Industrial Real Estate Update Q2 2023 – No Zero-Sum Games
In a recent article the Wall Street Journal discussed the state of industrial real estate in Southern California, traditionally an outperforming geographic sector. The article hit on some interesting, but not new, trends:
Vacancy rates for warehouses (industrial real estate) increased to 3.8%, reflecting net new warehouse space coming on-line in excess of warehouse space being leased.
The area is expensive relative to its historical rents, which indicates rent growth will be slowing, but by definition, still growing.
There are alternatives to geographic concentration.
Using Southern California as a ‘canary in a coal mine’, industrial real estate misses four key points we see in the aggregate across the US:
- While rent growth is slowing, there still is rent growth. Average rent growth reached 10.5% year-over-year. The question is, if rent growth is slowing, how much would that growth contract? Is a slower growth rate still attractive, especially in a flat-to-declining interest rate environment? Especially since many of the new leases are for longer time periods (roughly 5 years) which creates a more stable cash flow/income stream. Is less volatility bad in this market?
- There may be a normalization of trends as new supply is available—as we pointed out in this previous article. Despite the fact that new supply exceeds net absorption, 28% of warehouse space is greater than 50 years old, considered obsolete, and will be replaced as new tenants focus on more modern, class-A supply. This creates a medium-to-long term tailwind for the space.
- Industrial real estate is not a zero-sum game. Tightening in Southern California means other markets, such as Phoenix, are receiving new investments in the space. Two drivers here are: 1) supply chain diversification—potentially a benefit if we experienced similar port issues as in 2022, and 2) population migration will naturally lead to new supply like it has in Texas.
- New starts have decreased by 45%–which could lead to lower new supply in 2024 and 2025. This points to the current softening of the market as a near-to-medium term issue.
Also, according to the Wall Street Journal article, the 3.8 vacancy rate increase seen in Southern California is still below the national average of 4.8%. Prologis, one of the world’s largest industrial real estate owners and operators noted that despite the recent weakness, there are structural constraints to new supply in the region and a huge consumption base that provide significant tailwinds to the region, which remains attractive to the company.
So, yes, Southern California commercial real estate has definitely weakened. At the same time, parts of the US and the world are seeing an increase—like in Texas, Mexico and Latin America.
Is it reasonable to hypothesize that the weakness in Southern California is not the same bellwether it has been for the industry overall?
Could it be market dependent trends have caused an overheated industrial market to ‘normalize’ but still remain more expensive as it is in other Southern California real estate uses?
We don’t see cause for retreat from the space–as long as there is the understanding that the market has softened due to well-known causes.
At the end of the day, industrial real estate is not a zero-sum game and Southern California will eventually recover, most likely in the medium term.
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