West Coast Capital Seeks Value Amid Volatility

It’s no secret that the rising cost of capital has led to declines in CRE investment volumes, but where and which asset types are being most impacted? With so much uncertainty, West Coast investors are digging deeper for the differences between markets, submarkets, asset types, and sizes.

Industrial: Good Constraints & Small Ball

Thanks in part to favorable supply and demand dynamics, the Los Angeles and Orange County markets are the hottest relative to projected rent growth over the next few years. Meanwhile, the rent growth outlook is less favorable for markets where development barriers are lower.

“LA and Orange County are the most supply constrained, biggest consumption pockets, most established distribution networks, and have the least amount of pending new supply relative to current stock,” says Eric Cohen, Kidder Mathews VP.

In Orange County, a full point cap rate bump for industrial product translates into an approximate 10% decline in asset values since their peak in the first quarter of 2022, according to Cohen. Rick Putnam, Kidder Mathews EVP, notes that while larger industrial product are experiencing excess supply, smaller divisible buildings are performing well, and central and infill submarkets have an edge over peripheral areas.

Multifamily Moves Include Flight to Quality

Multifamily value declines range from 5% to a high of 20% in core markets in LA. Investors must come to terms with rent growth stagnation combined with higher operating expenses, says Kidder Mathews Senior Associate David Evans.

“However, in secondary markets in the LA MSA, we have seen lower value declines due to sustained investor demand in low inventory,” he says.

Evans reports a tenant flight to quality in the nation’s second largest MSA — “not just properties but cities and neighborhoods, meaning that renters who can afford $2,500 or more for a one-bedroom apartment are increasingly looking towards more suburban apartment markets such as San Gabriel Valley and Orange County.”

The effect of office conversions to multifamily remains to be seen, with borrowers having to negotiate a higher cost of debt to execute the strategy.

Office Facing Headwinds

With office transaction volume down over 90% in the past 12 months in most West Coast markets, it is very difficult to determine meaningful valuations. In the few assets that have sold or that are being marketed, pricing is 50% to 75% off peak values attained pre-pandemic.

“The great social experiment created by Covid, remote work, and questions of live-work balance have created a cloud over future office demand and as a result, over capital investment in this asset class,” says Andrew Miller, Kidder Mathews EVP in Bellevue, Washington.

Tech-focused markets, like most on the West Coast, are experiencing the greatest disruption with vacancy rates near all-time highs of 30% or greater. “The concern is that we have not felt the entire impact of reduced office demand until much of the pre-pandemic lease commitments roll within the next 3-4 years,” he adds.

“Optimistically, most large corporate users are now requiring employees back to the office for at least three days a week and tech hiring has resumed, albeit cautiously for now,” says Miller.

In addition, the few office assets on the market are starting to get activity from not only private equity but institutional value add capital as well. We expect this trend to continue, but primarily for best-in-class assets.

Retail’s Healthy Tenant Demand

Although rising interest rates have bumped up cap rates for Orange County multi-tenant shopping centers by a full point, smaller assets that are often cash and exchange-driven purchases are experiencing less price softening. Overall, tenant demand for Southern California retail remains strong and the lack of new construction will keep availability tight, according to Michelle Schierberl, Kidder Mathews SVP.

“The fallout of the Albertsons and Kroger merger may create some opportunities,” she adds. “The Amazon grocery store locations that have never opened is another item to watch.”

Looking at 2024, retail sales velocity will remain slow as low-interest mortgages and solid cash flows make for unmotivated sellers. Pressing needs from loan maturities or ownership structure changes will be the predominant transaction driver.

Outlook

Investors will have their eyes on the trillions of dollars of commercial mortgage debt coming due soon. Those owners avoiding distress through loan restructuring could still take a hit to cash flow and net equity. Opportunity will come with properties that can’t be refinanced due to both higher debt costs and lower valuations.

“The faster the distressed assets come to the market, it will bode well for maximizing value,” Schierberl says. “This is due to lots of capital looking for distressed assets with very few opportunities.”

With borrowing costs at the highest level since the beginning of the millennium, commercial real estate investors continue to look for stability including established asset pricing. Although the investor pool may not be as deep and broad as 2021 and operating expenses continue to escalate, players will explore beyond-core opportunities while well-located assets with good functionality and quantifiable risk profiles will continue to be popular.

Contact

BRIAN HATCHER President & COO brian.hatcher@kidder.com View Bio