Last week we took a look at new opportunities for the industrial sector in 2025, specifically as it relates to area businesses looking to renew their existing leases or sign new ones. Rent growth has flattened and vacancy has risen creating a deeper pool of quality lease space to choose from.
Today’s outlook is a far cry from more than a decade of short supply that sent rents soaring and vacancy to almost zero in some size ranges. Tenants have far more negotiating power these days and the savviest landlords are offering more generous concessions to shorten lease-up time and get those rent checks flowing again. Simply put, the leasing market has fallen back into better balance whereby tenants get better quality and better terms, but landlords are still getting premium rates from quality tenants if they’re willing to be flexible up front.
The sale market is a different and perhaps more complicated proposition. For more than a decade, sales prices rose annually by double digits, driven primarily by ridiculously low interest rates and thin supply. With demand and supply running in opposite directions for so long, property values tripled in most areas and quadrupled in others, especially in the smaller size ranges. Cheap SBA mortgages flowed like beer at a frat party, with rates falling to as low as 2.16% for a fully-amortized, 25-year mortgage. What’s not to like about that, right?
Alas, all good things come to an end, and for the industrial sales market that end came when the Fed stomped on the brakes in 2022 to stop runaway inflation that went from 1.5% to 9.1% in no time flat. Those same SBA loan rates more than tripled to 6.5% where they are today. Buyer demand screeched to a halt, but sales prices did not correct in response to the higher cost of capital as many expected. Instead, would-be sellers opted to hold onto properties with their low rate mortgages, so supply and demand fell simultaneously, keeping them both in relative balance.
And that’s where we are as we approach the middle of Q1. The combination of high prices and high mortgage rates has slowed market velocity and made the traditional owner/user scenario cost prohibitive. Typically, an owner/user buyer puts just 10% down and finances the balance through the SBA’s 504 loan program. But at today’s prices, the monthly mortgage payment at 6.5% equates to roughly $1 per square foot NNN more than the same space would lease for. Then add the higher property taxes precipitated by the sale, and the owner/user investor’s company has to pay nearly $3 per square foot on a gross basis to break the owner even before taxes. Even when depreciation and mortgage interest are taken into consideration, the after-tax cost of ownership is out of proportion to the lower cost and risk associated with leasing.
With borrowing costs so high, the buyer pool has shrunk mainly to those who don’t need maximum leverage to get a deal done. That may be why in the final half of 2024, the average asking price for buildings in Orange County finally began to pull back. So far, the decline has not been significant enough to call it a correction, but not every closing sets a sales price record as it did for the decade ending in late 2022. Fortunately, there is still enough demand from buyers in a good cash position to absorb anything that comes on the market at a realistic price point. So, we see the owner/user sale market limping along near current levels until there is either a significant drop mortgage interest rates or a spike in supply that finally throws shade on prices.
So, what does this mean to potential sellers in 2025? It depends on expectations. For those willing to sell at or near today’s justifiable price point, they can expect a relatively quick sale to a well-qualified buyer. For those who insist on pushing the price envelope, not so much. The cost of servicing debt is just too strong a hindrance to allow prices to rise significantly, and there is no clear evidence that mortgage rates will come down anytime soon. The Fed has halted its rate cuts under the pressure of stubborn and continuing inflation, and the yield on the 10-Year Treasury note, a key index for setting mortgage rates, has moved up in recent months in response to rising federal deficits and other economic factors. Add the inflationary potential of new tariffs imposed by the new administration, and there is little reason to think that we will see mortgage rates head south in the coming months.
Despite the foregoing challenges, the industrial sales market will plow through the rough spots, as it has in other challenging economic times as far back as the 1970’s. Industrial is still the strongest of the commercial property asset classes, and Orange County’s broad base of single tenant buildings in all size ranges will keep the sector in play even with higher capital costs. Developable land suitable for ground-up development is scarce and prohibitively expensive. So, owners of industrial buildings control irreplaceable assets, a generally good place to be in the world of investing.
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