[co-author: Darla Longo]
Though there has been consistently high occupancy and superior rate growth in the industrial market over the past several years, the deep economic recession has caused sentiment expressed in our latest Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey to drop precipitously in all markets except the East Bay Area. However, the panelists’ actions also indicate that they do not feel as pessimistic as the overall index suggests. Sixty percent of the panelists in Southern California and 43 percent in Northern California are planning at least one new development in the next 12 months, and 39 percent and 29 percent are planning multiple projects, respectively. When one considers that this is in the middle of a recession with a great deal of overall economic uncertainty, these numbers are quite telling.
If the demand for warehouse space and the stock of warehouses are increasing at about the same rate as projected, then 2023 will see a mild erosion of rental rates when adjusted for inflation, and there remains the possibility of some erosion in occupancy. However, that does not mean that industrial markets will be depressed, rather that they will not be as imbalanced as in recent years.
Industrial market industry leaders, Darla Longo of CBRE and Brad Nielsen of Allen Matkins, discuss what lies ahead for this sector of the California commercial real estate market.
1. INDUSTRIAL HAD THE LOWEST DROP IN SENTIMENT COMPARED TO THE OTHER ASSET CLASSES SURVEYED. WHY?
Longo: Even before COVID-19 hit, a significant change in consumer demand patterns had occurred over the past decade, driven by demographics, technology, and evolving consumer preferences. The response to the global pandemic—individuals staying inside their homes and stores closing their doors—has further pushed consumers to purchase goods online. CBRE research predicts that $1B of e-commerce sales = 1.25 MSF of industrial demand. Seven hundred MSF of new product is projected to be needed over the next five years. As a result, the sentiment towards industrial real estate demand continued to stay relatively positive and is expected to remain healthy as e-commerce penetration grows.
Nielsen: Even before the COVID-19 pandemic more people were ordering goods online, however, the pandemic accelerated what was already happening in our economy and the "Amazon Effect" has skyrocketed. The demand for all sizes of industrial buildings has increased as more people are staying at home and ordering goods to be delivered directly to their doorstep. This trend will seem to continue in the near term and the long term as many people who were ordering goods previously will increase their demand and many others who are new to online ordering learn that it is an easy way to get what they want without leaving their homes. This market acceptance of online ordering means less retail space and more industrial space will be needed. Another reason the demand for industrial is steady or increasing is that our economy is rejecting goods from China or refusing to wait for goods to be shipped to the U.S. As the demand for goods made in the U.S. increases, we will need more industrial space to store these goods. The market also does not want to get caught with a short supply of goods like toilet paper, paper towels, cleaning products, etc., so more industrial space is needed to store such items.
2. HOW WILL INDUSTRIAL DEVELOPMENT IN CALIFORNIA CHANGE MOVING FORWARD IN ORDER TO MEET NEW HEALTH AND SAFETY GUIDELINES AS A RESULT OF THE PANDEMIC?
Longo: Most of the new health and safety guidelines will be geared towards employee safety, and thus will be implemented by the occupier. These changes include temperature checks prior to starting shifts, less employee interaction during breaks and on the warehouse floor, and sanitizing the building more often. Any design changes will be relegated mostly to the office and break room portions of the warehouse. In these areas, changes will be made similar to what is being planned in office buildings. HVAC systems will be modernized, designs will not focus as much on employee mingling but social distancing, and there will be more stations for sanitation.
Nielsen: New health and safety guidelines will expedite the need for automated warehouses. "Healthy" industrial will dictate that as few people as possible work in large industrial buildings. As a result, fully automated warehouses similar to what Amazon, QVC, and others have already implemented may become more commonplace in warehouse settings.
3. WITH MAJOR RETAIL CHAINS FILING FOR BANKRUPTCY, CAN WE EXPECT TO SEE VACANT RETAIL SPACE CONVERTED INTO INDUSTRIAL SPACE? IF SO, HOW WILL THAT IMPACT THE INDUSTRIAL MARKET OVERALL, IN TERMS OF VACANCY AND RENTAL RATES?
Longo: There has been an increase in retail-to-industrial conversions over the past few years, and these will continue as more department store retailers go out of business. These conversions have happened in stand-alone buildings that do not have a large pedestrian vehicle flow (still open malls, for example, are not seeing these conversions of empty stores) and are located in parts of the city with the proper zoning or ability to easily change the zoning.
That being said, there is 16 billion SF of existing industrial space in the U.S. and nearly 3 billion SF of existing industrial space in California (CBRE Research: James Breeze). The addition of these conversions to the industrial stock is welcome because of the need for last-mile warehouses, but the total square footage of these conversions is not enough to sway overall fundamentals like vacancy or rental rates.
Nielsen: Although government prefers retail over industrial (e.g., to maximize sales taxes), government does not want vacancy. Also, as the demand for same-day delivery increases, well-positioned and vacant retail will become the ideal location for in-city warehouses to store their goods.
4. INDUSTRIAL LANDLORDS EXPERIENCING DELINQUENT RENT PAYMENTS ARE THOSE LOCATED NEAR PORTS, NOT AS A RESULT OF THE PANDEMIC, BUT DUE TO THE TRADE WAR WITH CHINA. HOW WILL THOSE LANDLORDS ADAPT IF THE TRADE WARS CONTINUE LONG TERM?
Longo: CBRE research has reported that industrial real estate rent collections remain much higher than office and retail. This points to the overall strength of the sector. While some port-related occupiers are struggling because of disruptions to imports since the trade war started, the pandemic has just added to this. Port markets still have the lowest vacancy rates in the country. Because of this and the corresponding record high rents in these markets, there will not be much incentive for landlords to forgive rent delinquencies. They instead will be willing to find new occupiers who are looking to move into a very tight, still in-demand region of the state.
Nielsen: Over the years, industrial buildings in close proximity to a port have achieved higher rental rates than industrial buildings not near a port, however, since ports are typically near large city centers (e.g., Los Angeles/Long Beach, the Bay Area, and Seattle), these industrial buildings are central enough to stay in high demand, even with the current and potentially long-term trade war with China.
5. WHAT ARE THE KEY FACTORS THAT WILL KEEP THE INDUSTRIAL MARKET THE STRONGEST MARKET SECTOR MOVING FORWARD? WHAT WILL BE THE BIGGEST CHALLENGES IN THIS SPACE OVER THE NEXT THREE YEARS?
Longo: Three major factors will keep demand robust across the country, but especially in the Western U.S. for the foreseeable future. One is the increase in e-commerce sales. Even before the pandemic, an internal CBRE forecast predicted e-commerce as a percent of retail sales would reach 39 percent in the U.S. by 2030. This increase in e-commerce sales will significantly increase demand for big box and last-mile distribution centers. Two other distribution center demand drivers are born from e-commerce, including reverse logistics and “safety stock.” (CBRE Research: James Breeze)
Having the ability to handle returned merchandise and keep more inventory onshore to protect against future disruptions will be a major driver of demand in the coming years, but occupiers will look to do this as cost-efficient as possible, so both of these uses could be ideal for Class B or older Class A facilities.
The final demand driver is population growth. While the ports are an important logistical advantage for California occupiers, what really drives demand is the ability to service the large population in California, and the growing populations of the interior West, including Arizona, Nevada, and Utah. This will keep occupiers in the region, keep development robust in markets with available land, and keep rents ascending past record levels for the foreseeable future.
The biggest challenge for the markets, especially Southern California, will be finding space. Coastal markets are infill, and land is being rapidly absorbed in the Inland Empire. While there is still land for development in the Inland Empire East, the question will be, once prime locations are developed, will Southern California occupiers who need modern space look to the growing Phoenix and Las Vegas markets as alternatives in the coming years, or will they be willing to stay in the state and look at places like the High Desert or Banning/Beaumont?
There is also a lack of supply in the building type that is showing the largest increase in demand, and that’s cold storage. Vacancy rates for cold storage facilities are practically zero. These facilities are specialized, costly, and are typically not built to spec. With higher land costs, will California lose out on this growing product type, or will location within the population center increase more build-to-suit developments in the coming quarters?
Other ongoing challenges are increased regulations that California has imposed and the challenging entitlement process.
Nielsen: Although all sectors do better when the economy is booming and we are experiencing job growth, a continued growth in the logistics sector shows that job growth is not necessarily needed to sustain demand for new warehouses. As described above, the "Amazon Effect" and the early stage of market acceptance of online ordering that we are experiencing may continue to cause the demand for growth in the industrial arena. That being said, the biggest challenge to industrial growth is government resistance to warehouses, both local government, regarding approving warehouses and state (CARB), and regional (AQMD) obstructions.