Market Report: San Diego Industrial - Second Quarter 2022
An unstoppable Force Meets an immovable object
What happens when an unstoppable force meets an immovable object? We’re about to find out in the San Diego industrial market. Twelve years into the current real estate cycle, we are starting to see market conditions emerge that could begin to slow down the rapid price appreciation that we’ve seen over the last 18 months. Although the fundamentals are in place to help protect the industrial market from a major correction, the broader economic environment could start to impact the market.
The San Diego County industrial market has been an unstoppable force for several years now. Surging demand combined with a lack of inventory have driven the market. These have led to all-time-high property valuations, with rent growth following suit. Since the start of 2021, industrial property values have appreciated nearly 50% in San Diego County and vacancy rates have reached 2.6% county wide. These statistics illustrate just how strong demand has been. The recent economic factors of record-low interest rates and government stimulus have undoubtedly helped fuel the market.
The immovable object that the market is beginning to run into comes in the form of rising interest rates that are being used to combat decades-high levels of inflation. Wage growth, the increased costs of materials, and record gas prices, among several other factors, are driving inflation numbers not seen since 1981. In response, the Fed is raising interest rates as rapidly as possible while trying to avoid a recession. This has increased the cost of capital for both investors and owner-users.
With GDP growth at -1.6% in the first quarter of this year, it is possible that we will soon enter into a recession, by definition. A recession is defined as two consecutive quarters of negative GDP growth, which we may be on pace for after this quarter’s economic data is released. Outside of the negative GDP growth caused by the pandemic in Q2-Q4 of 2020, we have not had any quarters of negative GDP growth since 2008 through 2009.
Going into the second half of the year, we will begin to see if these market dynamics have any impact on the fundamentally solid industrial market in San Diego. Common issues in downturns, such as overdevelopment and excess inventory, will not be a factor as development is currently limited outside of South County. Instead, we will watch to see if the broader economic conditions will be able to slow down the incredible momentum of the San Diego industrial real estate market.
MARKET OVERVIEW
The San Diego industrial market tightened further in the first half of 2022 with a million square feet of positive net absorption pushing vacancy and availability rates lower. The surge in construction over the past five years has not been able to keep up with the level of demand in the market. As a result, average asking lease rates continued their ascent, rising to another record high in Q2.
VACANCY & AVAILABILITY
Direct / sublease space (unoccupied) finished 2Q at 1.9%, a decrease of more than half from the previous year’s vacancy rate of 4.0%. A large portion of this decrease can be attributed to the delivery of Amazon’s build-to-suit facility in Otay Mesa in 2021. This added 3.4 MSF of occupied space to the countywide total. The availability rate decreased at an equal measure and finished 2Q 2022 at 2.9%. Ten years ago, the vacancy rate for the county as a whole was 9%. Today the vacancy rate for every submarket in the county is below 3%.
LEASE RATES
The average asking lease rate checked in at $1.26 per square foot per month, which is an increase of nine cents per square foot over the previous quarter. Compared with 2Q last year, we see a 16.7% annual increase. By and large, negotiating leverage in the industrial market remains in the hands of the landlords, and rental rates remain elevated. Over the past decade, the average asking rental rate in San Diego has increased a total of 75%, and over the past five years the rental rates have increased at an average of 6.5% per year. In many cases, tenants with expiring leases have no alternatives in their submarket, placing the negotiating leverage squarely in the hands of landlords. In the most competitive areas, landlords are increasingly able to backfill new availabilities before the existing tenant vacates. Fixed annual rental increases are also moving up. It is now common to see landlords insist on increases of 4% per year, rather than 3%, which had been the standard for many years.
TRANSACTION ACTIVITY
The total space leased and sold in 2Q was approximately 3.8 MSF, a 34% decrease from the 5.7 MSF of transactions in 2Q 2021. There were 195 lease transactions recorded in 2Q bringing the average number of leases recorded per quarter over the last year down to 205. The preceding five years had a quarterly average of 290 lease transactions. The market is so tight there are many tenants deciding to stay in their current location rather than move to a new facility because of the lack of available options. Three of the five largest leases in 2Q were in Otay Mesa buildings. This is a direct result of Otay Mesa leading the entire county in new construction the past couple of years. Sales activity picked up in 2Q with 68 industrial buildings trading for a total of $583.8M dollars in consideration. Record-low vacancy and record-high lease rate levels have fueled demand for investment in industrial real estate, 0M especially as retail and office market fundamentals took a hit from COVID-19. These factors have driven the average price per square foot in industrial real estate above $300, more than doubling over the past five years.
EMPLOYMENT
The unemployment rate in San Diego County was 2.7% in May 2022, down from a revised 3.0% in April 2022, and below the year-ago estimate of 6.6%. This compares with an unadjusted unemployment rate of 3.4% for California and 3.4% for the nation during the same period. Over the 12-month period between May 2021 and May 2022, San Diego County employment increased by 83,900 jobs, an increase of 5.9%. With the normal delay in reporting from the California EDD, employment figures from June were unavailable at the time of publishing this report. After 27 months, the total employment figure for San Diego County finally exceeded the pre-pandemic level in 2Q.
Forecast: The brief, but drastic, recession we saw with COVID-19 was not able to slow the growth in industrial real estate. In fact, it had the opposite effect. Going into the second half of 2022 we find ourselves in a high-inflation environment, entering a cycle of increasing interest rates. An increasing number of economic analysts are predicting recession by next year. In the short term, demand in the industrial market continues to remain strong. Over the longer horizon, a slowdown of the broader economy could have a cooling effect on the industrial market. On the sales side, rising interest rates will apply upward pressure on cap rates going forward.
CONSTRUCTION
4.7 MSF of new industrial projects were delivered in 2021, which was the fifth year out of the past six with more than 1 MSF of new construction completed. 1 MSF has been delivered in the first half of 2022 alone, with 1.8M more currently under construction. This is in stark contrast to the 360,000 feet per year of new construction which was the annual average from 2008 through 2015. With very little land in the central county area available for development, most new construction in the county is happening around the edges. Over the past six years there have been more than 1 MSF of new industrial development in each of South County, North County, and the I-15 Corridor, while Central County and East County combined have seen only a half a million total square feet of new development during that span. More recently, construction has been especially concentrated in Otay Mesa which accounts for 92% of the construction completions over the past 18 months, and 83% of the industrial real estate currently under construction.
ABSORPTION
There were 291,044 SF of positive net absorption in 2Q 2021. The San Diego market is on track for its twelfth consecutive year of growth to the total tenant footprint. The South County and North County areas each saw over 400,000 SF of positive absorption in the first half of 2022. These areas have seen the majority of new construction over the past decade, and this growth of industrial inventory accommodates the growth of industrial tenants.
