[co-author: Darla Longo]
Industrial markets over the past several years have seen consistently high occupancy rates and superior rental rate growth. While sentiment in the June 2020 Survey dropped precipitously, it immediately rebounded and has continued to improve. In the latest Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey, overall sentiment about the coming three years soared to its highest level since December 2015.
Industrial market industry leaders, Darla Longo of CBRE and Sandy Jacobson of Allen Matkins, discuss what lies ahead for this sector of the California commercial real estate market.
1. THE INDUSTRIAL MARKET CONTINUES TO BE ONE OF THE HOTTEST COMMERCIAL REAL ESTATE SECTORS, AND SURVEY PARTICIPANTS PREDICT IT WILL CONTINUE TO GROW AT LEAST OVER THE NEXT THREE YEARS. WHAT IS ACCELERATING THIS MARKET AND WHAT FACTORS, IF ANY, WILL EVENTUALLY SLOW IT DOWN?
Longo: The capital markets will remain robust with the entrance of new capital. We will continue to see cap rate compression with the lack of supply. A slowdown of cap rate compression will be inflation and an increase in the interest rates. Market demand has been accelerated from the large bump in e-commerce sales in 2020 which is holding steady in 2021. Other demand drivers include occupiers plans to hold more inventory on shore and an overall improvement in the U.S. economy which is keeping overall retail sales strong.
Comp rents are actually increasing at a faster rate. While year-over-year asking rents have increased by 7.1%, when looking at deals signed from Jan 1 to May 31, 2021, compared with the same time period a year ago, first year taking rents have actually increased by 9.7%. Markets along the coasts, near growing population centers or with inland port hubs, had the most growth in rents. First-year base rents in the Inland Empire grew by 24.1% year-over-year through May. It also have one of the lowest industrial vacancy rates in the country at 1.5%. The need to have facilities in these markets, coupled with record low vacancy rates, are leading in some circumstances to bidding wars among occupiers that are driving up rental rates.
E-commerce will continue to be a primary demand driver in the next three years. The spike in online demand sent occupiers scrambling to find space and we are still in the early innings of those expansion needs.
Headwinds will be lack of available space, a tightening availability of labor, and the possibility of delays in available first-generation space because of increased material costs and delays. From a lack of available space standpoint, we will continue to see conversions increase, this includes conversion of manufacturing or obsolete industrial, but also retail. While there are many barriers to retail conversion including zoning, site layout, and cost, in the right situation retail conversion could be a winner because they are typically located in well populated areas. This is something I think we will continue to see at a faster pace in the coming years.
Jacobson: The point, click, and ship model of purchasing soft goods gained momentum for years when the economy was flourishing in the pre-COVID-19 era. Although there are a variety of reasons that contributed to the growth of home shopping, the primary reason was that it made people’s lives easier by saving them time. Enter COVID-19. Home shopping became much more prevalent due to shut-down orders and/or fears of the virus. In other words, COVID-19 turned luxury shopping into necessity shopping in many different geographical areas and in different demographic groups. The conversion to “necessity” resulted in increased demand for warehouse space, distribution centers, and logistics providers. Despite the prior industrial sector growth, there still was not enough real estate available to cover the surge in demand that resulted from the effects of the pandemic. It is simple economics. When demand is higher than the supply, rents can and will increase. Until such time that the home shopping model ebbs or the vacancy rates increase (i.e., there is enough supply to meet demand), rents will continue to increase and land values for industrial development will continue to soar.
2. GIVEN THE HIGH DEMAND FOR INDUSTRIAL SPACE, WHAT ARE DEVELOPERS AND LANDLORDS DOING TO STAY COMPETITIVE AND CONTINUE TO INCREASE LEASE RATES AND DECREASE VACANCY RATES, EVEN BEYOND THE LEVELS THAT THEY ARE?
Longo: With record low vacancy rates that are projected to decline even further, it is definitely a landlord’s market. Landlords don’t need to do much to stay competitive. In many markets there are multiple tenants looking to lease the same space which is driving up rents.
Jacobson: It is not difficult for developers and landlords to find tenants to occupy their buildings and pay higher rents because the demand is so high. The bigger competition is amongst developers and landlords to lure good credit tenants to their sites and away from a competitor’s site. Developers and landlords of newly constructed buildings will always have an edge because the user will be getting a new building constructed with the latest technologies, a building with greater ceiling heights than older buildings, and more dock doors than some of the older industrial product. The trade-off, however, is that these buildings were more expensive to construct, so rents and taxes will be higher. In both newly constructed buildings and existing product, landlords and developers are utilizing a combination of free rent incentives, tenant improvements allowances, operating expense caps, and extension options to incentivize a tenant into selecting their building. Landlords and developers are able to amortize these “incentive costs” by making the lease terms slightly longer.
3. WHAT NEW TECHNOLOGIES OR SAFETY GUIDELINES ARE BEING IMPLEMENTED IN NEW OR REDEVELOPED INDUSTRIAL SPACE, EITHER COVID-RELATED OR DUE TO THE HIGHER DEMAND?
Longo: COVID health is having very little impact on space planning. Companies are keeping a 6’ guideline in mind, but it is not significantly impacting the overall design of the facility. However, e-commerce growth has led to changes in facility design needs, such as:
- added parking and staging
- 38-40' clear heights, flat roof
- ceiling hung loads
- maxmize dock loads
- increased power service and distribution
- air conditioning/ventilitation
Labor will continue to be important and markets with growing labor ability and affordability will win in site selection. A tightening labor market and increased demand for fast shipping will also bring about more automation in the coming years. We are already seeing implementation of automation in warehouses, not just with retailers, but also 3Pls.
Jacobson: There are a few changes in industrial development and redevelopment that are a result of the pandemic. These include changes to air ventilation systems within buildings and floor plan layouts to encourage better distancing. However, the bigger (and mor expensive) technological advances are increasingly being required by the governing agencies approving projects. Many developments and redevelopments are now having green energy requirements being imposed upon them by the governing agencies. The more typical new requirements include solar energy systems, electrical charging stations for both automobiles and trucks, and drought-tolerant landscaping. Some jurisdictions have even gone so far as to require projects to have fleets of electric trucks that can be used in the day-to-day operations. There are also more typical green energy requirements being implemented by, or imposed upon, developers, to help reduce trip counts, traffic congestion and other noise pollution. All of these technologies ultimately help the environment and help create efficiencies, but the increased development costs will certainly continue to be passed onto the users.