SoCal Industrial Market’s Comeback Story

Southern California’s industrial real estate market has long been recognized as one of the most dominant in the United States, and for good reason. With an industrial base serving 25 million people, and supporting the spending habits of 50 million, the region’s economic engine drives demand for industrial space on an unprecedented scale. This consumer base, coupled with the market’s strategic location and the record-breaking cargo volumes flowing through the Ports of Los Angeles and Long Beach, offers unparalleled efficiencies and opportunities for investors.

According to the National Council of Real Estate Investment, Southern California has been the highest-performing industrial market during the past four decades. However, this distinction comes with a caveat: It’s also the highest beta market, meaning it experiences more volatility than others. The silver lining? This volatility may have positioned SoCal ahead of the curve, as it has already weathered storms that other markets have yet to face.

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Market dynamics

The region has already witnessed a significant drawdown, with land values down approximately 40 percent compared with 2021, due largely to softening fundamentals. This suggests a mean reversion is on the horizon. This downturn began with a capital markets slowdown in mid-2022, triggered by interest rate spikes, followed by softening leasing fundamentals less than a year later and a surge in new supply and economic challenges.

Southern California’s high sensitivity to macroeconomic factors has positioned it as a leading indicator for national trends. From 2021 to 2022, the region saw lease rates soar by nearly 300 percent, far outpacing other markets. This dramatic rise, followed by a sharp correction, showcases the market’s high beta nature, where it tends to experience both booms and busts more intensely and rapidly than other regions.

While this volatility presents higher risks, it also suggests Southern California may be further along in its reset process compared with other U.S. markets. This could potentially position the region for an earlier recovery, offering both challenges and opportunities for investors who understand its cyclical nature.

Investment opportunities

To capitalize on the market, investors should pay attention to several key factors.

First, construction starts across the Southern California industrial market are down significantly from their peak in Q3 2022, thus limiting new supply. The lack of new construction starts paired with ongoing legislative changes in California, such as the introduction of AB-98, are making industrial development increasingly challenging. Thus, entitled sites and existing product have become more valuable.

This trend is especially apparent in the Inland Empire, where finite existing bulk product (500,000 square feet or more), limited large-scale land availability and increased entitlement challenges for projects larger than 250,000 square feet are resulting in healthy demand in the size segment.

Amid development challenges, the market is also witnessing a flight to quality as investors are capitalizing on a window to acquire assets at a discount to replacement cost (factoring in today’s reset land values).

It is now possible to find core deals in Southern California that offer well above a 5.50 percent average cash-on-cash return, a compelling yield in the current market environment. This shift makes Southern California an appealing destination for investors seeking stable cash flow, particularly those with a longer-term perspective. As a result, many limited partners are shifting expectations for total return, moving from a model that was heavily weighted towards appreciation (around 90 percent at the market peak) to one that now emphasizes cash flow (approximately 70 percent) over appreciation (30 percent).

This trend has led to a noticeable increase in activity surrounding core and core-plus transactions. The industrial sector now accounts for 39 percent of U.S. core investors’ (ODCE fund) exposure across property sectors, which marks an 18-percentage point increase from the end of 2019. So, investors are gravitating toward properties with credit tenancy, longer lease terms and high-quality, functional real estate because these characteristics provide stability and predictable cash flows, which are particularly valued in times of economic uncertainty.

The persisting challenge, however, is the ongoing bid-ask gap as investors are struggling to find conviction behind lease rates as the market continues to soften in certain pockets and size segments. As rents revert to the mean across Southern California, we expect investors to become more aggressive in their underwriting, narrowing this gap and thus resulting in a significant uptick in transaction volume across the market.

Future outlook and long-term potential

Based on Green Street’s Commercial Property Return Index, which reflects total return (capital appreciation plus+ income), the highest five-year returns were achieved in investments with a 2009 to 2011 vintage, highlighting the early-mover advantage. However, this advantage is already beginning to diminish, and core acquisitions’ gap to today’s adjusted replacement cost is starting to close, making now the opportune time for investors to enter the market.

So, while the Southern California industrial market has faced challenges, its underlying strengths remain intact. The region’s early reset, combined with its strategic location, robust consumer base, limited new supply and attractive pricing relative to today’s replacement cost, create a compelling case for investment.

As the market moves through this cycle, those with the foresight to act now may find themselves well-rewarded in the years to come. The Southern California industrial market, true to its history, is demonstrating its resilience and potential for strong returns, especially for those with a long-term investment horizon.

Makenna Peter is director, JLL Capital Markets.

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