Dynamics Shift for SoCal's Industrial Real Estate Amidst the Conclusion of the Fed’s Tightening Cycle

Nicholas Chang, CCIM, SIOR, Executive Vice President of NAI Capital Commercial's Investment Services Group, Shares his Insights on A Year of Transformation and its Effects on Industrial Real Estate Valuations and Pricing

November 2023 | J.C. Casillas , NAI Capital Commercial Research

In 2022, the Federal Reserve took aggressive action to curb persistent inflation, raising interest rates seven times. Notably, it implemented four consecutive 0.75 percentage point increases at its June, July, September, and November meetings, culminating in a 0.50 percentage points increase in December. In contrast, this year witnessed the Fed raising rates four times, each by 0.25 percentage points. Speculation now suggests that the Federal Reserve will maintain interest rates after its December policy meeting, signaling the conclusion of its tightening cycle.

Chief economists from major North American banks foresee a shift in the Fed's strategy, predicting a reduction of approximately one percentage point in interest rates for the coming year. It's important to note that the Federal Reserve maintained the federal funds rate close to zero in the first quarter of 2022.The swift series of increases in such a short span, amounting to more than five percentage points, has not surprisingly affected sales in the industrial real estate sector.

The commercial real estate market, particularly in the industrial sector, has undergone significant transformations in 2023, marked by the intersection of rising interest rates, post-COVID economic adjustments, and shifts in consumer and developer behaviors.

This Q&A with NAI Capital Commercial Executive Vice President Nicholas Chang, CCIM, SIOR , of the Investment Service Group, delves into the multifaceted impacts of these changes, shedding light on how they are influencing CRE (Commercial Real Estate) valuations, pricing, and demand. Nicholas provides his insights into the challenges and opportunities arising from this changing landscape.

In our discussion, as the Managing Director of Research with NAI Capital Commercial, I naturally started with a question for Nicholas: How have the rising interest rates impacted specific aspects of the real estate market for industrial assets, and what trends or changes are notable in terms of pricing and demand?

Nicholas emphasizes the dominant theme of the year—the rise in interest rates and its profound impact on CRE valuations and the broader consumer economy. Coupled with the conclusion of government-funded stimulus packages post-COVID, these factors have collectively shaped a challenging investment environment.

How Changing Fundamentals Have Affected Land Prices

He states, "On the CRE valuation side, lease rates have reversed by an average of 15% to 20% in some cases, land prices are down from the peak between 30% to as much as 40%, and we’ve seen at least a 200 to 300 bps increase in cap rate expectations."

Continuing to address the impacts on developers, Nicholas notes, “In the peak of the market, developers were underwriting land by applying 7% compounding annual rent growth rates and solving to a 5% yield on cost of the total project cost with a 4% exit cap rate on these proforma rents. In today’s inflated interest rate environment, now I’m seeing developers applying today’s reduced lease rates with flat growth rate leasing assumptions and solving to a 6.5% yield on cost of the total project. Because of today’s interest rate environment, the assumption is that these projects would trade in the 5% to 5.5% cap rate range on exit. Developers also must plug in longer hold periods, higher construction costs, higher construction financing costs. The net result of all of this is that now, developers are finding access to capital is pricier and just a touch more skittish… all for good reason."

Moving forward for at least the next 6 months, Nicholas foresees the trend in softening lease rates continue until the plethora of available inventory gets absorbed, especially in the class A 100,000 to 300,000 square foot range. He anticipates that land prices will likely stabilize at 30% to 40% off peak levels, with land trades resuming once landowners, en masse, acknowledge and come to grips with the fact that they missed their 'window.'

Prices For Existing Inventory Remain Resilient

Nicholas notes a remarkable resilience in sales prices for quality existing industrial buildings despite the challenges outlined above. Across all size classes, these prices have either maintained or closely approached peak levels. Specifically, he highlights that a high-quality building sub 100,000 square feet in the Inland Empire still commands prices in the range of $300 to $350 per square foot - or more in some cases. Similarly, buildings in some infill LA markets sell even higher, reaching $400 to $500 per square foot, often exceeding expectations. Moreover, institutional class A or B bulk industrial buildings with superior quality continue to be traded in the 5% cap range. This stability is attributed to the scarcity of inventory and the limited availability of potential opportunities in the market.

Nicholas also predicts a slight reduction in cap rate expectations, although he clarifies that they won't return to the ultra-low 3% to 3.5% levels seen previously. Instead, the decrease will align with the Federal interest rate policy coming out of Washington. He emphasizes that a return to 3% cap rates would necessitate a shift back to a 'zero' interest rate climate, a scenario unlikely to happen in the near or long-term foreseeable future.

In response to the question about advising clients on the buy and sale side, Nicholas provides a nuanced perspective based on the distinct needs of different audiences:

Private Individuals / Non-Institutional / Owner Users:

Nicholas emphasizes that for owner-users and small businesses, the decision to buy or sell should fundamentally align with the strategic needs of the business. Despite the prevailing interest rate climate and the softening of lease rates, he contends that it often makes sense for these entities to acquire real estate instead of leasing. He underscores the cyclical nature of interest rates, suggesting that there will likely be future opportunities for buyers to capitalize on lower interest rates through refinancing. He notes that one of the key challenges affecting transaction volume in the industrial market is the scarcity of available inventory for sale. Owners, particularly in Southern California, prefer holding onto their assets due to the region's highly valued industrial real estate. The market is notably institutionalized, with a majority of buildings owned by professional institutions, making it less common for them to be traded openly. Nicholas predicts that over time, the entire market will become virtually completely institutionalized.

Institutional Clients:

Nicholas identifies challenges for institutional clients, noting that capital tends to be conservative and, in some cases, "skittish." Looking ahead to 2024, Nicholas anticipates a market where lease rates will continue to modestly dip. In order to keep their pipelines filled with potential acquisition opportunities Institutional clients face the choice of either being patient or find creative ways to identify aggressive opportunities with distressed sellers. He acknowledges the competitive landscape, where everyone is pursuing similar opportunities. Nicholas also highlights a shift in demand, with industrial outdoor storage (IOS) experiencing a decline, but electric vehicle charging developers, predominantly based out of Silicon Valley, as an emerging and intriguing investment class.

While investors express concerns over rising interest rates, asset bubbles, and the potential for an impending economic downturn, Southern California industrial real estate still remains a top investment choice across various product types.

As highlighted in my conversation with Nicholas, there is a discernible shift in commercial real estate valuations, marked by a turnaround in lease rates and a significant decline in land prices, leading to an increase in cap rate expectations. Private individuals Institutional, non-institutional, owner/users, and developers are adapting their strategies, considering higher costs, extended hold periods, and adopting a more cautious approach to capital access.