By Peter Muoio, chief economist, and Chris Muoio, quantitative strategist, Ten-X
While commonly lumped together, each of the metros in Southern California has its own distinctive flair and ensuing fundamentals that drive its local economy and commercial real estate markets. Though all of these markets will rise and fall with the tides of the overall U.S. economy and its housing markets, each SoCal metro’s relative performance can vary.
San Diego is home to a large naval base, and, as a result, has many defense contractors in its economy. While this is normally a stabilizing presence, owing to the consistent employment base, it leaves the metro’s economy vulnerable to any sudden shifts in government defense spending or base realignment. This keeps its commercial real estate market as one of the more stable in the region, as its employment base is somewhat stable and less volatile than other sectors. The other traditional industry in San Diego is tourism, and it has also developed a biotech presence, which has added more diversification to the economy.
Orange County, on the other hand, is a West Coast financial hub and a massive tourist destination. Many mortgage-finance and bond-investment companies are headquartered in the metro, but it is also famously home to Disneyland, making the local economy extremely pro-cyclical, as both these industries are highly correlated to the overall economy. Unsurprisingly, its commercial real estate market is similar; hotel and office demand rises and falls with the tides of the overall economy, and both sectors can pivot rather quickly.
Riverside-San Bernardino, on the other hand, has a massive warehouse/distribution market, making it vital in trade. It has a large industrial market that is currently being driven by a cocktail of e-commerce distribution needs, data storage, and spillover from the coastal Port of L.A., which boasts a much tighter distribution market. The Inland Empire has also historically seen much of its growth driven by population inflows from the more expensive coastal metros. When this ebbs and flows, it can have a marked impact on the apartment and retail segment, as well as population-driven office users. Currently, as affordability is deteriorating once again in the coastal California markets, the inflow to Riverside-San Bernardino has picked up.
Each of these markets will struggle should the economic cycle wane and interest rates continue to rise, placing pressure on cap rates. As such, we do not expect any major changes in these commercial real estate markets, barring any sudden shifts to economic growth or interest rates, and all are currently grappling with the decline in the retail sector being seen across the country.
However, the unique nature of these markets results in each having its own idiosyncratic risks, in addition to any from the overall cycle. Riverside-San Bernardino is most at risk should the nascent ruminations of trade wars and tariffs spiral out of control. While e-commerce is poised to remain a healthy underpinning of its industrial market (at the expense of its own retail market), a shock or diminishment of global trade would have a negative impact on demand for space and investor appetite for the sector, as uncertainty would rise dramatically.
In addition to the overall drag of rising interest rates on commercial real estate investment, Orange County is particularly exposed should the rise go too far or too fast. The financial-services portion of its economy is dependent on low or falling interest rates for mortgage or refinancing demand. Additionally, volatility in the bond market could adversely affect one of the many bond-fund managers headquartered in the metro, thus damaging the local office fundamentals in addition to the headwind already presented to valuations from rising rates, magnifying the effect.
San Diego would appear to be the most insulated, as the large government and defense contractor presence seems to benefit from increased spending under the current administration. However, its commercial real estate market is not immune to a cyclical downshift or pressure from rising rates, though it could definitely cushion the blow. While this is a feather in the cap for the cycle, political tides can shift rapidly, and the exposure to government spending could become a risk factor at a moment’s notice.
A key mantra for economic growth and commercial real estate markets is “demographics are destiny.” In this regard, this broad region is once again split. A major issue beyond cyclical factors for these markets will be population growth. The coastal Southern California markets have always faced affordability issues, and these are increasing once again. Riverside-San Bernardino tends to benefit from flows generated by individuals seeking more affordable housing. If this single-family-housing-driven dynamic continues, it will have negative implications for apartment, retail, and office demand in the coastal markets and will boost demand in these segments in Riverside-San Bernardino.