SoCal Industrial Market Shifts Into Lower Gear: Research Insights with AIR CRE

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• Summer 2023 Brought Positive News of Increasing Cargo Volumes and Signed New West Coast Labor Agreement  
• Year Over Year Growth in Starting  Rents is Slowing
• Slowing Growth in Transaction Size and Premium Pricing for Large Transactions
• Free Rent Periods are Up Slightly Across Renewals and New Transactions
• Upcoming Challenges to Watch For

Summer 2023 Brought Positive News of Increasing Cargo Volumes and Signed New West Coast Labor Agreement  

Earlier this year, there was some concern for the level of port volume that had shifted from the West Coast to the East Coast as suppliers adjusted to supply chain challenges over the course of 2022. Market watchers in the southern California industrial market already had an eye toward rising interest rates, possible construction moratoriums, and wavering consumer demand as potential speed bumps. In addition, unease surrounding 13-month union negotiations added to those concerns and whether those forces would put additional downward pressure on industrial space demand, slowing the market in the process.

That uncertainty was at least partly demystified following September’s announcement that cargo volume at the Port of Los Angeles jumped from July to August. Media reports indicate the port handled 823,016 20-foot equivalent units (or TEUs) in August, a measurement standard for ocean cargo. This figure is reportedly an increase of 3% from the prior year and 21% above July. This welcome news comes after the conclusion of labor negotiations in June that resulted in a new contract that was ratified at the end of August and has some in the shipping industry wondering if it will mean a return to business as usual. But what does recent data say about the state of the Southern California industrial market and whether there is any evidence of a slowdown in 2023?

Year Over Year Growth in Starting  Rents is Slowing

Average industrial starting rents in the Inland Empire/Los Angeles/Orange County (IE/LA/OC) industrial market are still showing year over year increases as of 2Q 2023, albeit slower as compared to recent quarters, according to CompStak. Year over year change in the IE/LA/OC  industrial market reached 39.8% in 3Q 2022, and as of this most recent quarter has moderated to 3.4%.

This easing in average year over year starting  rental rates is part of a trend that emerged after industrial starting rents peaked in 2022, during which the average in the Inland Empire reached as high as 40.8%, according to CompStak data of transactions of 10,000 square feet and above.

Examining rent growth in the Inland Empire, Los Angeles, and Orange County markets individually provides a more detailed perspective. Year over year rental growth has indeed slowed in 2023 to date as compared to 2022 across each of these markets. However, the Inland Empire market is still growing slightly faster than the others, up 6.1% from 2022, as compared to the flatter growth seen in other markets. So far, year over year change in the Inland Empire remains highest among the three markets and slightly above pre-pandemic levels, while Los Angeles County is up just  0.1% year over year. However, while rent growth is slowing, CompStak data illustrates that rental rates are still likely to be up double digits from 2022 levels at year-end.

Slowing Growth in Transaction Size and Premium Pricing for Large Transactions

While average transaction sizes have increased dramatically in the Inland Empire, topping 100,000 square feet for the last nine quarters, they have shrunk during the first half of 2023. From 1Q 2018 to 4Q 2020, Inland Empire industrial lease transactions generally remained within a range of 100,000 to 140,000 square feet, as per data from CompStak. This stands in contrast to the spike seen in 4Q 2022, in which average lease transaction sizes spiked to over 244,000 square feet before falling back within the historical range to slightly over 104,000 square feet as of 2Q 2023.

CompStak’s data on average starting rents shows a pricing premium per square foot for transactions under 100,000 square feet compared to those over 100,000 square feet prior to mid-2022. In mid-2022, there was a notable shift in the dynamic between industrial spaces above and below that threshold in the Inland Empire market. Average starting rents for spaces over 100,000 square feet began surpassing those smaller than 100,000 square feet, and this trend has continued for two consecutive quarters.

Another statistic to watch is how landlords are pricing annual escalations over the term of leases. The average annual lease escalation now stands at 3.71% in the IE/LA/OC market—a slight decrease from the 3.86% reached in the first quarter of this year. Over the last two-plus years, average annual lease escalations tracked the period of rising inflation. Now, as inflation moderates, escalations are showing signs of plateauing.

Free Rent Periods are Up Slightly Across Renewals and New Transactions

Many market participants are reporting a growing push for affordability among industrial tenants. Notably, the rate of decline has been faster for new deals compared to lease renewals over the past five quarters, reflecting a growing trend where tenants are opting to renew rather than relocate. For example, year over year rental growth for renewals and new deals both recently peaked in 2Q 2022 but during this most recent quarter stood at 12.0% and 4.1%, respectively, according to CompStak’s data. 

Concessions, which have been minimal during most of this past robust period of growth, are beginning to increase, in another sign of an increasing push for affordability from tenants. Average free months for new deals ticked upward over the past three quarters to 1.3 months, and to 1 month for renewals. By comparison, free months during 2019 averaged about 1.3 months total for new deals and 0.6 for renewals. If tenants continue searching for more favorable rental rates, landlords may become more generous with concessions in the upcoming months.

Upcoming Challenges to Watch For

2023 has brought fresh challenges to the southern California industrial market. Among these are potential construction moratoriums on new industrial construction being pushed by a coalition of environmental, labor, community, and academic groups. To date, there hasn’t been any action taken at the state level. However, a few local municipalities have taken measures to restrict new industrial construction in their jurisdictions, placing temporary holds on new projects. While some moratoriums are set to expire by year-end, others have been extended with plans to rezone for other uses. This continued constraint on new supply could coincide with a resumption of port volume to previous levels.

Loan maturities in the industrial sector are also coming due and the trend in rents since origination are likely catching the eye of lenders and landlords alike. In the meantime, interest rates are still at 22-year highs and may reach another high as a result of the final two FOMC meetings of 2023, which continues to dampen new construction starts in all sectors. Another trend to watch is lease expirations and whether landlords will be able to recapture or renew tenants at higher rates. In case you missed it, CompStak covered this topic in last week’s blog, Assessing Industrial Market Risks and Opportunities using CompStak One. Click here to read more.