supply.
It would explain the rapidly rising rental rates, the high percentage of construction already spoken for, and the trend towards last-mile, last-yard, and livable cities.
And as a result of these firms and sectors driving the economy forward, other businesses will organically migrate or be born out of the abundance.
Toronto is already becoming a global city; the Canadian Silicon Valley tech hub and a financial centre.
Even with low demand, industrial rental rates will continue to grow to the low teens, however, at the current pace would break $11 or $12 PSF, or go even higher.
Strangely enough, if we considered demand to hit zero, it would still take the market over 5 years to adjust back to a normal 5% availability rate. This further illustrates just how much demand, albeit particular demand, remains to be processed.
Conclusion
Just as the Toronto Raptors have brought tremendous pride to the GTA and Canada through capturing the NBA Championship, the City as a whole has pushed through to a new identity under the international spotlight.
Users and occupiers recognize the value and opportunity that comes with investing in the Northern Star. While there are still many issues and growing pains that must be resolved, it looks to be that there will be a two-tiered demand for product.
Large investors and firms will pay the price to go big or buy location.
• Multi-billion landmark development projects that integrate into the City’s infrastructure will break ground more frequently.
• Specially-designed warehouse and distribution centres built to last for generations and cement a foothold, with
• Carefully chosen urban infill sites to access consumers will complete supply chains and make them more efficient.
While at the same time, lower- and mid-market players across verticals and asset classes will feel the pressure trickle down and continue to drive demand for smaller, older, or less-ideally located product.
Toronto has an opportunity to build a metropolis that supports work, life, and play among its citizens and visitors. The optimization of businesses’ ability to reach its labor and customers by focusing on well-located, top-quality product will, in turn, help consumers and the workforce lead better lives.
Industrial real estate will require more creative solutions that are not just the most cost-effective now, but that brings about income and profit for generations to come. To that end, if you are looking to buy, sell or lease space, then you might want to consider a wide range of options before making the final decision.
If that is you, feel free to reach out and inquire about off-market opportunities, or to get an assessment of your situation and needs.
