As the economy heats up, the California commercial real estate market is expanding and vacancies are dropping.
Mixed-use building is leading the way in new commercial growth. A mixed-use real estate development combines both residential and commercial uses. This type of construction is concentrated in two places:
- suburban areas where land is still undeveloped and available; and
- urban infill areas, which make use of the few available parcels of land available in California’s coastal cities.
Vacancies continue to decrease across nearly all commercial sectors throughout the state. As construction fails to meet demand for more space, this trend is escalating exponentially, experiencing particularly steep declines in the industrial market.
Read on for a thorough review of the current retail, industrial and office sectors of the California commercial market.
An abundance of retail space exists in most markets across the nation. This means vacancy rates are high and rent growth is slow.
But California defies the trend, with a dearth of retail.
Over the past four years, retail annual rent growth has averaged:
- 15% in San Jose
- 9% in Los Angeles;
- 9% in San Diego;
- 8% in Oakland-East Bay; and
- 6% in Sacramento, according to REIS.
In contrast, the national average retail rent growth is just 1.8% as of the third quarter (Q3) of 2017.
Further, store closings have marred the real estate market in most major metropolitan areas nationwide. This also translates to historically low vacancy rates. For example, in San Diego, the retail vacancy rate is at its lowest point in Q3 2017 at 3.5%, according to Voit.
first tuesday’s forecast: While low vacancy rates and high rent growth typically signal future construction, the retail situation is unique going into 2018 and presents a very different illustration of market pressures. The clear reliance on online retail continues to chip away at demand for brick and mortar retail stores, and the trend isn’t going away anytime soon. In fact, it will likely only accelerate as online shopping becomes an ever more ubiquitous component of modern life. Eventually, however, today’s vacancy rate and high rent growth will level out. This won’t be due to new construction, but fewer retail stores.
The industrial commercial market continues to improve, with positive absorption, fewer vacancies and rapid construction growth.
The vacancy rate as of Q3 2017 is:
- 4.1% in San Diego
- 4.0% in the Inland Empire;
- 2.3% in Orange County;
- 2.1% in Los Angeles; and
- 1.8% in the mid-counties area of greater Los Angeles, according to Voit.
first tuesday’s forecast: The industrial sector will continue to be a strong source of income for real estate investors and the agents who represent them in the years to come. That’s because, unlike office and retail, e-commerce has little negative impact on the industrial sector. In fact, in Q3 2017, the largest lease transaction in Los Angeles was Amazon’s lease of 650,000 square feet of industrial space in Rialto.
On the other hand, as space is rapidly absorbed, industrial tenants will need to make plans to either spend more on rent, or be prepared to move out of the city and deeper into the suburbs to obtain lower rates.
Compared to retail and industrial, the office commercial market is mostly flat in 2017. Job numbers continue to improve, with 15.7 million individuals employed in California in Q3 2017. But excess inventory continues to hold back any significant improvement in office vacancies or new construction.
The vacancy rate as of Q3 2017 is:
- 10% in Orange County, up slightly from a year earlier; and
- 11% in San Diego, down slightly from a year earlier, according to Voit.
While these vacancy rates are higher than in other sectors, they are a sizeable improvement over the 16%+ vacancy rates experienced in 2009.
first tuesday’s forecast: The office sector will continue to struggle in 2018. Further, as interest rates rise in 2018 and the years to come, investors will demand higher capitalization (cap) rates to compensate.
While a low cap rate may be acceptable today, in the future when today’s income-property buyer is ready to sell and interest rates are higher, future buyers will demand higher cap rates to cover these higher interest rates.
In response, sellers will need to offer a lower price to meet those higher cap rates, decreasing their long-term profit. This is an issue that will impact all commercial industries, but especially those sectors already struggling to make headway, such as the office sector — even in today’s expanding economy.