As you might expect, we’ve been giving a lot of thought to how shifting economic conditions will impact the commercial property market.
We will admit that we are thinking about it a lot and will even confess to losing a bit of sleep in the process. For months we have been trying to read the tea leaves for you in an effort to give you plenty of time to adjust your real estate investment strategies to minimize the impact of a potential market correction that would end the bull run of all time. Until recently, the market defied what we see as clear signs that the kegger we’ve been partying at for over a decade is finally running out of gas.
This is where we stand today. After a sneak peek at Q2’s market statistics in the past few days, there is little statistical evidence that the market is weakening. That’s because stats come after action is taken and a change in psychology precedes that action. And we can say without hesitation that the psychology of this market has become profoundly more pessimistic than it was just a few short months ago. We know this based on our current interaction with buyers & sellers, and tenants & landlords, but also on our experience with previous market disruptions. Yogi Berra said it best: it’s like Déjà vu all over again.
What we see is a decrease in current requirements to lease industrial space in Orange County. That means competition from multiple tenants for a given space is cooling off, which reduces upward pressure on price. Without the sense of urgency associated with that competition, space is taking longer to lease, which is contributing to an uptick in supply as new availabilities hit the market. Vacancy is still holding for now, but we think it will actually move higher in Q3 for the first time in years. The shift is not lost on tenants who are in the hunt for space. They are now able to play a little harder to get, opting instead to let landlords sweat a little bit, a card they haven’t been able to play in a long time.
That said, good quality, well located lease product is still moving quickly. It’s the product at the margins that are seeing the initial falloff in activity, especially older buildings with elements of functional obsolescence. This is to be expected: functionally obsolete space always gets hit harder when supply rises. This is one good reason for owners of such product to sell sooner rather than later, as they have reaped the maximum benefit of the supply-starved conditions that have sent their property values into the stratosphere.
The owner-user market is being heavily impacted by a sharp rise in mortgage interest rates. In just the past 5 months the SBA 504 mortgage, the most commonly used debt instrument in the owner-user universe, has risen from 3.21% to 5.19%. That’s almost a 62% increase in interest expense in pretty short order. Buyers are becoming less inclined to pay a record price for a building and then suffer much higher occupancy cost for the privilege. Something and/or someone has to pay the price and buyers are now signaling that it won’t be them. We have seen too many purchase requirements disappear in recent months to ignore it as a trend. It’s happening, folks, and it is likely to continue as interest rates across the board increase in response to the Fed’s firm foot on the monetary brakes.
Are we sounding the alarm at the risk of being seen as opportunistic naysayers. Yep, we are. We see it as our responsibility to do so. This is not our first rodeo. Suger-coating the situation would be a dereliction of duty in our view.
So, if you own industrial real estate that you had plans to sell in the next few years, do it now. If you have an industrial building up for lease, be the next lease to get signed in your size range and submarket. If you have a tenant with a lease expiring soon, renew them early if you can. Don’t expect anyone to be chasing you down to make a deal. Be prepared to take aggressive action to secure your situation in advance of what we believe will be some bumpy air ahead. You might leave a little on the table if the market just loses a little momentum and then picks back up again, which is also possible. If you sell, you’ll be doing so at or near a market peak. If you lease your space at or near today’s rates, you’ll be flush with cash.
If you do nothing, you could get steamrolled if the market enters a substantial correction. It’s that simple. If nothing else, you owe it to yourself to get informed because the next real estate decision you make could be a whopper, one way or the other.