Market Reports_Q2 2023 Industrial

CONSTRUCTION PIPELINE CATCHING UP TO SPACE CONSTRICTED MARKET

As of the close of Q2 2023, total industrial vacancy in the Sacramento region stood at 4.4%. This includes all industrial product types and categories. The region’s current vacancy rate reflects a slight decrease from last quarter’s revised rate of 4.6%--though it remains slightly elevated from the 4.1% rate posted 12 months ago.

The market recorded a total of 817,000 square feet (SF) of positive net absorption in Q2 2023. This brings year-to-date net absorption to just over 1.5 million square feet (MSF). Based on deals we are aware of in the pipeline, it is likely that the market will close 2023 with more than 3.0 million square feet of occupancy growth. Last year, Sacramento recorded a total of 2.9 MSF of positive net absorption. Incidentally, all the occupancy gains that have been recorded so far this year have been from traditional industrial warehousing and distribution space.

Even though industrial demand remains robust and deal activity brisk (though not at the breakneck pace of 2021 or early 2022), the market will likely end the year with higher vacancy levels than today simply because the amount of new product

Sacramento Industrial Market All Classes of Product Q2 2023

Sacramento Industrial Market: Supply/Demand/Vacancy

that is currently in the construction pipeline and that will be delivered over the final half of 2023 will almost certainly outpace net absorption. Just under 1.5 MSF of space has been delivered to the market over the first half of 2023. There is an additional 2.9 MSF of space under construction currently. Most of that will be completed before the end of this year.

Coming off record low levels of vacancy in which deal activity was hampered by a scarcity of available properties, this is not necessarily a bad thing. Local vacancy had dropped to a record low of 3.8% by Q1 2021 (for industrial/warehouse space it was even lower at 3.5%), as the pandemic vastly accelerated already strong demand for warehouse, distribution, eCommerce fulfillment and cold storage space. There is no doubt that the region lost some economic growth opportunities because the market was so space constricted. Many users that would have come to Sacramento ended up completing deals in neighboring markets like Stockton/Modesto, Solano County or Reno, Nevada. Meanwhile, local rent growth—which was already occurring at levels that were unsustainable in the long-run—accelerated further.

The current average asking rent for industrial space (all types) in the Sacramento region is $0.83 per square foot (PSF). This metric has grown by 12.2% over the past year, or more than three times the nation’s current inflation rate.

The Sacramento market consists of just under 174 MSF of product. We break the market out as two basic categories: warehouse or flex. Both of those categories include multiple subcategories. Roughly 154.5 MSF of space, or 89% of the total local inventory, is warehouse product—which includes the subcategories of distribution, eCommerce fulfillment, warehouse, cold storage, heavy manufacturing, etc. Meanwhile, flex pace accounts for roughly 19.0 MSF, or 11%, of the region’s inventory. Industrial demand and activity remain overwhelmingly focused on warehouse, distribution and eCommerce fulfillment product, both locally and nationally. Before we delve into those numbers, let’s start with a brief review of some of the region’s less active industrial product types.

FLEX PRODUCT

Flex inventory encompasses a relatively wide array of industrial uses; this category includes light distribution and manufacturing space, showrooms, telecom hotel/data hosting and R&D/Lab buildings. The largest concentrations of flex space locally are in the Roseville/Rocklin (3.2 MSF), Natomas/Northgate (2.1 MSF), Folsom/ El Eldorado Hills (2.1 MSF) and McClellan (1.9 MSF) submarkets. Deal activity was sluggish in Q2—we tracked just 277,000 SF in total transactions that translated into a modest occupancy decline.

Sacramento Industrial Market All Product Types Q2 2023

Sacramento Industrial Market: Median Price PSF/Average Cap Rate

The region’s flex market recorded negative net absorption of -18,000 SF in Q2. This is the second consecutive quarter in which flex occupancy has declined. In Q1, 73,000 SF of space was returned to the market. Year-to-date net absorption now stands at -91,000 SF. Overall vacancy for flex product currently stands at 7.0%, compared to 6.9% three months ago.

There are no flex projects currently under construction in the region.

Since 2015, the Sacramento region’s industrial sector has recorded 27.8 MSF of net absorption—flex space has accounted for just under 2.0 MSF, or 7.2%, of that. Yet, this product type has benefited immensely from the pricing surge that has occurred since that time. The current average asking rent for local flex space is $1.00 per square foot (PSF), on a monthly triple net basis. While this has only increased by 1% over the past year—it has increased substantially since 2015—as have all local industrial property types even though demand has overwhelmingly been focused on warehousing, distribution and eCommerce fulfillment.

The region’s rising tide of industrial warehouse and distribution demand has lifted all industrial boats.

INDUSTRIAL/WAREHOUSE PRODUCT

The Sacramento region’s warehouse 154.5 MSF inventory accounts for 89% of the area’s total product base but has driven nearly 95% of deal activity and 100% of development activity for the better part of the last decade. The warehouse category includes all the subcategories that would be thought of as traditional, heavier industrial product from warehousing to distribution centers, eCommerce fulfillment, manufacturing, cold storage and food processing.

The current vacancy rate for local warehouse product is just 4.0%. This is down slightly from last quarter’s 4.3% reading. Vacancy for this product type has not been above the 5.0% mark locally since the end of 2020. The market was already experiencing strong growth trends at the time (over the previous five years the vacancy rate had been halved from above the 10.0% mark). The pandemic accelerated that demand—over the past 30 months, Sacramento has absorbed 11.8 MSF of space and by Q1 2022 had posted a record low vacancy rate of just 3.5%.

The region’s construction pipeline has been ramping up since 2020, but with warehouse vacancy at just 4.0%, the market has a long way to go before approaching anything close to equilibrium between supply and demand.

The warehouse sector recorded a total of 835,000 square feet (SF) of positive net absorption this quarter, year-to-date net absorption now stands at 1.6 MSF. Not surprisingly, over 75% of the space that has been absorbed in 2023 has been in new construction within nine months of its delivery. Vacancy levels below the 5% range typically translate as few quality options for tenants. While the market has not been immune to the economic headwinds of the past year, there has been little impact yet in terms of vacancy, absorption or rent metrics. Most of what we have seen is tenant negotiations taking a little longer and leaseup times on new product being extended slightly.

These conditions obviously could change, and most economists believe that the chances of the economy slipping into recession over the final half of 2023 are substantial. However, most also believe it would be a brief and shallow downturn. We suspect that what’s just as likely as macro-economic issues to shape Sacramento’s industrial landscape over the final half of the year is the region’s robust construction pipeline.

Select Top Leases Sacramento Market 2023 YTD

Sacramento Industrial Rent Growth by Product Type

Only 366,000 SF of new warehouse product came online in Q2. However, this follows nearly 1.1 MSF delivered in Q1 and comes in advance of a major wave of new development that will be coming online over the final half of 2023. There is roughly 2.9 MSF of new space currently under construction locally, of which 2.7 MSF is scheduled for delivery before the end of this year. Assuming no delays, this will mean that we will close 2023 with roughly 4.3 MSF of new industrial product. While this would not set any new records—it would come very close. Sacramento added 4.0 MSF of industrial space in 2020. It followed in 2021 with an additional 4.1 MSF. The postwar record for new industrial deliveries in Sacramento was 4.5 MSF in 1999.

While current development levels may not set any new records, they will come on the recent heels of a slew of local warehouse records. The market recorded its lowest vacancy rate ever in Q1 2022. It posted its highest occupancy growth ever at 7.4 MSF in 2021. It has set records for rental rate growth as well; the current average asking rate of $0.78 per square foot (PSF) is up 13.0% from the $0.69 rate of a year ago. Keep this in mind; the average asking rent for warehouse space in Q2 2015 was $0.36 PSF.

Though nearly all the demand and focus (not just locally, but nationally) has been on warehousing, distribution and eCommerce space for most of the last decade, in Sacramento we have seen rents skyrocket for all industrial asset classes.

In eight years, rents have effectively doubled. These are astounding numbers. But they are completely unsustainable numbers. The question for the Sacramento market over the final half of the year will be if the combination of strong new development and economic headwinds will finally bring the region’s rent growth back to more modest, but sustainable levels.