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Roundtable – January 2019: What are your projections for SoCal commercial real estate in 2019?

Carrie Rossenfeld Roundtable

From SoCal Real Estate’s January 2019 issue:

 

Michael DeGiorgio | Courtesy a representative of CREXi

Michael DeGiorgio
CEO
CREXi

The Southern California commercial real estate market will be very healthy throughout 2019 despite some macro-market cooling largely resulting from interest-rate increases driving up debt-capital costs, yield requirements, and yield alternatives. The region continues to boast incredible demographics, a dynamic and diverse economy, and relatively scarce land availability, limiting the potential for overdevelopment. When coupled with gluts of capital supply seeking placement in core markets, institutions will continue to pursue and compete for investments, leaving institutional-sized pricing relatively unchanged even as debt becomes more expensive — equity in many instances has become less expensive, leading to an overall lower or unchanged weighted average cost of capital (WACC). While institutional activity will remain strong, entrepreneurial-sized properties may see some modest softening as investors using their own capital become more sensitive to risk and rising financing costs.

Soft spots and areas of concern are generally tied to the macro economy and real or perceived political risk. Areas to monitor include questions around whether SoCal’s rich rooftop saturation can overcome e-commerce risks facing many retailers and their real estate; how a trade war with China will impact SoCal ports and industrial warehouses; whether new tax laws financially penalizing residents in high-income tax states could drive business owners and baby-boomer retirees to other markets; and if we’ll see a housing correction as increased interest rates have made debt service more expensive and decreased affordability for already stretched homebuyers.

While macro risks may give some investors pause, the strength of the SoCal market fundamentals and gluts of pent-up capital seeking placement will preserve SoCal as one of the strongest commercial markets in the nation. Some softening may occur around the edges, but primarily on a deal-by-deal basis and less at a market level. In many ways, 2019 will be a continuation or “extra innings” from the last cycle in advance of 2020, which could become a pivotal year.

Sandy Sigal | Courtesy a representative of Newmark Merrill Companies

Sandy Sigal
President and CEO
NewMark Merrill Companies

In 2017, the predictions were easy to make: Amazon was going to conquer the world, retail was dead, and the march of retail bankruptcies was unstoppable. The graphs of closing stores, of online market share growing, and the declining stock prices made the inevitability of unstoppable destruction in the shopping-center space a certainty.

In 2018, the blurriness of disruption has become clearer: some bright spots in retail (off-price, experiential) and some signs the customer is not satisfied with only an online experience. In fact, the melding of online and offline is now fully evident. 2018 also showed an increase in traffic to strong centers, the elimination of those tenants who did not have the financial strength or will to adapt.

Our view is that 2019 will be a watershed year for retail — in the right spots, with the right message, and with the right mix. The first technology boom was entirely about the hardware (the IBM PC, the Apple II, the Walkman, and Laserdisc) and letter morphed into an integrated product, and so is the retail experience. Thousands of years of DNA have made humans hunter-gathers. We love to go out and explore and accumulate. How else can you explain why people travel, hike, and explore? The hunting has been supplemented by the ability to search for goods on the Internet, but more and more the gathering is about going back to stores that are interesting and spending money there. 2019 will show the continuation of some trends that will continue to show the way to success in the shopping-center world. Former online-only retailers opening more stores in brick-and-mortar locations since they have found their online sales go up sharply when they do so. The three-year trend of customers who say they will only shop online continuing to go down, while the number of those who say they only shop bricks-and-mortar are staying steady, yet there’s a sizable increase in those who use both methods of shopping. And the lack of new construction is continuing to force existing landlords to adapt, reinvest or exit the space as operators who know how to mix technology, customer service, and strong interesting tenants continue to prosper.

Finally, 2019 will show that owners of shopping centers who are creative and truly operate and those tenants who know how to connect with their communities will have great opportunities for growth and prosperity.

Jared Dienstag | Courtesy a representative of JLL

Jared Dienstag
Research manager
JLL

Through the first three quarters of 2018, the Orange County office market recorded -381,719 square feet net absorption, with the Airport Area, Central County, and North County submarkets sustaining occupancy losses while South County and West County experienced positive net absorption. There are anticipated move-ins for the fourth quarter, which would help balance out the absorption figures for the year. Balanced demand for office space is expected to continue in 2019 as the local economy steadily adds jobs, simultaneously with companies becoming more efficient with their real estate footprints.

One significant difference between the current Orange County economy and the one prior to the Great Recession is the greater industry diversification. Local technology and life sciences firms have combined to raise more than $1 billion so far in 2018, setting these industries up to expand their real estate presence in Orange County. Orange County is an emerging tech hub with a growing presence of cybersecurity, software, medical device, biotech, and other tech and life-science companies expanding in the market. One aspect to monitor is mergers and acquisitions, which can impact the amount of sublease space in the market. There is currently 1.2 million square feet of available vacant sublease space, the highest level since 2008.

The monthly overall average asking rent of $2.96 per square foot, full-service gross represents a year-over-year increase of 6.8 percent. The projected 2019 deliveries of the 457,000-square-foot Flight at Tustin Legacy and 1 million-square-foot Spectrum Terrace projects will place upward pressure on the market’s average asking rents as both are highly amenitized class-A developments that will command above-average rental rates. Much of the available commodity space should see minimal rent growth except for the most sought-after spaces, which can command a price premium. As tenant demands are creating a shift in space preferences, assets that have gone through extensive renovation will continue to attract much of the leasing activity in Orange County as tenants are drawn to the modern features that they also use to recruit and retain talented employees.

Charles Byerly | Courtesy a representative of US Storage Centers

Charles Byerly
President and CEO
US Storage Centers

What an interesting time for commercial real estate in Southern California. After an elongated expansion period dating back to 2009, SoCal real estate, both commercial and residential, has seen a climb back across the board.

It is my opinion that we have entered the late stage of this cycle, and smart analysts on both sides of the trade have good arguments for this cycle ending and this cycle having legs. From a real estate perspective, I see headwinds in SoCal that will make developers and acquirers sharpen their pencil for the next few years and definitely for 2019. Some of these headwinds include: rising interest rates, rising construction costs, and very expensive land in the areas developers want to build. Real estate acquirers have to consider what rising interest rates will do to cap rates and whether or not there is enough rent growth that can be had to offset these concerns.

These headwinds, coupled with California being a difficult and expensive place to build already, will put some constraints on outsized real estate investment in 2019. I believe these factors will limit further cap-rate compression and will limit new development across the commercial real estate landscape, including our world of self-storage. Although self-storage demand seems at equilibrium across SoCal, some markets have experienced a high-level of supply, and it will take time to work through that supply. However, because of the difficulty of building in California today, I don’t see a downturn to the magnitude of the 2008 global financial crisis. Despite all the current pressures in today’s market, we still believe opportunities can be found in any part of the cycle, especially when we are discussing infill SoCal real estate. With a long-term outlook, well capitalized trophy assets will always withstand bumpy roads.