Why is Transaction Velocity Slowing in Southern California?

For the past two years we have been seeing a decline in market velocity. Why? Here are five factors that explain it.

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In Orange County and surrounding submarkets, fewer transactions have been completed and less space has been sold and leased.

That has our clients wondering if that is good news or bad news. Our honest answer to them when they ask us about it is that is has elements of both and for a variety of reasons.

To be sure, it makes predicting future trends more difficult because there are fewer dots to connect to determine market direction. That leads to uncertainty, and uncertainty slows down decision making.

While we believe that uncertainty has definitely crept its way into the decision making process, here are a few other variables business and property owners must contend with when making real estate decisions:

Lack of Quality Inventory for Lease

On several occasions we have made note of the lack of functional product available for lease. New construction in Orange County and Mid-Counties markets has been notably absent throughout this economic recovery, now a decade old. Developers were unprepared to initiate projects to meet the surge in demand that absorbed the recession-induced glut of supply faster than anyone expected. Also, the high price of land, even after the recession dip, was still too high to justify ground up development until lease rates made a substantial recovery.

Without the addition of new inventory the vacancy rate tumbled and, as is always the case, the most functional space moved first. That supply fell further behind and tenants were forced into older, less functional product. But, lease rates rose sharply across the board and vacancy fell to near zero in some submarkets, leaving many businesses owners with no other option than to renew in place.

The result: time on market less functional space offered for lease is going up despite low overall vacancy. It now takes months rather than days or weeks to get many properties leased up. Also, some of the best product is reabsorbed without ever reaching the open market and is not included in market statistics.

Tenants are Deciding to Wait Out the Tight Market

Property owners know that vacancy in the 2% to 3% range gives them a significant advantage when negotiating with prospective tenants. They can charge a premium rate, insist on longer leases and push back on tenant concessions like free rent and tenant improvements, even if their buildings are functionally obsolete.

This take-it-or-leave-it posture poses a significant problem to tenants who need space but are loathe to sign leases with terms of five years or more on space at a rate approaching $1 per square foot that has functional issues like low ceiling height or inadequate loading facilities.

Instead, many of them are attempting to renew leases for shorter terms in the hope that the market will soften up in the next couple of years. These transactions don’t find their way into market metrics either.

Preference to Own Despite Record High Prices

Demand for buildings offered for sale continues to run well ahead of available supply. Property values have more than doubled since 2011 for owner/user buildings.

This is primarily due to strong economic growth coupled with historically low interest rates on long term loans available through the Small Business Administration. Currently, a user/buyer can acquire a new home for his business with just a 10% down payment and a 25-year, fixed rate loan for the balance of the purchase price in the 3.5% range. They like they idea of building equity for themselves through price appreciation and mortgage pay-down rather than doing the same for their landlord.

Unfortunately, few buildings reach the open market and competition to be the winning bidder remains intense. So, that unmet demand acts as a natural brake on transaction velocity.

Outsourcing Inventory to Third-Party Logistics Operators

While we don’t have any metrics to confirm this trend, anecdotally we are seeing more tenants engaging the service of third party logistics (3PL) firms to warehouse and distribute inventory they just don’t have room for.

The 3PL industry has been expanding rapidly throughout the country for several years, in large part to meet the demand from users who find can’t suitable facilities of their own. Outsourcing this function provides a short term solution and flexibility for tenants who are not willing to sign long term leases of their own at today’s price point. It also reduces leasing activity, as the space requirement is absorbed by the 3PL operators.

Economic/Political Uncertainty

The upcoming election, a global economic slowdown and signs of stress in the US economy are also part of the velocity equation, in our view.

Their exact impact is impossible to measure accurately, but we believe they add to uncertainty and thus figure into the decision-making timeline.

On a daily basis we are seeing more volatility in the bond and equity markets, as they react to headlines on the financial and political fronts, which are at best a significant distraction, but at worst a real warning of stormy weather ahead.