BKM in Real Estate Forum: Industrial Space Crunch
By Carrie Rossenfeld
What’s next for a region where the industrial market is on fire, vacancy is precipitously low and supply can’t keep up with demand?
It’s no secret that industrial space is hard to find in Southern California. Whether users are looking for large blocks or smaller individual buildings, pickings are slim. Vacancy rates continue to creep ever lower along with availability rates, new space coming on line is either built-to-suit or snatched up by users eager to locate near one of the busiest ports in the world and/or within trucking distance of a huge population base. Developers are struggling to build as much as they can get entitled for, but land constraints are enormous in this market, particularly as former industrial sites are being turned over to better use for much needed residential development.
All of the region’s major industrial markets are feeling the crunch. In February, JLL released a report showing that large industrial blocks of greater than 100,000 square feet in Orange County have diminished by more than half since 2008, and Voit Real Estate Services reports that as of mid-first quarter, the vacancy rate for Orange County has decreased 19.78% over the last 8.5 quarters to 3.65%, with the availability rate down to 5.53%. In San Diego, industrial rents are continuing to climb, while the number of annual lease transactions has decreased fairly steadily since Q3 2013, according to Voit. The same is true of the Los Angeles market, which saw 803 industrial lease transactions in Q2 2013, but only 457 in Q4 2014, and the Inland Empire—a highly desirable market, particularly for big-box industrial users—has been showing a similar trend, Voit reports. It’s clearly a landlord’s market, but what are users bent on a Southern California address—and developers looking to get a piece of the pie there—supposed to do?
“As yields contract, eventually developers will start to build smaller, multi-tenant business parks in search of return. However, we do not expect this to occur for several years.”
-BRETT TURNER BKM Capital Partners
“Developers are going to be looking closely at any and all infill properties within the Los Angeles basin,” Tim Joyce, SVP, capital markets, for PM Realty Group, tells Real Estate Forum. “Most folks would consider 2014 a banner year in absorption at more than 18 million square feet leased in the L.A./I.E. marketplace,” according to PMRG and CoStar industrial reports. “However, at the end of fourth-quarter 2014, more than 14 million square feet was under construction with over 20 million square feet expected to be delivered in 2015. Look for rents to have a small increase in 2015 with net absorption to be in the 13-million-square-foot range. Vacancies will end in the low-6% range, a small increase from the close of 2014.”
The Southern California market currently contains approximately two billion square feet of industrial space, and about 75% of this space is older infill product in Los Angeles, Orange and San Diego counties, Chris Macke, managing director, research and strategy for American Realty Advisors, tells Forum. “Given the difficulty of finding infill development sites, the Inland Empire has served as the release valve for Southern California industrial requirements and has increased its industrial base at an average of 13 million square feet per year over the past 10 years, from 400 million to more than 530 million square feet.” While these numbers may appear “staggering” at first glance, in the context of the entire Southern California industrial base it’s less than 1% per year, he says.
Macke adds his firm expects to see continued interest in infill sites, but, with land prices at $70-plus per square foot, larger tenants are forced to look further east. “The western I.E. is quickly becoming infill, and the I-215 corridor is not a pioneering location anymore. We expect to see twoplus facility distribution systems in the I.E. East where bulk storage and smaller infill warehouses are used to reach the end users quickly and efficiently.”
Land is still one of the biggest obstacles to development, Stephen Batcheller, a partner at Panattoni Development Co. Inc., tells Forum. “The biggest problem developers and investors have in Southern California is finding land to purchase at pricing that makes sense. Any well-located, entitled parcel of size that comes to market often generates 10 to 15 bids from qualified buyers. As a result, yields are being compressed due to the weight of the capital chasing the deals.” Even with record land pricing, relatively few sites come to market due to an overall lack of supply. Accordingly, “I see limited new development coming on line in Los Angeles, Orange County and the I.E. West.”
Batcheller adds that while the I.E. East has available land, the supply of finished sites is restricted due to the length of time required to obtain entitlements and the overall lack of infrastructure in place (i.e., roads, storm-drain systems, sewer systems), which must be constructed prior to the delivery of finished projects. “As a result, most of the new Southern California industrial development promises to occur in the I.E. East, with supply likely to come on line at a moderate pace and hopefully in equilibrium with tenant demand.”
With lease rates trending upward in the region for the past two-and-a-half years and some markets getting back to peak pricing, it would make economic sense for developers to build now—if finding developable sites wasn’t such a large problem, Jerry Holdner, VP of market research for Voit Real Estate Services, tells Forum. “Finding land that is priced correctly, rising development costs and the ability to obtain financing are the major challenges. There’s also heavy competition for land sites with apartment developers, which is creating higher land prices.”
For the sites that do get developed, Brett Turner, director of acquisitions for BKM Capital Partners, tells Forum he expects to see continued growth in big-box single-tenant development. “As yields contract, eventually developers will start to build smaller, multi-tenant business parks in search of return. However, we do not expect this to occur for several years.”
Despite the difficulties developers face in this market, construction financing is occurring, Gary Tenzer, principal and managing director for George Smith Partners, tells Forum. “We are currently working with a number of industrial developers to secure construction financing for new Southern California projects. As a result of the currently strong leasing market and low vacancy rates in the region, we have been able to secure these developers attractive long-term, fixed-rate, permanent financing at unprecedented low rates.”
Submarkets for Future Development
I.E. East is the logical place for future development in this sector, but clearly the backlog makes it necessary for other submarkets to step up, which typically means infill locations. “Several sites in the North San Fernando Valley can produce as much as 700,000 square feet of industrial development,” says Joyce. “These infill sites can command as much as $8 per square foot for good-quality industrial real estate. Perris Valley and the Moreno Valley 60 corridor have great potential as well.”
Batcheller says his firm really likes investing and developing in infill markets “to the extent that we can find land or existing value-add facilities at pricing that is accretive. The I.E. West, which has become an infill market, is one of our key targets. We have several new projects there and continue to look for new opportunities. We have new projects in Los Angeles County and Orange County as well, both two wonderful markets. According to CBRE’s Q4 2014 industrial report, the Los Angeles market was #1 nationally in terms of lowest vacancy (1.92%), with Orange County #2 (2.66%) and I.E. #5 (4.46%). This is where we are spending our time.”
“E-commerce is still an emerging trend, but this has a limited demand. Several of these types of distribution companies have already found homes.”
-TIM JOYCE PM Realty Group
Macke says his firm continues to see significant demand for renovated functional infill product across Southern California, particularly in the San Fernando Valley, San Gabriel Valley, MidCounties and Orange County markets. “Uses vary by area, but the demand side of the equation is strong enough to justify new infill developments at a cost of about $130 per square foot. With rent comps in the $0.60s and even some at $0.70, the return on cost required for build-to-core investments makes sense. The real difficulty is finding suitable sites for these needed developments.”
Due to the lack of developable land in many infill markets, Holdner says he is seeing more activity in the I.E. West, Corona and Chino in particular, “where the land is more readily available, but many developers would rather develop in infill sites closer to the ports.” In fact, Turner says the port markets near Long Beach and Los Angeles “are seeing demolition of older product to make way for new construction. Also, as the healthcare and defense sectors continue to grow, we expect to see R&D/flex industrial product to be produced in the San Diego markets such as Sorrento Mesa.”
In addition to some redevelopment in the South Bay area, Tenzer says he is seeing growth along the I-5 corridor from Valencia to the Grapevine. “With the reduction in the cost of fuel, logistics companies can now transport items at a lower cost, which will drive development in more remote areas.”
Development and Leasing in a Competitive Market Several development and leasing trends are emerging as the competition for industrial space heats up. “E-commerce is still an emerging trend, but this has a limited market demand,” says Joyce. “Several of these types of distribution companies have already found homes, so the push for this development needs to be cautious—probably more of a build-to-suit-opportunity for owners. High cube space for efficiency in costs and on-site secure truck storage are still going to be part of the standard for new development.”
Macke says he expects to see a lot more renovation, redevelopment and upgrades to the existing inventory, since certain business models need to be close to their customers and will do what is necessary to remain in the area. “At a recent institutional industrial investors’ roundtable, we asked if anyone had actually raised a roof on an industrial building recently. While all had considered the strategy, no one at the table had yet executed on it, but this is likely coming.” He sees more creative use of space and competition from tenants on the horizon, “and we have been acquiring certain well allocated infill functional B-quality assets to capitalize on this trend.”
Lease rates will continue to increase, and new development will be expensive as competition becomes more fierce, Holdner predicts. “We might begin to see some price resistance in the future, due to increasing land and construction costs.”
Turner says as companies expand with the growing economy, BKM has seen large credit firms take space in multi-tenant business parks to “test” new markets before signing large, long-term leases. “This has created a sharp tightening in vacancy within the business-park space.” Tenzer adds that over the past six months, his firm has seen rents in secondary and tertiary locations increasing and continuing compression on cap rates as a result of sector dynamics.
Will They Stay or Will They Go? The draw of less-expensive and less-heated markets threatens to drive developers, investors and tenants away from Southern California, but experts say this is not likely to happen in a significant way in the industrial sector. “The Ports of Los Angeles and Long Beach are some of the busiest ports in the world, and with that come major distribution requirements,” says Joyce. “It is unlikely that tenants will go outside SoCal with the need to be relatively close to these ports.”
Batcheller adds that Southern California is the second-largest population center in the country, behind the New York metropolitan area. “With the exception of the I.E. East, there’s precious little room for industrial growth anywhere else in the Southland. Therefore, the vast majority of industrial growth in Southern California ends up in the Inland Empire, a market that is close to the twin ports of Los Angeles and Long Beach. Notwithstanding the current labor negotiations, these are by far the largest ports in the country and are the conduit for more than 40% of the merchandise entering the US. There’s a simple reason for the size of our ports: they represent the shortest distance between China and the US. Billions of dollars in infrastructure have been invested to enable this ever-increasing global logistics trade. The big trend in logistics is building much larger, more functional buildings of one million square feet to 1.5 million square feet or more, with 36- to 40-foot clear heights. There’s no other place to construct buildings of this size in Southern California besides the I.E.”
The deterioration of the price of gas is a game-changer for large single-tenant users, says Turner, and he expects to see big-box users widen their search radius for space. “However, smaller multi-tenant business-park users need to remain near their major suppliers/clients regardless of the price of gas. As a result, secondary/ tertiary submarkets will see an expansion of large requirements, but minimal smaller requirements.”
Moreover, if the poor performance of the Phoenix industrial market in 2014 was any indication, moving out of Southern California does not appear to be a viable option for most users, says Macke. “We all know there are legal and economic pressures encouraging businesses to locate outside of California, but it does not appear to be negatively impacting industrial demand.
Unlike corporate headquarters or back-office operations that do not require proximity to a company’s end users, warehouse facilities place a high value on proximity to customers, especially in Southern California where proximity to 24 million consumers and the ports usually trumps other considerations. As a result, as warehouse vacancy rates decline and rents increase, rather than moving out of the state, firms are instead likely to move to weak, cheaper alternatives further east in the I.E.”
Holdner says some users will have to accept less-than-ideal sites in order to stay here and be close to their clients and customers, and Tenzer says while it is possible that Southern California will lose some industrial tenants to other markets, “with the continued growth in demand generated by trade with the Pacific Rim via the L.A./Long Beach Port, Southern California industrial markets will remain strong.” ◆