For the past 10 years, industrial property values have been on a tear, setting new records with every sale. But the market finally hit a cyclical apex in Q3 at a price point double that of the previous peak in 2007.
What a run and what a wild ride it has been. We don’t know anyone who accurately predicted just how high things could go, and anyone making such a prediction would not have been taken seriously. Yet we have statistical proof that many industrial properties throughout Southern California have quadrupled in value since the recovery began in earnest back in 2011.
There are two main reasons why: the first is cheap money and the second is scarcity. As recently as 2021, an owner/user buyer could secure a loan for 90% of the purchase price at a fixed rate of 2.2% through the SBA. Needless to say, business owners lined up for the opportunity to fix their occupancy cost for 25 years with such a loan. But, there just weren’t enough buildings to go around and vacancy plunged to less than 1% in many submarkets, sending prices up even faster.
The ensuing frenzy to be the winning bidder was mindboggling and one of the biggest problems we had was trying to counsel our clients on the true value of their properties. So, in many cases, we let the market do the talking and offered properties for sale without an asking price. Every sale set a new record, but the buyers were thrilled to acquire irreplaceable assets with 10% down and a long-term loan in the 2% to 3% range. Everyone felt like a winner, and in a way that was true.
My, oh my, how quickly things can change. In just the past few months, the Fed channeled its inner Paul Volcker and hit us with three outsized increases in the Fed Funds Rate. That sent bond yields, which are used as a guide for commercial property mortgage rates, spiraling up. The SBA 504 rate rose from 4% to 6.5% just in Q3. That’s a 50%+ increase in the cost of capital in 3 months. Not good. Owner/user demand has fallen sharply in response as has the appetite of institutional investors who are walking away from deals in progress or insisting on big re-trades to stay in the saddle. Put another way, the entire sales market has been upended overnight. Estimating value is just as tough as it was before, but in the other direction.
Interestingly, this shift has yet to show up in quarterly market metrics. Q3 results were solid, though lease and sale transaction activity did show the initial signs of the slowdown. Market stats are lagging indicators, so the underlying shift in psychology is not fully manifested in the numbers. For the moment, the feedback is anecdotal, but is worthy of your rapt attention. Those who waited for statistical proof of the shift in market direction, missed the top and will now be faced with a strategic reset to their exit strategies. Those with shorter exit horizons can still get out with huge gains since prices are receding from such a high point. But, they’ll have to accept the fact that they missed the peak. Our experience tells us that will not be easy for many of them. Some will hold on for the next cycle, but no one knows how long they will have to wait. Given the fact that cheap money fueled the run-up, it makes sense that it will take another era of low rates to reproduce the previous result. If the Fed allows rates to return to historic lows, it will be because they overtightened and sent the economy into a recession. That’s not good either.
The logical near-term result of the rise in the cost of money is a pricing reset if we are to expect the market to remain active. Investors are not going to borrow at 7% to buy property at a 4-cap. Negative leverage is a big no-no. It makes no sense. They will need to see cap rates come up and they’ll have to borrow less to make deals pencil out.
Likewise, users are not going to pay a premium price to lock in occupancy cost well above the cost to lease the same property. To keep the same mortgage payment at today’s rate versus the rate just 6 months ago, a buyer would have to pay almost 22% less for the property, assuming a 10% down payment. So, a $400/square foot building in Q2 would be worth just $312/square foot today. Taking such a huge discount will be a hard pill to swallow for potential sellers who will be kicking themselves for not getting out sooner. Even though they could sell at the lower price and still realize an outsized gain, it won’t feel like the big win that it is and they’ll hang on to their properties and ride out a correction of unknown depth and duration.
As we head into these uncertain times, sales activity will probably decline, as property owners and potential buyers study their options and wait for more clarity in terms of market direction. Those with huge gains and a strong desire to exit the market will be the sellers during the lull, and those deals will be the dots the rest of the players connect to gain a new sense of direction. The whole process could take a while, especially if the general economy heads into recession, the prospects of which are growing by the day.