Three forces behind the prolific run-up in property values currently being experienced in the Southern California industrial real estate market.
Since the recovery of property values began in earnest back in 2011, the price of owner/user industrial properties has increased by 100% or more throughout Southern California.
Had anyone predicted such a run-up back then, they would have been called crazy, really crazy or just plain nuts. Yet, here we are in 2018 and property values are still rising with no discernable end to the mother of all bull runs. How can this be? How much longer will it continue?
How high can it go before the reset button gets pushed? The answer is that no one knows for sure, but it does help to take a look back at what key market factors precipitated the turnaround and where those factors are today.
We believe that, as least as far as the owner/user market is concerned, there were three main reasons for the most prolific run-up in property values.
First and foremost, is the rock-bottom cost of capital. The second had to do with the depth of the property value decline during the so-called Great Recession and the third had to do with demand blasting ahead of a static supply of space throughout the region.
The Impact of Cheap Money
Back in 2008, the US Federal Reserve Bank, our beloved Fed, lowered its benchmark Fed Funds Rate to 0% and left it there until December of 2015. The initial move and ongoing “easy money” policy was meant to stimulate new investment from the business sector by making borrowing less expensive.
The results were mixed from the beginning, so in 2011 the Fed doubled down on its assumptions and began an aggressive bond-buying program known as Quantitative Easing (QE) to further flood the economy with cheap money. That brought the yield on the benchmark 10 Year Treasury Note (10yr) to record lows. Since commercial property mortgage rates are largely determined by adding a spread to the yield on the 10yr, mortgage rates for SBA 7A and 504 loans so popular with owner/users, fell to record lows.
That kicked off a buying binge and the rise in property values began in earnest.
It continues today.
Rates are still near historic lows and SBA programs still offer fixed rate loans at a rate under 5% for up to 25 years with just a 10% down payment. Buyers like these loans because they can fix their occupancy costs for the long term and build equity for themselves through principal reduction rather than send their landlord a check each month. Even at today’s elevated price levels, the concept is still a winner and should remain so until rates return to historic norms. More on that later.
The Great Recession
If we add in the fact that the market correction due to the Great Recession was so severe, we see more clearly why market values have risen as fast as they have.
Simply put, savvy buyers saw an opportunity to make a killing.
The previous market up-cycle also produced record prices, but the financial crisis that hit in 2008 was so devastating that property values in Southern California fell by as much as 50% despite the region’s strong performance history.
Those who believed that the region would weather another economic storm and come out ahead made their bets and started buying buildings with fixed-rate loans under 4%. Momentum kept building and prices have made double-digit gains for the last 5 years running. That trend continues today.
Constraints on Supply
Generally speaking, when demand for a product exceeds supply, the manufacturer simply increases production to meet the new demand and is often rewarded with even higher prices. That’s as it should be, but what happens when production can’t be increased due to a shortage of raw materials?
That’s an easy one: the price of remaining supply spikes.
That is exactly what has happened when it comes to producing more industrial real estate in Southern California. We have pretty much run out of land to build on and the cost to build on what land we have left is prohibitively expensive. This is especially true in Los Angeles and Orange Counties, which are now infill markets, meaning just a few sites scattered throughout the densely developed area are available…at a stratospheric price.
In Orange County, for instance, just one project, the Beckman Business Center in Fullerton, is under construction. The project features 8 buildings, none of which is under 40,000 square feet, where the bulk of the demand is concentrated. Smaller buildings are just too expensive to build even with prices at record levels. That is a fact not lost on the sellers of existing smaller buildings who point to scarcity as their justification for even higher prices.
Are we oversimplifying things? Perhaps a little. Every property, submarket and region has additional market forces that influence value. However, we believe that cheap money, the depth of the last correction and the ongoing lack of supply have caused most of the movement in industrial property values since the previous market peak.
Now, to the big question: how much more gas is in the tank to keep things rolling in the same direction? We will look into that in our next post….Stay tuned.