There’s Amazon and Then There's Everyone Else in Industrial

Originally posted at Globe St.

On pace to absorb nearly 120 million square feet of space a year, the e-commerce giant can’t help but make an impact on CRE.

By Erik Sherman

Of the ten largest industrial projects underway in the US this year, Amazon accounts for eight of them, with a total footprint of 28.3 million square feet—an area about the size of New York City’s Central Park, according to CommercialEdge.

At the same time, investment sales prices are on a steady climb for industrial products, averaging roughly, as of June 2021, $94 per square foot. Unless Amazon is a tenant. In that case—and since the beginning of last year, buildings with Amazon as a tenant accounted for 7% of all sales volume—investors will gladly pay a premium for the asset, according to CommercialEdge, of $145 per square foot.

Developers have taken notice of the activity.

“All of a sudden, these developers are buying industrial land and building,” says Aviva Sonenreich, head of the office and senior broker at Sonenreich & Co., which owns and operates warehouses in Denver. “National developers are fighting for these build-to-suit spaces. They can’t build fast enough for Amazon and other companies like Amazon.”

It is not easy to overstate the footprint that Amazon, which did not respond to a request for an interview, has in the commercial real estate industry. So much so, that it is easy to forget that Amazon’s main business focus is elsewhere. Volumes have been written about its sophisticated business model and in many cases, the story of its real estate holdings is left out. That is understandable if you are buying cloud computing power from it or using it as a platform for sales. But for CRE, it has become essential to monitor all aspects of Amazon’s operations in order to stay on top of its real estate needs. And its real estate needs are immense.

AMAZON’S CRE SCALE

In North America alone, according to the 2019 and 2020 annual reports, the company went from 236.5 million square feet of leased and 345.4 million square feet owned office space, physical stores, and fulfillment, data centers, and other properties to 330.6 million leased and 14.8 million owned in 2020. That represents year-over-year growth of 105.3 million square feet leased and 3.6 million owned.

The pandemic’s effect was like the addition of a turbocharger to Amazon’s real estate engine.

“We own about 9 million square feet over a $1 billion of industrial properties,” Allan Swaringen, president and CEO of JLL Income Property Trust, tells GlobeSt.com. “Amazon’s a tenant in one of our warehouses in East Bay, San Francisco. Even in running a diversified real estate portfolio, we see them in the office, the retail, and the warehouse.”

“They’ve been affecting things since 2015,” Juan Arias, CoStar Group senior consultant for industrial/logistics, tells GlobeSt.com. “In 2020, they greatly increased the speed which added to their distribution footprint by 50%.” In 2017 through 2019, the pace was closer to 30 million square feet a year and in the immediate prior year, between 10 million and 20 million.

The industrial sector has by far been the biggest area of investment for Amazon. “It’s pretty obvious that they are definitely throwing their weight around in supply chain and logistics,” says Erik Foster, a principal of Avison Young and the practice leader of the firm’s industrial capital markets group. “They are moving into secondary and tertiary markets with a speed that we haven’t seen other companies do. As a differentiator, they are trying to be everywhere in a very massive way. They have the capability, and the development machine is already built for them to already go into these secondary and tertiary markets.”

But Amazon’s expansion isn’t a story of just warehouses. Cloud computing means that another significant part of increases in industrial space is data centers because those computers and IT personnel must work somewhere. “They’re hyper-scalers in terms of building massive data centers,” Michael Silver, CEO of Vestian, says. “Clearly they’re a player on the office side as well,” Paul Leonard, managing consultant for office at CoStar Group says. “They are one of the largest office users … one of the top five or so office tenants in the United States. They’ve been pretty vocal about having their office workers returning to the office. That’s probably going to influence their employees and other companies in general.”

Then there are Amazon’s retail stores: between leased and owned, 21.8 million square feet worth in North America, although what Amazon will continue to do with retail space isn’t certain, according to Kevin Cody, a CoStar Group senior consultant in retail. “Amazon is exploring converting dead malls into distribution centers,” he says. “Not necessarily a good thing for the retail sector. They’re also looking at leasing space in existing shopping centers.”

Then again, Amazon also owns Whole Foods and its own physical stores. It could be that a cross between distribution and convention-al retail might be possible, like the old concept of combining shopping and customer pick-up in larger locations and smaller pick-up only locations that companies like Sears used effectively.

WHERE AND WHAT IT BUILDS

Like its omnivorous business tastes, Amazon’s interest in locations is geographically broad, stretching through primary, secondary, and tertiary markets, especially for industrial. The direction is a competitive differentiator that is key to the company’s success.

“There was a time when you could afford to take a couple of days to get products to people,” Steve Buss, founder of real estate investment firm Likewise Partners, says. Large distribution centers in select areas like New York City, Atlanta, Chicago, Los Angeles, and others were sufficient. The approach doesn’t work when a company wants to enable as much same-day delivery as possible to attract more consumers.

“For example, in Minnesota where my company sits, Amazon opened a distribution center to do large appliances in the same day,” Buss says. “They’re continuing to expand their distribution footprint to get more and more of their products in that faster delivery time. It’s not everything but it’s an increasing amount of items. That’s where the game’s being played ultimately. They have to expand their distribution network to get products closer to people.” To get the distribution they need requires locations close enough to everywhere to enable timely deliveries.

Graceada Partners is an investment manager in California’s Central Valley. Amazon’s expansive growth strategy is obvious in the area. “It’s like the Midwest of the most populous state in the biggest state in America,” says principal and co-founder Joe Muratore. “Amazon is a dynamic player in our space across the asset classes. The distribution centers are in between major metros. I was in Fresno last week looking at industrial buildings. Amazon distribution centers are anchoring industrial parks. When Amazon brands a spot and shows up, others want to be near it. Cities provide roads and infrastructure to support that. And it’s happening largely in tertiary towns. This is wonderful for tertiary towns and cities.”

Amazon also is investing in a range of different facilities. “They take 100,000 to 200,000 square foot buildings and snap them up,” says Buss.

However, the company has other needs that previously constructed buildings can’t meet. “When these big box industrial deals are closing, we’re the financier for these large developments,” says Matthew Gorelik, CEO of real estate private equity manager Township Capital. “Most industrial parks are not made for Amazon. There’s not enough ready-to-go industrial. It’s not like a multifamily where you can upgrade the bathrooms or kitchens. It has to be built like that. You can’t retrofit it.” The demand—which he says comes not just from Amazon but others like Walmart, Lowe’s, and Kohl’s—has become a fire lit under CRE developers.

IMPACT ON MARKETS

“Amazon needs a specific type of [warehouse running 500,000 to a million square feet] and a lot of the space didn’t exist five years ago,” says Sonenreich. Often those buildings are multilevel and optimized for robotic materials handling.

“What we’re seeing is a ton of land being sold, building mega, mega warehouses, specifically next to the airport. The whole airport area in the next five years is going to change with warehouses being built. This change we believe is here to stay.”

“The market is so strong and healthy, spaces are getting leased out from under you,” says Buss. “You’ve got to make decisions faster.”

It’s become a race that is affecting everything in commercial real estate. “I think Amazon and related companies are having a profound effect on the real estate landscape because they’re turning it on their head,” says Silver.

“Amazon has elevated industrial in the eyes of investors,” Foster observes. “Once the ‘ugly duckling’ of the CRE space, industrial is now the top asset class and draws global investors, not just market specific investors. Much of that is due to Amazon’s rapid growth and the residual impact on retail, logistics and related businesses. Investors want assets with stable tenants that will grow and produce strong returns. Buildings with tenants such as Amazon, FedEx, Target and other large consumer goods businesses fit that bill and are in hot demand.”

“Shopping malls are being converted into last-stop industrial assets for Amazon,” Silver says. “There’s a rebirth, when some things die, and some things are reborn. And that’s Amazon. To be blunt, they’re killing off some assets and reinventing others.”

“They’re on track to absorb another 120 million square feet in 2021,” says CoStar Group’s Arias. The industrial sector has by far been the biggest area of investment for Amazon because of the nature of its business, which would seem to be e-commerce but isn’t. Amazon has become a platform that provides services to other businesses, whether advertising, cloud computing, or logistics help.

The company’s 2021 first-quarter results noted that 55% of paid units sold through Amazon are from third parties. Although some sellers ship directly from their own facilities, an enormous part of Amazon’s need for logistics space is as a proxy for its business partners.

The warehouses are not just for Amazon, but its many business partners, large and small. Other companies—Walmart, Target, Kroger, Wayfair, and Newegg, to name a few—have also implemented marketplaces. The sales and marketing theory is that if you can’t get a sale yourself, you might as well get a piece of someone else’s. The result is also many more products and ranges of prices, which helps draw buyers.

TRICKLE-DOWN EFFECT

By serving so many businesses, Amazon has a foundation that is more massive than its retailing lines alone. In real estate, that has be-gun to affect everything, from pricing and availability of land and buildings, strategies of competitors, downstream companies servicing Amazon, and even the makeup of communities and housing markets.

“In terms of their hyper scaling data centers, they’re having quite a bit of impact on the electrical grid system and their decision making is around the best source of clean, uninterrupted energy,” Silver says. “They’re hiring another 75,000 workers.”

Amazon, as CommercialEdge numbers show, is pushing up the price of logistics buildings enormously.

“They typically pay 50% to 60% above market for industrial space,” CoStar Group’s Arias says. “Even prior to the pandemic, we saw a drive up for last-mile locations,” particularly in downtown areas, close to high-income households. “Those are some of the most attractive for e-commerce players and packaged ecommerce sellers.” Half of the delivery costs get concentrated in the last mile. “If you get closer to the consumer, you can help drive those costs down,” he says. “That piece of the industrial pie, we saw a significant run up in pricing in the last four to five years. Now seeing a run-up in the general industrial space because vacancies are so tight, there isn’t enough supply to match the demand. It’s specifically that we don’t have enough warehouse and logistics space.”

And the company that doesn’t establish quick delivery can be beaten. “It’s very simple: Without the last mile distributions, they’ll lose a customer order,” says Township’s Gorelik.

The high prices mean that investors want property that is Amazon-worthy. Gorelik offers an example from his own company, where normally a 20% internal rate of return would mean doubling the investment money in five years. “We have an asset that we sold to KKR with Amazon as the tenant,” he says. “That was a 24-month hold. It did a 60.34% IRR. That was a 4.75 multiple. That sale was in January of this year. This is all ground up industrial building.”

With returns like that, a company gets attention. “Amazon will pay more to get what they want, the rent is worth more because Amazon’s very strong credit, they’re sought after, so for a single tenant building, investors are accepting lower required returns,” Buss says. “A comparison would be in free-standing retail [where] Walgreens is the gold standard. To get Amazon to fill your vacancy is a big win.”

“My purview is really focused on the low yields that investors will pay to put these assets in their portfolios because of the growth of Amazon, because of the business model they have, because of the market share they have, the investor appetite is almost unquenchable,” Foster adds.

They may be willing, but investors are taking a significant future haircut. “We’re investing in Amazon,” says Paul Getty, CEO at First Guardian Group. “I’m looking at the leases and it is 1% increases for the next 20 years,” though he says that typically they are 1.5% annually. Even that far enough behind the low inflation levels of the last 15 years that it would represent a significant ongoing drop in revenue.

Then many other companies are affected because their business depends at least in part on Amazon, says Paul Getty, CEO at First Guardian Group. “What I do think you see is where Amazon goes, other companies follow,” says Swaringen from JLL Income Property Trust. “Everybody thinks it’s all Amazon trucks delivering everything, but often it’s many other distribution [companies]. Our warehouse in East Bay, San Francisco distributes goods through Uber and Lyft drivers, who come into the building, get a mesh basket of deliveries, and then do those deliveries while they’re also [providing rides to people]. It’s a very efficient way to have deliveries.” Or the companies following along could be the likes of UPS and FedEx. “They can rise the tide of an industrial market because of their presence.”

The impact spreads to housing because of the number of people Amazon hires. “Amazon provides a more stable jobs base which drives the overall economy,” says Graceada’s Muratore. “You could say the same for retail in that more people are employed: They get benefits, they make more than minimum wage, which drives retail and experiential spending.” But then rents increase from demand and the ability of people to pay more. Renting and rents are probably pressing on the edges of their income, so there will probably be additional adjustments. But it’s more positive than negative as economic development moves outward.”

Something important to remember, though, with all the focus on Amazon, is everyone else. “The flip side to this discussion is all the small to mid-sized tenants that drive industrial but don’t get the attention that Amazon gets,” Forster says. “Industry estimates indicate that the mid-sized tenant—under 75,000 square feet—is driving about 80% of industrial deals. These are auto parts manufacturers, local machine tool businesses, suppliers, et cetera, that are important to the overall flow of the sector. There also are many mom-and-pop e-commerce businesses that support Amazon that have been helped by Amazon’s rapid growth.”

One takeaway observation: Don’t get so focused on Amazon that you miss other important potential investments, opportunities, and deals.