The Orange County industrial sector remained healthy in the second quarter of 2006, marked by low vacancy rates, increased tenant demand and escalating lease and sale prices.
The market benefited from a perfect confluence of trends: strong employment and population growth; resultant robust demand; and a prudent pace of development, constrained to some extent by shortages of land that result in a fixed supply of available space.
Vacancy rates are headed downward and rents were showing large year-over-year increases. The overall vacancy rate dropped another 30 basis points from the previous quarter, to 4%. Total net absorption during the second quarter was more than 1.25 million square feet.
The average rental rates in OC increased 1 cent to 87 cents per square foot, triple net, from the previous quarter and 9 cents from a year earlier.
The diverse supply of efficient, small to midsize buildings continued to attract the region’s expanding small-business base. There is an increasing and consistent demand for industrial space in all size ranges.
The low vacancy rate has given landlords the leverage over tenants, enabling them to stay firm on rental rates and concessions.
The largest lease transaction during the second quarter occurred in the West County submarket with Money Mailer Inc., which leased 192,609 square feet in Garden Grove. The second largest transaction was a 152,849-square-foot lease by Meggitt Defense System in Irvine.
Market Assessment
As the market gets tighter, vacancy continues to fall as strong demand is taking more space from the market than developers are adding.
As a result, OC manufacturing and distribution space had an impressive second quarter with more than 640,000 square feet of net absorption.
In this sector, the West County and airport submarkets were most active. West County recorded the most activity with 675,856 square feet of net absorption, while the airport area saw 421,815 square feet of absorption.
Asking rental rates for manufacturing and distribution space were steady in the second quarter at 77 cents per square foot.
OC’s R & D; sector continued to be active in the second quarter. There was a total of 584,267 square feet of net absorption. The overall vacancy rate for R & D; space was 4%, a decrease of 60 basis points from the previous quarter.
The main reason for the decline in the R & D; vacancy during the past 12 to 18 months is the lack of space. Limited land and a shortage of quality space available on the market continues to put pressure on R & D; development.
The most popular type of R & D; space for sale is buildings that are 7,000 square feet and smaller. Average asking prices have risen to $280 per square foot. The average lease rate for R & D; space was 96 cents per square foot in the second quarter, up a penny from the previous quarter.
On the construction side, R & D; development remained quiet with just 31,988 square feet under way in North and South counties.
With interest rates on the rise, the user sale market has tempered slightly, though activity remained strong in the second quarter.
Most of the softening in the sale market has been with second and third generation buildings. Buyer activity for new buildings was very strong, especially for small buildings. The majority of activity continues to be for industrial buildings ranging from 10,000 to 35,000 square feet.
During the second quarter, there was more than 900,000 square feet of industrial space sold. The average asking sale price of manufacturing and warehouse buildings decreased slightly to $178 from $179 the previous quarter.
Construction activity remained steady in the second quarter with more than 1.3 million square feet of industrial space in the pipeline.
West County led the way with 884,164 square feet under construction, followed by North County with 376,512 square feet under way.
Opportunities and Challenges
The market remains strong despite rising interest rates, marked by low vacancy rates, increased tenant demand and escalating lease rates.
The reason for the strength: less supply and more demand. The national economy has been strong, with OC standing out as one of the best markets in the U.S.
Demand for warehouse space also is a product of OC’s proximity to the ports of Los Angeles and Long Beach. Rising interest rates should boost tenant demand as more potential buyers are forced to take a look at leasing.
Limited supply and high demand remains a challenge for tenants. The ability to find quality space is difficult. With a limited supply of land for development of large industrial buildings, tenants and investors are competing fiercely for the best quality facilities available.
As a result, leasing volume will be constrained, and this pressure will surely push lease rates higher by about 6% to 8% a year.
Due to the recent increase in interest rates, sale prices and cap rates are expected to remain stable.
The Inland Empire continues to attract companies with behemoth distribution operations by possessing a close proximity to the ports, a fresh supply of new space, available land and competitive rents.
And with single-digit vacancy rates across many markets, paired with high demand, the vast majority of new space is being built on a speculative basis,and it’s being absorbed.
Second-quarter absorption was nearly parallel to last quarter’s and that of one year ago.
A concern moving forward: How property sizes of speculative construction are evolving as developers aggressively build bigger.
During the second quarter, tremors were felt when two warehouses totaling 2.2 million square feet finished at Fontana’s Sierra Business Park debuted vacant.
Although short-term adjustments are likely, robust demand for large distribution space in the market’s western cities will eventually overcome any short-term numerical bumps. Newer speculative space in the market’s eastern cities,where users must contend with higher drayage costs of warehousing their products further inland,may encounter longer time lags to fill spaces.
Facing the region’s outdated infrastructure system, eastern landlords will counter the distance obstacles with tenant incentives ranging from utility discounts to more competitive market rents.
But, as the western Inland Empire is built out, the eastern cities (and eventually the High Desert) will become focal points for companies seeking expansions and consolidations while getting access to Southern California’s ports.
Market Assessment
The Inland Empire once again led the nation in construction activity in the quarter. In recent years, however, record growth has caused land values to double and larger parcels to become scarce as developers built in the market’s western cities.
Now, with construction pushing east and speculative space debuting in cities such as San Bernardino and Moreno Valley, newer submarkets are becoming indicators of how strong tenant demand is.
Although property size thresholds are increasing, a quick glance at the numbers can be misleading. In Fontana, two warehouses totaling 2.2 million square feet in Sares-Regis’ Sierra Business Park completed construction during the quarter and were vacant,pushing Fontana’s second-quarter vacancy rate to 7.6%, up from 1.1% recorded in the first quarter, and causing market-wide asking rental rates for warehouse space to drop 6%.
Future activity will smooth out these adjustments. During the quarter, Lake Forest-based Sole Technology Inc. became the first company to acquire an address at the 3.1 million-square-foot Sierra Business Park. Sole Technology bought a 315,000-square-foot building.
Another OC company, American Sporting Goods Corp. in Anaheim, has leased more than 300,000 square feet at Sierra Business Park.
The market-wide vacancy rate was 3.8%, an increase from first quarter’s 2.8% and the 2.7% recorded a year ago (a jump partly attributed to Sierra Business Park).
Quarterly absorption, meanwhile, was 3.9 million square feet,not far from the 4.4 million square logged a year ago,while sale and leasing activity registered 5.6 million square feet, down from 7.9 million this time last year.
Nine of the quarter’s transactions were greater than 100,000 square feet. And six of the nine were in the market’s highly sought after western submarkets.
Leases comprised 4.3 million square feet, or 77%, of total sale and leasing activity across the Inland Empire in the quarter.
There was 21.9 million square feet of construction under way in the quarter, up 12% from a year ago.
Forecast
Bordering Los Angeles County, which had the lowest vacancy rate in the nation at 1.8%, the Inland Empire will remain a destination point for company distribution operations by offering competitive rental rates, expansion potential and local incentives.
Evidence of this was seen in a first-quarter transaction when Korean-based Kumho Tires outgrew space in Fontana and expanded to a 830,300-square-foot building in Rancho Cucamonga. The move more than tripled the size of its North American distribution center and headquarters.
By relocating to another Inland Empire community, the company remains within 50 miles of the Port of Long Beach, where Kumho’s tires enter the country. Kumho’s logistics manager said the company could have found cheaper real estate further inland, but higher drayage costs and soaring fuel prices would have decimated any savings.
Where a company decides to locate inland is driven by transportation costs. Large distribution centers, such as Fontana’s Sierra Business Park, will be magnets for future users, while newer centers in locations further east may encounter time lags to fill space.
This, in turn, will potentially impact submarket vacancy rates until equilibrium is reached. In anticipation of demand levels, investors acquired big-box facilities in Fontana and Rialto for short-term holds.
In Rialto, Principal Global Investors bought the Opus Logistics Center for $50.6 million. The four-building, 809,403-square-foot park completed construction in June with all buildings delivered in shell condition. The buyer has each building listed for sale.
Looking ahead, rental rates are under modest upward pressure due to high construction and land costs, difficult entitlement processes and rising energy prices. Re-sales, while interest rates are still reasonably low, will provide a lucrative opportunity for investors.
The Los Angeles industrial vacancy rate again dropped below 2% in the second quarter.
Carrying momentum from 2005, total net absorption posted an impressive 3.5 million square feet as strong international trade, entertainment productions, the defense/aerospace sector and a leveling manufacturing sector all contributed to solid demand for industrial space.
As a result, all five submarkets continued to experience positive absorption, with South Bay and San Gabriel Valley giving the strongest performances.
Together, these two submarkets recorded more than 2.2 million square feet of absorption, accounting for 63% of all net absorption in the county.
Given the continuing strength in the regional economy and international trade, Los Angeles will continue to reign as the tightest market in the nation in the near future.
Low vacancy rates naturally brought higher rents. Average warehouse and distribution rental rates for the county increased 11% versus a year ago.
Sale and leasing activity totaled about 11.5 million square feet this quarter, down slightly from pervious quarters,a decrease primarily due to the lack of available space on the market and the razor-thin vacancy rate.
Some 445 leases compared to 106 sales transactions were inked during the quarter. On a per square foot basis, user sales accounted for a healthy 30% of sale and lease transactions in the quarter.
On the investment front, buyers remained bullish despite climbing interest rates. Investment sales this quarter totaled 758,335 square feet.
One of the quarter’s largest transactions took place with the sale of Heritage Corporate Center in Santa Fe Springs, where Legacy Partners reportedly paid $84.5 million (6.8% cap) for a leasehold interest on the 720,000-square-foot property.
Central Reigns
The Central Los Angeles submarket tightened a bit during the second quarter of 2006 when the vacancy rate decreased by 10 basis points, closing at a mere 1.3%.
Net absorption posted a healthy 418,704 square feet, while under construction activity maintained the same level as the previous quarter. Almost all new construction in Central Los Angeles consists of residential, retail or mixed-use developments.
Of the five submarkets in Central L.A., only Commerce/Bell/Pico Rivera showed any relevant level of industrial construction activity. New supply to the market is almost nonexistent and under construction projects account for only a tenth of a percentage point of existing inventory.
Sale and leasing activity, continuing an upward trend as users fought for any available space, marked a quarter-over-quarter increase of 24%. As the supply of quality properties on the market dwindled, volume on the investment front started to show signs of easing.
Solid Mid-Cities
The Mid-Cities’ industrial market continued a solid performance in the second quarter as the vacancy rate dropped to a low of 2.4%, a decrease of 10 basis points from the previous quarter.
Sale and leasing activity gained traction as the submarket attracted tenants from the tight Central L.A. market.
Lease activity remained strong with more than 1 million square feet logged as large distribution buildings in the Mid-Cities region have been in high demand due their proximity to the nearby ports of Long Beach and Los Angeles, which see about 45% of the nation’s goods pass through.
On the sale side, prices for buildings smaller than 25,000 square feet have increased the most, trading for more than $125 per square foot for older buildings and $165 or more for newer buildings.
Despite rising interest rates, investors are aggressively pursuing industrial space and paying top dollar for buildings of all classes in this steady and strategically situated market.
As the market continues to tighten, lease rates and sale prices for industrial buildings are set to climb in all size ranges due to strong activity and persistent demand. Looking forward, lease rates are expected to rise another 2% to 5% in the second half of 2006.
Forecast
Although rising fuel prices and interest rates have put the brakes on fast growth, the overall national economy is still on track toward a healthy expansion.
Despite a slowdown in the housing market, the Los Angeles economy will likely give a solid performance in 2006. International trade, commercial aerospace and technology will continue to fuel industrial demand.
On the supply side, new development projects will be a rare sight. Land and construction costs remain at record levels while developers and cities gravitate toward the profitability of retail and mixed-use developments.
Given the continual imbalance of supply and demand, rents should rise further over the near term.
Opportunities and Challenges
Rising fuel prices will remain a factor in the logistics and distribution industries. Transportation costs and traffic congestion have started to modify site selection criteria for many firms in the market.
However, due to a lack of supply, many of these firms may not be able to find choices in desired locations. Therefore, a careful and strategic approach has become increasingly necessary for tenants and owner-users to plan for their real estate needs.
On the flipside, developers fortunate enough to obtain prime industrial land or a choice infill parcel may be in a position to capitalize on current fundamentals in the industrial sector rather then risk an extended ride on the condo building craze.
Analysis by Grubb & Ellis Co.
