How Industrial is Faring in Four SoCal Markets

Tomaselli: “Tenants are now considering bifurcating operations to open up alternatives and separate logistical space from manufacturing-assembly and corporate-office functions.”

SOUTHERN CALIFORNIA—The industrial real estate sector in this region is still undergoing a major shortage of supply and phenomenal fundamentals. GlobeSt.com spoke exclusively with JLL executives in Orange County, San Diego, Los Angeles and the Inland Empire to compare industrial fundamentals and trends in each of these Southern California markets. GlobeSt.com: What surprised you about the Q2 industrial activity in your area? Louis Tomaselli, senior managing director, Orange County: Landlords and tenants like to ask, “Where are we in the Cycle? Are today’s rents lower or higher than last cycle?” As of Q2, average asking rent for class-A industrial product in Orange County now meets or exceeds previous 2008 peaks and is setting new historical peak pricing for in the 250 million-square-foot OC industrial market. In Q2, the leading class-A lease comp was Atosa International‘s lease of 126,681 square feet at a year-one $.68 NNN per square foot for a portion of the newly constructed class-A, 367,194-square-foot distribution-center building completed in Q4 2015 in Brea, CA, breaking the 2008 peak. We anticipate year-one rents will range from $.65 to $.72 NNN per square foot going forward. Joe Anderson, senior associate, San Diego: The biggest surprise about the San Diego Q2 industrial activity was the resiliency in the market. At the end of Q4 2015 and the beginning of Q1 2016, there were a lot of macroeconomic factors (slowdown in China’s economy, low/volatile oil prices) on the horizon that threatened to take some steam out of the momentum in our market. While there are always macroeconomic issues on the horizon, the fact is that the fundamentals in San Diego County remain strong, and businesses continue to need additional space to help deal with expanding inventories and increases in demand. While it remains to be seen how long this lasts, for the time being our market in 2016 has been extremely resilient. Paul Sablock, managing director, Los Angeles: I was surprised about how quickly deals come together on new product coming to market. I think the tight market is making users move quickly so they don’t lose out on the opportunity. Peter McWilliams, international director, Inland Empire: We knew activity throughout the Inland Empire industrial market had been strong, particularly in the east, but we didn’t realize that this quarter would mark the best quarter ever on record for net absorption in the East. 2015 went down as the year of the 1-million-square-foot user, and 2016 is shaping up to follow closely in its footsteps. Absorption was driven largely by several large move-ins by General Mills, Medline and Amazon , among others. GlobeSt.com: What drivers are impacting industrial rents in your area?  Tomaselli:   Demand is still outstripping supply by at least 1.5 to 1. Overall OC vacancy maintains at a historical low of 1.5% over a 250-million-square-foot base, and class-A industrial vacancy is below 1%. Both conditions are creating multiple offer pressure on available inventory and pushing earlier renewals for occupiers unable to find space alternatives and unwilling to take the market risk. Anderson: The biggest impact on industrial rents in San Diego is an overall lack of supply throughout the county. While there are a few exceptions ( Techbuilt ‘s 90,000-square-foot spec building and Murphy Development ‘s Scripps Ranch Tech Park , which are targeting flex/R&D users), we are running out of land in our central submarkets and have very limited functional space available. The lack of inventory in the central markets pits occupiers and users with a choice to pay higher occupancy costs for older product or venture into other areas of the county (Oceanside & Otay Mesa, for example) that might not be desirable from a location perspective. For firms that have a strong desire or a strategic operating imperative to be in the central submarkets, competition for available space will continue to drive rents. Sablock: Obviously, having less than a 1% vacancy is driving rents up, up, up.  A year ago, one would underwrite rents that seemingly have gone up over 10% to 12%. McWilliams: Vacancy has been the strongest contributing factor to recent rent growth, with vacancy rates in the western part of the Inland Empire in the 2% range. The small-box market, in particular, has really corrected over the past 24 months, and nearly any availability is being met with multiple tenant offers, helping drive up rates even further. Continued development challenges and longer entitlement periods is also helping limit new construction opportunities and driving up the price of entitled land and thus rental rates as well. GlobeSt.com: How will new construction or lack of construction play a role in the future of industrial in your area in the 12 months?  Tomaselli: The logical answer is that lease rates would increase to take advantage of the demand and low vacancy condition. However, that is a very simplistic view, and we think it gets more complicated than that simple response. Going forward in Q3 and Q4, we see lease rates and sale prices continuing to climbing above historic peaks and multiple tenants competing for space. We are experiencing a new response to the lack of alternatives and peaking rents, and that is tenants are now considering bifurcating operations to open up alternatives and separate logistical space from manufacturing-assembly and corporate-office functions. Office functions or key manufacturing or tech space that require the proximity to the depth and breadth of the OC skilled and educated talent pool remains in the market and pays the market rates required. The purely logistical warehouse and distribution space user looks to move out of the OC and consider supply-chain-friendly markets like Phoenix, Las Vegas, Reno and the Inland Empire as a Southwest region start. Anderson: How will new construction or lack of construction play a role in the future of industrial in your area in the 12 months? New construction will play a role by continuing to offer occupiers a choice, either paying a premium for new or slightly less for older product in the central markets, or making the decision to find newer, more functional options in our outer markets like Otay Mesa and Oceanside. The limited supply of new construction in central San Diego will continue to force occupiers to choose whether to hold tight if they can, step up to rents that might be higher than they’d like to see or consider other geographic areas. Sablock: The lack of new product being built and existing product that is NOT coming available will only exacerbate the status quo. Users are going to be forced to look at other markets. McWilliams:  Construction in the Inland Empire has really escalated to keep up with demand over the past three years, and the Inland Empire will see another year of 20 million square feet plus of construction deliveries. Given the low vacancy rates, this construction is very much needed, and we’re seeing a lot of pre-leasing activity in that last 30-to-60-day period prior to building delivery since tenants are still tending to be as risk-averse as possible. GlobeSt.com: What are the biggest trends you are seeing with industrial investment in your area?  Tomaselli:  Rising lease rates and steadily dropping cap rates for the past five years straight have in Q2 pushed investor price per square foot at or above some owner-occupier prices. For as long as I can recall, owner-occupiers’ pricing always exceeded investor cap rate pricing because owner-occupiers simply can pay what they want if they like the space and want to move their business, while the investor is solving for 10-year or other annual average return rates based on IRR or cap rate et al. Peaking lease rates and historically low industrial cap rates at 4% to 5% have pushed per-square-foot pricing so high that even owner-occupiers in many cases now are not willing to reach that high. Anderson: The biggest trends that I see with industrial investment is the continued heavy demand for industrial product in San Diego. There is a strong appetite from local owners/investors in the market, but also from institutional investors up and down the West Coast who get a little bit higher yield by placing capital in San Diego. Buyers are also more comfortable underwriting to continued rent growth due to strong fundamentals, lack of inventory and the rent growth that has taken place year over year throughout the county. We have a lot of capital chasing a handful of deals in San Diego. Sablock: The biggest trend is not a trend: it seems as though no one is selling anything investment-wise in the central market. The institutional players are standing pat, and the individual owners are not selling due to the lack of 1031 product into which to roll. McWilliams: Buyers are starting to be more selective about the product they’re buying, especially if they’re really stretching on the cap rate and buying in the 4% cap range. On the development-acquisition side, it’s all about entitlements and timing with developers wanting to put a shovel in the ground as quickly as possible. The one area where we’re also starting to see a lot of attention is the focus on union labor and recent lawsuits under CEQA that can potentially drive up development costs by 15% to 20% on projects that are not already through their entitlements . This actually gives a bit of value boost to existing building portfolios which are not subject to these higher costs and will compete favorably based on their lower cost basis when facing rollover. GlobeSt.com: What industrial trends will we be talking about at this time next year? Anderson: I think that next year people will be continuing to evaluate their supply-chain strategy and see how they can continue to increase efficiencies and get their products out to their customers, suppliers and vendors faster. More companies will look to place more distribution centers as close to their customers as possible. I also think last-mile-delivery will be a term that will be much more common to everyday people in the coming year. Sablock: Next year, we will be only tighter if things don’t change. We are in an election year, so maybe this will cause something in the market to shake. McWilliams: E-commerce this holiday season, with a lot of our big clients pouring billions of dollars into technology and capital projects to boost online sales. We will likely be talking about how tight vacancies continue to be in a market with solid rent growth and inflating costs. With developers leveraging development and redevelopment opportunities across all property types, how can you capitalize on this activity?  Join us  at RealShare Orange County on August 16^th for impactful information from the leaders in Orange County CRE. Learn  more .