What California CRE Market Sectors Should Anticipate in 2023 and Beyond

The Winter 2023 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey revealed some interesting trends in California CRE markets. Most notably, some of the optimism expressed in recent surveys has reverted to a less-than-confident outlook. To unpack these results, John Tipton, Partner at Allen Matkins, facilitated a discussion between Jerry Nicklelsburg, Director at the UCLA Anderson Forecast, Paul DeMartini, Senior Managing Director at Tishman Speyer, and Lew Horne, President of Greater LA, OC, & Inland Empire at CBRE. Here are key takeaways from the conversation and their insights into the factors affecting CRE market sectors.

1. Office Is Still Waiting for Employees to Return to In-Person Work

Despite the headlines calling for workers to return to the office, employers continue allowing employees to work from home after strong backlash from employees and unions. The tight labor market—especially in high-skill jobs—gives workers more bargaining power to demand remote and hybrid work options. For now, corporate leaders appear unwilling to force a full return to the office and terminate people who refuse to comply.

However, the panelists expect this situation to shift as the labor market softens and employees face global competition for their jobs. Lower wages will likely outweigh the perceived benefits of working remotely and encourage workers to return to the office, where they have more networking opportunities. For now, developers are taking a wait-and-see approach to office space, prioritizing space located near neighborhoods, convenient to amenities, and features enhancements like audio and video technology.

2. Adaptive Reuse Is an Option for Office in Select Areas

The abundance of relatively empty office space and the lack of residential units has raised questions about repurposing offices to meet residential needs. In many cases, this is easier said than done, according to the panelists. First, the buildings must have the correct dimensions, including adequate space for mechanical and plumbing systems needed in a residential building. In some buildings, this doesn’t leave enough room to adequately divide the remaining space into usable units. Second, developers have to ensure the building meets seismic codes, which can require significant and costly upgrades.

Ultimately, converting offices to residential is a risk for developers. Not only do they have to ensure the building meets code, but they also have to consider the location. People want to live in areas they perceive as safe and convenient to amenities. These conversions also require waiting for office tenants to leave or going through the eviction process, which can take years to complete. With increasing financing costs, developers are more reluctant to take the risk. Nevertheless, the panel noted some successful office-to-residential conversions, especially after the City of Los Angeles’ adaptive reuse ordinance and the residential surge it created.

3. The Consequences of Legislative Actions Continue to Affect Multi-Family

Multi-family has remained relatively stable in the survey data, in line with the need for housing and an increase in long-term renters. However, regulations from state and local governments continue to pose a significant risk for developers. As cities seem to be taking a more aggressive stance on rent control and ballot initiatives aim the Costa Hawkins Act, developers have fewer incentives to build residential spaces.

The panelists agreed that CEQA reform would likely be a key factor in solving the housing crisis, and legislators should carefully consider the consequences of their proposals. They pointed to examples like Los Angeles’ ULA tax, which was intended to raise money to ease the homelessness issue through an additional real property transfer tax. If it leads to a reduction in transactions, the measure may not have the intended effect. Similarly, changes to criminal law can affect housing, as the number of criminal acts reported in a neighborhood affects whether residents perceive it as safe.

4. Retail Continues to Move Forward

The retail sector appears to have reached a state of equilibrium, with some survey panelists taking a more bullish stance. There’s been an uptick in retail interest, but it looks different than it did before COVID and has shifted to infill. Much of the retail activity is taking place near new housing developments where new residents need places to shop.

Another interesting trend is a shift in the nature of retail toward experiences. Retailers and developers are using technology and data to analyze what people are buying in specific areas. Then they create curated collections of stores, products, and services to meet consumer needs. Developers also have been opening closed malls and adding hospitality and residential services to revive the space. For the next 12 months, though, developers will likely pull back on building until uncertainty in the economy lessens.

5. Industrial Remains the Hot Spot, but the Landscape May Be Changing

Without a doubt, industrial has been the strongest CRE performer thanks to low vacancy rates and high demand for space. Some developers are taking a more neutral stance thanks to an increase in supply and limited available land for building, which raises some concerns about the sector. However, the panelists point out that the sector still has plenty of room for continued growth.

This is, in part, due to the variety of companies that rely on industrial space and the different ways they use it. Industrial space encompasses more than bulk warehouses used by e-commerce giants. Companies that make products or engage in research and development rely on industrial/flex space to operate. The market for space between 5,000 and 200,000 square feet is still hot, but developers should not expect to see much movement for larger buildings because of the lack of land.

Overall, CRE sectors are well positioned for developers, but much depends on what happens with interest rates and the broader economy. Pushing the interest rate for a 30-year fixed mortgage to the 7% range will certainly affect builders and developers of non-residential properties.