Tax Reform, Rising Real Estate Costs, Marijuana

Weston Yahn, Senior Associate

2018 is underway and commercial property owners have many reasons to continue celebrating market conditions tipped in their favor. Scant supply of flex and industrial product in Central San Diego has driven prices up exponentially since 2011. Sale transactions peaked in 2015 with $78 million in sales volume for owner/ user transactions. Currently, only 38 properties are currently marketed for sale in the entire region, which is expected push prices even further into record territory.

Leasing: What is Going On? Multi-tenant industrial tenants that are approaching their lease expiration are currently facing sticker shock. Leases signed 3, 5, and 7 years ago set to expire in 2018 will have tenants experiencing a heavy dose of sticker shock. For example, a typical space leasing for 5 years back in 2013 carried an average lease rate of $0.80 gross per square foot. That same space today would lease for roughly $1.15, a 43% increase. Not only are tenants facing higher lease rates rents. Landlord concessions like free rent and interior improvements have all but disappeared.

Based on a study by BizMiner, the average Industry Rent to Revenue Ratio in San Diego for warehousing, distribution, and storage-related tenants averages 20%, highest among all business sectors. Higher occupancy costs are driving traditional distribution-based businesses to peripheral markets and being replaced by tech, biotech and e-commerce users willing able to pay a premium for prime Central County space.

Leasing Advice: So Now What? If your business needs to remain in Central County, be prepared to pay a premium for space, but make sure you look for ways to optimize space efficiency to offset higher occupancy cost and the higher incidence of functional obsolescence. Take anticipated growth in your business into account when it comes to how much space you take and for how long. Don’t make the mistake of leasing too small a space that will force another unwanted move. Consider taking more than you need today to allow for future growth, as the shortage of inventory is expected to continue even if the market heads into a correction. The development phase in Central County is all but over. Land is scarce and very expensive, making it unlikely that new product will be built to take the pressure of tight inventory.

Even if your lease is not expiring soon, you still have options. Always be looking for the optimum location and if you find it, consider sub-leasing your current space and moving early. If your existing space still allows you to operate efficiently, you might consider approaching your landlord with an early renewal proposal to secure the space for a longer term. You may be paying an under current market rent and that could be used as leverage to secure tenant improvements or other concessions from your landlord. No matter what your situation, always insist on an annual review of operating expenses charged back to you.

Marijuana: California’s voters passed Proposition 64 and the state has set its regulations in addition to the City of San Diego’s efforts to manage the sale of recreational marijuana. Here’s what we do know: the City of San Diego will allow 36 outlets, not to exceed four per Council District. To obtain these licenses, the business owners must find properties zoned for the use with a landlord willing to take the risks associated with doing business with the industry. The liability for owners to lease to marijuana users is high. At the federal level, marijuana is still designated as an illegal drug in the same classification as heroin and cocaine. Banks are reluctant to work with the industry, making it an all cash business that poses a safety risk. Heavy parking use is another potential problem, but that won’t become known until after the businesses are up and running. The majority of institutional owners will not lease due to the associated risk. Owners of marijuana businesses can’t get a loan to buy a building, so that leaves a smaller pool of cash buyers in a supply-constrained market. The recreational marijuana business is certainly going to go through some growing pains in 2018, but problems will ultimately be sorted out, unless Attorney General follows through on his recent promise to repeal the Obama era policy that restrained federal authorities from interfering with the states to legalize marijuana.

Tax Reform:

The commercial real estate industry at large should benefit from the bill recently signed into law by President Trump. Property owners will still be able to deduct mortgage interest and property taxes for commercial property and 1031 exchange rules for real property were left untouched. Pass-through entities such as LLC’s, partnerships and S-Corps will now be able to deduct 20% of their income before applying new lower individual marginal tax brackets that top out at 37%. Generous new expensing rules including bonus depreciation and in section 179 expense limitations will help both property owners and tenants mitigate the cost of building improvements. We will be preparing a more detailed analysis of the new law’s impact on commercial real estate as more details and IRS rulings become available.

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