Many anticipated a significant shift in market conditions heading into the new year. We count ourselves among them.
With inflation continuing to run hot, gyrations in the equities markets and see-saw bond yields as a backdrop, it is logical to assume that the resulting uncertainty would trickle into industrial market metrics in Orange, Los Angeles, Riverside and San Bernardino Counties. Yet, here we are two months into 2023 and the key indicators like vacancy, lease rates and absorption haven’t changed significantly.
However, higher mortgage rates have definitely sent many buyers to the sidelines, reducing demand from owner/users and investors, both private and institutional. This likely means that peak pricing is behind us for the moment, but it doesn’t mean that acquisitions have fallen completely out of favor. What it does mean is that buyers are becoming more selective in their acquisitions and investors who were acquiring assets based on future revenue streams are now basing their underwriting on in-place income with a keener focus on strong credit.
Likewise, owner/user buyers are only looking at high-quality, functional assets that justify the higher occupancy cost that comes with elevated mortgage rates, which have doubled in the past year. Supply is still thin, which helps protect the market from a steep and sudden correction, something many in our industry have feared for some time. In a nutshell, good quality owner/user buildings are still selling near peak pricing in selective submarkets. On the other hand, buildings with functional obsolescence are taking longer to sell and price reductions on lower quality listed properties are becoming more common.
The demand shift from the sales side has given leasing demand a boost, so much so that lease rates for good quality industrial product are still moving higher in many submarkets. This comes as a shock to many business owners who come into the market anticipating softer conditions that will force prospective landlords to offer substantial concessions like free rent, tenant improvements and lower annual rental increases. But, landlords are holding the line on concessions for the most part, pointing to persistent low vacancy as justification. That said, time-on-market is moving up, especially for lesser quality product. The days of 10 offers at once are gone and it takes months to secure tenants rather than weeks or days. But, there is still enough demand to absorb all the space that comes to market, even if takes a little longer to get things done.
Overall, we are surprised at the resilience of the Southern California industrial market. Sales prices are definitely under pressure due to higher interest rates, but adequate demand is there for owners to execute their exit strategies. Perhaps the biggest change we’ve seen is from the institutional buyers who have moved away from speculative repositioning projects and land deals, as they have lost confidence that rent growth will remain robust enough to cover their higher capital cost. Instead, they’re keeping their powder dry while they enjoy strong cash flows on projects that benefitted from the steep run-up in lease rates we have seen over the past several years.
The foregoing leaves us cautiously optimistic that we can avoid a big correction. We went into the current economic uncertainty with the lowest vacancy in history, which will provide pricing support for both sale and lease product. That doesn’t mean the market won’t correct if inflation persists and fed keeps jacking up interest rates to stop it. So, we are back to dealing with the reality of dealing with opposing economic forces after years of highly- speculative fast-paced action that drove sales prices and lease rates into the stratosphere. Even a 20% pricing pullback across the board, would only put us where we were this time last year, as strange as that may sound. Perhaps we will be able to let just some of the air out of the balloon this time and avoid another 2008 disaster. We will be constantly evaluating conditions on the ground and will let you know if anything changes. Stay tuned.