It looked like just another Southern California office deal when a couple of low-rise office buildings with plentiful parking lots traded for $175 million in August.
Except the buyer was Brentwood-based Rexford Industrial Realty, one of Southern California’s largest owners of warehouses, distribution centers and manufacturing properties.
Plans to convert the buildings aren’t the result of distress at the Santa Ana properties — both are leased up, with tenants including Behr Paint’s corporate headquarters and Deutsche Bank. This is a matter of Rexford’s commitment to the industrial segment and its rosy long-term outlook for the sector.
Rexford’s plans call for overhauls of the properties into new industrial facilities as leases expire. Behr’s isn’t up until 2032.
The strategy exemplifies the latest trend in commercial real estate, where the pandemic has made the outlook for offices uncertain as industrial turns red-hot.
The two-pronged effect has major players like Rexford buying older, Class B or C office buildings. With developable land hard to come by across Southern California and demand soaring, industrial investors are getting more creative. Some are pushing ever farther into the desert. Others are acquiring properties on sizable portions of land that can be converted or demolished and replaced entirely.
Last month, Duke Realty bought an office building in Orange County with plans to build a 120,000-square-foot distribution center once Raytheon exits its lease there next year. Amazon recently bought a 30-acre office campus formerly leased to Bank of America for conversion.
Since 2018, around 2.1 million square feet of office space in the Greater Los Angeles market has been converted or included in plans for redevelopment into industrial properties, according to Newmark. The properties are typically older, with 1980 being the average year they were built.
There is room for the trend to continue. Orange County had 95 million square feet of office space with a 16.1 percent vacancy rate at the end of the third quarter, according to Newmark. Offices still had average asking rents of $2.76 per square foot, more than twice as much as industrial space. But the 262 million-square-foot industrial segment had a vacancy rate of just 2.3 percent.
The numbers aren’t specific to Orange County. The office market in Los Angeles totals 211 million square feet with a 19.2 percent vacancy and asking rents averaging $3.63 per square foot. L.A.’s industrial segment has a bit more than 1 billion square feet with a vacancy rate of 1.2 percent and asking rents that average $1.03, according to Newmark.
“There’s arguably an oversupply of office space,” said Patrick Schlehuber, Rexford’s head of investments. “We don’t need as much.”
In the 1970s, most office space was built in core urban areas. A 2000 study from the Brookings Institution found that 74 percent of office space was found in central cities in 1979. By 1999, this number had dropped to 58 percent, with the majority of new space being built in suburban areas.
Los Angeles-area offices started to move south and more inland to Orange County, following population growth. Big office properties started to get built in smaller cities, such as Brea and Orange.
As newer office properties started popping up across Los Angeles and Orange County — such as the Irvine Spectrum submarket, where Irvine Company has built hundreds of thousands of square feet of new space — demand for these older, suburban office properties started to dwindle.
“There’s been little rent growth in the last 10 years, but management costs still go up,” said CBRE’s Michael Longo, who has brokered office deals for industrial developers.
The pandemic accelerated the trend.
Take Bank of America, which moved into a 640,000-square-foot office campus in Brea when it was built in 1982. The pandemic prompted most of its call center employees to work remotely. In October, the bank, headquartered in North Carolina, said it would terminate its lease and exit the property next July. A month later, Amazon bought the complex.
“There is no land, really, not anything meaningful for industrial,” Rexford’s Schlehuber said. “You’re going to have to knock down something.”
Amazon is expected to turn the property into a distribution center, though plans have not yet been filed.
The Rexford and Amazon acquisitions are two of eight deals involving office properties slated for conversion into industrial space in the last 10 months, according to JLL’s Blake Bokosky.
It’s all about zoning
But developers aren’t looking for just any land.
“We need to be able to do industrial by right,” Schlehuber said, adding the firm will only acquire office properties that already have the zoning rights that allow for conversions to industrial sites.
Duke Realty is planning to build a 120,000-square-foot complex on the Orange County site it bought for $34 million last month, once Raytheon’s lease expires in June.
When owner HPA Realty put it up for sale, JLL’s Bokosky noticed the property was zoned for industrial use, meaning a buyer would not have to spend money or time on a rigorous entitlement process.
“We’re not going to take an entitlement risk to rezone,” Rexford’s Schlehuber said.
Rexford is willing to wait until Behr Paint exits to redevelop the Santa Ana site into Class A industrial, but “if something crazy happens and Behr decides to leave, we’ll have an industrial property,” Schlehuber said.
Most industrial developers don’t want to wait that long.
“Prove a path to the land in a couple years, you have a ton of appetite,” CBRE’s Longo said. “But five to 10 years is much less desirable.”
Reaping the benefits
Though the office sector has struggled during the pandemic, landlords have found opportunities in industrial developers’ willingness to pay a premium.
In the case of Amazon’s purchase of the former Bank of America campus, the e-commerce behemoth paid $258 per square foot, or $165 million — 50 percent more than the $110 million Cerberus and Greenlaw paid for the property in 2014.
Office properties that are most likely to be converted to industrial space “are older suburban assets with an average land area of roughly 15 to 25 acres, located within four miles of a major highway,” plus zoning considerations, according to an analysis by Newmark.
These requirements could make finding properties difficult, but it’s easier than finding empty land in Southern California. When discussing Duke Realty’s deal, JLL’s Bokowsky consistently referred to the price as $150 per square foot of land, rather than existing property.
Demolition can also be cheaper than making structural improvements, knocking down internal walls and adding to buildings’ height.
“There is no land, really, not by any meaningful definition,” Schlehuber said. “You’re going to have to knock down something.”