Los Angeles Industrial, Retail: Overlapping Industries Adapting to Post-Pandemic Change
As the pandemic recedes, unusual supply and demand trends have taken root in retail and industrial markets throughout the nation. Factors that caused upheaval even before the arrival of COVID — the changing face of retail due to e-commerce and the growing demand for industrial real estate — continue unabated two years past the pandemic lockdowns. Los Angeles County may act as a bellwether for the rest of the country in retail and industrial trends, especially in high-cost, high-density areas, where these two real estate types often compete for space.
Bayard (By) Cartmell, senior director at Walker & Dunlop, Los Angeles, has extensive experience with commercial real estate in the Los Angeles area. He has seen unprecedented demand for industrial space and growing investor interest in retail cap rates in the Los Angeles area. Cartmell sat down with REBusinessOnline to talk about the outlook for industrial and retail in Los Angeles, their intersections and the sector trends he expects to see in the coming year.
Los Angeles Industrial — High Demand
REBusiness: What are you seeing in terms of demand for industrial space — particularly in Los Angeles?
Cartmell: There is currently almost unlimited demand for industrial space, of any size, in Los Angeles County and the Inland Empire. If you are an industrial landlord in these areas with a five-year lease coming up for renewal, you can basically double your rental rate from five years ago.
REBusiness: What is investor appetite for these properties in the Los Angeles metro?
Cartmell: Until the 10-year United States Treasury (UST) increased by 100 basis points, investor demand for industrial was nearly unlimited. Cap rates on newer product with good leases are now regularly at 3 percent.
Right now, buyers are trying to get lower purchase prices, but sellers are still holding firm. We don’t know who is going to blink first, but my guess would be that prices will get a little softer in the near term.
REBusiness: What types of industrial properties are most in demand, and who are the most active buyers?
Cartmell: Bulk distribution is still the number one product type, due to ecommerce.
Every possible group is equally active in buying: institutional investors, family office, wealthy individuals — everyone. The one that wins these deals is the individual in the most desperate 1031 exchange situation. Or, if the deal is north of $25 million, an institutional investor with money that needs to be placed usually wins out.
REBusiness: What types of industrial tenants are most active in the market?
Cartmell: Distribution is still number one in activity simply because they sign such huge leases. But there is just as much activity from small- to mid-sized users who either are involved in light manufacturing or have service businesses. However, for small- to mid-sized users, their average building lease is 25,000 to 50,000 square feet, while the average distribution tenant uses a building 10 times that size.
CBRE just put out a report indicating that for the approximately 1 billion square feet they track in the Los Angeles market, the industrial vacancy rate is 0.5 percent, the lowest on record. Meanwhile, rents are trending at 10 to 15 percent annual increases.
Los Angeles Retail — Cap Rates Promote Cautious Interest
REBusiness: What is the investor appetite for retail properties in the area?
Cartmell: We have seen a cautious pickup in retail purchasers. Individuals who have significant existing retail properties are actively looking to acquire because they can buy at cap rates 200 to 300 basis points higher than available in the apartment or industrial markets. Also, the debt used to purchase retail is only around 50 basis points higher than in multifamily or industrial sectors so cash-on-cash returns are much better.
The properties in greatest demand are, first and foremost, retail properties in good demographic areas with good access and parking. Food service businesses form a large part of retail collateral, as they were often the most stable retail tenants during COVID.
The most active buyers in this space are individuals with existing portfolios of retail properties.
REBusiness: What types of retail tenants are in greatest demand as the pandemic ends?
Cartmell: Tenants with a high level of human touch points — food, entertainment and products that need to be held first rather than just ordered on the Internet.
REBusiness: Where are vacancy rates and what sorts of deals/concessions are tenants getting in retail?
Cartmell: Vacancy rates are still very high. The 3rd Street Promenade in Santa Monica is at least 50 percent vacant — 80 percent vacant without the food tenants. Downtown, street-level Beverly Hills is also 40 to 50 percent vacant. Any viable tenant can expect at least $50/square foot of tenant improvement and six months of free rent.
Overlap Between Industrial and Retail: Ecommerce, Trends, Growth and Challenges
REBusiness: How are you seeing demand for retail real estate and industrial real estate impact each sector?
Cartmell: Approximately 85 percent of gross retail sales still take place in brick-and-mortar real estate. It takes three times as much real estate square footage (including industrial warehouses and distribution centers) to get a retail product to an end user via ecommerce channels than it does through a retail store. Consequently, brick-and-mortar retail still has a very large future.
One of the biggest problems with ecommerce is dealing with returns. Goods returned via shipping services to large, industrial warehouses (like Amazon’s) are usually thrown away or sold at a deep discount.
In-store returns can be put back on the shelf, avoiding waste. We are seeing major retail chains regularly converting 10 to 20 percent of their stores to last-mile distribution centers and return processing operations, in part to avoid the losses related to the ecommerce return process.
REBusiness: Nationwide, we’ve seen interest in converting large obsolete retail properties to logistics facilities — especially to handle last-mile logistics in large metro areas. Are you seeing that in Los Angeles?
Cartmell: Not really in West Los Angeles. The area is just too densely populated, and the land is much too valuable to build industrial. The first option here is to tear down and build four-to-six-story apartments. We are seeing things like the West Side Mall on Pico and Westwood being converted to office, and a few of the older department stores mid-Wilshire have been converted to museums. East Los Angeles, Ontario and Moreno Valley are a very different story. I know of several old power centers that have successfully converted to distribution. But once land gets over $100/square foot, industrial rarely makes sense.
REBusiness: What trends are you seeing in Los Angeles retail and industrial this year?
Cartmell: Retail will come back but as a continuing evolution of on-line and in-store sales.
Industrial rents will continue to grow at 10 percent a year or more in Southern California for the foreseeable future. Land prices, coverage ratios and the insane difficulty of getting anything approved by any governmental agency in California means costs to construct are now well north of $300/square foot.
This means industrial rents will be higher than $1/square foot/month. We are now financing 200,000-square-foot deals in the Inland Empire with monthly rents of about $1.50/square foot/month. At a 4 percent cap rate, that means industrial buildings will be selling for about $450/square foot or more. Basically, one-story, concrete industrial buildings are now worth more than office buildings.
REBusiness: What factors bode well for retail and industrial sectors in Los Angeles in the near future?
Cartmell: Commercial real estate is a derivative industry. That is, we derive our value from the businesses that need our structures in which to live, work or allow recreation. As long as Los Angeles’ job market continues to expand, so will Los Angeles’ commercial real estate values.
REBusiness: What factors will restrict growth or investment in these markets?
Cartmell: The most important obstacle is the difficulty of Los Angeles governmental approval structures. It is not at all uncommon for an apartment building to take more than five years to get final approval. The costs of governmental approvals and permits can be two to three times the cost of the land. All these costs must be built into the rent. At some point it makes more sense for the business to move to Arizona or Texas, where rent can be significantly cheaper.