From SoCal Real Estate’s August 2018 issue
American billionaire Sam Zell was his typically blunt self when he spoke at the recent NYU’s Schack Institute of Real Estate’s REIT Symposium. I found his comments about warehouse and industrial distribution space to be particularly interesting:
“My guess is that it’s getting too exciting. We’re building too much industrial space … We’ve got a lot of people owning a lot of industrial space today, and I’m not sure there are enough tenants.”
Indeed, according to JLL’s U.S. Industrial Outlook for Q1, there is a lot more industrial space under construction than there was a few years ago in the U.S. as a whole. Markets with a fairly large percentage of this pipeline that have relatively high market vacancy (greater than 5 percent) and few barriers to entry are more likely to have supply issues when the next economic downturn hits. These include Atlanta, Chicago, Dallas/Fort Worth, Phoenix, and Las Vegas, to name a few. However, all industrial markets are not created equally when it comes to supply, demand, and development constraints.
Being that our office is located in Orange County, California, we are pretty close to the epicenter of prime distribution markets in the U.S. Due to its proximity to the Ports of L.A. and Long Beach, the Western Inland Empire industrial submarket is widely considered to be the strongest in the U.S. if not the world. Over the past few years, market dynamics have remained incredibly strong, and vacancy in that market is in the very low single digits. Every major retailer and logistics operator has jumped in with both feet. Land that would have sold at $15 per square foot just a few short years ago is now valued at close to $30 per square foot. Yes, rents have increased as well, but with land and construction costs soaring, the yields on new class-A product have begun to resemble Treasury bonds in certain cases.
The markets closer to the coast are in a similar situation, albeit for different reasons. For years, industrial buildings in Orange County and much of Los Angeles County that went on the market were purchased by residential developers, demolished, and redeveloped as apartments or for-sale subdivisions. The buildings that weren’t bought by residential developers frequently went to owner/users. This has caused supply to decrease substantially while demand has remained strong, pushing land values into the stratosphere. As a result, there has been very little new product built in these markets since there is often a higher and better use for potential infill industrial land. We are starting to see select cases of the previously inconceivable scenario of industrial developers being given as much consideration as their residential counterparts for prime redevelopment sites and entering into competitive bid situations where discretionary entitlement approval is needed for residential use.
This recent industrial market activity in California runs more than a bit counter to Sam Zell’s statement above. It certainly doesn’t seem as though Southern California is experiencing the overbuilt condition that he referenced above, considering the dwindling supply and almost non-existent vacancy in the market today. However, we seem to have reached a point where the market is priced to perfection, and any upward movement in vacancy or downward movement in rents will be exacerbated by the incredibly tight underwriting required to make a Southern California industrial development pencil in the current environment. Well-located, class-A industrial property appears to have entered the phase where no yield is too low from an investor/developer standpoint, and the asset class is largely viewed as “safe money” — taking the baton that multifamily had held for several years.
It seems to me that this is the point of the market cycle that should warrant the most caution since underwriting assumptions are now aggressive to the point that they are getting difficult to achieve, even under the best conditions. But here’s the rub: much like what we are seeing in the residential market, it’s very difficult to have a meaningful market correction without excess supply. The prime industrial markets in California have sub-2 percent, and in some cases sub-1 percent vacancy. In addition, the coastal markets have been losing square footage — for example, Orange County has lost around 7 million square feet of industrial space in the past 15 years — rather than getting overbuilt. This is not a trend that is likely to reverse anytime soon.
It’s easy to look at astronomical prices and thin returns and assume that the market is topping out. It’s considerably more challenging to figure out what will cause supply to increase to the point where it causes prices to peak.
In closing, I don’t doubt Mr. Zell is absolutely correct when he says that there are markets where distribution space is getting overbuilt. However, Southern California does not appear to be one of them.