Impact of Supply Chain Disruptions in Industrial Real Estate

Posted by Cesar Castro on May 15, 2020 10:33:39 AM
Cesar Castro

Industrial CRE - COVI-19COVID-19 has significantly impacted the global economy as countries took sweeping measures to combat the spread of the virus. Halts in production, logistics activity, and consumer demand have had outsize effects on the globally intertwined supply chains many companies have built. Zencargo, a logistics startup, predicts supply shocks will generate $700 million in losses for the U.S. retail industry alone in the period from March 9 to April 20. This has led many supply chain experts to formulate risk mitigation strategies accounting for a variety of factors from labor costs, to capital investments. Many companies had one pain point in common: high supply chain concentrations in China. The effects of production halts are still being felt across many sectors. It is likely this crisis will force companies to assess the risk of reliance on one source for so many inputs and finished goods. One potential effect is the increased buildup of manufacturing and distribution capacity in the United States. A large-scale shift to domestic buildup has important real estate implications, particularly for industrial properties. From modifications to existing properties to entirely new development of custom facilities, the new demand could represent a strong opportunity to generate returns for investors that can lead and respond to these changes.

How Did We Get Here?

A good case study in supplier concentrations is the retail sector. The supply chain intertwines a broad scope of manufacturing, assembly, and transport that spans the entire globe. Recently, large portions of the supply chain have been concentrated in China, exposing many companies to the risk of geo-political and other supply shocks. Cushman & Wakefield illustrates this well, looking at the percentage of imports from China for multiple industries. For the shoe industry, 49% of imports come from China, 44% for electronics, and 29% for building materials. This analysis looks at the entire sector. Individual companies can have a much higher presence. Initially, many companies looked to China as an opportunity to lower labor and production costs. They also saw an opportunity to access a vast consumer market, bolstered by a growing middle class that was otherwise difficult to break into. Over time this has created high-risk concentrations in this market. COVID-19 broke this link in the chain, with its effect being felt for an extended period. Now companies are being forced to price in this new risk as part of their business and investment decisions. The economics of outsourced production have changed and as the economy recovers, companies will reassess their strategy.

What Comes Next?

In the short run, businesses will be focused on weathering the storm. There is still a lot of uncertainty around how to treat the virus and the potential for a vaccine or mitigation strategies. The reduced profit for many businesses will slow down or even halt investment spending. In the longer term, however, there will be a need to assess how to best allocate investment dollars to weigh risk mitigation and the costs of implementation for these policies. This buildup period is key for CRE advisors and other key players. This is a time to build and tap into corporate relationships to assess future business strategies. This in turn will lead to a more informed view of potential new demand and can lead to the opportunity to take charge on future projects. A highly collaborative approach is required to be able to solve such a complex retooling of the supply chain. Real estate is the backbone of that change, building or allocating the infrastructure to carry out business plans.

Key Questions to Ask

1. What product type will companies demand?

Business needs drive the real estate demand and that holds true more than ever when considering an investment with a long time-horizon. No one has a crystal ball as to the exact nature of product demand, but we can establish a framework guided by supply chain needs and extrapolate potential demand. Real life is of course more complex, given the variation in company size, potential tax incentives, and future impacts we may not be able to predict. Nonetheless, it is helpful to think about two key aspects of supply chain operations: production and distribution.

Labor-Intensive Production

We can analyze the production process through the lens of labor requirements. The economics of labor-intensive processes are very different in both the long and short term than those that are capital intensive like automated manufacturing processes. Labor-intensive firms are not likely to drive up domestic demand. Even after pricing in risk, there is still a very large disparity in labor cost between the U.S. and countries like China, Vietnam, and Mexico. The risk reduction may not be enough incentive to expand domestic capacity.

The exception may be those companies producing very high-margin and high-price items. For them, building out small manufacturing plants may be worthwhile as geographic concentration is diminished. Their final product will dictate the nature of the manufacturing facility they need. For high-tech, labor-heavy manufacturing like computer chip production, facilities must be heavily customized. It requires a lot of equipment such as HVAC systems capable of maintaining a very clean environment. Another possibility might be high-margin industrial products like aerospace and metalworking. All require a relatively heavy lift to prepare for production. It is a segment of the market that will likely require a lagging response to meet demand.

Capital Intensive Production

For companies with highly automated supply chains and economies of scale, there is a lot to gain from building up their domestic supply chain. The presence of economies of scale improves returns to the high capital outlays required to construct a high-tech manufacturing facility. Additional cost savings such as reduced logistics requirements and decreased company travel will only help further drive this trend.

Just like standard manufacturing buildings, there is a lot that goes into building a facility capable of housing the key equipment and space necessary to manufacture. The first consideration is the infrastructure for the machinery. This includes stable power sources, flexible space to accommodate the desired layout, and other support systems that ensure optimal operation like HVAC systems. In addition to this, automated facilities require more IT equipment. This includes servers, IOT devices, and connectivity infrastructure that ensures all systems are properly integrated. Square footage requirements depend on the scale of production and final goods. It is a heavy lift to accommodate a new tenant, but the long term gains can prove beneficial to all parties involved.

Distribution Strategy

The demand for distribution centers is the most likely outcome. It is easier to build in inventory cushions than to have to entirely retool a supply chain. The scale of demand will depend on how firms approach this. Some may pursue centralized distribution centers catering to major metropolitan areas. Others may want a decentralized model, particularly as the Coronavirus has impacted states differently. While costing more, it reduces concentration risks. The last possible outcome is to tap into third-party logistics capacity. This generates derived demand for distribution space and creates efficiencies as firms with logistics expertise develop the best strategy for transporting goods across the country.

The benefit of adopting this strategy is the lower costs relative to other alternatives. There’s relatively low customization for most distribution centers. Bigger considerations tend to be bay count, roof height, and parking capacity. There’s also much more flexibility to increase, divide, or scale down space as necessary. End-market considerations are also easier to implement. If a firm is focused on getting products to customers as quickly as possible, they can lease or buy smaller space in different cities.

2. Where is demand likely to rise?

Forecasting demand in local markets may prove difficult. Cities have distinct advantages and disadvantages, from cost, to current sector expertise or favorable labor environments. Large enough increases in demand may also increase tax incentives, as local and state governments compete to build up industries in their given sector. Key points to assess will be logistical advantages and disadvantages, labor supply, the business environment, and real estate prices.

To illustrate this, we can look at Silicon Valley. The area commands a premium for land and property prices of all types, yet there is still an incentive to build manufacturing or distribution capacity in the area. The area has access to key ports on the California coast. For a company that needs the capacity to export or import key components, this is a big advantage. There is also access to a heavily populated state with a strong consumer products market. The region also has access to one of the deepest skilled labor pools in the country. If technical expertise is a requirement, the area is best positioned to deliver it. The disadvantages are the high property prices and a highly regulated business environment. Extensive labor and environmental regulations can make it costly. It is an area best suited for manufacturers of high-value items, with largely automated processes, and deep technical needs.

Another possibility to consider is that manufacturing may not be in the United States at all. Even before the COVID-19 outbreak, geo-political tensions with China generated interest in equally low-cost alternatives. Other Asian countries and Latin America have the infrastructure to scale up production. These countries are also better positioned geo-politically with agreements like NAFTA in place. Trade negotiations with China were halted, but rising tensions with the current administration are not generating optimism for their future. Many tariffs are still in place but have been on the back-burner given the urgency of containing the virus. Once economic activity ramps up again, tariffs and quotas will be at the forefront and could potentially get worse. The key takeaway is that supply chains being decoupled from China in no way guarantees a scaling of U.S. capacity.

3. To lead or to follow?

This is a more difficult assessment to make, particularly in the uncertainty generated by the current environment. No one wants to be left holding vacant property if new demand does not materialize. On the flip side, moving into the space late means losing out on valuable returns relative to competitors. While most firms do not fall into such a black and white assessment, they nonetheless must measure their risk tolerance and assess their conviction in material changes to the industry and their translation into increased demand for U.S. industrial properties.

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Topics: Market Update, Investment

Cesar Castro
Written by Cesar Castro

As an Associate Intern, Cesar supports RRA Capital’s business development initiatives. Cesar recently graduated with degrees in Finance & Economics from Arizona State University.