California’s commercial property shortage is making investors desperate

Strong commercial property reports are still trickling in for the first part of 2022 — but can commercial’s rebound last in the face of rising interest rates and an unstable economy?

U.S. mortgage origination volume for commercial properties — including multi-family — increased a significant 72% over a year earlier as of the first quarter (Q1) of 2022. By property type, mortgage volume increased:

• 359% for hotels;
• 145% for industrial;
• 88% for retail;
• 81% for healthcare;
• 57% for multi-family; and
• 30% for office, according to the Mortgage Bankers Association (MBA).

Accordingly, outstanding commercial mortgage debt increased 1.8% from the prior quarter in Q1 2022. Multi-family mortgage debt rose 2.1%, according to the MBA.

For reference, commercial mortgage originations were recently at their lowest in 2020 at the outset of the pandemic and 2020 recession, but quickly rebounded alongside rising demand. Commercial lending rose to a decades’ peak in Q4 2021. In a typical seasonal adjustment, originations fell back in Q1 2022, while remaining significantly higher than a year earlier.

The rise in commercial mortgage originations is a direct result of available commercial property falling below tenant demand, plunging vacancy rates to historic lows and encouraging investors to purchase.

California lacks all property types

One often hears about California’s housing shortage and its negative impact on residents’ quality of life. But the housing shortage is just one part of a broader scarcity of property.

Here in California, industrial remains the hottest property type, with vacancy rates falling to essentially zero, or:

• 2.1% in San Diego, down from 4.3% a year earlier;
• 1.3% in Orange County, down from 2.5% a year earlier;
• 1.1% in Los Angeles, down from 2.6% a year earlier; and
• just 0.7% in the Inland Empire, down from 2.7% a year earlier, according to VOIT.

Multi-family property is also failing to meet tenant demand. California’s rental vacancy rate declined to 3.8% in Q1 2022, down from 4.8% a year earlier and well below a healthy vacancy rate of around 5.5%. Some of the state’s lowest multi-family vacancy rates are:

• 2.4% in Riverside;
• 3.0% in Sacramento; and
• 3.4% in Fresno, according to the U.S. Census Bureau.

Related article:

California’s distinctly low vacancy rates signal the need for more construction

When supply lags demand, the natural economic response is increased prices. California’s real estate market has been no exception.

With California home prices rising 19%-28% above a year earlier as of April 2022 and annual rent increases ranging from a low 9% in San Jose to an eye-popping 32% in Riverside, the housing shortage has torn through household budgets.

On the other hand, commercial tenants have experienced more mixed results, depending on the industry. With few options in the tight industrial and multi-family industries, prices for rents and purchases are rising briskly. But property types which suffered the most during the pandemic continue to experience a buyer or tenant’s market, with landlords more likely to offer lease concessions in the office and retail industries.

Thus, expect to see more conversions from poorly performing properties, particularly with less desirable Class C space. While it’s unlikely we will see many retail or office properties being converted to high-demand industrial space, watch for more retail- or office-to-multi-family conversions.

Related article:

2022 commercial market to be led by industrial and conversions

The cap rate cushion

While it may be tempting for investors seeking to purchase in today’s low inventory market to accept unfavorable terms and lower capitalization (cap) rates, prudent investors will wait for a better deal.

Today’s investors need to be demanding higher cap rates. That’s because 2022’s rising interest rate environment is setting the stage for what’s to come: more interest rate increases, which will put downward pressure on sales and prices, increasing the risk of future defaults, which will lead to further price drops.

In recent years, investors have gotten used to rapidly rising prices, and thus were able to rely on a hefty profit on the sale of property. But when interest rates rise significantly, profits are no longer a sure thing and higher cap rates are needed to ensure an investor’s annual yield remain sufficient to cover any future losses.

Either way, from an investment perspective, 2022 is not the time to buy property — and today’s rising interest rates and price cuts in less desirable property types are quickly making it too late to sell.

For investors who wish to sell but are unable to, prepare to enter a hold phase. Property prices are expected to fall heading into 2023, not to hit bottom for another 18-24 months.

Related article:

Why property investors need to demand higher cap rates now