With the Federal Reserve increasing interest rates four times so far this year, the local commercial real estate market—including industrial, office and retail—is cooling, with properties sitting vacant longer. Asking rents, however, are still strong as uncertainty remains, according to experts.
At the onset of the coronavirus pandemic, the Fed slashed its target rate to 0%-to-0.25%, where it stayed for two years. On March 17 of this year, the board began increasing the target rates starting with a 25 basis point bump to 0.25%-to-0.5%.
After three more increases of 50, 75 and 75 basis points in May, June and July, respectively, the rate currently sits at 2.25%-to-2.5%, its highest point since the summer of 2019. Fed Chair Jerome Powell in June said the rate is expected to reach upward of 3.8% by the end of next year.
Despite the upward pressure on interest rates caused by inflation, the local industrial real estate market remains strong, if stifled slightly, according to Lee & Associates Principal Brandon Carrillo.
“What’s amazing is seeing how quickly things shifted upon the interest rate increase,” Carrillo said. “Usually, these types of things take time to trickle down to our local markets, but it’s crazy how instantaneously it impacted deals right out of the gate.”
Before the rate hikes, Carrillo said industrial buildings were being bought up quickly, mostly with seasoned institutional buyers paying all cash and closing deals fast. Those groups, however, began to scrutinize deals more as rates went up, he said.
Sellers’ gazes shifted toward owner-users, who often utilize U.S. Small Business Administration loans, which have lower interest rates. These deals usually take longer due to government oversight of the money, Carrillo said.
Carrillo noted that even with recent hikes, the Fed’s target rate is historically low. In 2000 and 2006, the rate was 6.5% and 5.5%, respectively.
In the South Bay, net absorption was negative 615,252 square feet during the second quarter, meaning more space was vacated or newly opened than was leased, according to a Lee & Associates report. From April to June, 1.6 million square feet of industrial space was leased, the lowest amount since the third quarter of 2004, the report states.
Slower velocity of sales and leases does not mean that demand for industrial space has significantly dropped, especially near the ports of Long Beach and Los Angeles. The vacancy rate ticked up slightly quarter-over-quarter to 1.3%, which is still an extremely low supply.
Average asking rent, meanwhile, increased from $1.35 per square foot in the first quarter to a record high $1.55. Average rents were below 90 cents per square foot five years ago and have continued to climb amid the constrained supply and high demand.
“I did a deal five years ago, and their lease renewal is coming up,” Carrillo said. “They’re getting sticker shock because the rent has almost doubled.”
The average sales price for industrial space in the South Bay was $361.71 per square foot during the second quarter, up from $322.37 the previous quarter. In the second quarter of 2017, the average sales price was less than half the current rate at $162.45 per square foot.
The area’s re-emerging aerospace sector is one of the factors contributing to the continued demand in the region, especially in Long Beach, Carrillo said. Over the last seven years, rocket manufacturing and launch service providers have flocked to the city. First came Virgin Galactic—now Virgin Orbit—in 2015, followed by SpinLaunch in 2019 and Rocket Lab and Relativity Space in 2020.
“It’s pretty amazing to see how vibrant [the sector] is,” Carrillo said, noting that Virgin and Relativity have expanded their presence in the city since they moved in. “We’re seeing the wave of the future.”
Long Beach’s retail market is still recovering from the pandemic, which took its toll on countless businesses, especially restaurants that were forced to close for months on end. Many eateries never reopened.
Fortunately for the market, people will always need to eat, and restaurant concepts are bountiful, Doug Shea, a partner at Centennial Advisers, said.
“We are still seeing second-generation restaurants flying off the shelf,” Shea said. A second-generation restaurant is a new concept that takes over a space already built out for restaurant use.
“We can get that space filled every single day,” he said, adding that small retail spaces are sitting on the market for “quite a while.”
But inflation is hitting restaurateurs and retailers hard as well. Shea said one of his clients in Naples is going to have to raise his prices twice this year, when he has sometimes gone as long as three years without any increases.
Not only are goods for restaurants and retailers becoming more expensive, consumer spending is decreasing. According to a Lending Tree survey, 43% of Americans plan to take on new debt in the next six months on necessities such as housing, transportation and health care, which leaves fewer dollars for luxury items and dining out.
There are numerous vacancies along the historically popular Second Street corridor in Belmont Shore as well as the newer 2ND & PCH retail center up the street, Shea noted. And a decrease in consumer spending is not likely to help.
Those two areas, however, along with the Long Beach Exchange retail center near Lakewood Village, have some of the highest rents for restaurant and retail space in the city. Those areas can have asking rent between $4 and $6 per square foot, Shea said, with Second Street being on the lower end.
Older spaces, however, even those that have recently been remodeled have much lower rents, Shea said. The Los Altos Market Center, for example, is 100% leased, he said, noting that the former Sears location was recently purchased, though he does not know what store, or stores, will take over.
At The Landing, a strip mall at the corner of Clark Avenue and Atherton Street that recently underwent facade improvements, rents are about $3.25, Shea said. The Centennial team recently got an offer for a new cafe, a med spa and a butcher shop in the center.
When it comes to retail, Shea said discount stores—furniture, clothing, etc.—and big-box brands like Target are thriving. A Five Below discount store is coming to the Los Altos area, he added.
Uncertainty continues in Long Beach’s suburban and Downtown office markets, in large part due to companies navigating the post-coronavirus work environment, Cushman & Wakefield Senior Director Robert Garey said. While some companies have brought their workforce back into the office, others have held off—and some employees will never return.
“People were saying, ‘office is dead,’ but I never believed it,” Garey said. “We’re seeing it come back to life with some repopulating their offices—but not every company.”
Some companies have embraced a hybrid model for employees, which sees them come in two or three times a week. This model requires less office space per employee, which has resulted in some companies downsizing to match their need, Garey said.
While there may be fewer employees at the office at any given time, Garey did note that many companies are spacing their employees out more and even bringing back personal offices in response to health concerns that arose amid the coronavirus pandemic. While that may offset the downsizing somewhat, Garey said it likely will not be enough.
With demand for office declining, Garey said some office buildings like 401 E. Ocean Blvd. and 1500 Hughes Way could be repurposed into residential or industrial use. Several buildings in the Downtown area have already been converted to residential, including the former Verizon building at 200 Ocean Blvd.
“This will shrink the available space in the marketplace, which will create a more healthy balance for owners,” Garey said.
Construction costs also are wreaking havoc on property owners who are looking to upgrade their buildings to attract tenants. Many jobs have about doubled in price compared to before COVID, Garey said.
The office vacancy rate in Downtown remains at its highest level in over two decades. During the second quarter, the overall vacancy moved from 26% to 25.9%, according to reports by Cushman. The area’s net absorption was negative 26,029 square feet, only slightly better than the negative 33,154-square-foot net absorption in the first quarter.
During the second quarter, 54,329 square feet of office space was leased Downtown, and the overall average asking rent was $2.49 per square foot, up from $2.47 the previous quarter.
The suburban office market is faring only slightly better, with a vacancy rate of 22.9%, according to Cushman. The rate marks a slight increase from 22.1% in the first quarter.
After negative absorption of 724 square feet in the first quarter, the suburban market saw positive absorption of 5,956 in the second. That area saw 192,272 square feet of space leased, including over 71,750 square feet by Blue Shield of California at 3840 Kilroy Airport Way.
The overall average asking rent in the suburban office market increased 7 cents quarter-over-quarter, from $2.61 to $2.68.
Rental rates remain strong in large part because operating expenses, particularly utilities, have gone up with inflation, Garey said. Maintenance and landscaping also have become more expensive. To offset the steady rents, however, many property owners are offering more concessions, Garey said, including offering free rent for several months in order to close deals.
“It’s still a very bumpy road in the office sector,” Garey said. “There’s more clarity in the world, but it’s not clear yet in the office market.”