Higher commercial mortgage rates are freaking people out, even our children! And there is a chance they may go up one more time before the end of 2023! That has had a noticeable drag on sales volume as the market navigates a period of price discovery. About $1.2 billion worth of industrial assets traded hands in the first half of 2023, a 55% decline from the same period a year earlier. Higher debt costs, tighter lending standards and macroeconomic uncertainty are expected to keep transaction activity modest over the near term, negatively impacting cap rates and prices. Newly built assets are trading in the low to mid 5% range with some best-in-class assets leaking into the high 4% band.
The Phoenix industrial market is beginning to normalize as the sector transitions from the boom seen in years following the onset of the pandemic to a more typical trajectory. Vacancy has drifted up from an all-time low of 4.1% in mid-2022 to 6.8% in 23Q3 and further increases are expected in the back half of the year. Though leasing activity has shown some signs of moderating since 22Q1’s peak, the primary factor driving the recent uptick in vacancy is the metro’s substantial construction pipeline, which is starting to outpace demand.
As many market participants were expecting, the unprecedentedly strong rent growth seen in 2022 is beginning to decelerate. Quarterly gains have eased from the 4%+ range in the first half of last year to 2.5% in 23Q2. Nevertheless, at 13.5% year-over-year, the current rent growth figure remains well above the pre-COVID five-year average of about 5.2% and outpaces the national level by over five percentage points. The deceleration is expected to continue through 2024 as the full impact of the construction pipeline is felt.
LEASING
The Phoenix industrial market started the year off strong, as robust leasing activity caused the metro-wide vacancy rate to compress from 4.7% at the end of 2022 to 6.8% in 23Q3. That figure leaves the market at one of the tightest levels seen in several decades, sustaining healthy property performance. The historically low vacancy rate will be tested in the coming year as one of the largest construction pipelines in the country begins to deliver. CoStar’s current baseline forecast, which includes a moderate recession in the second half of 2023, indicates new deliveries will moderately outpace space demand, causing vacancies to drift upward. This will bring Phoenix back into alignment with where it was entering the pandemic as the market enters a period of normalization.
The area’s broad range of demand drivers provides a powerful long-term tailwind for the industrial market. Not only has Phoenix established itself as a prominent link in national supply chains, but it also has tremendous momentum in terms of manufacturing. These industries were key factors underpinning the 15.9 million SF of net industrial space that was absorbed over the past 12 months.
RENT
Tight vacancies coupled with the delivery of new high-end products caused industrial rents to surge 13.5% in the past 12 months, one of the strongest rates of growth in the nation. Moving forward, however, there are several indications that rent growth has peaked as the market enters a period of normalization. The pace of rent growth has decelerated in two consecutive quarters as base effects begin to play a role. Additionally, the quarter-over-quarter change has eased from more than 4% during 2022 to the low 3% range today.
Historically, rent growth in Phoenix had lagged behind the National Index, but after gaining momentum in 2019, rent growth has consistently outpaced the U.S. average. Yet, Phoenix maintains its position as a relatively affordable market for its size. Rents average $13.10/SF, which is near the national level and 30%-40% below asking rents in California markets.
Over the next 18 months, the pace of rent growth is expected to decelerate to a trajectory more in line with the recent historic average, according to the Base Case scenario. The wave of speculative deliveries in Phoenix together with a potential economic disruption may limit landlords’ leverage to raise rents in some high-construction areas.
CONSTRUCTION
Phoenix’s rapidly growing west-side suburbs have been the primary target of development. The region’s proximity to California and affordability of land have fueled demand for new manufacturing and distribution space. Major transit networks including; the I-10, I-17, and the Union Pacific and BNSF railroads support firms with port dependencies and those that serve West Coast markets. Additionally, the expansion of the Loop 303 and 202 freeways will strengthen connectivity with the rest of the valley and catalyze new industrial construction. The Glendale, Goodyear, and Surprise submarkets comprise about half of the current construction pipeline.
On the other side of the Valley, developers have also been active, particularly near the Phoenix-Mesa Gateway Airport. In the five-mile radius surrounding the airport, about 16 million SF of industrial space is underway. The East Valley in general boasts a high-quality labor force and a more extensively built-out infrastructure network. Other logistical advantages like widespread freeway access and the Union Pacific Railway line make the area a key manufacturing and distribution hub. The first phase of Gateway Grand is currently underway. The speculative project includes a pair of 537,400-SF industrial buildings with 40-foot clear heights, 98 dock doors, and ample utility access via the SRP 69kV transmission line. Other notable developments include The Cubes at Mesa Gateway, Gateway 202, and Skybridge, as well as a series of data centers for Facebook.
SALES
Sales volume is easing from the records seen in 2021 and the first half of 2022 to a level more in line with the pre-COVID historical average. In the second quarter, about $630 million worth of industrial assets traded hands in Phoenix, outpacing the three-year average leading up to the pandemic of about $500 billion per quarter. While elevated interest rates and tighter lending standards are undoubtedly weighing on transaction activity, deals are still progressing with newly built, well-located assets receiving considerable interest from investors.
The lack of consensus on the economic outlook and future path of monetary policy is leading to a pricing expectations gap between buyers and sellers, slowing transaction flow. A pick-up in investment sales could materialize if interest rates begin to stabilize and clarity returns to the market. Overall, investors remain attracted to Phoenix’s value proposition, sustaining healthy buyer demand. Strong rent growth, an expanding population, and tailwinds related to supply chains and advanced manufacturing support the area’s long-term outlook.
ECONOMY
Phoenix remains one of the nation’s better-performing markets for employment growth recording more than 42,700 job additions in the trailing 12-month period ending July 2023. The labor market now has 154,800 more jobs than before the pandemic, the fourth-largest gain in the nation. The local economy was highly resilient during the pandemic, thanks to a diversified employment base across a broad range of industries. Metro Phoenix lost about a quarter million positions in March and April 2020 but by July 2021, Phoenix fully regained those losses, which was nearly a full year ahead of the U.S. This marks a stark contrast to its protracted recovery from the global financial crisis, when Phoenix didn’t recoup its job losses until well after the broader nation did.
Businesses are selecting Phoenix to expand because of the extensive labor pool and favorable regulatory treatment. Numerous employers have announced expansions and relocations since the pandemic. Taiwan Semiconductor Manufacturing Company (TSMC) made national headlines when it confirmed plans to build a second fabrication plant in north Phoenix. The move increases the firm’s investment from $12 billion to $40 billion, creating 10,000 high-tech jobs. Preliminary estimates from city economic development officials indicate the investment by TSMC could bring up to 45 additional businesses to the Valley that support and supply the plant. Additionally, Intel is underway on a $20 billion expansion at its Chandler campus where the semiconductor giant is building two new fabs alongside its four existing ones. Amazon recently opened several last-mile and fulfillment sites throughout the metro and leased a 95,000-SF office in Tempe, which will generate thousands of new jobs. Microsoft, Google, and Apple have invested in data centers throughout the metro. While labor is the primary driver behind the market’s business attraction success, relative affordability and a more accommodating regulatory environment help tip the scale in favor of Phoenix when companies make their site selection decision.
Phoenix remains one of the nation’s better-performing markets for employment growth, and the diversity of industries has helped sustain the region’s long-term stability. If you have any questions about commercial real estate or are looking for assistance regarding commercial property, please do not hesitate to contact us.
Team Trbo
Source: CoStar
View the full CoStar report here.