MARKET INTEL: Taking the Temperature of the SoCal Industrial Market: Q4 Insights with AIR CRE

SKIP AHEAD TO:

• Industrial Outlook Mixed Amid Wavering Consumer Confidence and Rising Retail Inventories
• Rising Interest Rates, Cost of Capital Yield Falling Investment Volume and Upward Cap Rate Pressure
• Lease Transactions Still Showing Double-Digit Year Over Year Base Rent Growth
• Proposed Inland Empire Warehouse Moratorium and Shift of Port Volumes East Are Market-Specific Headwinds
• Inland Empire and Los Angeles County Industrial Buildings Built Before 2000 Have Lowest WALTs
• Most Valuable Transactions Show 2022 Drop in E-commerce and Amazon Dominance

This week CompStak is pleased to recap last week’s webinar, AIR CRE Town Hall: Q4 2022 Research Insights. Thank you to AIR CRE for inviting CompStak to share our latest data on the industrial market in the Inland Empire, Los Angeles County, and Orange County. The key themes presented on this major industrial market include:

• Industrial outlook is mixed amid wavering consumer confidence and rising costs of capital
• Market specific headwinds include a proposed Inland Empire development moratorium and a recent shift of trade volumes to the East Coast
• The pace of year over year double-digit rent growth has not slowed yet for closed transactions
• Inland Empire and Los Angeles County industrial buildings built before 2000 have the lowest WALTs
• Most valuable transactions completed show a 2022 drop in e-commerce and Amazon’s dominance

Click here to read more on insights presented during this webinar.

Industrial Outlook Mixed Amid Wavering Consumer Confidence and Rising Retail Inventories

Retail spending and consumer confidence data has been sending mixed signals over the last few months. Through the pandemic, a significant portion of the industrial market’s growth came from an increase in spending on goods over services, but is this slowing or reversing due to inflation and economic pressures?

The answer is not straightforward. Consumer sentiment as measured by the University of Michigan reached an all time low in June 2022. Now it has increased four of the last five months but remains well below its historical average. Meanwhile, 2022 holiday season spending came in below expectations according to the U.S. Census. While it grew 4.8% year over year in December 2022, inflation (CPI, All Items) outpaced it, growing 6.4% over the same period. 

However, another month of retail data was released last week and displayed a 3.9% jump in January sales year over year which exceeded expectations. The data surprised analysts because January is traditionally a lackluster month and the holiday season indicated spending might weaken further.

As a result of wavering demand and increased past ordering to counter supply chain challenges, many retailers and suppliers continue to sit on record levels of inventory. This is an ongoing industrial sector tailwind as tenants seek space to store excess product now even as they are making plans to cut ordering in the future. Despite these record retail inventories, we are seeing continued signs that supply chain issues are easing. The NY Federal Reserve Global Supply Chain Pressure Index was down 78.0% in January 2023 from December’s 2021 peak and it is falling back in line with historical levels.  Of greater concern to supply chain participants is the need to reign in cost. After years of pandemic run up in demand forcing supply chain players to move goods at any cost, companies are now facing tighter bottom lines and are looking to create greater efficiency.

Rising Interest Rates, Cost of Capital Yield Falling Investment Volume and Upward Cap Rate Pressure

As of February 2023, the Federal Reserve has raised rates 8 times and will meet again at the end of March to contemplate the ninth rate hike. January’s rate hike slowed its pace somewhat from a 50 bps to a 25 bps rate. The stronger than expected retail sales data, recently released inflation data and a stronger than expected jobs report for January will all weigh heavily on whether the federal reserve maintains this pace or accelerates it. In January, total nonfarm payroll employment rose by 517,000 and the unemployment rate held steady at 3.4 percent, according to the Bureau of Labor Statistics.

Despite uncertainty about how high interest rates may go, there is evidence that rate hikes are yielding a slowdown in commercial real estate investment, even in the industrial sector, and there is upward pressure on cap rates. AIR CRE’s presentation displayed that sales transactions in the overall Inland Empire/Orange County/Los Angeles County/Ventura County market have been falling for four consecutive quarters and are down 56.0% year over year. Meanwhile, CompStak’s data on sales transactions, focused on trades completed by the top ten largest industrial landlords in this market, illustrated that the average cap rate has remained below 4% for the last nine consecutive quarters but ticked up slightly in the fourth quarter. While investors are slowing their capital deployment, they are still maintaining optimism about the industrial sector overall because even a moderate slowdown in rent growth would show positive momentum.

Lease Transactions Still Showing Double-Digit Year Over Year Base Rent Growth

Despite a drop in investment sales, closed industrial lease transactions through the end of 2022 did not signal a slowdown in rent growth yet. According to CompStak’s lease transaction data, the rate of growth in base rents for closed transactions has been posting double digit annual growth for the past five quarters. 

Average base rents are up more than 42% year over year for this overall market and this fell just slightly from last quarters pace of annual growth, suggesting that growth rates may be moderating, according to CompStak’s data. AIR CRE presented that asking rents, on the other hand, have been stabilizing for the past three quarters for direct lease listings and are now up 19% year over year.  This is in contrast to sublease listings, as presented by AIR CRE, where asking rates have been increasing for the past four quarters.

In other indicators of pricing movement, CompStak’s data also shows that annual lease escalations are beginning to plateau. The average annual lease escalation has now  averaged about 3.8 to 3.9% for the past two quarters. Still, it has increased substantially from a 3% level at the beginning of the pandemic. With double digit annual rent growth in the market, landlords increasingly priced in larger increases over the past 9 quarters to attempt to keep pace with the market.

Proposed Inland Empire Warehouse Moratorium and Shift of Port Volumes East Are Market-Specific Headwinds

Other than increasing interest rates and fluctuating consumer demand, the Inland Empire/Orange County/Los Angeles County market is also facing several market specific challenges. New construction has proliferated in the Inland Empire, where projects have increased in size and footprint over the last several years. According to CompStak’s data, the average transaction size for closed deals in the Inland Empire has steadily increased over the last seven quarters and has topped 100,000 square feet for the last five quarters. In addition, transaction sizes are increasing fastest for new construction; the average transaction size for 2022 deals in buildings built within the last 10 years is more than four times the size of transactions completed in all other buildings. 

Moreover, the total square feet of construction has not slowed in the Inland Empire. AIR CRE’s data shows a 61% increase year over year in square feet under construction in the Inland Empire. With the increase in size and volume of new construction, anti-development pressure has been rising, specifically in the Inland Empire. AIR CRE noted a coalition of environmental, labor, community, and academic groups is pressuring California’s governor for a moratorium of up to two years on new warehouse development. This could be one of the most significant challenges for the market ahead.

A development moratorium could threaten future supply, but a changing landscape of port volumes across the United States could impact the demand side for industrial space in this market. Over the course of 2022, port volumes shifted to the East Coast as suppliers adjusted to supply chain challenges including reduced imports from China and threats of labor disputes in West Coast ports. The Port of New York and New Jersey’s total twenty-foot equivalent units (TEUs) volume outpaced volumes at the port of Long Beach and Los Angeles for four consecutive months in late 2022 before Los Angeles rose back to its traditional first place in December 2022. Over the last two years, the Inland Empire and Orange County industrial market has experienced some of the fastest growing average starting rents nationwide. While the average starting rent in the Central and Northern New Jersey market (the primary market serving the Port of NY and NJ) has not yet surpassed the average for this market, will it catch up or surpass it due to this increase in port activity on the East Coast?

Inland Empire and Los Angeles County Industrial Buildings Built Before 2000 Have Lowest WALTs

CompStak evaluated the WALT (the average weighted remaining lease term) across this market by industrial building size and age. Although investors have stayed increasingly on the sidelines recently, the search for yield still involves finding properties with shorter WALTs in order to recapture tenants at current market rents sooner, often at significant multiples. For example, if a tenant renewed a deal at the end of 4Q 2022 after originally signing a lease in mid-2018, the new transaction would have a starting rent about 2.1 times higher now that the original deal, according to CompStak’s data.  The average WALT is the shortest in the Inland Empire and Los Angeles County for buildings built before 2000.  Breaking apart WALTs further by building size, the average remaining is smallest for buildings over 700,000 square feet and built before 2000 in Los Angeles County (31.0 months) followed by 36.8 months for Inland Empire buildings built before 2000 and smaller than 300,000 square feet. 

The spread between the average current rent in place and the average starting rent over the last 12 months differs significantly across building sizes and vintage. Not surprisingly, considering the demand for new construction and larger properties, the largest spread is in Inland Empire buildings larger than 700,000 square feet and built before 2000. For this category, the average starting rent is more than 181% above the rents being paid today by existing tenants with active leases. Other substantial spreads were found in buildings between 300,000 and 700,000 square feet in Los Angeles County (70.6%) and in Orange County (87.3%).

Most Valuable Transactions Show 2022 Drop in E-commerce and Amazon Dominance

Much of the runup in demand over the last few years came from e-commerce, retail trade and the logistics companies that support moving, managing and transporting these goods in this market. CompStak analyzed the top 10 most valuable deals inked from 2019 to 2022  and uncovered some notable changes from 2022 as compared to the previous years. While the top 10 deals inked the highest total value over the last four years in 2022, e-commerce and Amazon were notably absent from the past year’s top ten deals by value. In addition, brick and mortar retailers’ share grew in 2021 and 2022 as compared to previous years’ levels. Outside of industry, the Inland Empire with its increasing transaction size and volume of new construction captured the lion’s share (75%) of most valuable deals over the past four years.  Deals that ranked in Los Angeles County and Orange County did so by capturing higher average starting rents at smaller transaction sizes. 

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