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Inland Empire's Retail Real Estate Market Jockeys for Success in 2023

Like many of you I’m excited to watch the Kentucky Derby this weekend. The infamous race is known for its pageantry and unpredictability, with different horses and jockeys vying for the win.  Similarly, SoCal’s Inland Empire retail real estate market is also full of twists and turns, with a multitude of factors affecting its success making the current market one of the most interesting and complicated I have witnessed in my 30+ year career.

The differences of opinion on whether we are in a recession, if interest rates will go up or down, whether the region’s economy will remain strong, the uncertainties around supply chain and construction costs and similar questions are a part of almost every conversation. The opinions are as diverse as which horse to bet on in the Kentucky Derby (FYI – as a lifelong horse racing fan I like Practical Move & Skinner).  

Our team at Progressive Real Estate Partners specializes in multiple sectors of commercial real estate including landlord representation, investment sales, tenant representation, owner/user sales, land sales, and gas station/car wash sales. In this blog I take a look at each sector and its performance during the first four months of 2023 and offer insights as to what we might expect for the balance of the year.

Landlord & Tenant Representation

Low Retail Vacancy Rate: The current vacancy rate is 6.1% which is the lowest it has been in 15+ years. On a base of 200M square feet, this represents about 12M square feet much of which is very challenging space (ie vacant movie theaters or mall anchors, obsolete space or space in outdated retail centers).  The low vacancy combined with a lack of new development is giving landlords a lot more leverage in their negotiations. The higher the quality of space, the more likely there are to be multiple tenants interested.  That being said, each unit is unique and the combination of tenant exclusives as well as prohibited uses, city zoning, and landlord preferences makes many spaces more challenging to lease even in areas of high demand.

Fewer Transactions: Despite strong demand leasing activity was only 830,000 SF in the 1st quarter of 2023 largely as a result of the issues stated above. This is the least amount of leasing activity in any quarter over the past 10 years except for the 2nd quarter of 2020 at the onset of the pandemic. Although positive net absorption (more space being leased vs becoming vacant) was 1.3M square feet in the past 12 months, that figure is down over 50% from the prior 12 months.

Lease Rates Climbing: Costar reports that lease rates in the Inland Empire have climbed 5.5% over the past 12 months. Calculating such figures is very challenging as information on completed transactions is held pretty closely by most brokerage firms. Anecdotally, we are seeing more space that was $3.00/SF/NNN space heading to $4.00/SF/NNN and $1.50/SF/NNN space heading to $2.00/SF/NNN. This is clearly a time to push rents.

Limited New Development Mostly Preleased: Development is primarily limited to anchored projects that are mostly pre-leased or single tenant buildings. According to Costar, 75% of deliveries were pre-leased. And I would venture to say that figure may be even higher as it could be spaces that appear to be delivered vacant are actually leased, but not announced yet. New shop space development is minimal. Some of the larger recent building deliveries included a Costco in Murrieta, Sprouts in Moreno Valley, and 99 Ranch Market in Eastvale.

Tenant Activity Remains Strong:  Tenant activity remains very positive, although tenants are clearly exercising caution regarding construction costs, the time required to obtain government approvals, and equipment delivery timelines for new store openings. We have heard many instances of tenants ordering equipment on spec with the idea that they will need it at some location by the time it arrives. Our team has had some transactions fail because of construction costs or the inability of the landlord and tenant to come to an agreement regarding the required time to get all city approvals.

Investment Sales

Less Product, Fewer Transactions: Retail investment sales volume peaked at $943M in the 4th quarter of 2021 and has been decreasing ever since with $439M of property transacted in the 1st quarter of 2023. That amount still exceeds the $300M quarterly average over the past 10 years. Higher interest rates have definitely put a damper on sales, but in many ways this is still a very good time to be a seller. While this may seem self-serving, I try to call it how I see it.  In addition to a lack of quality inventory, there is also a lot of overpriced property that has been sitting on the market for a while. Decent property in the right locations is still selling but the odds of us seeing 2021 and 2022 pricing levels any time in the next decade is not likely.

Rising Cap Rates?: The reduction in transactions is making it difficult to compare and determine if cap rates in the Inland Empire are rising or not. Anecdotally, we believe that a bread & butter multi-tenant strip center that may have sold for a 5.25% to 5.5% cap rate a year or two ago, is more likely to trade north of a 6% cap rate. We are back to a time where location, quality of tenant mix, property age, price point, price/SF, and all the other factors that go into a buyer’s perspective are making a big difference. However, quality single tenant properties are more likely to trade closer to their pricing from a year ago because there just are not many available due to the reduction in development. The cap rates for less desirable properties are definitely trending higher as the amount of unsophisticated and desperate money in the market is down substantially.

Land Sales

Residential Land in High Demand: We have expanded our business to include not only land for retail uses, but also land for residential. Because of state mandates, cities have shifted their efforts from retail development for sales tax benefits to residential development to satisfy California mandates for more housing. This shift in philosophy has resulted in a few of our retail deals going sideways as a substantial amount of land is currently being rezoned to mixed use from pure commercial.

Infill Preferred: Infill sites are definitely in much higher demand. Land prices have softened due to developers’ higher cost of capital and concern over the lease and/or sale value of the intended apartments or condominiums upon completion of the project. We recently had a couple of transactions which required price reductions in order to keep the buyer motivated to close.

Retail Land Moderating in Value & Demand: On the retail land side, most sales are for projects below 3 acres. We have seen comps showing rising prices, but these are for deals that were likely negotiated 12 to 36 months ago. Landowners have recognized some of the exit prices that developers achieved recently and as such have been trying to push prices. This is the problem of trying to value land with a rearview mirror. Developer’s higher cost of construction, higher cost of capital, and lower expectation of exit value is putting pressure on tenants to pay more rent and for property owners to lower their prices in order for a project to go forward. This has resulted in deals not being completed and I suspect retail land prices are going to need to soften or the tenant/developer will just move on to other opportunities.

Owner/User Sales

Owner/User Sales at Slower Pace: From 2020 to mid-2022 we did a record number of owner/user sales. Most of these sales were powered by SBA loan rates that at the time were below 4% and frequently around 3%. Freestanding buildings that came on the market as a result of Covid resulted in those with healthy balance sheets and an entrepreneurial spirit to acquire buildings for their businesses. In early 2023 we are still seeing owner/user sales but at a slower pace and lower per square foot pricing than the past couple of years.

Benefit of Buying VS Leasing: The debt service for these acquisitions was substantially below what the rental value of the property would have been resulting in a huge benefit for the buyer compared to leasing. Regardless, for many owners, selling their vacant building and trading into another single tenant property is likely a much better route than leasing to an independent tenant. Furthermore, potential buyers will probably soon realize that historically a 6% interest rate is still very good especially based upon the ability to recognize appreciation, depreciation, and wealth accumulation as a result of owning versus buying.

Car Wash & Gas Station Sales

Higher SBA Rates Impact Value: This business is also impacted by the current SBA loan rates which are now between 6% to over 10% since many of these acquisitions use fixed rate debt for the real estate but variable rate debt for the business acquisition. With Prime Rate currently at 8.25% and spreads for 7A loans generally at about 2.75% over Prime, business valuations are certainly being impacted. Also, higher labor costs for full-service car washes are putting pressure on car wash values.

Shift to Electric Vehicles: What hasn’t impacted value yet is the threat of a shift to electric vehicles. Most gas station buyers still see plenty of runway before electric cars take over. Many don’t believe that electric vehicles will become dominant in the next 20 years. Furthermore, most gas stations have profitable convenience stores and sit on quality real estate. Ultimately, I think buyers of gas stations today are recognizing the deprecation benefits of owning these properties, the substantial profits that exist in these businesses, and the long-term value of the real estate.

Conclusion

While we are certainly in a more challenging market than in the past two years, we see this as more of a “return to normal” versus a recession. The lack of retail development despite record high lease rates and low vacancy is very positive for property owners. Tenants will likely continue to struggle to find their desired space and pay more than they planned. The investment sales, land, and auto related business sale sectors will continue to be impacted by higher interest rates and product desirability.

It will be interesting to watch how the market evolves through the rest of 2023. And, as we look forward to the Kentucky Derby race this weekend, our team is also looking forward to the new opportunities that lie ahead.  Personally, I’m betting that the Inland Empire will continue to be one of the best regions for retail real estate opportunities in California for the foreseeable future.

 

The post Brad’s Blog – Inland Empire’s Retail Real Estate Market Jockeys for Success in 2023 appeared first on Progressive Real Estate Partners.