The Summer 2023 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey presents a cautious outlook for the commercial real estate market. The state’s economy continues to grow, but mixed signals from increasing interest rates and cap rates, along with a postponed recession, have created a sense of uncertainty among industry players. However, amidst the ambiguity, some bright spots have emerged, particularly in new home development and associated retail development.
The survey reveals that California’s economic trajectory suggests a milder impact from any potential slow growth period or mild recession compared to the rest of the nation. This has infused a sense of optimism about future opportunities in the real estate market. Despite this optimism, panelists across all segments of commercial real estate and regions in California are facing a more challenging financial landscape. They anticipate an increase in required equity percentages and investment return (IRR) hurdle rates over the next three years.
The Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey gathers perspectives from developers, owners, and investors regarding the market three years into the future. The three-year time horizon aligns with the average time it takes to complete a new commercial project, though some projects with significant entitlement and environmental issues may take much longer.
Office Space Markets: Pessimism Prevails
For developers in the office sector, rationalizing existing office space and planning for a return to the office will be crucial factors in determining where and when to invest. In 2022, sentiment turned positive as the return to the office began. However, that optimism has waned over the last year, and all eight surveyed markets now reflect decidedly negative sentiment.
The panelists expect both rental rates and occupancy rates to weaken in the coming year, and they do not anticipate a full recovery to current levels before the end of 2026. This leads to the conclusion that there will likely be less new office construction in the near term.
Over the next three years, approximately half of the panelists in both Northern and Southern California foresee a deterioration in office market economics. While some return-to-the-office is expected, the demand for office space is not projected to match supply. This discrepancy in demand and supply, combined with high vacancy rates of 30 percent or more in major cities like San Francisco and downtown Los Angeles, contributes to the current pessimism among office developers.
The current Federal Reserve policy, aimed at cooling the economy, has also impacted the office space development sphere. The very high vacancy rates, coupled with challenging financial markets, make it unlikely that lending conditions will ease in the near future. Office building loans facing refinancing will also need to confront asset value rebasing and potential defaults depending on existing lease quality.
The UCLA Anderson Forecast presents two scenarios for future Fed policy. In the first scenario, aggressive interest rate increases induce a recession in the third quarter of 2023. In this case, private office-using payroll employment contracts slightly but eventually rebounds. In the alternative scenario, moderate interest rate increases lead to a steadier growth trajectory.
Given the current market conditions, the uncertainty about future asset values and demand, and the unknown form and function of the future office environment, significant new office development is not expected before the survey’s horizon in 2026.
Retail Rebound: A Promising Path to Recovery in California
After enduring a challenging period, the retail sector in California is showing signs of resilience and recovery. Analyzing recent Surveys and developer/owner sentiment, there are positive indicators for a revival in the retail space, although the sentiment in Southern California remains somewhat mixed. The collective data points towards the beginning of a new retail cycle by 2026, promising a brighter future for the industry.
Nationwide, retail sales are on the rise, and California’s retail trade component of GDP has shown solid gains through the end of 2022. While the Sacramento/San Joaquin region’s panelists are relatively neutral about the next three years, factors like work-from-home arrangements and hybrid-work policies by the State Government have impacted the sentiment. Despite Sacramento being the fastest-growing large city in the state, the expectation of a positive sentiment has been pushed back slightly, possibly by one or two quarters.
In Southern California and Silicon Valley, three powerful forces are driving overall optimism in the retail markets. Firstly, the partial return to the office has generated increased demand for retail in certain areas of these regions. While it has not fully reached pre-pandemic levels, this is a positive step forward. Secondly, the construction of new housing developments has created a demand for retail in close proximity to these residential areas. Thirdly, there is a growing expectation for retail establishments to transition to an open-air post-COVID concept to attract consumers back to stores. While city centers are still on a long road to recovery, these factors have sparked optimism among panelists.
Despite the current high level of sub-leases and slow-walking leases leading to an increase in vacancy rates, panelists also anticipate real rental rates to increase. This positive trend is attributed to the demand for the reconfiguration of retail spaces to suit the changing consumer preferences post-pandemic.
The retail development opportunities in the state are solid, especially in areas with new housing developments springing up, according to the research study. Despite the possibility of a recession, planned housing construction will continue to drive demand for new retail development over the next three years.
However, event though the sentiment indexes point towards a turnaround, the percentage of panelists planning new developments in the next twelve months is notably lower than those who started new projects in the previous twelve months. Northern California developers remain the most pessimistic, with many planning to remain on the sidelines in 2023.
Nonetheless, the data indicates a positive turnaround and the beginning of a new retail building cycle before the middle of 2026. This gradual recovery in the retail sector presents exciting opportunities for developers and investors alike to re-enter the market and capitalize on the growing demand.
Industrial Space Development: Cooling Amidst High Demand
The industrial space has emerged as the star performer in recent times. Despite robust development efforts in 2022, the industrial sector continues to shine with record-high occupancy rates and exceptional lease rate growth. However, the latest Winter 2023 Survey reveals a moderate drop in developer sentiment for industrial space in three of the five markets surveyed. The most recent Survey now shows decidedly negative sentiment across all five markets, signaling a potential turning point in the industry.
For a while now, industrial markets throughout California have experienced high demand and overheated conditions. This has led to a slight cooling of development activity, as indicated by the shift in sentiment. In Southern California, the demand for large warehouses has been significant, with numerous million-square-foot projects currently under construction. Los Angeles and the Inland Empire have seen vacancy rates plummet to below 1 percent. Although these rates have increased to around 2 percent, supply still struggles to catch up with the demand.
The panelists’ response in the previous and current Surveys suggests that 2026 may not be as profitable as 2023, mainly due to the expected increase in vacancy rates as supply begins to meet demand. Despite this projected downturn, a contract agreement signed between the International Longshore and Warehouse Union (ILWU) and the Pacific Maritime Association in July 2023 is set to increase the demand for warehouse space next year, even as economic growth softens.
Interestingly, a greater percentage of panelists interviewed are planning multiple new industrial projects than at any time in the last eight years, except for 2021. Moreover, a greater percentage are planning a single new development project compared to any time in the last eight years, except for 2017. This indicates the highest level of planned development reported in the Summer Surveys since the Great Recession of 2008/2009. This robust development trend is also evident in the two Northern California markets surveyed, where vacancy rates hover around 4 percent. In these regions, 91 percent of the panelists are planning new industrial development.
Despite signs of cooling sentiment, it is evident that industrial space development remains in full swing across California. Developers continue to respond to demand and are strategically planning new projects to cater to the thriving market.
Multifamily Real Estate: Optimism Amidst Softening Rents
The multifamily real estate market in California has faced its share of challenges, with rents softening in recent times. However, the outlook remains bullish as panelists in each of the eight surveyed markets, including San Francisco, expressed optimism about the coming three years. The extent of their optimism varies across markets. In Southern California, specifically Los Angeles, the Inland Empire, and Orange County, panelists expect vacancy rates to remain as low as they are today, with rental rates projected to increase more rapidly than inflation over the next three years. San Diego also anticipates rental rate improvements, although with a slight deterioration in occupancy rates. Conversely, in the Northern California markets, vacancy rates are expected to rise, largely influenced by the Bay Area’s high percentage of jobs that can be partially or fully remote, impacting demand.
While there has been a pullback in development across the nation in the past year, the reduction in new multifamily development has been less severe in the Golden State. According to the current Survey, 55 percent of the panelists are planning to begin one or more new projects in the coming year, with a slightly higher percentage in Southern California than in Northern California.
Several key factors are driving new multifamily development from 2023 to 2026. First, the inland areas of the state are experiencing growth in logistics and infrastructure construction, creating demand for additional housing options. Second, a series of state laws, including SB8, SB9, SB10, AB2011, AB2097, and AB2234, have streamlined building approval processes, opened up land zoned for single-family homes for small multi-family structures, and reduced barriers to multi-family construction in transit corridors. Early data indicates that these legislative changes are set to have a significant impact in the coming year, as multi-family building permits in the state increased by 1.8 percent over the twelve-month period ending in April 2023.
The combination of optimistic panelist sentiment and favorable policy changes is driving confidence in the multifamily real estate market. Despite rent softening, demand for multifamily housing remains robust, and developers are eager to seize the opportunities presented by market dynamics and legislative reforms.
