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11/13/23
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This report provided by real estate services firm NAI Capital Commercial
In the third quarter of 2023, commercial real estate sales in Los Angeles County experienced a significant year-to-date decline in sales volume, accompanied by an increase in cap rates. Notably, the spread between the U.S. 10-Year Treasury Yield and commercial real estate cap rates, historically averaging about 250 basis points, underscores the challenge facing buyers and sellers as commercial markets adapt to shifting market fundamentals. Despite historical averages, cap rates appear to adjust begrudgingly in line with this historical norm.
“In the commercial real estate market, there is a noticeable lag in sellers' perception of cap rates,” stated NAI Capital Commercial CEO Chris Jackson. “Many sellers continue to price their deals at 4.5-5% cap rates, while the market currently hovers at 6.5%. This discrepancy is expected to rectify itself by the first quarter of 2024.”
Following two interest rate hikes by the Federal Reserve earlier in the year, they temporarily paused their efforts to combat inflation. Notably, it marked the first instance in nearly two years when the Fed left its federal funds rate unchanged at consecutive meetings. This decision left the Fed's benchmark short-term rate at a 22-year high of 5.25% to 5.5%, after an aggressive campaign aimed at mitigating the most significant inflation surge in four decades, resulting in decreased sales volume of commercial real estate.
Besides the benchmark interest rate rising from near zero, the Covid-19 pandemic has forced commercial real estate to confront unique challenges specific to each property type. The implementation of Measure ULA, along with the newly imposed property transfer tax effective from April 1st, 2023, in the City of Los Angeles, significantly impacted the sales volume of apartment buildings and commercial properties. Measure ULA adds a 4% tax on sales/transfers of real property exceeding $5 million, and 5.5% on properties of $10 million or more, contributing to a 65% decline in sales volume for multifamily properties in Los Angeles County.
In the City of Los Angeles, though challenging, deals are still being successfully closed. “Every deal is unique, but a few elements include (a) owner/users still seeking to be in a specific location in the city, (b) sellers meeting the market with interest rates to get deals done, (c) deals trading below $5M and therefore not impacted by ‘Measure ULA’ mansion tax”, declared Senior Vice President Rose O'Sullivan.
The industrial market has displayed remarkable resilience; however, high prices and increasing interest rates have subdued sales of industrial buildings. With lower economic growth, companies are keen to shed excess space, while some are seeking more cost-effective alternatives. A slack demand for retail space has forced landlords to lower prices to close deals. Retailers are returning to brick-and-mortar operations after the pandemic shutdown, and investors are following suit, with sales volume registering 3.1% above the 2020 sales volume.
Executive Vice President Tina LaMonica notes, “In the current market conditions, convincing sellers to sell can be quite challenging, as many are holding onto their prices from a few years ago and are hesitant to let go unless they are forced to sell due to partnership or loan issues. Retail and office investment properties are particularly hard to finance, with lenders still preferring owner/users. There is a noticeable disconnect between sellers and buyers when it comes to pricing, leading buyers to put down more money to secure loans. Interest rates, especially for retail investment, have climbed significantly. Banks have adopted a conservative approach to lending.”
Tina added, “However, we are adapting to these market conditions by lowering prices, increasing down payments, and exploring seller financing options. Owner/user transactions remain active, and banks favor these deals, particularly when involving service professionals or medical practitioners, where SBA loans are still an active financing option.”
Concerns about the return to the office are shaping the slow recovery of Los Angeles County's office market. Landlords are offering concessions such as months of free rent, tenant improvement allowances, and rent reductions to attract tenants to their projects, but these measures are impacting the market value of office buildings. Consequently, office buildings have fallen out of favor and have experienced a decline in sales, reaching a new low in Q3 2023 at 36.6% below the 2020 sales volume.
Compared to last year, the average sale price per square foot for office, retail, multifamily, and industrial real estate has decreased. However, the industrial and multifamily sectors have demonstrated resilience by decelerating at a lower rate, positioning them as frontrunners in terms of growth rate and offering a preferred hedge against inflation.
Ongoing pressures, reflected in occupancy trends, such as easing supply chain issues for industrial, companies mandating employees' return to the office, the resurgence of brick-and-mortar retail, and government regulations on affordable housing in the multifamily sector, are compelling Los Angeles County's commercial real estate markets to adapt and impacting real estate values.
The labor market is expected to experience significant cooling as companies respond more to slowing demand caused by higher borrowing costs. According to the Labor Market Information Division of the California, unemployment in Los Angeles County increased to 5.8% in September 2023, up from 4.3% in September 2022. This data suggests to investors that the labor market could be easing, raising hopes that the Federal Reserve may be done hiking interest rates. However, the upward momentum in Treasury yields suggests that pricing pressure in commercial real estate markets will continue to challenge sellers and buyers.
Source: NAI Capital Commercial Research, Costar
This report was prepared by J.C. Casillas, Managing Director, Research, NAI Capital Commercial
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