What’s behind Petaluma’s softening commercial real estate market

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Petaluma industrial real estate lease volume was up in 2023, but square footage was down and sales dropped. Office leasing in the city increased in volume, but there was only a slight increase in vacancy.

There were 29 industrial leases signed in the city last year, up from 2022. However, total square footage was down from 193,000 square feet in 2022 to 153,600 in 2023.

Average lease size was down as well (5,300 square feet). The largest industrial lease was 19,845 square feet with a three-year two-month initial term at 2220/2240 S. McDowell Extension, after close to 15 months on the market. Within that same immediate neighborhood, Thermo Fisher (NYSE: TMO) announced their decision to close their approximately 90,000 square feet location at 2200 S. McDowell when their lease expires. Industrial spaces are sitting for longer. Tenants looking for industrial space larger than 10,000 square feet have several properties to consider.

Industrial sales dropped by a third to six total sales during 2023 with an aggregate value of $16.8 million. Most of that value was carried by three sales while the other three were all under $1 million. The largest was sold as a leased investment to Simon Levi Cellars at an impressive $422.46 a square foot.

Total transactions are a fraction of the 2022 closings, which exceeded $100 million. We currently have surplus industrial space in Petaluma. When you look at Petaluma’s current industrial vacancy, estimated at just under 13% with neighboring Rohnert Park estimated around 10%, it seems like we have some soft-market vacancies.

That’s particularly clear when viewed in comparison to Marin County, where there is virtually no industrial space available. Head up to Santa Rosa, and vacancy is 4.8%. Head further up the corridor (Sonoma County airport area), and it drops down to 3.3%.

One potential factor in this slowed activity rests on the desire for triple-net (NNN) leases by industrial landlords and investors. A NNN lease shifts the costs of property taxes, building insurance, and most maintenance to the tenant. If treated as an accounting principle (meaning a lower base rent cost per square foot), it’s equitable to a gross lease.

For illustration, I can use a hypothetical offering that is not based on real numbers. Let’s say I’m offering a space on a monthly per square foot basis for $1.00. The tenant is directly responsible for their own utilities and to pay their share of, for example, landscape maintenance and building security. All in the tenant is paying a hypothetical $1.20/sf gross rent. That is a very simplified “gross lease” scenario.

If the lessor wanted to switch to a NNN structure (where the tenant pays for property taxes and insurance), they would ideally drop the base rent to make it still come out to $1.20 a square foot monthly all-in.

However, if the landlord keeps the base at $1.00 with the maintenance and services bringing it up to $1.20, and the taxes and insurance bringing it up to $1.35, that’s a disproportionate increase in the tenant’s obligation. The actual percentages vary, but the end result is a higher initial rental obligation and a certain level of surprise when the final obligation is calculated.

My suggestion to lessors and their agents is to publish both the asking price alongside the other costs upfront. There’s a certain transparency needed in softer markets to draw in tenants.

For a while, office landlords tried to approach NNN scenarios and have largely reverted back to full service and gross lease scenarios.

The full-service approach isn’t realistic in an industrial setting as there are too many variables for each individual tenant. Full-service deals fold in maintenance, utilities, taxes, and insurance, so they’re notably higher per square foot at the beginning of the lease. The tenant usually pays a proportionate share of the increases in subsequent years (known as operating expense pass-throughs), but these are more predictable.

Thirty-nine new office and medical leases (not renewals) were reported to CoStar for 2023. The largest was a full-service lease at 201 First St. (roughly 7,600 rentable square feet).

The next largest was a new 6,970 rentable square feet sublease to Bay Alarm at 1670 Corporate Circle, reported at an asking rate of $2.25 a square foot full service and a seven-year term. That same tenant followed up almost immediately with a 3,200-square-foot expansion at the same building under similar terms.

The balance of leasing activity was individual leases clocking in at 5,000 square feet or less. There were four reported office subleases within the market and 35 direct leases. These totaled approximately 85,300 square feet, with an average square footage of 2,187. Average discount from asking rate was 3.8%, and annual rental increases remained firm at 3%.

When compared to office leasing in 2022, volume was up and average size was down. But the end results still represented a 12% increase in transacted office space. Ideally that would bring down the vacancy percentage from 2022’s 23.7%, but we ended up with a slight increase in vacancy to 25%.

Office sales slipped with only two small office closings reported in 2023 as opposed to six in 2022. Last year’s financial headlines largely focused on inflation and the Fed’s key rate increases used to slow it. While we appear to be down to manageable inflation, the Fed hasn’t increased its rates since last year and has predicted three rate cuts this year. But that is a moving target. Energy costs remain a concern as well.

We’re approaching another election that promises to be contentious. I tactfully keep the topic on business. As a species, we’ve made poor decisions born of spirited philosophical debates. This isn’t the time to take that approach

. Even when in agreement with someone, I avoid those conversations within a business environment. Regardless of the outcome, they promote a wait and see approach. Anybody who was involved in commerce during the Great Recession or COVID shutdowns knows that tact halts business. There is always somebody who avoids the tea leaves and ends up at the top of the food chain as others flounder within a wait-and-see mindset.

We are at an opportune time within the market. Capitalization rates need to reflect interest rates, so it’s a good time to invest. Those fortunate enough to have signed tenants during the height of the market can sell at a higher cap rate and still be ahead of the competition. There is a great selection of mid-sized to large space within the market and landlords are becoming competitive. Give me a call and I’ll get you sorted.

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