“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually, then suddenly.” - Ernest Hemingway’s “The Sun Also Rises”
We are witnessing a generational disruption in the global supply chain. As I write, the number of ships anchored along the coast of the LA/Long Beach Ports is hovering near one hundred carrying in excess of one million total containers! One cause, among others (i.e., the pandemic, truckdriver shortages, inefficient port management, etc.), is the insufficient amount of warehouse space to accommodate the ever-expanding demand driven by the rise of e-commerce and commensurate logistics. The Southern California industrial market provides a case study of the structural shift that has driven vacancy to virtually zero and forced rental rates to skyrocket.
Rents have historically grown at a solid pace in Southern California (but not much more than inflation), and vacancy has trended downward. This reflects the geographical advantage Los Angeles, Orange County, and the Inland Empire have due to their proximity to the Ports. For years, developers have been moving east into the Inland Empire to accommodate the increasing demand and give refuge to tenants trying to escape rising occupancy costs. This migration kept rapid rent growth at bay, and increased supply, provided by this new development activity, could keep up with user demand. But, with apologies to Ernest Hemingway, we are seeing “change happening gradually and then all at once.” In the last fifteen months, all these trends have accelerated, reflecting the enormous impact that e-commerce has generated by siphoning off vast swaths of the retail market.
As logistics have moved east, increased truck traffic, pollution, degradation of infrastructure, and noise have been some of the consequences faced by IE locals that have motivated them to organize. Cities have increasingly become more hostile towards warehouse development and, in some cases, have even put moratoriums in place at a time when new supply is needed more than ever.
Local governments have many tools at their disposal to make it more difficult for much needed warehouse space to be developed. The most common is CEQA, which is now tremendously litigious and is frequently wielded by cities to slow construction projects and force developers to pay for the cities’ never-ending wish lists. Adding more frustration to the equation, much of the local resistance to new projects takes place on land that is already zoned for industrial uses or has older, obsolete warehouses on it.
This aversion to development has culminated in full moratoriums on warehouse development in several cities. Riverside passed a45-day moratorium in March 2020. Jurupa Valley passed a 1-year moratorium in January of this year. Chino and Colton both have current moratoriums in place that expire in December and May, respectively. San Bernardino fell short of passing its own moratorium by a single vote on its City Council. The message is clear; the Inland Empire is slowing down on its development binge, and there is no reason to believe this anti-development sentiment has any end in sight. HPP is not often a developer for this very reason; political environments can turn sour, and that uncertainty is not something that any investor wants to be involved with.
It is basic economics. With the quickly emerging prominence of e-commerce and the various recent governmental stimuli, demand is off the charts. High demand combined with very little new supply coming on the market has led rents to be bid up precipitously.
These market dynamics are bittersweet music to our ears hereat Hager Pacific. Winners in all of this have been landlords that have seen renewals climb to rates that were unfathomable just a few years ago. However, at some point, high rents will force tenants and users to consider other locations and other distribution schemes to avoid these high costs, which are often passed to the consumer.
In the current political environment, rents are likely to continue to trend upward but at a more sustainable rate. Unless wholesale political changes are made, regulations in Southern California will continue to serve as a barrier to entry that will limit supply and fail to address the seemingly insatiable demand. Tenants that can afford to remain near the Ports will pay a hefty premium for that space. Developers, worn down by red tape, will have no choice but to build even further east into Palm Desert or north into markets such as Bakersfield and Tejon Ranch if they want to stay in the region. Moreover, there is massive development activity in other western markets such as Phoenix and Las Vegas. While these places seem ripe now, if history is any teacher, they too will eventually change attitudes towards industrial development that increase the value of existing properties.