The Airway Commerce Center just south of Reno Tahoe International Airport.
Northern Nevada’s white-hot industrial market is cooling faster than a late-fall sun slipping over the Western Sierra skyline.
The last five years saw unprecedented industrial development across Northern Nevada, capped by new construction deliveries of more than 7 million square feet of Class A industrial space in 2023. That’s 1.5 million more square feet of industrial space delivered than any other year in market history, and more industrial buildings are expected to come online before year’s-end.
But the spigot of nearly unlimited investment capital has been shut off.
Kyle Rea, partner and chief operating officer of Tolles Development Company, told NNBW in an interview last week that TDC erected 3.8 million square feet of new industrial buildings in Northern Nevada over the past four years. Only one of those buildings was a build-to-suit project; the rest were speculative buildings constructed with capital partners, Rea added.
Other industrial developers — mainly, Dermody Properties and Panattoni Development — were just as busy with both build-to-suit and spec buildings. The unmatched pace of industrial development stemmed from a perfect storm of economic factors, Rea said.
“You had low interest rates, rising rental rates, and an influx of institutional capital that was rushing into the industrial real estate space,” Rea said. “That all led to a ton of construction starts.
“Demand couldn’t keep up with supply,” he added. “As soon as something came to market, tenants snatched it up.”
There’s no shortage of new industrial buildings still under construction in Northern Nevada — as much as 4 million square feet is still coming out of the ground, Kidder Mathews stated in its recent third-quarter industrial market report. There’s also another 5 million square feet planned for the region, but time will tell how much of that product actually gets built.
Demand isn’t the problem — countless companies are still clamoring for industrial space in Northern Nevada. It’s a math equation that basically translates into increased investor risk for no additional reward.
“It’s all interest rate-driven,” Rea said. “The value of buildings is driven by the total cost of the building and the total rent that you can get. That equation is called the return on cost. Return on cost got so close to the interest rate, and in fact, today’s interest rates exceed a lot of return-on-cost deals that were getting done a year ago.
“If you think of capital as risk agnostic as to where it’s invested, and you can get 5 percent in Treasuries, why would you buy a 5 percent return-on-cost cap rate industrial warehouse in Northern Nevada? Buying Treasury Bills from the U.S. government is a lot less risky. Investors need to buy real estate at a discount compared to where they can invest somewhere else. That’s the fundamental shift that’s happened in this market.”
Rea said the moment that adversely skewed the equation happened in June of 2022, when the Federal Reserve hiked benchmark interest rates .75 percent, following more modest rate increases of .25 percent in March and .50 percent in May. The June rate increase — the single-largest rate increase since 1994 — was a bellwether that storm clouds were forming on the horizon.
“That was the real panic moment for every real estate investor and developer across the country,” Rea said.
What followed was a deluge, with three additional rate hikes of .75 percent, and five more rate increases through July of 2023. The federal funds rate rose from a modest 1.5 to 1.75 percent in June of 2022 to an effective federal funds rate of 5.25 to 5.5 percent today.
New construction will be minimal at best until there’s some easing on federal interest rates, said Mike Nevis, executive vice president and shareholder with the Reno Kidder Mathews office. The capital markets that fund commercial real estate projects are going “pencils down” until rates stabilize, he added.
“Globally, capital markets are at a standstill because they don’t feel comfortable investing in projects,” Nevis said. “It’s not just in Reno; it's everywhere – but it’s very different from the Great Recession, where the economy basically shut down. The economy is being slowed by the Federal Reserve.
“I’m thinking that as we go into 2024, interest rates should normalize on a global scale,” Nevis added. “And even with this huge construction pipeline, we are still at a relatively low vacancy rate overall. Absorption for the year is about half of what we average, but going into the fourth quarter with deals that are pending we should be able to squeak out an average absorption rate for Reno.”
Overall industrial vacancy in the third quarter hovered around 5.2 percent, Kidder Mathews reported, which is still relatively low compared to a balanced market of around 8 percent.
Moving forward, Rea said industrial developers will be hyper-focused on executing and delivering projects currently underway — TDC has nearly 900,000 square feet under construction at Airway Commerce Center just south of the Reno Tahoe International Airport. Developers also will be much more stringent on taking on new projects, he added.
“We plan to diligently look at everything that comes across our desks and push the button only when it’s the right deal,” Rea said.
It’s not all doom-and-gloom, either. E-commerce is still on the rise, and people and companies are still moving into the region, Rea noted. That likely will translate into lower industrial vacancy and increased rental rates, which will bring industrial developers back into the fray.
“We turned off the spigot of supply, but demand isn't going anywhere,” Rea said.
