For months we have been focusing our communications with you on the potential impact of higher borrowing costs for commercial real estate.
Clearly, low interest rates fueled the run-up of property values for over a decade. So, logic supports the notion that as borrowing costs increased, property values would reverse course. To a degree that has been the case, yet the commercial property values have been remarkably resilient and it has been market velocity that has changed rather than market dynamics. Vacancy is still low, new inventory deliveries are non-existent (except in the Inland Empire) and there is still enough demand to absorb available inventory, albeit at a slower pace. It seems as though whatever correction might be in the works, could be more orderly and predictable than those that preceded it.
Now we have a new drama at center stage and we are back to scratching our heads in confusion again. The recent collapse of several major regional banks and the takeover of Credit Suisse by UBS has unfolded with amazing speed. We won’t rehash the details of those failures here, but suffice it to say that confidence in the health of our banking system has been visibly shaken. Even rampant inflation has been relegated to page two just as the Fed’s FOMC gets set to decide on another bump in the Fed Funds Rate. And that comes as fingers are being pointed at the Fed for causing the latest banking crisis in its attempt to put the inflation fire out. You just can’t make this stuff up.
One thing we do know for sure: we are glad to be in the real estate business right now. We feel for our colleagues and friends in the banking industry, as they battle with market forces driven by an instantaneous shift in market psychology. Old-fashioned fear has millions of Americans moving massive amounts of cash into US Treasurys and bigger banks. Even the most stable, well-managed regional and community banks are feeling the pinch as deposit withdrawals have accelerated in search of safety. That’s exactly what happened to Silicon Valley Bank, and its complete collapse took just a matter of hours. Wow.
Thank goodness for industrial real estate. While not immune from darker market forces, your real estate is one of the most tangible and safest assets you own. That’s all good. There will always be a need for the property you own, even if it’s just for the land under your building. Industrial real estate in Southern California has been a steady performer for decades, and we believe that trend will continue for the simple reason that every industrial business needs a place to call home. Unlike a bond or a stock, which can be rendered valueless in an instant (like shares in the aforementioned Silicon Valley Bank) industrial buildings have ongoing value even if they become vacant and temporarily underperform. In fact, an industrial building that becomes vacant today probably increases in value, as lease rates have risen to unprecedented levels and demand for quality product is robust enough to absorb any building that comes to market. The same cannot be said for many other asset classes, or for all other real estate product types.
The biggest challenge the industrial property markets face today is the cost of borrowing. Mortgage interest rates have doubled since the Fed started tightening. This can and will weigh on property values going forward. But, the underlying fundamentals of the industrial market remain strong. Unlike previous correction periods, Southern California submarkets are not overbuilt. In fact, most are starved for quality space and construction of new product is conspicuously absent.
So, if you are an owner looking to dispose of your real estate as part of your investment strategy, market conditions remain in your favor. If you are looking to acquire property, either for investment or for your own use, it may still be a good time to do so. To be sure, it will be more expensive to service debt, but you will be acquiring an irreplaceable asset. Most submarkets are completely built out, and what little construction there is (mainly in the Inland Empire) is concentrated in very large buildings that do not compete with the vast majority of industrial buildings, which are under 100,000 square feet.
How this banking issue plays out is anybody’s guess at this point. But, unless it turns out to be our next Black Swan event that undermines the general economy, we think hanging out with commercial real estate is a good place to be.