Supply Can’t Keep up With Surging Demand in San Francisco Bay Area Industrial Market

San Francisco industrial Bay Area Oakland JLL Prologis Northmarq Fundrise Briana Harney
Photo by Victor on Unsplash

Robust leasing activity and growing rents are fueling investment activity.

By Briana Harney

The San Francisco Bay Area industrial market continues to experience relentless demand as the e-commerce explosion fuels retailers and third-party logistics providers to fiercely compete for space. 

This includes highly coveted, last-mile, urban distribution centers for quick delivery of products and warehouses to stockpile goods to hedge against supply chain backups. Demand, however, far outweighs supply.

Furthering the space crunch is the competition for big warehouses by expanding life sciences and biotech companies looking for new R&D and lab space. This is creating new demand for industrial space in the Bay Area on a scale that has not been seen before.  

Harney

Why is the market so hot?

A major driver for the industrial boom is the region’s access to major ports and airports for distribution nationally and globally. The Port of Oakland in East Bay, for example, is one of the most active ports in the U.S. Additionally, the Bay Area offers access to major thoroughfares throughout California and the western states, including Highway 101 and Interstates 5 and 80.

Due to the dwindling pool of available options, companies are jockeying for existing space. Amazon, FedEx, UPS, Target, Walmart, and other e-commerce players as well as logistic providers are gobbling up warehouses and distribution facilities. To meet the growing demand for warehouse/distribution space in the red-hot East Bay, for example, that submarket needs 13 million square feet of additional inventory while only 5.7 million square feet is in the proposed pipeline, according to a report by JLL.

High barrier-to-entry market makes development difficult

The Bay Area is a high-barrier-to-entry region. The availability of land is very limited, particularly for large parcels that would be necessary to develop major industrial assets. That makes it challenging to develop new product.

There are also regulatory obstacles to develop new industrial properties. Further, steep land values and increasing construction costs hinder new development. These factors, among others, will keep the development pipeline quite limited going forward.

Pent-up demand means rates continue their swift ascent

Vacancy rates are below 1 percent in the South Bay and 3.7 percent in the East Bay Oakland industrial market. In San Francisco, vacancy is hovering around 4 percent. Tight market conditions produce increasing rents and tenants are willing to pay to maintain their Bay Area locations.

These robust fundamentals are catching the attention of investors. As demand for industrial soars, investors are hot on the trail spending millions on San Francisco-area properties. Buyers are attracted to the higher lease rates combined with cap rate compression. Those factors combined have created high asset values and strong fundamentals for investors, who believe that their properties will increase in value over time. 

San Francisco-based private REIT Prologis Inc. and private equity giant Blackstone are active in the Bay Area as are other private and public REITs, pension funds, private equity, and family offices. Some core investors are seeking stabilized assets that are leased and operating. Others are value-add investment firms focused more on transitional assets. There are also opportunistic or development firms seeking to build new industrial properties and parks.  

Getting creative due to space shortage

With a dwindling number of options, big players like Prologis are looking at multistory facilities in tight urban areas so their tenants can deliver products to consumers quickly. Additionally, there have been acquisitions of sites that were formerly other uses being converted to industrial uses.

Lending markets are highly liquid 

Lenders have historically been very active in industrial, and particularly, in the post-pandemic world, industrial is recognized as a safe and secure asset for both investors and lenders.

In 2020 and 2021, industrial assets composed a large part of many lenders’ portfolios, and that trend continues in 2022. The most active lenders for middle market and institutional product are life insurance companies and banks. Life companies are highly competitive on industrial assets and able to provide long-term, fixed-rate financing with attractive terms including early rate lock. In today’s volatile interest rate environment, early rate lock takes the interest rate risk off the table for the borrower for the 60 days that it can take to close a loan, as well as for the next five to 10 years, depending on the loan term. Additionally, life companies often can offer some interest-only periods, whether it is several years or full-term interest only, which can help with investor returns as well over the lifecycle of the loan.

Also, for value-add acquisitions and business strategies, debt funds are competitive in this space.

While capital is available for borrowers, rising interest rates are having an impact. Most forecasts call for an extended period of rising interest rates. Interestingly, oftentimes there is a cap rate adjustment that accompanies a rise in interest rates. In the Bay Area, however, that has not really played out yet. The Bay Area has still seen trades at very compressed cap rates in the industrial sector, in the low to mid 3 percent range.

Deals exemplify financing options and competitive market

Financing options for industrial assets are available and often customizable to meet investors’ business plans. Northmarq recently closed a 1,000,000 sq. ft., six-property industrial portfolio with properties in Arizona, Virginia, Georgia, and Maryland. Fundrise, the largest direct-to-investor real estate investment platform in the U.S., acquired the assets either all cash or with short-term debt, enabling the company to close quickly and aggregate the properties into a portfolio.

Northmarq worked with Fundrise to place $97.75 million in debt on the assets via a portfolio loan. One of Northmarq’s correspondent life insurance companies offered a competitive interest rate with early rate lock and compelling structure that allowed flexibility for Fundrise during the term of the loan. Financing the assets as a portfolio enabled both borrower and lender to spread risk across the assets. This deal structure is indicative of how investors throughout the country including the Bay Area can be competitive on acquisitions while still leveraging the debt markets to optimize returns.

In a Bay Area deal in February, Northmarq negotiated a $35 million refinance for a private owner of a seven-building, 337,585 sq. ft. industrial property in San Jose. The multi-tenant property is well located, just off Interstates 101 and 880, with easy access to the San Jose International Airport. The transaction was structured with a 10-year, interest-only term. Northmarq secured the permanent-fixed loan for the borrower through its relationship with a correspondent life insurance company.

Northmarq was able to quickly rate lock while the 10-year Treasury rate was attractively low. This transaction is indicative of how strong market conditions in the Bay Area attract competitive financing options from lenders.

What will drive financing for the remainder of 2022? 

For lenders, there is a flight to quality for both assets and sponsors. Lenders will be most competitive on well-located properties that are stabilized and have solid tenancy. Meanwhile, the sponsor’s track record and experience in the market are very meaningful to lenders, particularly during volatile times. Lenders will be more diligent in considering those two aspects of a given transaction before committing to lending.

Briana Harney is Vice President, Debt & Equity in Northmarq’s San Francisco office.

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