Regulatory Forecast for California Industrial Real Estate Market: Unsettled

Economic forecasting is much easier than permit and regulatory forecasting, and nowhere more so than when it comes to industrial development and the local, state and federal agencies that control growth, particularly in California.

Due in large part to the educational efforts of the industrial development community, many cities and counties now understand that logistics facilities have positive economic and fiscal benefits for both municipal coffers and the local economy in terms of job creation. Additionally, air pollution impacts have been drastically reduced due to implementation of California Air Resources Board and regional air quality management district regulations. Nonetheless, even if developers successfully complete California's rigorous entitlement processing, they still face several additional challenges. The major hurdle is dealing with what kindly can be called "opportunistic" California Environmental Quality Act (CEQA) challenges. Virtually every logistics project now is being challenged by various groups, which use CEQA as a weapon to realize economic or other benefits rather than improvements in the environment. Also, for those projects that require clearances or approvals from federal or state agencies, these agencies do not have the same balanced perspective or incentives of local officials, which can stymy or delay projects significantly. These factors are somewhat pumping the brakes on the white-hot industrial real estate market, particularly in Southern California.

Backdrop

In its First Quarter 2019 report, the NAIOP Industrial Space Demand Forecast predicts that net industrial space demand nationwide will remain steady in 2019, at approximately 57 million square feet per quarter. This is unchanged from the average actual 2018 quarterly absorption of 57 million square feet.

According to NAIOP, the risk of a downturn in the industrial market is slim, with the nationwide vacancy rate at 7%, a historical low. The report states that gross and net asking rents are at all-time highs.

Many of these industrial properties, particularly in Western and Sunbelt states, are logistics and distribution centers. In Southern California, where logistics centers process the bulk of the goods imported from Asia through the ports of Los Angeles and Long Beach, the vacancy rate hover around 3%. Industrial rents are trending consistently upward, depending on the type of facility.

As more consumers shop online for goods, and specifically perishables like groceries, the need for “last mile” centers near major metropolitan areas will increase. Last year, online sales of goods in the U.S. were $504.6 billion. That figure is projected to exceed $735 billion in 2023.

The industrial market will continue, then, to be tied heavily to U.S. consumer spending. NAIOP predicts that overall U.S. economic activity will remain steady, with annualized rates of GDP growth in the mid 2% range. The labor market and overall consumer confidence is also expected to grow. Finally, and perhaps most importantly, NAIOP predicts that industrial space is the asset class in the best position to weather a recession or other macroeconomic downturn. This is primarily due to a historic shift to online shopping and the resulting shift from brick and mortar retail to logistics facilities.

Market Potential and Constraints

According to the Allen Matkins/UCLA Anderson Forecast, there is an estimated 15 million square feet of new industrial space under construction in the Inland Empire. Projects are getting larger and more complex, including several buildings exceeding one million square feet. Experts expect no problems with absorption.

Rather, it’s the lack of adjacent industrial parcels and the regulatory and permitting process that is slowing growth in the sector. Older industrial properties from the 1970s and 1980s are often not sufficient for the needs of modern, robotic-driven logistics and distribution centers, which require higher ceilings and fewer or no columns, for example.

Here are the top regulatory issues for Western states.

WOTUS Confusion and Delay

In late December, the federal EPA published its revised definition of “waters of the United States” (WOTUS). The Trump administration is seeking to significantly limit the scope of regulated waters, which was expanded during the Obama administration. If a piece of property is determined to touch wetlands subject to federal jurisdiction under WOTUS, it is then subject to permitting by the Army Corps of Engineers. The new EPA proposal specifically exempts ephemeral waters (i.e., creeks or drainages that have water in them only after rain storms), which significantly impacts Western states in particular.

Even if federal loosening of its WOTUS regulations occurs, California already has reacted, by announcing the formulations of new California regulations that will fill any void created by new federal rules.

CEQA Litigation

CEQA litigation, filed by environmental groups and others, such as profit-driven litigation groups masquerading as environmental groups, continues. The mere filing of a lawsuit can make it virtually impossible to get funding for a project, or secure a buyer or a tenant of a project subject to such litigation. With CEQA litigation showing no signs of abating, the art of managing potential litigation comes down to creative settlements that control costs without significantly impacting the development.

CEQA and Level of Service (LOS) v. Vehicle Miles Traveled (VMT)

California is replacing LOS with VMT as the metric it uses to gauge transportation impacts in the environmental review process under CEQA. While this may streamline the permitting process in the long run, in the short term it adds another layer of analysis and uncertainty. It will also affect commercial properties, which are often in downtown financial centers, differently from industrial properties, which are often in outlying areas. Additional uncertainty arising out of assessing either LOS or VMT impacts centers upon how to characterize logistics facilities. Are such facilities highly automated, decreasing transportation impacts, or are they labor intensive? During the entitlement processing stage, it is usually unknown what type of end user will occupy the facility. Also, how should a redistribution of existing trips figure into the analysis? Such logistics facilities (and, virtually all developments) are proposed because of pre-existing demand for such facilities; new development is not based upon a "Field of Dreams" assumption, i.e., "build it and they will come." Such new facilities generate some new trips, but not 100% of the project's trips. It will require thoughtful approaches to address these uncertainties.

Smarter Diesel Engines, Electric Vehicles, and Autonomous Trucks

Thanks to the development of cleaner diesel engines, the air quality in Southern California is greatly improved, despite the tremendous growth in the region. This means that the trucks serving warehouses are much cleaner than they used to be, and development can proceed without compromising air quality. Further advances in transportation industry technology will fuel growth in the industrial real estate sector, although developers need to be careful to agree to any limitations on operation of their projects that could decrease the project's marketability.

Conclusion

Managing regulatory uncertainty is one of the keys to industrial property development. Mastering the approval process, particularly as rules and frameworks are in flux, is vital to controlling costs and bringing projects to market in a reasonable time.