By Jack Stubbs
Heading into third quarter 2019, the Sacramento region’s office and industrial markets are off to a strong start, with the current market cycle characterized by low vacancy rates—which in turn are leading to higher construction costs and a constrained marketplace, according to a recent report. Increasing interest from local- and out-of-town investors and companies looking to plant their flag in the city of Sacramento and the surrounding area is precipitating a myriad of different impacts across the commercial, residential and industrial real estate sectors.
On May 9th, Cushman & Wakefield released an office/industrial market report showing several metrics, like rising absorption rates and lower vacancy rates, in relation to past cycles. While they bode well for the Sacramento area, rising construction costs and a general lack of available inventory hint at challenges ahead for the expanding region.
“As it relates to the office, and this is certainly consistent for industrial as well, we are experiencing record-level low vacancy in our marketplace. In normal markets, this would be offset by a relative amount of speculative and built-to-suit construction,” said Ron Thomas, executive director in Cushman & Wakefield’s Sacramento office. “But in California, Sacramento here and across the country, construction costs are such that it is very expensive to build—so we’re seeing developers sitting on the sidelines [and waiting] to build new office on a spec-basis.”
The office market kicked off the year with a strong 171,000 square feet of net absorption, with vacancy falling to 8.6 percent (down from 9.7 percent in first quarter 2018 and 9.2 percent in fourth quarter 2018), which marked the first time for office vacancy to fall below 9 percent, according to Cushman & Wakefield’s report. Meanwhile, the industrial sector added nearly a quarter of a million square feet of occupancy growth. Overall vacancy rates hit yet another new record low of 4.4 percent (down from 4.9 percent in first quarter 2018), which marked the thirteenth consecutive quarter setting a new record-low vacancy rate in the Sacramento area’s industrial market.
For both office and industrial products, the Sacramento area market is characterized by strong market fundamentals, helped along with more private entities coming into the local marketplace: since first quarter of 2016, net absorption has exceeded 100,000 square feet in nine of the last twelve quarters, according to Cushman & Wakefield’s report, while vacancy has fallen 300 basis points, and asking lease rates have risen 12.9 percent during that same time.
On the industrial side, there were 987,000 square feet under construction (across all asset classes), according to Cushman & Wakefield’s first quarter 2019 Sacramento Industrial Market Overview, which was up from the figure of 935,000 square feet under construction as of fourth quarter 2018. Over that same time period, average asking rents rose from $0.48 to $0.68.
Similarly to the Sacramento’s office market, the industrial market has over the last few cycles experienced a period of expansion, according to Matt Cologna, senior director in Cushman & Wakefield’s Sacramento office. “Things are very similar with industrial. Looking at the real estate cycle and all the different product types, if you looked at multifamily two or three years ago, it had some of the highest rental increases in the country here in Sacramento and was kind of the darling-child and investment in Sacramento,” he said. “The next product class that stepped into that place arguably was industrial, which is the new asset class that everyone wants to be a part of.”
However, one of the results of the increasing demand for industrial product—and limited available inventory—is that new tenants looking to come into Sacramento have fewer options, either to enter into or expand within the market in 2019, according to Cologna. “We’ve got approximately 1 million feet [of industrial product] under construction right now, which is all speculative. On the books this year, between breaking group and completions, we should see somewhere around 1.5 to 2 million square feet…some of that’s getting absorbed, which takes a little longer here in Sacramento,” he said. “This year, we’ve almost hit that equilibrium where rents have gone up enough to justify new construction. But virtually all new construction is larger, because you can’t afford to build the smaller projects and get the ROI that you need on them.”
In spite of the relative lack of available inventory in relation to cycles past, one of the broader trends occurring in Sacramento’s industrial marketplace is a greater diversity of users entering the market, a shift somewhat indicative of larger national patterns, according to Cologna. “Given some of the other trends that are happening nationally, we’re seeing a lot more e-commerce; [companies] need a place to distribute all those e-commerce goods from. Whereas it used to be all logistics, a lot of it now has to do with labor force availability and construction-related services,” he added.
On the office side, much of the demand for office space continues to be driven by co-working companies like WeWork, according to Thomas. “From an industry standpoint, there’s quite a bit of activity from co-working users, in particular WeWork planting a flag,” he said. “There are also several other [users] that, while not quite as prominent as WeWork, are circling the market for co-working space.”
Some of the prominent statements of intent made by companies in the area include medical device Penumbra’s 160,000 square foot lease—signed in October 2018—in Sacramento’s Roseville submarket, and WeWork’s recent 47,000 square foot lease at the 400 Capitol Mall property in Sacramento’s central business district adjacent to the revitalized Downtown Commons shopping complex.
Similarly to the Sacramento area’s industrial market, where a wider variety of users are coming in to capitalize on the region’s strong market fundamentals, the office market in Sacramento—and as some of the recent leases indicate—is sustained in large part by a diversification of different sectors like healthcare, education technology and the life-sciences coming to the fore in Sacramento.
“Historically, we were much more of a government-driven town, a sector that doesn’t typically lead to peaks and valleys; but our economy is much more diverse now, especially on the private sector side,” said Thomas. “Healthcare continues to drive some of the growth in our marketplace. We’re also seeing some life-science and agricultural food-sciences, some of which is led by UC Davis’s food-sciences program,” Thomas added. As one example, Kaiser Permanente in late January 2019 announced that it had purchased an approximately 18-acre parcel located at The Railyards in downtown Sacramento. The company plans to build a new medical center there, which will be the third location that it has established in downtown Sacramento since 2016.
And with interest for both office and industrial space coming from a broader user base than in cycles past, it’s perhaps little surprise that transaction activity throughout the Sacramento region is as robust as ever. After record-setting sales volume in 2018 of approximately $1.4 billion annually, office sales activity was strong in first quarter 2019 with $187 million in activity, a more than 17 percent quarter-over-quarter increase, according to Cushman & Wakefield’s report.
In late February 2019, New York City-based Morgan Stanley Real Estate has acquired the 287,539 square foot Parkway Corporate Plaza medical office building in Roseville for $79 million, or roughly $275 per square foot, from Anchor Health Properties. At the time of the sale, the portfolio was 100 percent leased to a number of companies including Kaiser, Sutter Health, Wells Fargo and UC Davis, according to The Registry’s reporting.
In early May 2019, Cleveland-based Boyd Watterson Asset Management acquired a 399,636 square foot office building located at 1515 S. Street in downtown Sacramento for around $115 million from an entity comprised of Hines, Oaktree and JMA Ventures. Also in early May, JLL Bay Area Capital markets experts began the process of marketing for sale 1130 K Street, a 140,908 square foot historic office building in the heart of downtown Sacramento’s K Street Corridor.
Looking ahead, the hope is that the renaissance and momentum seen in the office and industrial markets—in terms of interest from tenants and public- and private investors—will contribute to a rising-tide effect across the board in Sacramento, one which hopefully bodes well for the city and region’s ability to grow effectively in the longer-term. “That lack of diversification in the job-force has impeded our ability to grow long-term; now there’s a breath of fresh air in terms of new companies coming in and broadening the employment base,” Thomas said. According to Cushman & Wakefield’s report, the overall unemployment rate in Sacramento’s MSA was 3.6 percent in first quarter 2019 (down from the four percent reported in fourth quarter 2018), and it is projected to drop further over the next twelve months.
Thomas estimated that there are around 800 multifamily units under construction in the Sacramento CBD and another 3,000 that are proposed, with around 300 single-family condos either under construction or proposed. “We’re seeing a lot of housing being delivered into our urban core, which is going to continue to fuel the engine so that people can live, work and play in our urban core, much like any other city that has gone through this renaissance and rebirth—and we’re right in that right now,” Thomas added.
In the longer term, much will likely depend on ongoing regional issues like the streamlining of transportation networks and ongoing infrastructure projects that serve to connect Sacramento with the Bay Area to the southwest—whose residents might look more closely at Sacramento as an alternative as pressure begins to mount, thinks Cologna. “We see some spillover from the Bay Area, which is very constrained. In previous cycles, [companies] would spill into Sacramento and then just recede back to the Bay Area. Now, because our market has diversified, we’re seeing more of that happen as a result of serving the local and regional population rather than being a step-child of the Bay Area,” he said.