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Q3 INDUSTRIAL market report

Gallelli Real Estate 3005 Douglas Blvd #200 Roseville, CA 95661 P 916 784 2700 GallelliRE.com

2023 | GALLELLI REAL ESTATE

market overview

Q3 23

4.6%

±-149,000 SF

$0.84

Direct Vacancy Rate

Net Absorption

Average Asking Rate (NNN)

±4.6 MSF

4.5%

4.6%

3.8%

Under Construction

Sacramento Unemployment

California Unemployment

United States Unemployment

DESPITE UPTICK IN VACANCY MARKET REMAINS TIGHT As of the close of Q3 2023, total industrial vacancy in the Sacramento region stood at 4.6%. This includes all industrial product types and categories. The region’s current overall vacancy rate reflects a slight increase from last quarter’s revised rate of 4.3%, but a continued trend of vacancy creeping upwards off recently historic lows. A year ago, this metric stood at 4.1% and, as recently as Q1 2022, the market posted record low vacancy of 3.8%. Since then, vacancy has been climbing, though not always in a straight line. Despite continued strong demand both nationally and locally for modern distribution, as well as eCommerce fulfillment space, the reason this metric has been slowly climbing is due to a combination of factors. First, the Sacramento region has added 13.8 million square feet (MSF) of new, largely speculative, inventory since 2020. Against the total size of the market at the start of 2020, that level of development effectively increased the local industrial inventory by just under 10.0% (9.7%, to be precise). The other part of the equation has cooled from white hot to warm. For example, gross

absorption, or total deal activity, set a local record in Q2 2021 when just under 5.5 MSF of deals were transacted. But over the past three months, total deal activity amounted to just 1.5 MSF. While heightened economic concerns have played a role in this, the availability of quality, modern product in the region has remained a factor in constraining deal activity, though to a significantly less degree than it has in recent years. Still, this combination of factors translated into negative net absorption in the region to the tune of -149,000 square feet (SF). This is the first time since Q3 2020 that the market has not recorded occupancy growth, following a record setting 2021 when Sacramento experienced a whopping (and record setting) 7.7 MSF of positive net absorption. That performance was followed by a robust 2022 in which more than 2.9 MSF of positive net absorption was posted. Though Q3 2023’s totals are in the red, the market has recorded a total of 1.5 MSF yearto-date. This lines up just below the 1.7 MSF of annual growth that Sacramento averaged throughout the 2010s (2010 – 2019), assuming the market returns to growth in Q4. Of course, performance has not played out the same over different industrial product types. We break the market down into two basic building categories spread across 16 distinct submarkets throughout the greater Sacramento region: warehouse (which includes traditional distribution, cold storage, eCommerce fulfillment, manufacturing, and dead storage space), and flex space (which is typically hybrid industrial mixed with office or retail components). Let’s begin our analysis with the region’s smaller, and less active industrial product category, flex space.

FLEX UPDATE Flex space in the Sacramento region currently has a 7.8% vacancy rate. This metric increased in Q3 from last quarter’s 6.9% reading and is also elevated over the 6.5% rate posted one year ago. However, unlike the overall market and warehouse product, flex space in the region has not set any records as of late in terms of either vacancy or absorption. Since 2021 it has hovered in the 6.0% to 8.0% range. Flex space accounted for -169,000 of negative net absorption in Q3, which drove overall totals into the red. Seven of Sacramento’s 16 submarkets recorded negative net absorption this quarter, though the lion’s share of this came from multiple space givebacks from tenants in the Natomas/Northgate (-118,000 SF), Power Inn (-57,000 SF) and Roseville/Rocklin markets (-49,000 SF). Growth leaders this quarter were the Folsom/El Dorado Hills submarket (+35,000 SF), Davis/ Woodland (+23,000 SF) and Elk Grove/Laguna (+18,000 SF) trade areas, but with no other market recording more than 10,000 SF of positive net absorption, it was not enough to keep overall totals in the black. But this segment of the market accounts for just 18.9 MSF, or 10.8%, of Sacramento’s total industrial inventory. The current average asking rent for flex space is $0.97 PSF on a monthly triple net basis, exactly where it stood one year ago. The region’s largest growth spurt in this type of inventory occurred in the 1990s and early 2000s, but since then very little new flex product has been built. Locally, the last new flex building to come online was three years ago and the last time that more than 100,000 SF

of product was delivered was 2008. The focus of tenants, investors, and developers alike has been warehouse—particularly large cube distribution and eCommerce fulfillment warehouses. This is where the action has been, remains and will continue to do so.

WAREHOUSE UPDATE The region’s warehouse inventory accounts for 155.4 MSF of the region’s total inventory of 174.3 MSF (89.6%). As of the close of Q3, warehouse vacancy stood at 4.2%, up from last quarter’s 4.0% and an all-time low of 3.5% in Q1 2022. Occupancy for this product category grew in Q3, though only by 21,000 SF. However, the market posted just under 1.3 MSF of total gross absorption—the lowest amount of transactional volume posted since Q1 2020. Meanwhile, 428,000 SF of new speculative inventory came online. This combination of reduced deal flow and continued deliveries of new product is what drove vacancy up a couple of notches over the past three months. That said, nine of the region’s 16 submarkets recorded positive net absorption in Q3. However, space givebacks more than 30,000 SF took place in the McClellan, Northeast, Power Inn, and Sunrise/Highway 50 submarkets substantially mitigated occupancy gains exceeding 30,000 SF that took place in the Davis/Woodland, Natomas/Northgate, Roseville/ Rocklin, and West Sacramento trade areas. Despite the combination of new product coming to market as leasing is cooling, the current average asking rent for warehouse space in the Sacramento region is now $0.82 per square foot (PSF) and up 12.3% over where it stood ($0.77 PSF) one year ago. Sacramento has been

averaging double-digit rent growth for warehouse product since 2016, when the average asking rent was just $0.38 PSF. There are a couple of reasons why warehouse rents have skyrocketed. In 2016, there was only a limited supply of modern distribution space in the region—most of Sacramento’s warehouse inventory was 25 years old or older. The higher cost of building new, modern facilities was already a factor driving outsized rental rate growth before the recent wave of inflation created even greater upward pressure on prices. But, ultimately, it comes down to demand and even in light of recent trends, incredibly tight leasing conditions remain in the Sacramento warehouse market. In terms of equilibrium, while the market has crept slowly towards greater balance between supply and demand, the pendulum still swings in favor of landlords over tenants with just 4.6% vacancy. This is why the warehouse construction pipeline has continued to grow. Two new warehouse buildings totaling 428,000 SF of space came online in Q3 in the West Sacramento market. But there are an additional 26 projects currently under construction totaling 4.5 MSF in the development pipeline across the region with deliveries slated through early 2025. The Natomas/Northgate submarket (and home to one of the region’s current epicenters of growth, Buzz Oates’ Matro Air Park project) accounts for 3.3 MSF of this space. Projects within the Sunrise/Highway 50 corridor account for an additional 747,000 SF of space under development, while the Roseville/Rocklin, Mather, Elk Grove/Laguna, Davis/Woodland, and Auburn/Newcastle account for the rest. Looking ahead, this level of development, the majority of which is speculative, is likely to drive local vacancy rates upwards, it is critical to note that the current warehouse construction pipeline of 4.5 MSF

still equates to just 2.9% of the existing inventory. While we think it likely warehouse vacancy tops the 5.0% mark in the next six to nine months and that rent growth will likely start to flatten, this all depends on how quickly the market can absorb this space. Should the US economy be able to avoid recession ahead, we think that this space will move quickly—though not at the breakneck pace of 2021 or 2022 (when the market respectively averaged net absorption of 1.8 MSF and 717,000 SF per quarter).

LOOKING AHEAD Since April of last year, economists have been debating whether the Federal Reserve could engineer a “soft landing” in its attempts to curb inflation, or whether a recession was a given. In August 2022, 72% of the members of the National Association of Business Economists (NABE) anticipated a recession within the next six months. That pessimism has since reversed itself. In their recently conducted August 2023 survey, 69% of NABE economists said they see a “soft landing” on the horizon. So far, the economy has proven to be far more resilient than analyst expectations with both consumer spending and the labor markets defying forecasts and outperforming. This has certainly remained the case for the labor market;

Select Sacramento Region Industrial Leases Q3 2023 Address

Submarket

SF Footage

Tenant

3765 Channel Drive

West Sacramento

159,270

TK Classics

10050 Foothills Boulevard

Roseville/Rocklin

146,016

Keysight Technologies

8250-8292 Industrial Avenue

Roseville/Rocklin

132,570

Denman of California

141 Commerce Circle

NE Sacramento

52,100

Discovery Boat & RV Storage

8360 Belvedere Avenue

Power Inn

42,000

Emerald Textiles

5860 Alder Avenue

Power Inn

40,000

Electric Equipment Company

4119 S. Market Court

Natomas/Northgate

34,306

ENO Glass

4522 Parker Avenue

McClellan

20,000

Quincy Compressor

4530 Raley Boulevard

McClellan

11,530

Highlands Community Charter and Technical School

3134 James Way

McClellan

8,250

AmeriaCorps

industrial market report September’s job report reflected job creation of a whopping 336,000 new positions. However, the biggest drivers of growth were leisure and hospitality (+96,000), government (+73,000), and healthcare (+41,000). Employment growth for the categories that drive office employment were substantially below those levels with professional and business services (+21,000), financial services (+3,000), and information (-5,000) job growth reflecting an entirely different picture. Meanwhile, consumer spending has been coming back to earth. The most recent retail sales report from the Census Bureau reflected 2.5% annual growth in August. Despite the elevated inflationary pressures that have been in play since late 2021, this metric has remained positive since the early days of the pandemic (May 2020). But this metric has measured outsized gains in 2021 (averaging 19.0% y-o-y for each month) and 2022 (averaging 9.8% annual growth). But since March 2023 retail sales have fallen below the 5.0% growth rate.

As of Q3, with economic indicators remaining mixed, the US economy is in what could be best described as a “hold your breath moment,” where it will soon become apparent if the Fed has successfully engineered a “soft landing,” versus a bumpy one, or a crash landing. Economic readings regarding job creation, retail sales and inflation will have outsized importance over the next few months as the longer-term impacts of the Fed’s rate hike campaign increasingly become clear. However, most economic forecasters that see a recession as likely in the next six months believe it likely to be short and shallow. What is likely to be more challenging for the commercial real estate market is the continued possibility of future Fed rate hikes. August’s inflation report (the most recent data as this report went to press) reflected an uptick in from 3.4% to 3.5% annually. That number was thanks to elevated energy prices that were in place before the October Hamas attacks

JKG

Q3 23

on Israel, which have initially resulted in additional upward pressure on oil. Meanwhile, September’s incredibly robust jobs report is another factor that makes it more likely the Fed will raise interest rates yet again.

As for impacts on the industrial market? We expect that over the final quarter of the year net absorption will return to positive levels thanks to several major deals that are currently in the pipeline. Meanwhile, we are not currently aware of any significant (+30,000 SF) planned vacancies. But this will not stop us from seeing additional upticks in vacancies. Assuming multiple projects in the development pipeline can keep to their delivery schedules, we will likely see somewhere between 500,000 and 700,000 SF of new product being delivered, most of which is speculative. Both occupancy growth and vacancy to increase in Q4. That said, we are still likely looking at a vacancy rate in the low 5.0% range with rents holding firm. Assuming the economy escapes a recession, we anticipate demand levels to tick up heading into 2024. But, one does occur over the next six months and economist predictions of a brief and shallow downturn are correct, we are still likely to see demand ticking back up in recovery, which would likely be over the second half of 2024. Like every other commercial real estate property type, industrial investment activity has been deeply challenged by the Federal Reserve’s campaign of interest rate hikes over the past 18 months. This is particularly acute for industrial properties because of the aggressive rental rate growth of the past few years and the fact that cap rates had compressed for premium product to the 4.0% to 5.0% range. Investors searching for yield were already starting to look elsewhere before interest rates increased by 500+ basis points. The higher cost of money brings with it downward pressure on pricing; thus, we continue to see few owners wishing to part with their investments unless they have to and we continue to see a significant gap between asking prices and seller bids. We expect this situation to continue until we begin to see greater economic clarity over the next six months.

Net Absorption Submarket

Existing Vacant SF

Vacancy Direct (%)

2,717,011

Inventory

Total Quarterly

Last Four Quarters

SF Delivered

SF Under Construction

Avg. Asking Rate PSF

Avg Asking Rent PSF One Year Ago

Average Asking Rent % Change Annually 49.2%

Warehouse / Distribution Auburn/Newcastle

15,495

0.6%

7,262

66,258

37,440

$0.97

$0.65

Flex Warehouse

663,860

14,995

2.3%

7,762

4,573

$0.70

2,053,151

500

(500)

61,685

37,440

$1.05

$0.64

64.1%

Davis/Woodland

16,764,334

218,196

1.3%

90,736

32,735

107,612

$0.64

$0.56

14.3%

Flex Warehouse

844,034

47,004

5.6%

22,919

(13,381)

107,612

$1.78

$1.96

(9.2%)

15,920,300

171,192

1.1%

67,817

46,116

37,440

$0.59

$0.50

18.0%

Downtown

2,463,646

136,337

5.5%

(3,377)

23,745

$0.88

$0.83

6.0%

Flex Warehouse

455,995

3,007

0.7%

(3,007)

$1.30

2,007,651

133,330

6.6%

(370)

23,745

$0.85

$0.83

2.4%

East Sacramento

539,688

32,457

6.0%

13,200

$1.55

$2.00

(22.5%)

Flex Warehouse

55,619

10,457

18.8%

$2.00

484,069

22,000

4.5%

13,200

$1.20

6,425,859

Elk Grove/Laguna

37,033

0.6%

20,319

174,817

59,100

$1.08

$0.72

50.0%

Flex Warehouse

370,610

9,785

2.6%

18,402

6,110

$1.26

$1.07

17.8%

6,055,249

27,248

0.4%

1,917

168,707

59,100

$1.00

$0.68

47.1%

Folsom/El Dorado Hills

5,173,942

215,117

4.2%

36,464

(31,957)

$0.94

$1.04

(9.6%)

Flex Warehouse

2,062,661

164,090

8.0%

34,693

(12,937)

$0.84

$0.96

(12.5%)

3,111,281

51,027

1.6%

1,771

(19,020)

$1.17

$1.16

0.9%

Mather

5,342,293

315,735

5.9%

(25,913)

(41,038)

155,076

$0.88

$0.72

22.2%

Flex Warehouse

1,575,171

221,924

14.1%

(31,125)

(95,749)

$0.84

$0.98

(14.3%)

3,767,122

93,811

2.5%

5,212

54,711

155,076

$0.88

$0.61

44.3%

McClellan

17,456,322

901,505

5.2%

(216,077)

157,933

149,000

$0.98

$0.71

38.0%

Flex Warehouse

1,858,369

323,785

17.4%

8,088

53,943

$0.82

$0.80

2.5%

15,597,953

577,720

3.7%

(224,165)

103,990

$1.03

$0.68

51.5%

Northgate/Natomas

21,084,272

1,190,841

5.6%

14,714

995,567

3,279,725

$0.73

Flex Warehouse

2,073,084

175,257

8.5%

(117,546)

(103,226)

$0.83

$0.82

1.2%

19,011,188

1,015,584

5.3%

132,260

1,098,793

3,279,725

$0.71

Northeast Sacramento

6,084,625

310,986

5.1%

(27,161)

(19,012)

$0.84

Flex Warehouse

937,701

33,256

3.5%

6,687

24,348

5,146,924

277,730

5.4%

(33,848)

(43,360)

$0.83

$0.84

(1.2%)

Power Inn

26,725,469

682,751

2.6%

(192,839)

(232,186)

$0.91

Flex Warehouse

1,155,046

116,129

10.1%

(56,737)

(73,232)

$1.12

$1.08

3.7%

25,570,423

566,622

2.2%

(136,102)

(158,954)

$0.90

Richards

3,994,542

198,785

5.0%

(13,127)

49,909

$0.68

$0.59

15.3%

Flex Warehouse

200,227

14,007

3,794,315

198,785

5.2%

(13,127)

35,902

$0.68

$0.59

15.3%

Roseville/Rocklin

19,085,922

360,494

1.9%

66,859

391,938

30,000

$0.86

$0.80

7.5%

Flex Warehouse

3,224,034

92,370

2.9%

(48,943)

(70,415)

$1.22

$1.06

15.1%

15,861,888

268,124

1.7%

115,802

462,353

30,000

$0.73

$0.67

9.0%

South Sacramento

4,370,194

1,030,525

23.6%

19,426

(83,624)

$0.87

$0.89

(2.2%)

Flex Warehouse

157,238

15,226

9.7%

(6,091)

6,948

$0.83

4,212,956

1,015,299

24.1%

25,517

(90,572)

$0.89

Sunrise

12,054,877

454,852

3.8%

(48,994)

223,980

13,500

747,346

$0.87

$0.55

58.2%

Flex Warehouse

1,904,611

220,607

11.6%

(8,345)

17,522

$0.88

$0.83

6.0%

10,150,266

234,245

2.3%

(40,649)

206,458

747,346

$0.86

$0.54

59.3%

West Sacramento

23,981,919

1,928,275

8.0%

123,023

310,446

414,741

$0.82

$0.69

18.8%

Flex Warehouse

1,387,116

28,342

2.0%

4,005

(1,374)

$1.10

$0.89

23.6%

22,594,803

1,899,933

8.4%

119,018

311,820

414,741

$0.79

$0.68

16.2%

Totals

174,264,915

8,029,384

4.6%

(148,685)

2,032,711

428,241

4,565,299

$0.84

$0.77

9.1%

Flex

18,925,376

1,476,234

7.8%

(169,238)

(242,863)

107,612

$0.97

Warehouse

155,339,539

6,553,150

4.2%

20,553

2,275,574

428,241

4,457,687

$0.82

$0.73

12.3%

SPECIALTY SUBSETS: Cold Storage/Food Process

4,660,249

875,577

18.8%

155,076

$1.00

Warehouse

15,129,923

283,880

1.9%

(88,687)

113,774

998,000

$0.76

$0.74

2.7%

JKG

GALLELLI BROKER TEAMS INVESTMENT Gary Gallelli

CEO - Partner gary@gallellire.com

Pat Ronan

Vice President pat@gallellire.com

Aman Bains

Associate Vice President abains@gallellire.com

Adam Rainey

Associate Vice President arainey@gallellire.com

RETAIL Kevin Soares

Bob Berndt

Matt Goldstein

Kurt Conley

Robb Osborne

Brandon Sessions

Executive Vice President | Partner ksoares@gallellire.com

Vice President mgoldstein@gallellire.com

Executive Vice President | Partner bberndt@gallellire.com

Jeff Hagan

Senior Vice President | Partner jhagan@gallellire.com

Senior Associate kconley@gallellire.com

OFFICE Partner rosborne@gallellire.com

Senior Vice President bsessions@gallellire.com

CAPITAL MARKETS RESEARCH Kristopher Krise Capital Markets Advisor kkrise@gallellire.com

JKG Gallelli Real Estate 3005 Douglas Blvd #200 Roseville, CA 95661 P 916 784 2700 GallelliRE.com

Garrick Brown VP, Real Estate Intelligence & Business Development

gbrown@gallellire.com

Kannon Kuhn

Associate kkuhn@gallellire.com

Phillip Kyle

Senior Vice President pkyle@gallellire.com