26 minute read

Sacramento CRE Outlook

from 2023 Gallelli Forecast Report

from 2023 Gallelli Forecast Report, page 19

HOUSING WHIPLASH CONT.

Office Market Overview

Digital disruption has come to the office market in much the same way it came to the retail market starting in the early 2000s with the ascendancy of eCommerce. For office landlords, the disruptor is workfrom-home (WFH), remote or hybrid work models that emerged out of necessity during the lockdown days of the pandemic. To be clear, it is estimated that 15% of workers already worked from home offices prior to lockdowns. Remote work is nothing new to most regional sales representatives, for example. But, at the peak of lockdowns, it is estimated that between 75% and 85% of the office-using workforce in the US was working from home. The reason we mention retail as having gone through significant digital disruption is to point a few things out. In the early 2000s it was not uncommon to hear “futurist” types prognosticate on how there would be no more shopping malls in 20 years. Of course, while there would be immense pain in that sector, the mall still exists. In fact, while there are about 400 fewer malls in the US today than there were in 2002, most merely have been redeveloped into other shopping center types or mixed-use development. Retail real estate faced great challenges before, and during, the pandemic but “apocalypse” storylines in the media turned out to be overblown. Likewise, earlier in the pandemic, there were some futurists that predicted a permanent decline in as much as 40% of office usage. That, too, will be proven to be an overblown take for multiple reasons.

All Classes of Product,

2022

The reality is that many employees thrive with WFH or hybrid work models. But just as many do not. The challenges are more profound for younger workers who have not yet built experience or expertise in their chosen fields. Remote work means they miss out on the training and mentoring that comes with being in office with coworkers. Perhaps most importantly, they lose much of the critical social interaction with others that is most important to those that have not started their own families yet. Meanwhile, some employees simply struggle with the discipline required to be productive in this model.

All Classes of Product, Q4 2022

The challenge of managing and training employees from afar is a serious one—particularly for larger organizations. And even with new tracking tools that can monitor employee productivity from afar, managers often find themselves struggling with the new hybrid reality when it comes to issues of trust, sometimes with good reason. At the end of the day, we see greater normalization occurring simply because of the gravity of human psychology.

We absolutely believe that remote and hybrid work models are here to stay, but that the ongoing trend of normalization will continue to occur as CoVid slowly fades into the rear-view mirror. Organizations will increasingly revert closer to the historic mean in terms of the number of workers in-office, though with far more freedom accorded to trusted, seasoned, and experienced employees with a proven track record of productivity. If roughly 15% of employees had a hybrid relationship with office work prior to the pandemic, we think it a safe assumption that the new norm may settle out in the 25% range.

Comparisons of the digital disruption now impacting the office market vs. those that impacted retail have one great big difference: leverage. Retail is about catering to the desires of the consumer— the shopper holds all the cards. But while conscientious employers certainly know that part of the formula for success means a happy and productive workforce, the leverage for most industries remains with management, with few exceptions. At the end of the day, it is a lot easier for employers to demand employees to work on-premises than it would be for malls to demand consumers to shop on-premises. None of this means that we will be rolling the clock back to 2019.

Of course, how much space a user can consolidate will depend on their individual hybrid models, the size of their current footprint and, critically, their industry. For example, three days in office per week seems to be the formula favored by most employers offering hybrid work currently. While replacing individual cubicles and private offices with more flexible hoteling workstations and expanded meeting room space can certainly create efficiencies, these can vary significantly. All told, we think it a safe assumption that the space needs of a user in 2019 will likely shrink an average of 10% to 20% going forward as part of the new hybrid reality. Those space givebacks obviously started in 2020, but still have a way to go, especially as leases inked prior to the pandemic come up for renewal. Whether we have a recession or not in the coming year, we will continue to see space givebacks likely over the next few years. A recession is bound to result in higher levels of negative occupancy growth simply because more space users will be looking to tighten their belts. There will certainly see some businesses that see the opportunity to ramp up remote work simply to save rent costs. However, greater fear of layoffs among workers could very likely drive a greater return to the office, especially within sectors facing the greatest potential cuts. the lowest tallies came from the two largest tech-focused markets in the United States, San Francisco (35.8%) and San Jose (31.0%). The number of workers returning to their offices in those cities has simply not budged in over 18 months. A shortage of skilled tech workers has meant these workers have had the leverage to demand WFH or hybrid models. However, with tech sector experiencing a significant reset following its pandemic boom, some of that leverage is bound to evaporate as layoffs mount. “Out of sight, out of mind, out of a job,” may become a painful reality for some remote workers.

As of the close of Q4 2022, the total size of the Sacramento office market was 68.0 MSF and vacancy in the region stood at 14.9%. This reflects an increase from the 14.5% rate posted three months ago and the 13.9% level recorded one year ago. The market recorded 257,000 square feet (SF) of negative net absorption in Q4. All told, 785,000 SF of previously occupied space came back to market over the course of 2022 (roughly 1.2% of the market’s total inventory).This past quarter also reflects the ninth consecutive quarter of negative occupancy growth in the region; vacancy had been on a downward trend until Q1 2020 when it fell as low as 10.8%. That was, of course, the quarter in which the pandemic arrived. Since that time, just over two million square feet of space has been returned to the market. As daunting as those statistics may sound, we saw nearly twice that amount of space vacated in the aftermath of the Great Financial Crisis.

While the impact of WFH, remote and hybrid models will continue to be a major disruptor for the nation’s office sector, Sacramento will be spared the worst impact that are likely to be felt in neighboring Bay Area markets. For example, prior to the CoVid crisis, office vacancy in San Francisco had fallen to just 4%, it now stands at roughly 26% and analysts there fear it could approach the 40% level by the end of 2023 due to numerous large tech leases that may not be renewed in the coming year.

There are multiple reasons for Sacramento’s comparative strength; nearly one third of the region’s office space is occupied by governmental entities—which largely have not shifted their real estate strategies (a few smaller build-to-suit projects for the State of California were delivered and occupied in 2022, helping to reduce overall negative net absorption numbers by roughly 156,000 SF). While the region is home to multiple corporate campuses and corporate headquarters users, the bread and butter of the Sacramento office market is the smaller professional business tenant. In general, these users have both less space to consolidate and have been less likely to move to hybrid or WFH models. The largest space givebacks nationally have been from large block corporate users—particularly in the tech sector. While Sacramento is home to Intel and other tech players, the local presence here is dominated by small space startups.

According to Kastle Systems’ Back to Work Barometer Index, keycard and building security data indicate that the percentage of workers in office had reached a pandemic era high in January 2023 of just under 50%. While some Texas markets posted numbers as high as 65%,

Look for office vacancy in the Sacramento region to climb over the coming year, but for the local landlords and investors to experience far less pain than their counterparts in other major US markets. Submarkets with exposure to large block users are likely to experience the greatest challenges, though the likelihood of a recession—even if it proves to be brief and minor—is going to be another factor impacting demand. That said, flat rent growth in 2023 may be the best that landlords can hope for. It is highly likely that some submarkets may see rates dropping. Expect a growing trend of flight to quality ahead; active space users will increasingly see the opportunity to upgrade space (though many of these will be footprint consolidations) in the current rent environment.

The impact of remote work on office space demand remains both a question mark and a dark cloud hanging over the investment market. Add into the mix greater economic uncertainty in 2022 and increasingly challenged commercial real estate lending and you have a recipe for what turned out to be the slowest year for deal volume since 2014. The good news for local owners is that the Sacramento region will fare better than most markets because of its high concentration of smaller, professional firms that are less likely to give back large blocks of space in 2023. But we do anticipate an uptick in vacancy.

The region’s medical office space will be immune to the remote work givebacks simply because of the in-person nature of the services they offer. In fact, one of the more significant transactions of 2022 was the sale of the four building, 245,000 SF Blue Shield of California campus in El Dorado Hills to ProEquity Asset Management for a reported $49.3 million, or $201 per square foot.

We anticipate that Class A projects will face their fair share of space givebacks, but they will be better able to backfill those spaces. Tenant flight to quality is likely to accelerate in 2023 with space givebacks—many will trade up as they are shrinking office footprints. The greatest challenges are likely to be faced by large Class B projects. But here Sacramento has another factor going for it that will benefit Class B owners—the heavy presence of government users that have always been active locally in this type of space.

While the region’s office investment market will experience challenges in 2023, we also expect opportunities to arise as uncertainty regarding remote work impact and the economy start to lift. While we expect a lot more clarity regarding the economy by the second half of the year, it will likely be at least another year before the dust settles regarding hybrid office use impacts.

Industrial Market Overview

As of the close of Q4 2022, the total size of the Sacramento industrial market was 161.4 MSF, of which just 5.8 MSF (4.0%) was vacant. While this reflects a slight uptick from the 3.8% mark of three months ago and a more substantial increase over the 3.5% reading of Q4 2021, it still reflects an incredibly tight marketplace.

The market posted 567,000 square feet (SF) of occupancy growth in Q4, bringing annual positive net absorption totals to 2.5 million square feet (MSF). While still a robust figure, this falls slightly below the nearly 3.1 MSF of occupancy growth that Sacramento has averaged annually for the last decade. It also reflects a considerable drop in demand from the region’s all-time growth record of last year. Over 7.5 MSF of occupancy

Sacramento Office Market All Classes of Product, Q4 2022

growth was recorded over the course of 2021. That remarkable level of tenant activity translated into the region’s lowest vacancy rate on record by Q1 2022, when the metric for total industrial vacancy (all product types) fell to just 3.4%.

The recent climb in vacancy, despite continued strong growth, reflects two trends, the impact of rising development levels and a slight cooling of demand. Roughly 956,000 SF of new industrial product was delivered to market in Q4 2022, outpacing occupancy growth by just over 40%. All told, nearly 3.4 MSF of new warehouse and distribution space was delivered in 2022, against 2.5 MSF of occupancy growth—hence, the uptick in vacancy levels. Meanwhile, sublease availability in the Sacramento region has doubled in the past year from roughly 623,000 SF to over 1.2 MSF of space. Keep in mind, against the total market inventory of more than 161 MSF of space, this is a very modest increase. But it does reflect a slight cooling in demand levels. slow national tenant demand in 2023, though an increased availability in product locally could see activity levels in the coming year above the inventory-constrained realities of 2022.

Look for demand for eCommerce logistics space to continue to move further away from the mega million SF warehouse regional model to the 250,000 SF to 400,000 SF (or below) local delivery model. Additionally, cold storage space continues to be in short supply and high demand in the Sacramento region. We anticipate that warehouse and logistics space will continue to be the focal point of local demand in 2023. Flex product, which currently boasts a 6.2% vacancy rate and accounts for roughly 19 MSF of inventory in the region, accounted for just 56,000 SF of positive net absorption in 2022 and simply hasn’t been a strong driver of demand. The same holds true for manufacturing space, which experienced negative occupancy growth in 2022 to the tune of -141,000 SSF but only 15 MSF of local product.

Ultimately, we see all of these as signs that the market is cooling from what been unsustainably, white hot growth levels to merely hot.

Much attention has been paid to Amazon’s recent downshift in activity. The eCommerce behemoth has pulled back from dealmaking significantly (and not just for industrial—they have also done so for their retail concepts, primarily Amazon Fresh). In January 2023, they also issued the first layoffs in their history. We see this as merely part of the ongoing reset for tech and eCommerce from unsustainable pandemic highs to the new emerging norms of the post-CoVid era. It was bound to happen. Actual numbers are hard to define because Amazon enforces strict confidentiality on their real estate deals and does not comment publicly on strategy. However, during their pandemic industrial dealmaking surge, it is estimated that they singlehandedly bought, leased, or purchased land to develop somewhere between 120 MSF and 130 MSF of industrial product— essentially within 30-month time frame. That is roughly the same size as the Sacramento region’s entire warehouse/distribution inventory. Those levels of astonishing growth, fueled by Amazon’s drive to build same day delivery capabilities throughout the continental US, were bound to eventually come back to earth.

While any increase in vacancy is bound to cause concern for landlords and developers, but keep in mind that one of the reasons why occupancy growth in 2022 fell below the region’s ten-year average was the lack of available quality product. Of the roughly 161 MSF of industrial space in the region, 127 MSF (or nearly 80% of the entire marketplace) is warehouse/distribution space (this includes cold storage as well as modern eCommerce logistics product). This is, and will remain, the sector driving activity throughout North America. Both the pandemic era surge in demand and an already tight marketplace have conspired over the past three years to drive some metrics that are simply unsustainable in the long run. Warehouse/distribution vacancy currently stands at 3.8%. This is up from a record low of just 3.2% for this industrial product type in Q1 2022, but still reflects an incredibly tight marketplace where tenants have few, if any, options. This lack of product hasn’t just negatively impacted deal levels, it has set in rent growth levels that cannot be sustained forever.

The average asking rent for industrial space in the Sacramento region currently stands at $0.77 per square foot (PSF) on a monthly triple

However, it would be a mistake to assume that we won’t continue to see significant demand from other eCommerce players, distribution, warehousing, and logistics concerns. But the potential of an economic downturn, as well as Amazon’s pause in the marketplace, are sure to

INDUSTRIAL MARKET OVERVIEW CONT.

net basis. Even with slightly lower deal activity levels, increased deliveries, rising vacancy and looming economic concerns hanging over the market in 2022, this metric is up a full 10.0% from where it stood a year ago. Incidentally, the year before (2021) saw asking rents spike by 16.7%. Over the past five years, the overall industrial asking rate has increased by a whopping 57.1% from $0.49 PSF to the current average of $0.77 PSF.

Against these metrics, that developers have aggressively moved to build new, speculative industrial product (almost exclusively modern warehouse/distribution/logistics space), with over 12.4 MSF of new inventory added in the past five years. As of the end of 2022, there was another 2.5 MSF of new construction in the pipeline, slated for 2023 deliveries—much of which is being delivered on a speculative basis. There are additional projects we anticipate will go forward shortly in 2023, however, we also anticipate the development levels of the pandemic era, and its accompanying surge are going to slow slightly in 2023 simply because of the impact of inflation on construction costs that has become a greater challenge for developers and merchant

Industrial Investment Outlook

While the region’s industrial market is likely best positioned to weather the challenges of 2023, the investment market is likely to slow. Pricing was already showing signs of softening in late 2022 with cap rates creeping up slightly from what had record lows. One of the challenges we are seeing across all product types is a widening spread between bid and ask. Until there is greater economic clarity we will continue to see this connect—which has varied by property type but typically the gap is between 10% and 15%. We anticipate that due to industrial’s extremely robust leasing fundamentals that many sellers simply are not going to lower pricing unless forced to by market conditions. This won’t change the fact that there will be some value erosion due to higher interest rates— it may not impact industrial as much as other property types, but it will occur. That said, we see owner-users that need properties as continuing to be active in the Sacramento region in 2023 but anticipate some cooling on the institutional investor side. If industrial leasing is going from white hot to hot, industrial sales are likely to go from mildly hot to warm. However, of all asset classes locally, industrial will be in the best position to recover lost value in the next upswing of the economic cycle because its underlying fundamentals are rock solid.

builders. The price of construction materials had skyrocketed as high as 60% (year-over-year) as of May 2022, though this rate of inflation has thankfully come back to earth since that time. According to the FRB, year-over-year inflation for building materials had fallen back to 20% to 30% range (depending on the materials, i.e., wood, concrete, steel, etc.) as of December 2022 and are expected to moderate further downward along with overall inflation levels. Yet, even with Sacramento’s outsized industrial rent growth of the past few years, this spike has made it harder for new projects to pencil. Assuming the Fed can successfully bring inflation back to the 3% range by the end of 2023, this may provide developers with some relief. However, that remains a big “if.”

While we expect vacancy levels to tick up further, we also expect continued rent growth—though it is unlikely to match the same aggressive pace of the past few years. Even if the market may be in the earlier stages of transformation to a new post-pandemic reality, we are a long way from market equilibrium between supply and demand. The pendulum still favors landlords and will continue to do so for quite some time.

Sacramento Industrial Market All Product Types, Q4 2022

Retail Market Overview

Retail has always had to adapt faster than other property types, simply because the consumer space is always evolving, and it is doing so at a faster pace than ever. Digital disruption from eCommerce is what was driving the sector’s pre-pandemic issues and the often overblown “retail apocalypse” stories in the media. Then, CoVid-19 arrived in 2020 and it seemed briefly as if the sector was now actually in a real apocalypse. Yet, the crisis ended up demonstrating that retail may be the most resilient of all commercial real estate types.

That resiliency is best demonstrated by the wild swing in retail demand that has occurred since 2020. The sector set records in terms of bankruptcies and closures in the wake of the pandemic. COVID-19 accelerated the demise of dozens of chains that had already been struggling. Other chains accelerated right-sizing plans, expanded already planned strategic closures, or withdrew from the marketplace completely.

have gone toward services, travel, and entertainment elsewhere (those sectors would not see a rebound in spending until the arrival of vaccines).

The impact of an unprecedented $6 trillion in stimulus would only further fuel what would become a retail sales holiday. By March 2021, growth was in the double digits, averaging 22.6 percent over the next 14 months. Sales numbers only began to falter in May 2022 as the impact of inflation started to take a bite out of consumer spending.

The stimulus also led to a surge in asset prices from homes to equities; 2021’s booming stock market led to a round of retail initial public offerings (IPOs), with multiple newly public retail concepts announcing robust growth plans. Business investment surged, as did new business formation. All these factors would spur retailers to their most aggressive growth levels in the better part of a decade.

This includes dollar stores and discounters, which have driven retail growth tallies for the better part of the last decade. But the automotive, convenience stores, cosmetics, fitness clubs/gyms, grocery, hobby stores, home furnishings, off-price apparel, pet concepts, shoe stores (athletic), and sporting goods categories have all accelerated expansion plans.

Meanwhile, the categories hit hardest were those that had been e-commerce-resistant bright spots of the retail landscape prior to the pandemic. Service retail from restaurants to fitness clubs and from experiential to entertainment concepts faced the greatest challenges. Though quick service restaurants (QSRs) with drive-throughs fared far better than their dine-in counterparts, more than 110,000 restaurants failed in the first six months of the pandemic alone. This sector would not see overall sales rebound until March 2021 as vaccines became widely available. For an industry dominated by small business (including franchisees) and already operating on narrow margins, COVID was an unprecedented disaster.

Though a combination of government aid (PPP loans), operator grit, and landlord largesse kept the damage from being far worse, it is critical to remember that the pandemic disproportionately hammered small businesses across all retail sectors. For many large national credit chains, this would become an opportunity to aggressively grow market share heading deeper into 2021.

This was only further fueled by outsized spending. Monthly retail sales had averaged 2.9 percent annual growth in the 20 years preceding the pandemic. This metric turned negative for the first three months of lockdown. But consumers quickly reallocated dollars that would

Grocery remains white-hot, with growth bolstered by aggressive expansion plans from newer market entrants like Aldi, Lidl, and until recently, Amazon Fresh (they paused store openings in late 2022 and had not resumed activity by the time this report went to press). Offprice apparel has returned to robust growth, with players like Kohl’s and Burlington experimenting with smaller-format stores to facilitate expansion into new markets. Fueled by QSRs and new fast casual concepts, major chains nationally were poised to add as many as 7,000 stores through 2024. Dominant players like Starbucks, Chipotle, Chick-fil-A, McDonald’s, and Dunkin have all ramped up growth and intensified competition.

Select Retail Leases 2022 - Sacramento Metro Market

Of course, not all retail sectors are in growth mode. Theaters remain deeply challenged and we anticipate consolidation ahead. Retail banking continues to deal with digital disruption, driving less need for overall branches and smaller footprints. Drugstore chains are reducing store counts, though online pharmacy has yet to emerge as a major disruptor. Department stores, particularly outside of the luxury sphere, still largely need to downsize and evolve their models to remain relevant. Store closures in 2022 account for the lowest numbers in a decade, while occupancy growth nationally was the highest it has been since 2006.

this regard for three consecutive years and is on track to do it again in 2022. Nationally, less than 30 million square feet of new retail space came online in 2021, with the market on track to deliver roughly 20 million square feet in 2022. With roughly 11.87 billion square feet of total retail space in the United States, this reflects an increase in inventory of 0.25 percent. This metric has not surpassed the 0.60 percent level in 15 years. Nearly all new development has been in strong population growth areas in the form of retail’s strongest-performing asset class, grocery-anchored centers.

The real question is whether retail’s rebound can hold heading into 2023, in either a no or mild recession scenario.

Retail Investment Outlook

The other significant factor aiding the recovery of the retail sector has been historically low development levels. The sector has set records in Retail property sales volume in the Sacramento region ticked up significantly in 2022. According to Costar, there was more than $1.6 billion in deal activity last year. The average sales volume over the previous three years had been roughly $1.0 billion.

Grocery-anchored assets and net lease retail (particularly fast-food properties with drive-throughs, assuming long-term leases are in place to gold standard, national credit tenants) opportunities have dominated the retail investment landscape for most of the past decade. The greatest challenge has been finding quality available properties in a marketplace where everyone is chasing the same thing. Do not expect this to change in 2023, though higher interest rates and greater challenges in lending will have an impact on activity. However, with greater uncertainty around office product and years of investors having picked over the industrial and multifamily landscape (and driving significant cap rate compression), retail may increasingly be an acquisition target for institutional investors that had shied away from it in recent years. Retail asset pricing will simply offer better returns on quality product than will industrial or multifamily.

There may also be increased demand in 2023 from buyers looking for opportunistic plays that may arise from changes in the debt markets, across all property types. While plenty of challenged assets remain across the wide spectrum of retail property types and geographies, the real question for these buyers is whether tighter debt markets will depress prices on high-quality assets. While stand-alone, occupied retail product and community/neighborhood centers remain good opportunities, we could potentially see an uptick in demand for lifestyle centers due to their high viability but still generally depressed valuations.

Meanwhile, the trend of mixed-use redevelopment and densification playing out in the mall arena is likely to expand to other property types. Nationally, there are multiple players actively looking for class B properties in class A locations where there is an opportunity to repurpose lifestyle, power, even grocery-anchored centers to mixeduse live/work/play projects. This trend could potentially play out in Sacramento in 2023.

Select Retail Sales 2022 - Sacramento Metro Market

Sacramento was one of the markets that benefited from pandemic migration trends. The Sacramento region has always acted as a pressure valve market for the Bay Area—when housing costs soar there, in-migration of residents occurs in Sacramento.

In the decade prior to the housing crash that began in 2006 (1996 to 2006), the Sacramento region averaged 16,194 new single-family residences (SFRs) per year. From 2007 through 2019, it averaged just 5,561 new units per year. This level of under-development has historically been a key factor behind the region’s strong multifamily rent growth. There simply has not been enough housing in the area SFR or multifamily.

SFR development, however, began to significantly ramp up by late 2020 as in-migration from the Bay Area ticked up and then home prices began to climb. In 2020, developers added 10,953 new SFRs locally. In 2021, there were 12,075 single-family permits issued, the most in the region since 2005. But those development levels have come back to earth as the one-two punch of construction cost inflation and higher interest rates, slowed the trend. There were 10,591 permits issued in 2022—but 65% of them were issued in the first six months of the year. SFR developers are pulling back significantly.

Apartment vacancy in the Sacramento market posted its sixth consecutive quarterly increase during the final three months of 2022, closing the year at 6.7%. Our data only tracks competitive multifamily projects with a minimum of 25 units and does not include smaller complexes or fourplexes, nor does it include senior, student, or Section 8 housing.

as those restrictions were lifted. So, while vacancy numbers have increased, this at least reflects an improved situation for landlords that were not earning income on many of these units but whose hands were tied in respect to finding new tenants.

Vacancy is up from the 5.8% rate of three months ago as well as from a year ago when it stood at 4.2%. Over the course of 2022, the market added over 2,200 new units from construction deliveries while simultaneously seeing unit occupancy fall by approximately 760 units. However, not all of this news is bad news for landlords. One reason for the vacancy creep has been loosening pandemic era restrictions that precluded many owners from carrying out evictions for non-payment of rent. For example, in the City of Sacramento, tenants were spared eviction if they could pay 25% of their rents due by the close of Q3 2021. However, evictions of those tenants were prohibited until April 1, 2022. Not surprisingly, unit occupancy growth turned negative

Even while vacancy numbers climbed in 2022, the reality is that Sacramento’s population growth has increased since the arrival of the pandemic. The Sacramento region has acted as a housing pressure valve for its pricier neighbors by the Bay for the better part of the last 40 years. This in-migration has come in multiple significant waves; in the early 1990s as the initial tech boom ramped up, in the early 2000s as the second tech boom arrived and, most recently, with the arrival of the pandemic. For example, it is estimated by the Census Bureau that in the year 2020 the City of San Francisco lost approximately 140,000 residents, or nearly 19% of its population. Only a small percentage of these movers left the state. Most of the movement was temporary—it is estimated that roughly half of these residents had returned by mid2022. Many were first-time homebuyers (primarily Millennials) that drove a suburban housing boom and national spike in single-family residential (SFR) pricing. Others were renters that took advantage of remote work capabilities to leave town. Many landed in Sacramento where average asking rent per units typically are near 50% below those of San Francisco, the Peninsula and San Jose.

The in-migration trend is demonstrated clearly by occupancy trends in 2020 (the Sacramento apartment market absorbed over 2,500 units) and 2021 (positive net absorption of just under 1,800 units). Incidentally, new deliveries in both of those years were below 2022 levels. Developers added just over 1,300 new units in 2020 and another 1,800 the following year. Incidentally, that construction pipeline remains strong going forward. As of the end of 2022, there were over 4,400 units in development throughout the region with delivery timetables slated through early 2024. This is the highest number of units under development that we have tracked in 20 years. But it is important to remember that in the wake of the housing collapse and the Great Financial Crisis, very little new product came to market. Less than 1,600 new apartment units were delivered in the region between 2008 and 2014. This shortage of product resulted in Sacramento taking its place as one of the top US markets for multifamily rent growth multiple times over the last decade. That rent growth, obviously, has also fueled the aggressive return of new development. That said, the current rate of new development accounts for less than 3% of the existing inventory. Years of underbuilding and the recent surge in in-migration since the pandemic mean this level of development isn’t just sustainable but it is simply not enough to return the marketplace to equilibrium. by the Federal Reserve, the ability to make the jump from renter to firsttime homeowner will remain significantly strained. The issue of affordability for first-time buyers is not likely to improve for a minimum of a couple of years. This means many renters are going to be remain renters, which should bolster multifamily occupancy growth totals.

The current average asking rent per unit throughout the region is $1,832. This reflects an increase of just 1.1% from the $1,813 per unit reading of one year ago. But it is still up 18.7% from where it stood prior to the pandemic. Over the past decade, this metric has climbed a whopping 70.9%.

We anticipate increasing vacancy in 2023, but with strong net absorption as well. Ultimately, we see continue strong underlying leasing fundamentals for multifamily product. However, the potential for recession ahead remains a significant risk. The consensus among most economists is that if one occurs in 2023, it will likely be mild and brief, barring any unforeseen or “black swan” events. However, after the record rent growth of most of the past decade, a real question remains as to how much further Sacramento landlords can push rents. The ability for owners of Class C projects to push rents will be limited by the fact this asset class will be most exposed to tenants that simply may be priced out. Class A projects will continue to face a ceiling of where SFR rental units are priced. Class B projects likely have the most room for upside, but not without risk of lower occupancy rates if moves are too aggressive. Regardless, we expect modest rent growth ahead if for no other reason that new product built at elevated construction prices will set a new premium Class A rent and move the goalposts.

So with supply (new deliveries) outpacing demand (net absorption) in 2022 and multifamily rent growth slowing after years of recordsetting trending, where does this leave us for 2023? Development levels are going to remain elevated at least through the remainder of this year. However, due to the lifting of eviction moratoriums, we don’t think 2022’s net absorption tallies are a good indicator of what will happen in the coming year. In anything, this was the market finally clearing its books of a challenging issue—especially for mom-and-pop landlords or smaller property investors.

With interest rates on the typical 30-year home loan now effectively double where they stood one year ago, SFR activity has plummeted, though high population growth and lower cost of living markets have been spared the worst impacts. According to a January 2023 report from the technology-powered residential brokerage RedFin, 24.6% of the service’s users were looking to relocate to lower cost of living markets in Q4 2022. Their top relocation markets were Sacramento, Las Vegas, Tampa and Phoenix. Assuming this plays out, it will mean continued in-migration will have a mitigating impact on local price declines, even if much of the SFR deal activity will be driven by buyers relocating to the region. That is positive news for current owners and their existing equity. It’s bad news for renters—it means there won’t be a major reset in SFR pricing here and that with interest rates likely to be raised again

The real challenge ahead may be on the investment side. Demand for multifamily and industrial product has driven investment activity for the past five years. Cap rate compression has left little room for yield and a lack of available quality properties means that would-be sellers have little to trade into. Though we see underlying leasing fundamentals as remaining strong, we also see a disconnect between buyer and seller pricing that will likely continue for the short-term.