Today marks the end of the first
half of 2024. Wow! Christmas decorations will grace the shelves of do it yourself
retailers in no time. Be sure and buy yours early. After all, you’ll want to
make sure your Christmas lights are donned by Labor Day. But, I digress. Today,
I thought it would be interesting to take a look at the predictions I made in
January of this year to see how they are progressing. It’s always a good idea
to make sure you’re on the right track - especially when advising owners and
occupants of industrial real estate in Southern California.
So with that as a backdrop, let’s
review what I had to say six months ago, how those predictions are faring, and
what’s in store for the balance of the year, shall we?
Here’s what I had to say
in January 2024. Industrial lease rates will soften. This
time last year, a client of ours was facing an expiring lease. We tried to find
a suitable alternative to move his operation. Nothing was ideal. We advised him
to stay put, negotiate a short term fix - 6-12 months and continue our search.
His owner would only agree to six months so we had a new deadline - June of
2023. We nearly struck pay dirt in March but jettisoned the opportunity due to
its size - just not quite big enough. Once again, we approached his owner
asking for some more time. He agreed to extend through December. Our gamble
paid off as we secured a suitable building at a 15% discount! Why, you may
wonder? Simple economics. We tracked new avails and ones leaving the market and
noticed an imbalance. Yep. More was coming than going. We knew someone would
drop their rate to secure a great tenant. Expect more of the same this year -
especially with Class-A buildings above 100,000 square feet. At last count in
the OC - eleven were open for business and seeking a resident. Two left the
market last year. Hmmm. Someone will get motivated and make a deal, comps will
reset to the new level and the frenzy will begin. What’s
happening now. Yes! If you read my column
from last week, where I discussed the stages in which price reductions occur,
you will realize that we are in the concession stage of price reductions. By
that I mean, owners, in order to get their industrial buildings leased, are
offering more concessions, such as free rent, enhanced brokerage fees, and
potentially moving allowances to attract occupants to their vacancies. I would
expect this trend to continue until all of the class a inventory above 100,000
ft.² is absorbed. How long will it take you may be wondering? It’s difficult to
say, but I suspect by February or March 2025, will be in a short supply
situation once again.
Here’s what I had to say
in January 2024. Expect sales volume to increase. The
forces outlined in the paragraph above will trickle into the sales world. By
that, I mean an owner awaiting a tenant may choose to sell. A
further catalyst could be the underlying debt on the asset. Imagine you’ve
originated a short term construction loan to build a class A structure. You
considered construction costs, time to build and lease. Your calculus was based
upon conditions in early 2022. You’ve delivered a new building into an entirely
different market - longer vacancy and lower rates. Your lender might be getting
a bit nervous. When will the maturing debt be repaid? Thus pressure to dispose
of the new build. What’s happening
now. In the inland areas of Southern
California, such as the inland Empire, we are seeing some institutional owners
opt to sell their vacancies as opposed to waiting for that elusive tenant. In
this manner, they are able to re-deploy the money into a different market with
better fundamentals or return principal investment to their investors. If a
building has near term vacancy, meeting a year or two, expect this trend to
continue.
Here’s what I had to say
in January 2024. Recession or no? I say no. Last
year I took a contrarian approach and predicted we would avoid a recession in
2023. Recall, recession is a decline in gross national product for at least two
quarters. I believed in the resiliency of the United States economy, especially
the consumer, and we skated by a recession in 2023. As I write these
predictions today, the only storm clouds I see on our horizon, are global
uncertainty in the Middle East. Specifically, will the Red Sea shipping lane
disruption cause inflationary pressures on goods delivered? If this proves to
be the case, the federal reserve may be persuaded to delay cuts in interest
rates, which are predicted for this year. However, I’m reminded of our status
in January 2020. We were rocking along when a microscopic foe sent us to our
spare bedrooms. Therefore, beware of the Black Swan event. What’s
happening now. So far, so good. In fact,
aside from retail sales, our economy seems to be performing fairly well. Unemployment
has crept up slightly, but is still at historic lows. Granted, interest rates
are higher than they were two years ago, but still much lower than we have
experienced in other decades. Will the federal reserve choose to cut interest
rates later this year? Only time will tell, but I believe we may see an
interest rate cut after the election.
Here’s what I had to say
in January 2024. Interest rates. Last year,
for the first time in a couple of decades, you could actually make money on
idle cash. We saw a peak in Treasuries occur last year when the 10 year T-note
eclipsed 5%. The rate this morning is slightly above 3.8%. This is good news
for borrowers, bad news for savers and could cause an uptick in institutional
buying activity. These behemoth money managers are constantly seeking return
and might view commercial real estate as a safe haven to earn some additional
juice. I believe the 10 year notes will level at around 4 to 4.25% percent this
year. What’s happening now. As
of this writing, the ten year T note is hovering around 4.2 to 4.3%. This is
significantly lower than the 5% we saw at the end of 2023. As mentioned,
Treasury interest rates are a great metric for savers but not such a good
metric for those reliant upon borrowing - expanding businesses which need to
lease space, buy a facility or machinery and hire. I still believe we will end
the year with 10 year rates well below 4.5%.
So there you have it., What I said,
what’s happening now, and what I expect for the balance of 2024 I wish you and
yours a very safe and sane Fourth of July. Let’s make the second half of 2024
the best ever!
Allen C. Buchanan, SIOR, is a principal with Lee &
Associates Commercial Real Estate Services in Orange. He can be reached
at abuchanan@lee-associates.com or 714.564.7104. His
website is allencbuchanan.blogspot.com.
Recently, we discussed price
reductions and the factors which cause them. In short, when supply exceeds
demand, a shortage occurs - also called an imbalance. This imbalance is like a
seesaw - it’s hedged toward either side with one side up and the other down. In
our industrial market, the number of occupants needed to fill our vacancies is
surpassed by the addresses available. Ok. One of the ways to absorb the excess
is through price reductions. Today, I’ll take an in depth look at the steps you
can anticipate when lease rates soften as outlined by the stages of an economic
cycle.
The Economic Cycle Stages:
1. Vacancies Narrow: Initially,
as the market tightens, available spaces get leased quickly. Businesses expand,
new companies move in, and the surplus of vacant buildings decreases.
2. Rents Grow: As
vacancies narrow, landlords gain pricing power. Increased demand leads to
higher rents. Businesses are willing to pay more due to the scarcity of
available spaces.
3. Developers Build: Seeing
rising rents and low vacancies, developers enter the market. New projects are
initiated to capitalize on the high demand and favorable leasing conditions.
4. Leasing Activity is
Robust: With new developments and a
thriving economy, leasing activity peaks. Companies scramble to secure space,
often agreeing to higher rates and fewer concessions.
5. Developers Over-Build: Eventually,
enthusiasm leads to overbuilding. Developers, eager to take advantage of the
booming market, construct more spaces than the market can absorb.
6. Vacancies Increase: As
the new spaces come online, the market shifts. The supply of available
buildings starts to outpace demand, leading to increased vacancies.
7. Time on Market Expands: With
more options available, properties take longer to lease. The average time a
building sits on the market extends as businesses take their time to choose the
best deal.
8. Concessions Appear: To
attract tenants, landlords begin offering concessions—such as free rent
periods, tenant improvement allowances, and other incentives. These concessions
aim to make properties more appealing in a competitive market. By
the way, this is where we are.
9. Prices Soften: As
vacancies continue to rise and concessions become standard, lease rates start
to soften. Landlords adjust their pricing expectations to align with the new
market reality.
10. Demand Returns: Over
time, the lower prices and favorable leasing terms attract new tenants.
Businesses take advantage of the softened market to expand or relocate.
11. Vacancies are
Absorbed: As demand picks up, the
surplus of vacant buildings gradually diminishes. The market starts to balance
out, with supply and demand reaching equilibrium.
12. Rents Start to Grow: With
vacancies absorbed and demand steady, rents begin to rise again. The cycle
comes full circle as the market moves back toward a landlord's market, setting
the stage for the next economic cycle.
Conclusion:
Understanding these stages helps
businesses and investors gauge the ever-changing industrial real estate market.
By recognizing where we are in the cycle, you can make informed
decisions—whether it’s the right time to negotiate a lease, start a new development,
or make strategic investments. In today’s market, with lease rates softening,
it’s essential to stay informed and adaptable. The key to success lies in
anticipating the next phase of the cycle and positioning yourself to take full
advantage of the opportunities it presents.
Allen C. Buchanan, SIOR, is a principal with Lee &
Associates Commercial Real Estate Services in Orange. He can be reached
at abuchanan@lee-associates.com or 714.564.7104. His
website is allencbuchanan.blogspot.com.
Last
week, we spent some time discussing the morphing industrial market and its
impact upon pricing. To review, north Orange County - especially in large
logistics boxes - approaching an imbalance weighted upon those who occupy.
Supply exceeds demand. Only time will tell if price drops will spur demand -
also known an elasticity.
With
that backdrop, today I’d like to offer some suggestions if you find your
company heading out to make a deal - either a purchase but especially a
lease.
Know
the market. Let’s
say your requirement is 100 to 150,000 ft.² of logistics space in North Orange
County. You should be keenly aware of everything that currently exists or will
become available during your search time. By this, I mean, what tenants will
vacate spaces that you could backfill. Coupled with an understanding of the
available inventory is knowledge of the transactions that have recently
occurred. By the way, transactions occur as sales, direct leases, subleases,
and renewals. Sales are a matter of public record - their terms are easy to
determine. Direct leases and subleases are more difficult to track because no
deed is recorded. Renewal deals are the most difficult to review as frequently
renewal deals occur between an owner and his occupant. These are typically not
marketed and therefore difficult to gauge. It is imperative that you engage a
commercial real estate professional, who really understands the marketplace in
which your requirement will compete. Another factor with which you should be
aware is the type of owner holding title to the property. An institutional
property owner such as a pension fund advisor or a real estate investment trust
will likely have more guard rails around the terms and conditions under which
they can negotiate. A private owner may be more flexible in agreeing to
favorable terms. Regardless, you must understand the owner’s motivations in
order to secure the best possible sale price or lease rate and terms.
Know
your capabilities. Things
such as how long you will be able to commit to the space, what variances from
the typical amenities will you require, what is the timing of your present
lease expiration, do you own a facility that must be sold prior to transacting,
is there anything unique about your use of the building that might cause a
timing delay, and other questions should be seriously considered with carefully
thought out answers. We recently represented a tenant who was able to sign a 10
year lease, use the improvements in the building largely as they existed and
had a lease that expired with enough time to enable the building to become
market ready. We were an ideal match for the owner. Had any of these components
been lacking, our requirement would not have been as favorable.
Understand
your strong suit.
If your company is ready to move upon closing a sale or signing a lease, and
the building you are pursuing is vacant, you are potentially golden. However,
the converse could be true if you are ready to make a deal yet the building
won’t be available for another nine months. As you can see, something would
have to change with this set of circumstances. Either you would have to delay
possession or the owner would have to figure out a way to make the building
available sooner. Is your company financially strong? In this rapidly changing
market, credit is king. The last thing an owner wants to do these days is sign
a long-term commitment with a financially shaky occupant. Turnover is expensive
and owners want to avoid this at all cost.
Be
aware of your blind spot. If all of the interest in a
particular piece of property were laid side-by-side, how does your interest
compare? By this I mean, do you require bank financing in order to complete the
deal? Is board approval a part of your process? Is there anything particular
about your requirement, which could add time to your ability to say yes? Will a
hefty legal review of all of the documents ensue upon the handshake? How does
the purchasing or leasing entity look financially? Let’s say you want the very
best purchase price available yet are hamstrung because of your need to procure
financing. This adds an uncertainty to the transaction which may cause a seller
to go a different direction. Of course, this assumes there are other potential purchasers.
If your sense is you are his only alternative, you may be able to get a great
price and the timeframe needed to close the deal. Certainty of clothes these
days is more important than the very highest price. Consequently, structure
your deal accordingly.
Don’t
get greedy. The
biggest mistake I see occupants make in this rapidly changing market, is trying
to take advantage of an owner. Owners of commercial real estate are generally
sophisticated entities with tons of market expertise. It’s safe to assume
they’re acutely aware of their situation. If you are trying to extract the best
sales price, lead with data. By understanding the owners exit strategy - lease
up and sell or hold long-term, you can chart the course to completion. Using
the lease up and hold exit, an owner will have to procure a tenant for his
building before selling it to an investor. Therefore, understanding the rental
market - rate, concessions and terms - you have a starting point. Once a tenant
is in place, what is the market capitalization rate for this income. Assume
$21.60 NNN annually and a 6% cap. The resulting price per square foot value
would be $360 ($21.60 / .06). But the tenant is not there yet. So, it would be
reasonable to expect some origination costs should be subtracted. After all, to
procure the tenant will require some free rent, potential modifications to the
building such as lighting or dock levelers, and brokerage fees. To compute this
cost requires assumptions. Overestimate and the greed enters the picture.
Thus,
negotiating the best deal in today’s industrial real estate market requires
thorough market knowledge, a clear understanding of your capabilities, and
strategic negotiation. By focusing on data-driven decisions and avoiding greed,
you can secure favorable terms in a challenging market.
Allen C. Buchanan, SIOR, is a principal with Lee &
Associates Commercial Real Estate Services in Orange. He can be reached
at abuchanan@lee-associates.com or 714.564.7104. His
website is allencbuchanan.blogspot.com.
Our industrial market in Southern
California is rapidly morphing into a buyer’s/tenant’s market. By that I mean, a
supply of available buildings which exceeds demand and a softening of prices.
We’re seeing this especially in the large logistics spaces constructed in the
last building craze. At their peak, rents topped $2.10 per square foot triple
net for these concrete caverns. On a 100,000 sf building, that’s $210,000 per
month plus an additional $40,000 for operating expenses. In context, these
rents for a seemingly lower and lesser use - industrial - than an office
building eclipsed the price paid for a suite of office space.
Prior to June 2022, these boxes were
devoured by hungry occupants before construction was completed. Now they sit.
In some cases for months. Those deals that have transacted are much less than
the halcyon days of two years ago. Now a credit worthy tenant can expect to pay
$1.75-$1.85 triple net for the same address which commanded 17% higher numbers
not that long ago.
What about the sale market? In north
Orange County - Anaheim, Placentia, Brea, Orange, Yourba Linda, Fullerton and
la Habra - we’ve also seen softening. However, not to the extent rents have
decreased. The inland areas tell a different story.
Factors Contributing to
the Shift:
1. Increased Supply: The
recent building boom has resulted in an oversupply of large logistics spaces.
These buildings, once in high demand, are now struggling to find tenants. This
surplus is driving down rental rates as owners compete for a shrinking pool of
occupants.
2. Economic Uncertainty: Economic
factors, including inflation and rising operational costs, have made businesses
more cautious about expanding their industrial footprints. Companies are
re-evaluating their space needs and, in many cases, opting for smaller or more
flexible leasing arrangements.
3. Changes in Consumer
Behavior: The rapid shift towards
e-commerce during the pandemic has now stabilized. As consumer behavior
normalizes, the frantic demand for massive warehouse spaces to accommodate
inventory surges has waned.
4. Financing Challenges: Higher
interest rates and tighter lending conditions have made financing new
acquisitions and developments more challenging. This has tempered the pace of
new investments and developments in the industrial sector.
Opportunities for Tenants
and Buyers:
1. Bargaining Power: With
a glut of available spaces, tenants have greater bargaining power. They can
negotiate more favorable lease terms, including lower rents, longer rent-free
periods, and tenant improvement allowances.
2. Strategic Acquisitions: For
buyers, especially those with readily available capital, this market presents
opportunities to acquire properties at more reasonable prices. Investors can
capitalize on distressed assets or properties that have been sitting vacant.
3. Long-Term Planning: Businesses
can take advantage of the current market conditions to secure space for future
growth at attractive rates. Locking in long-term leases now can provide
stability and cost savings in the years to come.
Challenges Ahead:
1. Vacancy Rates: High
vacancy rates can strain property owners who rely on rental income to meet
their financial obligations. This could lead to increased property turnover and
potential distress sales.
2. Maintenance Costs: Maintaining
large, vacant industrial properties can be costly. Owners must continue to
invest in upkeep to attract potential tenants, even as rental income declines.
3. Market Uncertainty: Continued
economic uncertainty and potential regulatory changes could further impact the
industrial real estate market. Stakeholders need to stay informed and adaptable
to navigate these challenges.
Conclusion:
The Southern California industrial
real estate market is undergoing a significant transition into a
buyer’s/tenant’s market. While this shift presents challenges for property
owners, it also offers opportunities for tenants and buyers to secure favorable
terms and strategic investments. By understanding the factors driving this
change and staying adaptable, stakeholders can navigate the evolving landscape
and capitalize on new opportunities.
Allen C. Buchanan, SIOR, is a principal with Lee &
Associates Commercial Real Estate Services in Orange. He can be reached
at abuchanan@lee-associates.com or 714.564.7104. His
website is allencbuchanan.blogspot.com.
