Still a Chance to Grease the Landing

Throughout this past year we published numerous warnings of a potential correction in industrial property values. Our fear was based on the logical conclusion that when the cost of capital to acquire assets more than doubles in less than a year, prices would come down to compensate for the increase. At least that is what history told us to expect. What we got was something quite different and very interesting…

Since the last half of 2022, the institutional side of the industrial property market has been the most effected. Until then, prices were breaking new records with every sale as institutional investors were able to pencil low capital cost and high expectations for rent growth into their underwriting. It was a veritable feeding frenzy that had them scrambling to put billions of dollars of other people’s money in play, while still levering deals up to take advantage of cheap money.

When the cheap money went away, so did the deals. Buyers were canceling deals left and right, some walking away from 7-figure deposits on deals that no longer made sense. In our minds, it was just the first stage of a market correction.

Interestingly, the institutional cash to invest was still there and ready to be deployed, but the nature of the deals changed. Buyers set aside the add-value plays that carry more risk in favor of more stabilized assets with stronger credit tenants, just like they did in the good ol’ days. Transaction activity slowed as a result, but industrial was still the preferred product type within the institutional space. So, pricing held up better than we expected.

Then there’s the owner/user side of the business. It too is driven by the cost of mortgage capital, as business owners look to control their occupancy cost with fixed rate mortgages that ranged from 2% to 4% for over a decade. Sales prices more than tripled as demand exceeded supply of good product by orders of magnitude. But demand fell sharply early in 2023 due to rising rates and we thought that would bring owner/user pricing down immediately. It didn’t happen.

Instead, supply fell along with the demand, as property owners, many of whom had very favorable low rate debt in place, or no debt at all, decided to hunker down and wait out the expected turbulence in the market. So, the result thus far is a slow market in terms of transaction velocity, but without the correction in pricing. The year ended with higher vacancy and sluggish absorption, but with sales prices near record highs.

The leasing market also exceeded our expectations for the year. The fierce competition for space we’d seen for over a decade went away. Without it, it only made sense that lease rates would decline in response to weaker demand. That didn’t happen either and we finished the year with asking lease rates at an all-time high.

What did happen, though, was a significant increase in time-on-market for space offered for lease. Instead of days or weeks to secure a signed lease, it took months.

Tenants lost their sense of urgency as competition decreased, and they are now more willing to wait for the right space that truly fits their needs. That phenomenon has actually improved the balance between supply and demand, the result of which has been a leveling out of lease rates near their recent market peak. It’s like a jet that has leveled off after reaching cruising altitude.

So, what does ’24 have in store for all of us? At this point our response is: more of the same. That’s quite a shift in our thinking from just a few months ago. Economic growth may cool, but it is expected to remain in positive territory. Unemployment, which was expected to spike, will likely inch up throughout the year, but is expected to remain historically low. Inflation has moderated and seems to be coming under control.

Mortgage interest rates are heading lower due to lower Treasury yields and the Fed has not only indicated that the rate hikes are over, it’s hinting at multiple cuts in 2024. That could really change the psychology of the industrial property market and result in a rise in demand from investor and owner/user buyers. The SBA 504 mortgage rate already fell 41 basis points in December and is expected to fall again this month. 

Vacancy is still in the 3% range depending on submarket and size range, and there is enough demand to lease or buy every building that comes to market, albeit at a slower pace than we were at during the feeding frenzy that ended in the last half of 2022.

All in all, market conditions seem to reflect overall economic conditions more than they did when ridiculously low interest rates sent sales prices into the stratosphere. We may just be returning to a more sane and predictable market for industrial property in Southern California, and grease that soft landing after all.