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Developers Eyeing Industrially Zoned Offices As Last-Mile Opportunities

A convergence of the bottom-up softening of certain parts of the office market, the white-hot demand for Class-A industrial space that is close to consumers and the lack of available space for that use has caused industrial developers to, at least temporarily, get into the office business. 

Goodman purchased this property, which is two-thirds industrial and one-third office, in the North Orange County city of Cypress.

Developers like Goodman, Rexford Industrial Realty and Black Creek Group are looking for and acquiring office space that is zoned industrial, even if it has tenants in it, with plans to replace those offices with new industrial space once leases are up. 

Rexford spent roughly $105.3M on the Behr paint company headquarters in Santa Ana last month, the Orange County Business Journal reported, and $70M on the Volt Campus in the city of Orange in late August — both office properties with tenants with years left on their leases — with plans to turn both into industrial space. 

“We had never really focused on doing office conversions before this pandemic,” Rexford Industrial Realty Executive Vice President of Investments and Acquisitions Patrick Schlehuber told Bisnow

In the past, industrial properties were getting purchased for office developments, because office was the higher-revenue use, Schlehuber said. That isn't always the case now. 

Over the past decade, the demand for industrial space has been intense, especially spaces close to consumers that can fill in the so-called last mile of the e-commerce equation. But the coronavirus pandemic poured gasoline on the fire of industrial demand, RCLCO Managing Director of Strategic Consulting Eric Willett said. Over the past two years, interest in any available parcel and weighing its potential for industrial usage has definitely increased, Willett said.

“The fact that the end user or the supplier of goods to the customer is wanting and needing to be closer to the population is leading groups like ourselves to look at these types of opportunities in a different way,” said Lang Cottrell, Southwest regional director for Goodman North America. 

CRE professionals said that although this isn’t necessarily a new concept, these deals have become increasingly popular as the availability of land in these infill areas becomes ever scarcer, as the prices for industrial land rise, and as the strong demand for industrial space intersects with the weakening demand for certain kinds of office space. 

The Volt Campus in Orange

In Orange County, where a number of these deals have taken place, CBRE found the Q3 vacancy rate for industrial was 1.3% — a record low. Another record was set by the 2.3M SF of projects under construction “as developers respond to record low vacancy paired with insatiable demand from occupiers,” the report’s authors wrote.  

In the South Bay area of LA County, where these deals are also playing out and where developers are looking for prospective spaces in Carson, Gardena and Torrance, the overall Q3 vacancy rate was 0.6%, CBRE reported. In LA overall, industrial and logistics capital markets are experiencing record activity, thanks to e-commerce growth, CBRE said. 

Office, especially outside of the highly amenitized low-rise campuses of the Westside and premier areas and trophy spaces, has not been experiencing the same boom. In Torrance, CBRE’s Q3 count found office vacancy at 14% but industrial vacancy at 0.3%

Cushman & Wakefield Capital Markets Group Vice Chair Jeff Cole said the market for low-rise commodity office buildings, like the ones that are favored in office-to-industrial transactions, has struggled significantly. 

“The rates have gone down, vacancy has gone up and the alternative for that office owner is to try to re-lease the building in a very soft market or try to sell the building,” Cole said.

The pricing on those two choices is so much lower than what owners can expect if they sold to an industrial developer, so when the option arises, office owners bite.

“They invariably decide that it is a good alternative strategy for them to sell to an industrial developer,” Cole said. 

There are some commonalities in what developers look for. Industrial zoning makes a property attractive, eliminating the hurdle of having to rezone the site, which can push out the timeline for industrial transformation. 

South Bay areas that have lots of industrial space with offices mixed in or similar areas in North Orange County or South Orange County, where Lake Forest is, are ripe for these kinds of office-to-industrial transitions because the underlying properties are often zoned for industrial, Cole said.

A joint venture between Western Realco and RREEF Property Trust snapped up four neighboring office buildings totaling about 222K SF in South Orange County’s Lake Forest in April. The JV plans to turn them into 240K SF of new Class-A industrial space once the office tenants have moved on. That same month, an adjacent roughly 145K SF office building in that same park sold to Black Creek Group for $34.9M, public records show.

Buyers with office-to-industrial plays in mind don't see tenants in the building as a hurdle. Though developers are definitely looking at how long they are slated to stay in the building, several of these deals included office buildings with long-term leases in place. 

Goodman purchased the Cypress Technology Center with a 330K SF industrial building on the site, but the remaining third of the site is occupied by a 150K SF office building. Both buildings have leases in play for six to 12 months, which provides Goodman some cash flow while it figures out how best to use the space, Cottrell said.  

Location in an industrial area is ideal because then the new industrial use fits in. Infill sites are attractive because they are close to people, but those people don’t always want to be close to a last-mile-type site. Several of the industry professionals who spoke to Bisnow mentioned the importance of being sensitive to the community throughout the planning phases of these projects, as community pushback against them can complicate city approvals. 

Cottrell said that at the Cypress site, it is exploring whether it could adaptively reuse the property, which would help get it online faster and with less environmental impact. But it is also evaluating a possible redevelopment of the site with a three-building campus of Class-A industrial space. 

While there are clearly a fair amount of these types of properties in infill areas where these deals make financial sense, it isn't a trend that will be cropping up in every neighborhood. Though these deals aren't confined to Orange County by any means, the economics that make office-to-industrial attractive don’t work everywhere. In Culver City, West LA and other markets where tech, media and entertainment tenants are still attracted to office space, these types of deals don’t pencil. 

“These aren’t happening in Playa Vista or Santa Monica,” Cole said.