San Diego Industrial Market Report

A Tale of Two Offerings

Within the middle market space of San Diego Industrial, Q4 2023 exemplified two staunchly different stories within the owner-user and investor markets. The landscape of offerings was barren for investors looking for leased properties, whether it be stabilized or value-add. There were record-low investment sales closings and for-sale opportunities on the market when December 31, 2023, passed, marking the end of the quarter. The apparent item to point out is interest rates, but let’s dig a bit deeper.

Higher interest rates have dissuaded buyers from purchasing as most deals still result in negative leverage. As rents cool and begin to roll back off of market highs, buyers are having a more challenging time believing the value-add story of buying under market and pushing hard on rents without facing significant vacancy. Stabilized return on cost has often not been an appetizing enough proposition for buyers to take the gamble on. The approach of purchasing vacant and leasing up the asset is extremely difficult. This is due to the fact pricing hasn’t come down nearly as much on vacant buildings because of the solid owner-user demand for sites. A second underlying factor is that last year, from December of 2022, most exchange buyers in California had their 1031 ID and closing period extended to October 15 due to natural disaster relief efforts. This likely contributed to the many investment listings that came to market over that time, most of which were cleared by the time Q4 rolled around.

On the other hand, the market for vacant buildings targeting owner-user buyers remained highly active. Multiple markets are achieving record price per square foot comps and inventory remaining reasonably available across the county. So, with owner users also facing high-interest rates, what has kept this niche segment so active and is causing Owner Users to pay record-setting prices?

One of the main drivers we have identified is a scarce number of available owner-user options over 2021 and 2022. This resulted in pent-up demand for companies looking to purchase a building to house their business. Investors were willing to buy vacant and take a more speculative lease-up risk when interest rates were low, and the leasing market was red hot. This led sellers to pick this buyer profile over users because, in many cases they were all cash or more easily financed, thus resulting in a higher probability of close. Secondly, owners with vacancy pop-ups were more likely to first attempt to lease up the property. As record low vacancy rates drove lease rates up, lowered lease-up downtime and allowed owners to sign up tenants with little or no concessions. At this moment, the prospect of buying over leasing poses potentially up to a 30% higher occupancy cost. However, there is solace in three main factors for owner-user purchasers. First is the ability to lock in the fixed occupancy cost moving forward and not face annual increases that have mainly become market at 4%. Second is the possibility of a falling interest rate environment over the next 18 to 24 months. This would make way for refinances, lowering that delta, and potentially bringing a revised occupancy cost below market lease rates. Lastly is when there is available inventory for purchase for users and the desire for these buyers to lock up a building while the market sits in their favor.

Pulling it all together – where is the opportunity? For owners with leases that represent a significant portion of their building’s occupancy rolling over in the next 18 months or less, this is the time to evaluate a lease vs. sale analysis. Suppose it seems that there is an opportunity for outsized returns via way of an exit to an owner user. In that case, there may be justification for executing that business plan and trading into a new investment with higher cash flow than what would not have been otherwise achieved. Putting properties on the market for lease or sale is also a strong strategy. This strategy will let market activity dictate the business plan direction.

For users, seek value in purchases but only if you see the building being a home for your business for the medium to long-term future. Don’t let the sticker shock steer you away from the purchase. San Diego has almost all of its developable land already built. There is not going to be a flood of new supply coming anytime soon. This will fundamentally keep pricing propped up and likely continue to push it higher in the future.

Matthew’s is one of the most active private client teams in San Diego. As such, we are happy to provide advisory services to help evaluate business plans in this rapidly changing market. Please feel free to reach out with any questions.

Market Performance

The vacancy rate has undergone a year-over-year (YOY) change of 2.8%. It reached 6.1% as net absorption recorded approximately -3.6 million square feet in the last 12 months. This follows a vacancy low of 2.8% in the first half of 2022.

Key Indicators

• Absorption: -3.6M SF
• Deliveries: 2.7M SF
• Rent Growth: 5.7%
• Vacancy Change: 2.8%
• Logistics RBA: 89,726,227
• Specialized Industrial RBA: 64,869,478
• Flex RBA: 54,350,060
• Market RBA: 208,945,765

With a 5.7% year-over-year rent growth, it remains higher than the long-term average. However, the combination of increased interest rates and declining demand in recent quarters has contributed to a gradual slowdown in the San Diego industrial market.

Sales By The Numbers | Last 12 Months | Source: CoStar Group

• Average Cap Rate: 5.1%
• Sale Price per SF: $274
• Average Sale Price: $6M
• Sales Volume: $909M
• Sale VS Asking Price: -6.5%
• Average SF: 24.6K
• Months to Sale: 6.7