Although widespread job growth is slowing in California this year, this has more to do with running out of people than running out of jobs. In the construction sector labor supply constraints and a wet 2023-2024 winter have both contributed to a slowing of growth. The Summer 2024 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey reflects this overall slowdown in new projects started as well as the basis for continued growth in industrial, retail and multi-family sectors. Not surprisingly, developers of office space are facing a more challenging environment, and the Survey is indicating a multi-year process of contraction before a new building cycle begins.
The Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey compiles the views of commercial real estate developers, owners, and investors with respect to markets three years hence. The three-year time horizon was chosen to approximate the average time a new commercial project requires for completion (though projects with significant entitlement and/or environmental issues often take much longer). The panelists’ views on vacancy and rental rates are key ingredients to their own business plans for new projects, and as such, the Survey provides insights into new, not yet on the radar, building projects and is a leading indicator of future commercial construction. For example, if a developer were optimistic about economic conditions in Silicon Valley’s office market in 2027, then initial work for a new project with an expected ready-for-occupancy date of 2027 — a business plan, preliminary architecture, and a search for financial backing — would have to begin no later than the latter part of 2024. Although optimism does not always translate into new construction projects, this sentiment is usually a prerequisite for it.
Statistical forecast analysis has as its basis the proposition that past statistical relationships hold into the future. A knowledge of those correlations, current data and perhaps some assumptions about data not yet known, lead to the forecast. In addition to the summary measures of developer sentiment reported here, the Survey has a rich set of questions such that, with past trends in the Survey’s indexes, we can now infer a more nuanced turn in commercial real estate markets.
About 65% of the 2024 Summer Survey panelists are forecasting that the demand for retail space in southern California will grow more than supply. The panelists’ three-year-forecast for vacancy rates are for them to fall in the Los Angeles, Inland Empire, Orange County and San Diego retail markets and for rental rates in these four markets to rise faster than inflation. Approximately half of the panelists have new projects planned for the next 12 months, and slightly less than half began new projects in the previous 12 months (Chart 1). The upward trend in sentiment, including in San Francisco, has been historically associated with a turn in the market. Throughout the state, the forecast for retail that it is now poised for an expansion of development in the coming several years.
In Northern California there is no significant change from the Winter 2024 Survey in the share of respondents having plans for beginning new projects over the next year. However, the share has significantly increased since last summer’s survey. The financing of retail development is expected to become more stringent with a forecast of a higher percentages of equity and higher IRR thresholds being required. In each of the Northern California sub-regions, vacancy rates are forecasted to be lower over the next few years, and increases in rental rates will not keep up with inflation. With the exception of San Francisco, the panelists are optimistic overall about the future of retail space markets.
In the Southern California retail space markets, there is less concern with equity participation in new projects, but the panels share the view with the Northern California panels that the required IRR hurdle rate will be increasing. Overall, the panels for the Southern California sub-regions expressed an optimistic view of both the rental and vacancy rates outlook through 2027. Relative to the previous survey, the Summer 2024 Survey shows noted improvement in the composite sentiment index in every region other than the Inland Empire. It should be noted that sentiment by the Inland Empire panelists has been optimistic for the past year and remains so (Chart 2).
“As retail tenants change, they want flexibility to pivot to different trends, such as entertainment-focused retail, or experience-based retail. We’re seeing a lot of flexibility not only in permitted uses, but also in a lack of prohibited uses that we used to see, especially from big box tenants.”
Brian W. Michel, Partner, Allen Matkins
Not surprisingly, there is little optimism on the part of the office space panelists in the Summer 2024 Survey (Chart 3). While expressing pessimism with respect to the office space market, the sentiments’ indexes are on the rise for five of the eight regions, an indication of panelists’ beliefs that while their markets might not improve over the next three years, they are unlikely to be much worse than today. The pattern of the index over the last 18 months for Los Angeles, Orange County and San Diego, however, indicates a forecast of a market that is less likely to turn around by 2027 and could possibly deteriorate a bit more.
Planned office space development reported in the Survey dropped substantially with only 5% of developers planning to begin new office space development in Northern California in the next 12 months (Chart 4). Uncertainty with respect to remote work, a shifting landscape of how work is being performed, and higher costs of construction are all factors contributing to the decline.
In Northern California, the three-year-forecast for vacancy rates in office markets has improved, indicating an expectation that today’s high vacancy rates will begin to decline. With respect to rental rates, the Silicon Valley panel is forecasting a moderate erosion relative to inflation. In the other three markets the expectation is that there will be some significant declines in rental rates. Relative to the Winter 2024 Survey, about 62% of respondents, down from 72%, believe that they would be required to hold more equity in their projects over the next three years, and 63%, expect their investment IRR threshold requirement to increase over the next three years. The index for non-labor building costs in Northern California increased by 10 index points in 2024, relative to 2023.
In Southern California, the share of panelists having started new projects in the previous 12 months declined by about eight percentage points. The non-labor building cost index for Southern California rose as well, although not as fast as in Northern California. The three-year-forecasts for rental rate changes and for vacancy rates are pessimistic everywhere in Southern California. Also in Southern California, 62% of the respondents in the current survey expect to be required to hold more equity in their projects over the next three years.
“One of the trends we’re seeing in office space is that tenants are investing in smaller, better space, and there are a few ways we’re seeing this. One is a flight to quality where tenants are moving to smaller space in markets that have more amenities.”
— Erin L. Murphy, Partner, Allen Matkins
In the Winter 2024 Survey, the panels indicated a cooling of the red-hot industrial sector, though they were not predicting a contraction. The return of traffic at California’s seaports and the holding up of consumption have contributed to a more positive sentiment in the current survey. Three out of the five markets surveyed: the East Bay, Sacramento/San Joaquin and Orange County had a composite sentiment index greater than 50, implying optimism about improved market conditions over the next three years (Chart 5). The Los Angeles panel is forecasting markets to remain as robust as today, and the Inland Empire panel is forecasting a slight cooling of the market. Nevertheless, one should keep in mind that pessimism only means that rental rates and vacancy rates will be no better than today. In a perennially hot market this is not pessimism in the usual sense. Over the three-year-horizon, the Summer 2024 Survey reports growth in demand surpassing supply and the differential has increased from that expected in 2023 in both Northern and Southern California (Chart 6).
In both the East Bay and the Sacramento/San Joaquin regions the expectation is for rental-rate growth to exceed inflation and for vacancy rates to decline over the next three years. The percentage of panelists starting new projects during the last 12 months and the percentage planning to begin new projects over the next 12 months has declined, though this is only a reflection of a normalization of developer activity.
While a majority of the respondents expect vacancy rates to grow over the next three years in the Los Angeles, the Inland Empire and San Diego regions, the opposite is the case for the Orange County panel. In the Los Angeles and Inland Empire regions, rental rates are not expected to increase fast enough to keep up with inflation, and in Orange County and San Diego the panel expectations are for greater than the rate of inflation rental-rate increases. About 65% of the respondents expect to be required to hold more equity to achieve a higher investment IRR threshold over the next three years than today. Forty-four percent of the panelists started new projects over the last 12 months and 50% reported plans to start new projects in the coming 12 months. In addition, the panelists are expecting demand to grow more than supply over the next three years.
“In the industrial space, we’re seeing a lot of growth nationwide, but it’s moving towards geographic locations that have strong workforces, as well as low-cost construction, low-cost regulatory compliance, and in the data center space, availability of power.”
— Alykhan Shiva, Partner, Allen Matkins
“There is a major skilled labor shortage, and I think that’s driving where the hubs for industrial and distribution are really growing the most.”
— Evan Kantor, Head of U.S. Commercial Investment Group, Kennedy Wilson
