Tight markets are starting to turn around in the CRE space
Commercial mortgage brokers are always trying to find the next hottest sector and region for new commercial deals.
While there is still a wide variety in the commercial sectors and how they are currently performing, recent data showed that geographic variations are smoothing out a bit.
As the overall commercial market has stabilized, metro-level data shows that the variation between cities has decreased. It’s a trend brokers should be aware of, and one senior economist said it’s a good reminder of how quickly things can change.
Xander Snyder (pictured top), senior commercial real estate economist for First American, said while some trends continue in city markets, new trends can pop up based on changing market conditions.
“The big lesson is to think beyond where demand is today,” Snyder told Mortgage Professional America. “It’s easy to think that a market is uniquely advantaged when rents are rising and space is tight, but the Los Angeles market showed how that can change. Even markets with constrained new supply and demand that seem certain at one moment in time can shift, if tenants find sufficient, cheaper alternatives.”
A West Coast shift
Cap rates in Los Angeles and the Inland Empire, the area adjacent to coastal Southern California in the greater Los Angeles area, cratered post-pandemic, dropping near or below 4%. Today, both markets have seen increases, with each approaching 6%.
While both have surged, Snyder said each has its own reason for the drop and rebound. For Los Angeles, areas were overpriced during the pandemic surge.
“In short, Los Angeles and the Inland Empire got to the same place by different paths,” he said. “In LA, cap rates moved higher because pricing had gotten too aggressive during the pandemic boom. Investors were underwriting Los Angeles infill industrial as if port-adjacent scarcity would keep rents rising indefinitely. But when trade volumes softened, retailers worked through excess inventory, and tenants began rightsizing, so that assumption broke down.
“More space came back to market through move-outs and subleases, even without much new construction, just as higher interest rates were putting upward pressure on cap rates. When port activity recovered, leasing demand did not fully recover with it, suggesting some occupiers had either reduced their space needs or shifted them elsewhere.”
In the Inland Empire, which includes areas like Riverside, San Bernardino, and Fontana, the market wasn’t as constrained by a lack of space for construction, and therefore, there was room to expand inventory.
“The Inland Empire was a different story,” Snyder said. “It benefited from some of the same demand surge during the boom, but unlike LA, it had room to build, and it did. That means the cap rate move there was driven more by new supply coming online, alongside some demand shifting inland as occupiers looked for lower-cost alternatives to LA.
“Going forward, the sharpest part of the adjustment is likely behind us, but I would expect some further normalization rather than a return to the ultra-low cap rates seen at the peak, especially as Southern California industrial continues to lose some of the exceptional pricing premium it once commanded.”
Midwest still seeing discounts
Cap rates in Chicago and Detroit continue to lead the way among the top 10 cities by square feet of industrial space. Detroit's cap rate is approaching 8%, while Chicago is just shy of 7%.
Just like on the West Coast, these two Great Lakes cities have different reasons for discounts. In Detroit, a good mix of building types is one of the reasons.
“There’s no single reason for the discount, and each city has unique drivers,” Snyder said. “In Detroit, it’s due in part to building mix. Compared with other major industrial markets, Detroit has more manufacturing properties than logistics properties that are in high demand by many investors. That, plus the exposure to the cyclicality of manufacturing, is in part why cap rates have remained higher there than elsewhere.”
Meanwhile, in Chicago, the vast amount of industrial space is driving market conditions. Because the supply is so high, pricing is kept in check compared to other metro areas.
“In Chicago, there’s a huge amount of industrial space,” Snyder said. “It’s the country’s largest industrial market. That means both tenants and investors have lots of alternatives, which makes it harder for the whole market to command the kind of pricing premium that Los Angeles did when cap rates were at troughs.
“Chicago also has a wide mix of newer, highly desirable logistics buildings as well as older, less competitive properties. The abundance of older, less-modern properties pulls the average cap rate up, but there are also new, high-quality logistics assets in Chicago with cap rates in line with other major distribution hubs.”
Conditions should improve
Snyder said that, barring any unexpected surge in demand, conditions should continue to improve across all markets.
“Expect steady and gradually improving, unless there’s a demand shock,” he said. “As an example, persistently elevated energy prices could sap consumers’ ability to spend on other items, reducing the demand for goods and warehouses to store those goods. This would be counterbalanced, in the long run, by the progressing needs for modern logistical infrastructure in the country, and the steady, continual rise in ecommerce sales relative to total retail sales.”
As far as the impact on cap rates, Snyder said they could move either way, but brokers shouldn’t expect a major change.
“Cap rates could move up or down over the next year, but probably not by too much,” he said. “The blip in negative net absorption in the second quarter has not been repeated for the last three quarters, so that is beginning to appear like a one-time adjustment as retailers reacted to changes in trade policy, rather than an ongoing process.”
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