California Commercial Real Estate Trends with Erik Hernandez #444

Bruce Norris is joined this week by Erik Hernandez. Erik is the senior vice president and principal with Lee and Associates. During his career he has worked individually and with a team of brokers within Lee & Associates where the team achieved regional and national recognition within Lee & Associates and real estate community for team success.  He has been involved in over $1 billion worth of commercial real estate transactions during his career.  He specialized in industrial real estate as well. They talk about California commercial real estate trends.

Bruce Norris is joined this week by Erik Hernandez. Erik is the senior vice president and principal with Lee and Associates. During his career he has worked individually and with a team of brokers within Lee & Associates where the team achieved regional and national recognition within Lee & Associates and real estate community for team success. He has been involved in over $1 billion worth of commercial real estate transactions during his career. He specialized in industrial real estate as well.

Bruce said his world is normally residential, so Erik is their sole contact for the commercial world. The last time they talked it was still in the tank, which is not true anymore. The pace of recovery in the real estate world caught a lot of people off guard. A lot of people were waiting on the sidelines expecting a repeat of the 90s, and this did not happen. This was amazing because the downturn they had in 2006 and beyond was way worse than the 90s, so you would have thought the recovery would have been much more delayed and more gradual. However, in the niche in which Erik is an expert, industrial, this has not been true. Erik said there were very few properties that actually went back to the bank, and the properties that did were typically B and C properties. The number of true A class properties that went back to the bank were very few, especially in the market in the Inland Empire.

There were a handful of For Sales. The market was helping people to generate positive investment sales and very solid buyer-interest in the properties based on the price points. Typically those were deals that had been funded by insurance companies or they were unable to roll over their financing. They were still able to find active buyers with all cash or pension funds looking to deploy cash and looking for yield, especially in a stock market that has been beat down hard. One of the big fears was the resets. You looked at the charts of all these millions of dollars of resets that were coming, and you thought this was really going to hit the fan. We are at the peak of these resets and have been for the last 2-3 years, and it does not seem like a big deal.

With the timing of the resets, it is hard to imagine it working out any better if you were an owner of real estate. Sheila Bair was the chairperson of the FDIC, and she was the one who said very early on that their mission was to try to prevent the wholesale liquidation of real estate that happened in the 90s. There was a very different margin that happened in the 90s. Bruce was the buyer of properties constantly at auctions at less than 50% of the current value. The way they were marketed at the time, they were able to buy properties for 50% or less off of that day’s value. That did not happen this time.

In Bruce’s market there were a lot of homes that went all the way back. On the commercial side, the wholesale liquidation of commercial real estate that happened in the 90s did not happen this time around. You can go back and look at some of the signals and guide posts; and the further we go forward you can look back at what Shelia Bair said and see how the mission she said would happen did happen. On the other side of that, you need the demand. The way they did it in residential real estate coincided with all-time low interest rates. Bruce asked if the decision not to foreclose on people who had not made a payment in three years was replicated in the commercial world or solved by demand. Erik said it was both. There were borrowers who were able to get a blended extent.

There was an old quote saying that instead of mark-to-market, it was mark-to-fantasy. Everybody thought things would get much worse, and quite the opposite happened. It turned out there was a tremendous amount of cash that had been built up and was sitting on the sidelines. A lot of these people have to deploy cash, especially the teacher retirement fund. They have now become very active in the real estate world in the last 10-15 years. Their acquisitions people would come in and say they wanted to buy assets at specific values, and people would look around the room and say ok. They next quarter they would come back and see what they had for them. Eventually they would have to get back with their people and get asked why they haven’t bought anything. They were told to hit specific guidelines and deals.

Everybody was looking for 8% cap rates, and they realized everybody wanted to buy the deals but no one was willing to sell at those prices since the sellers who were holding onto assets wanted to buy more assets. They yield expectations had been driven down. Once they had gotten to a point where the yield expectations were low enough and prices were higher, you started to find willing sellers. With a cap rate that is low enough, you also have construction that is possible. This has not happened in the residential world in Riverside County, especially south Riverside County since you still have the big boxed houses that were built by the ton were going for below replacement cost.

It is very interesting that the commercial world seemed to have solved itself much quicker than he would have ever imagined. He does not know if this was true in all product types since commercial real estate covers a wide area. Industrial real estate happens to be the niche on which the Inland Empire has done an extreme comeback. Bruce asked if this holds true on other product types, such as office. Erik said the people he talked to on the retail and office side all talked about the big price appreciation and rental spikes they are seeing as well as how difficult it is to find quality space, especially on the office side. Office and retail are really the last two sectors to come back.

If you had to rank them in terms of when they came back, the multifamily was really the first to bounce back since financing was readily available. They also knew they would have the occupant call the former house owner. They had plenty of tenants, and the apartments saw some nice rental growth, even during the downturn. When there’s demand, you turn hundreds of thousands of people from homeowner to wandering where to go. This was a natural transition and a good time for people to have rentals.

The Inland Empire is not only one of the best markets in Southern California from a logistics standpoint, but also one of the top markets in the entire country. Bruce is not in this world except through reading the reports, and one of the reports had the Inland Empire number one in the entire country. This shocked him, and he did not understand this. Bruce wondered how an A, B, C classification comes about for industrial real estate and what drove the demand for it, especially with the unemployment. Bruce wondered why it improved so much and what the difference between A, B, and C is in the industrial world. Erik said the big difference is buildings with over 100,000 square feet.

A class A building would be a 30-foot minimum clear height inside the warehouse and would have a ESFR sprinkler system and a truck port deep enough to accommodate the loading and unloading of trailers and an additional area to park 53-foot trailers. Typically that truck port would be anywhere from 180 to 195 feet depending the configuration of land, especially with the amount of containers that come in from overseas. A lot of these logistics companies have a need to not only be able to park the trailers they are loading and unloading, but also have significant additional trailer parking to keep the containers on site until they are ready to be moved.

In the Inland Empire, B buildings would typically be 24-26 foot clear and a shorter truck port. They would also not have the additional truck road. They would also have an older sprinkler system, .60 or below. For some commodities, a sprinkler system of that calibration is fine, but for others it is not. You ask the question of why the Inland Empire was one of the first to bounce back. Erik said we have been a sub-market of the LA basin for many years. Before he was practicing real estate, one of his mentors would tell him that people were afraid to come out here to buy land and build since they did not call it the Inland Empire, but the endless empire. There was vacant land as far as the eye could see, and some people thought the City of Industry would be the eye of the hurricane, which has leap frogged.

One of the things that also drove this recent wave of expansion was the tremendous improvement and advancement in technology and warehouse automation. For a company in LA, for example, with 3-4 facilities and a couple hundred square feet or more, to take advantage of the latest technology and warehouse automation. A lot of buildings in LA or Orange County are older, so for them to even consider a 500-700 square foot building, there were not many choices in LA and they had to look at different buildings in order to get the benefit of that technology and automation. In order for them to do that, they had to come out here.

This idea scares Bruce, but it is the field of dreams. This market out here is very optimistic that if you build it they will come. It is a little bit of a future’s market and has been for many years. Bruce asked who the occupant is and what they do. Erik said it has been a lot of companies; for example, Amazon has made a huge impact out here as well as the children of Amazon and a lot of the e-commerce companies. QVC made a recent agreement to make 1 million plus square foot facility at Vineyard and the ten freeway on the north side of the Ontario airport. This is a major announcement that got approved at the city level. A lot of these types of companies continued to follow this, and a lot who did deals out here were expansions of existing companies.

Georgia Pacific recently announced they had leased a 1.6 million square foot facility in two buidings in Rancho Cucamonga. This is an expansion for them since they have been in the market for quite some time. A lot of these existing companies that have been out here have been organic growth, while some is consolidation from other places across the country. It makes sense to have more of the product on the West Coast.

Bruce asked what the journey has been for land prices in industrial land. Bruce asked where it peaked, what the bottom was, and where it is now. Erik said we are approaching the peak for the land prices that were seen at the end of the last cycle. The 2-3 best examples were sold in Ontario as well as one bought in Chino. Depending on how you calculated net, those prices were $21-$23.50 a foot. He had heard of a couple deals that are approaching these prices, so it is almost all the way back. Bruce wondered if the retail price is close to this as well. Erik said on the rental side we are there and it feels like there is still room to go as far as the rental rate in terms of what landlords can charge for rent. The big recovery out here for several years was in big buildings, and that rental growth has translated all the way down to the multi-tenant incubator, 5,000 square foot user. They were really the last to go to their landlord for renewal and find that rents had popped 20-40% since the last time they leased a building.

Since he does not deal with this product, Bruce thinks industrial is that small space, like a 2-5,000 square foot space where there is a pile next to each other. Erik is now saying a big bulk of this is huge spaces for these big companies. It is definitely several different segments of the market, and the bulk industrial product is very different from the median-sized business that may occupy buildings from 10-50,000 square feet. These would often be regional or headquarter type facilities, maybe the only location those businesses could have. Often they could be partnerships or family businesses that have a specialty or service in which they are involved. The prices of that real estate has really taken off in the last couple years. Now we are at the point where several clients are looking for real estate and will bid on a building that will have three offers on it. It can be frustrating when you think you have a deal but do not have one until you are in escrow.

Bruce asked what the cost is to construct and the value of it when it is done. Erik said he would get in hot water when talking about the cost of construction since there are so many variables. He likes to back into it so one can take the value of the land and plug into it. You can then take the value of construction. A lot of clients will think they can buy land and build a building themselves to save money. The difference with this is you could buy land at today’s prices at about $1 million per acre and look at all the different conditions. Erik likes to see why people are building buildings, and typically those people will try to sell at the highest price. There are three contractors out here people typically call to have a good gauge on the pricing. If you talk to those three, you can get a good sense of it. The construction cost of a 10,000 square foot building is different than the cost to build a 100,000 square foot building. Prices could be meaningless since it depends on what size the building is.

Bruce asked if most of the buildings are built on spec or a known user. Erik said most are built on a spec, and sometimes people say to build with a build-to-suit. However, if you really look at the definition of a build-a-suit, it would be to build a building when you already have a tenant or occupant ready to take it. Often what happens is the building breaks ground. A tenant will come along saying they like the building and ask if they could add more doors or office space after they have broken ground. If they have broken ground they already have their construction loan, so the clock is ticking. This is not really build-a-suit, but rather a spec pre-lease. If he had to guess, he would say 98% of the deals are spec. You can count on or two hands the number of deals that are true build-a-suit.

At this point they feel like the outcome is certain. There are some users, like Target, who like to buy land and build their own buildings. They built a high-tech facility in North Rialto where they have a specialized automation system that takes advantage of the height. It is a fascinating thing when talking about automation, or robotics. Bruce has friends who work with this, like 3d printers and robotics, technology he did not even know existed. One of the things Bruce was told regarding unoccupied vehicles is that the first will be the big commercial trucks. It will be interesting to see how they work when unloading.

Erik toured a large grocery company’s warehouse in LA last summer, and the bulk of warehouse was completely automated. In that type of operation, they are not just using boxes at a time but big pallets of goods.

Tune in next week as Bruce continues his discussion on this topic on next week’s radio show. For more information, you can contact Erik at (909) 373-2934.

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