Navigating in a dynamic real estate market growth in uncertainty

Nov 30, 2023

DAVID LICHTMAN (Market President & Publisher, Sacramento Business Journal): We are with LDK Ventures, which runs McClellan Park and The Railyards in the Sacramento area and multiple projects throughout the United States and particularly the West Coast. So let's start with the question of how has construction changed as it relates to industrial and multi-family development in the 10 years since the building crash of the recession in 2008 and since we started recovery in 2012?

DENTON KELLEY (Managing Principal, KDK): I’ll start with that. The key thing is costs have probably gone up anywhere from two to three times where they were 10 years ago, whether it's on multi-family or industrial.

That's been a function of a few different factors. The labor market for construction labor is very tight and it is only unfortunately, getting worse, not better. The code cycle within California is incredibly stringent and challenging, and every few years it gets updated for mostly energy code, but sometimes it can be water efficiency related. Just as one example, now you have to put water meters on every apartment unit.

The code cycle update every few years within the state continues to create cost escalation.

And then there are all the lead time issues associated with building supplies. Whether it's electrical switchgear, or windows, or whatever the item is, the lead times were especially problematic during COVID, but even now. Things I mentioned like switchgear, it's still a year plus lead time from the time you order it to the time it delivers, and obviously you can't get a Certificate of Occupancy on an industrial building or a multi-family project without your switchgear.

DAVID: Define a switchgear for me, as a person not in the industry?

DENTON: A transformer transforms the power from the curb into the building and once it hits the building, you have a whole set of breakers that form your switchgear that distributes the power through the building.

JOSH LEACHMAN (Vice President, Project Development, LDK): When constructing a building that's more advanced, it takes longer to approve, to design, and to build. The life cycle of the project from beginning to the end where you’re ultimately leasing, gets extended for all those reasons.

JASON KLIER (Senior Vice President, Leasing And Acquisitions, LDK): And the other challenge I think that everyone has had to deal with in the construction industry is communicating how the industry has changed to tenants. Tenants typically are not getting in front of their renewals, or their expansion plans, or their growth plans that are going to correspond with that of designing, permitting and construction timelines of today. So, what have we seen? We’ve seen landlords do spec office spaces in industrial buildings, which is something that was never done before, but you have to get in front of the tenant needs today more so than ever in order to deliver a product in time.

DENTON: Most industrial developers are now doing spec office suites, spec’ing the warehouse lighting, doing some amount of dock packages, all a bet on the outcome of getting a prospective tenant.

You have to speculate more tenant improvements on the front end to hit the timeline needs of the tenant in the market.

DAVID: So industrial being one piece, how's multi-family? How much slower does that make putting up a multi-family building?

DENTON: The complete life cycle from the time you start design, you get it through permit, construction drawings at the county, at the city, the longer lead times associated with certain things like the switchgear or other materials, in aggregate, even if it's not a real bumpy ride with the city or county, it can take three and a half, four years before you actually get a product delivered and residents living in the space. From the time you start, it's a very long lead time.

DAVID: So as the landscape has shifted, how does that change development plans in both areas, industrial and in multi-family?

JOSH: For the Railyards, I would say in some ways we benefited from not having an already built environment around us, so we can remain nimble and flexible. For instance, we can right size the amount of retail or office given the world we are in. We can respond to the market. If the market is demanding additional amenities for work-from-home for instance, then we can appropriately plan for those both in a particular project, but then we can take a step back and say, "How will this affect the larger landscape of the Railyards?" and design accordingly. So we have the benefit, of a blank canvas.

JASON: For industrial at McClellan Park and the west side of the property, which is going to be our area for growth; we are making a decision to move forward with development, analyzing the market and projecting where you’re going to be 12 months from start of construction. So in order to do that, I think the critical part of your business plan is understanding the competition, market demand and how that leasing activity compares to the amount of available space that's on the market. So, there is a need more so than ever to understand the competitive landscape before you decide to put a shovel in the ground.

DENTON: I think the other aspect is, given those long lead times we’re talking about getting, it makes you recognize how much value there is in land that is fully entitled, infrastructure complete, shovel ready to go vertical for a tenant. And then when you actually look at the landscape, say, in Northern California, and Sacramento, specifically in the industrial world, there really isn't a lot of well located, entitled, infrastructure complete, shovel ready to go industrial sites in Sacramento. Metro Air Park, which has been kind of the incremental supplier of land and inventory this cycle so far, they still have a little ways to go, but at some point in time and in the next five, 10 years, that inventory will be gone. Where are we going to find the future supply for industrial land for development at scale in Sacramento? There are some other smaller infill projects coming online, but the Sacramento industrial market is fairly land constrained. McClellan Park will have another 200 acres coming online in the next few years for a few million square feet of buildout, but there's no more other Metro Air Parks coming online in the foreseeable future. And it's too challenging from an infrastructure cost perspective to ever replicate something of that scale ever again in Sacramento.

DAVID: What do you see as the horizon on industrial properties and multi-family housing as far as demand that you can project and work against? What do you see in five years, 10 years, 15 years?

DENTON: I can't see past the next 12 months, really. But nevertheless, we always say we’re in this for a marathon, not a sprint, so we’re in it for 10 or 20 years. I mean, The Railyards and McClellan Park are great examples. If you believe in the long-term fundamentals in the region you’re investing in such that you strongly believe the demand will be there when you bring inventory to market. Recessions happen and you just have to be positioned for that. Use McClellan as an example, very well-located project with three highway interchanges in a two-and-a-half-million MSA market with rail service, private airport, 10 million feet of commercial buildings, 400 acres more to develop. You just kind of know that on the surface, all those ingredients are going to work over a long period of time.

I can't tell you exactly how much demand's going to appear in any given year, but you can look at it, just say, "Hey, we’ve got a 150-million-square-foot industrial market, and you should be able to deliver 3%, 4%, 5%, 6% of that a year for new product. We can build into that demand and have a good business deal on that."

DAVID: Apartment rents have been rising rapidly in the Sacramento area and they’ve fallen off a little bit. Is that concerning or is that just a cycle that you see as normal?

DENTON: I think it's just part of the normal cycle. You’ll have pockets where it's weaker, pockets where it's stronger within the broader Sacramento area. I was looking at it recently, I think we’re delivering, or we currently have under construction in the Sacramento, I want to say, close to 6,000 apartment units, but we have an inventory of 155,000 units so the amount under construction as a percentage of the total inventory is about 4%, and that's a very healthy place to be. I mean, you have markets where you’re delivering 10% of the total inventory and it may be in those markets, they have the job creation to warrant that amount of inventory being delivered. But here in any market where you’re 5% or under, you could still see some softening around this for a year or two while all that new product delivers and competes for most of the same residents.

There are not a lot of projects being started right now because the capital markets are so challenging. So, on the other side of that, it should stabilize, and I don't really see much distress coming out of that.

JASON: And I think that also parallels with industrial, where you have markets such as Phoenix and Arizona that are delivering 50 million square feet of new available product. We haven't had that percentage of our existing inventory delivered to market in any given year. We haven't been overbuilt in the last five years so that will help with rents and market stability moving forward, here more so than some other western markets.

DAVID: What roles have private public partnerships played in your regional development here?

DENTON: They’ve been huge. For McClellan Park, this was a public private partnership in the greatest sense of the word, and at the end of the day, the strength of public private partnerships is in that each party recognizes their strengths and weaknesses and that a county, a city, a public entity recognizes that the best value they bring to a project is by being a friendly development partner and expediting permits, being reasonable on discretionary approvals, working with you on infrastructure, and the developer brings the creativity, the capital, the know-how to get the infrastructure built and get the buildings built and at least tenanted and generating revenue for not just them, but for the county or city.

And the Railyards is no different. It's a public private partnership in the greatest sense of the word, and just as we’ve worked very collaboratively here at McClellan Park to get many grants over the years, federal grants, and we’ve worked very collaboratively with the city to get many grants as well for the Railyards. All for infrastructure, public infrastructure by the way. But those types of dollars that we can bring into the region through partnership with our cities and counties help economic development and they are critical to making projects that are very challenging on the surface, like McClellan or the Railyards, ultimately successful. They wouldn't be successful without those partnerships and those dollars that you can jointly bring to the table.

JOSH: I’d actually even go further and say for those large-scale projects, it's the only way to implement, to go in, locked arms and pursue these different public private partnership opportunities because there's just so many moving parts in these projects. It takes that creative energy of the various stakeholders to problem solve and implement the type of solutions necessary to get these projects out of the ground.

DAVID: With more product available in the downtown core, what does that mean for the market?

DENTON: When you have either more supply than demand or more supply than you historically had, it can translate to more of a renter's market. There may be two or three options that have similar offerings and amenities, and renters have more leverage in the negotiation. So it means that maybe you’re not getting the rent increases you thought you were, and you’re just leasing it at your proforma market assumption. At the same time, competition's a great thing in that everyone has to hone their blade to be the sharpest product in the market. You have to have the better on premises and nearby offsite amenities and more dynamic public space, just essentially a better value proposition. So if we’re not offering a better or the best value proposition to renters because we lack competitive amenities around our projects, then that's on us. We have to provide those, right? And so it forces everybody to up their game, if you will, to provide a better value and a better experience for renters and residents.

DAVID: So how do you plan to create a unique destination experience in the Railyards to tie into that? Because you’re putting residential units there now, and it's got a lot more to go before it gets done.

JOSH: I think we have a really unique opportunity with the rehabilitation of the Central Shops to establish a cultural and experiential destination. When you think about those iconic buildings being rehabbed into a concert venue, an entertainment destination, outdoor amenities space, plaza, food and beverage, destinations, and at the scale we’re talking about, I think there won't be a similar experiential destination in Sacramento. With the AJ coming online and this first phase of the Central Shops happening later this summer, I think we are providing that sort of experience that would attract tenants to want to be in The Railyards. You look at this progress and then combine it within the larger context of access to transit, access to the riverfront, access to downtown, you start to see that we have a compelling value proposition for tenants moving into the Railyards.

DENTON: I think the general vision for the Railyards is that we have to be able to offer the kind of unparalleled experiences that you can't have anywhere else in the region. Simple as that, right? Josh mentioned the Central Shop buildings and historical buildings, concert venue, but one of the things, when I moved home many years ago from living in New York and San Francisco and was walking around Sacramento, there was a very clear absence of any real dynamic kind of urban public space. Then you had Golden 1 Center happen and that was a great example of what is possible. What could be here, right, and the public realm they created on the plaza there, which is great. You’ve seen what the Bridge District has done. You get a kind of hint and a glimpse of what can be done.

And I think that with what we’ll do in the Central Shops and the plaza with all the surrounding entertainment and food and beverage and bars and tap rooms and things like that, that when you’re surrounded by these historical buildings and you’re looking at downtown, I do think we’ll offer something that no one else in the region has that will keep people coming back for more and more of that experience. That's what we have to create, otherwise they’ll just go to a lifestyle center in the suburbs.

DAVID: Josh, you mentioned Central Shops Historic Buildings possibly starting later this summer-

JOSH: Late summer, early fall, it will start.

DAVID: How important is the potential soccer stadium to the whole picture?

DENTON: It's something we’d love to see happen. It's always been completely out of our control. We’re landowners, land sellers. We’re not the perspective franchise owner. Something we’ve obviously been very supportive of, endorsed, and I’d love to see happen, but at the same time, it's not something we’ve ever viewed as a make-or-break amenity for the ultimate success of the Railyards. It would be great, don't get me wrong, but we firmly believe with the plan we have, everything Josh is working on in the Central Shops and all the tenants that we’re working with and Kaiser coming online, starting construction sometime in the next few years, that we’re going to have plenty of economic drivers and amenities to have a very vibrant, successful project.

DAVID: That’d be the icing on the cake then in your mind.

DENTON: It very much would be the icing on the cake.

DAVID: Because you feel you’ve got the cake built, it's going to be beautiful. You’ve got everything you need, all the layers. That would be a little extra.

DENTON: Definitely. And we would love to see it happen.

DAVID: With the funding for the multimodal Transit Hub next to the Railyards how does that affect your plans?

JOSH: I think establishing that as a regional amenity and regional asset is wonderful. With our proximity to the multimodal station, we have always benefited from access to transit, light rail or the Capitol Corridor passenger rail, and access to the regional freeway system. It's what separates our project from other areas.

DENTON: And I think it goes to part of what makes for a unique urban experience in Sacramento. As the Sac Valley Station gets built out on the other side of the rail tracks from us, it's a huge benefit for people living or working in the Railyards. People coming to visit and go to a Niner game and taking the Capitol Corridor train or go into Oakland or San Francisco or wherever. But there's really nowhere else in Sacramento you can do that, where you have that point of connection to be able to travel somewhat seamlessly via public transportation from Sacramento into the Bay Area, into Davis and into San Jose. For the most part, we’re not building or widening any more freeways in this state, this region and the Bay Area, so that's only going to become a more important piece of infrastructure going forward in the future.

JOSH: With this first phase of the Central Shops, we will expand our entrance into Sac Valley Station. There's a pedestrian tunnel in place, that will be broadly enhanced providing direct connection and ability for future residents to experience both the Railyards and the multimodal facilities at Sacramento Valley Station.

DAVID: You talked about the Central Shops buildings. What about public spaces in contrast to the urban grid, how are you going to activate public spaces in the Railyards?

JOSH: I’ll focus on the Central Shops. With this first phase we’ll bring forward a public space that will truly be unique in Sacramento. It will be a large urban plaza experience situated in the middle of the rehabilitated buildings, providing proximate access to transit, curated with a mixture of complimentary tenants and broad event programming. So, taking a step back, I would say within every project that we’ve done or that we focus on now, we ask ourselves how can we create public space that draws in residents and users? From the residential projects that we’re building and/or designing, to the office buildings that we’re designing, particularly coming out of COVID, we realize the value of these gathering spaces for residents and tenants.

JASON: In all of our conversations regarding the Central Shops we are defining who our customer is and what the merchandising plan should be. But what is even more important than that is creating a safe and enjoyable atmosphere for visitors of the Railyards.

JOSH: People respond to authenticity. When you visit the Central Shops and understand its historical context, specifically, the western terminus of the Transcontinental Railroad, these buildings are rich in stories and impact for the Sacramento region. Combining the building rehabilitation with an urban plaza will create a destinational experience for the entire region. So, we look forward to bringing those on later this year.

DAVID: Talked a little bit about the Railyards, but what about suburban areas? What's your approach to suburban development of multi-family?

DENTON: A lot of similarities just in terms of recognizing the importance of outdoor space. We are trying to engage that ethos of people and recognizing that they want to be together, they want to be outside, they want to be active, and also the similar response to COVID of just the importance of accommodating remote work environments, whether that's in the actual unit itself, or is that something you’re building out more within the common area amenity. It's a mix of both, but then also making sure you have all the infrastructure behind that just in terms of all your internet and Wi-Fi and all that connectivity so that residents can seamlessly bounce around wherever they are in that multi-family project and work from anywhere.

DAVID: That goes to the next question. How has COVID and now post-COVID impacted design in multi-family? Remote work is the new norm. How does that affect what you’re designing in multi-family and then what the market's asking for?

DENTON: It depends if it's an urban multi-family unit that's a little smaller versus maybe something that's suburban and a little larger where you can accommodate it in the unit. But in general, in the urban context, in the grid, you’re generally accommodating that more as a common area amenity; whether that's private offices people can rent out, conference rooms, or making sure you have all the technology and the bandwidth and things to support that throughout the building. One thing we found is that people are willing to work from anywhere. It's like if you’re home in your house, you can work from your couch, you work from your kitchen table, you work in your office, you work on the patio, you just kind of move around.

DAVID: Historically a multi-family dwelling would be built basically for the units themselves. Now do you need to design significantly more common space than you might have done before?

DENTON: I think that's right. It was a slight pivot, but really a reinforcement of trends that were already in place. People recognizing how important outdoor space is, but in some sort of an engaging way. Not something that's passive, but something you can engage with or use. In the case of working outside, whether you’re on an outdoor patio or a roof deck or out in the courtyard or wherever.

JOSH: Design is evolving. I think the regions have projects right now that are leasing, so they have addressed it in ways that the existing design to accommodate. The design was already approved and in process, so they took a step back and said, "How do we address work from home?" And they added incremental solutions to provide this amenity.

I think with this next wave of projects coming out, the response will be a bit more sophisticated. You’ll see larger work from home amenity spaces. It’ll be more thoughtfully designed. It will mimic co-working environments we typically see. All of the conference rooms, scheduling systems, the technology that enable it will be more and more advanced in order to be competitive. I think we’ll continue to see the design evolving as tenant requirements and preferences become better understood.

DAVID: So, it actually brings the multi-family experience much closer to someone who has a single-family residence and their ability to spread out, create an office space, work in multiple places. This creates much more balanced opportunity for someone in a multifamily world.

DENTON: Yes, that's right.

DAVID: What challenges do you see in the capital markets, the labor markets? What challenges do you see that still need to be overcome?

DENTON: Well, I think the capital markets are probably the most current issue. We’ve been dealing with labor issues for 10 years on both multi-family and industrial construction. It just got a lot more challenging in the last few years with COVID and supply chain issues. But I think the capital markets are the one that's obviously changed the most over the last year. We essentially went from close to free money at 0% to 5% interest within a year.

You’ve seen loan rates more than double. A loan you could have gotten for 3%, 3½%, it's now 7%-8% today. And that's just the cost of money. The availability of money is going down in terms of loans. You can't go get a 70% loan-to-cost. Now most of the loans you’re seeing done are 50% to 55% loan to cost for both multifamily and industrial, which means there's a much bigger equity check to fund the construction or development of that project.

At the same time, a lot of equity sources are looking at the market and saying, "Well, Mr. Developer, I can get 5%, 5½% just parking it in risk-free money market. So why should I give it to you to go do a 6% return on cost deal?" It has a lot more risk.

And so the world is fundamentally kind of upside down from where it was a year ago in the capital markets. And there's good and bad news in everything. The good news is that it's going to help constrain supply. We talked about multi-family earlier, you’ll have a surge of supply we’re working through over the next two years for projects that are already under construction, already approved, already financed. But then the valve will shut off. There's very little new product coming out of the ground today.

The industrial market is seeing some projects shelved and canceled. But it seems like the industrial market is pushing through that a little bit more than the multi-family projects are right now, just because it seems to be a little more institutionally backed and deeper pockets, more discretionary funds raised to fund industrial development. They’re just committed to the cause allocating to industrial because that is their mandate.

You are still seeing most development projects on the industrial side move forward. But what you are seeing is the land market for both multi-family and industrial have seized up. There's just not a lot of land transactions because construction costs are stubbornly high and don't seem to be going lower. Interest rates are twice what they were a year ago. Cap rates are up 150 basis points or more depending on the asset class.

So, one of two things must happen. If those things are constant, then land values have to go down to help them underwrite, or rents have to go up a lot more to support land values. And we’ll see; I don't know.

And land prices are going to have to come down, and that's a process for sellers to get through. Our rents are going to have to go up a lot more. And I struggle to see that. But we’ll see. That's what makes this industry and life interesting.

JASON: It's been a long winter in the capital markets, and you look at the major brokerage houses, they’re 50-plus percent down in terms of transaction volume. The one thing that's going to help with pricing, especially that for land, is additional data points. I don't think we have enough of a market to look at and say, "This is what happens when interest rates go from 3% to 7%." We just don't have enough information to tell us what the new norm is. I believe that there will be a baseline. It just hasn't been set yet.

DAVID: LDK Ventures is unique in my mind in that you do industrial and multi-family mixed use. A lot of developers do one or the other. How is that an advantage or a challenge for your organization?

DENTON: I think the biggest challenge for me personally is always making the decision of, "Do we just go forward and focus on one thing, or do we keep doing what we’re doing?" Because both have worked out very well for us on both side of the ledgers. So, if both are successful, why don't you just keep doing both? It's a lot easier to focus on one and just do one. I do ask myself, "shouldn't we just focus on this?" Well, no, they’re both working really well, and why don't we just keep doing what we’re doing?

But the reason we’ve chosen both of those is because we always felt that they were not subject to a lot of the same risks and issues that you see in other asset classes. They have low re-tenanting costs, they’re very durable demand characteristics, they’re not subject to substitution risk. It's like now… people can work from home instead of working in the office. Well, you see how that's playing out. You lose an industrial tenant, you put a new one in. Your re-tenanting costs are pretty low. Office, they’re very high. Multi-family, people always have to have a roof over their heads. One tenant leaves yet another resident moves and all it costs you is some paint and carpet.

These factors create a more predictable cash flowing asset. They’re durable assets that our economy will always need more of in order for our economy to thrive. That's just the simple way we’ve looked at it.

DAVID: What are you most looking forward to in the next 12 months?

DENTON: Seeing the Central Shops project getting underway.

JOSH: You take a project like McClellan Park or The Railyards, you’re constantly pushing that ball up the hill. However, we’re close to a point in the next 12 months where the AJ is leasing up, our next residential unit project starting, while also advancing an incredible amount of additional, supportive infrastructure in the Railyards. All this progress, combined with the first phase of the Central Shops, we can see the vision coming together. On top of our progress, the progress of other supportive and catalytic projects, such as kaiser, the new county courthouse and the DGS state adds to this excitement and momentum. You’re going to start to see the transformation of this area that sat dormant for so many years.

DENTON: That's a great way of putting it.

JASON: I think one aspect of McClellan Park that I really enjoy, and it gets me going every single day, is seeing the organic growth of our tenants. We have over 20,000 individuals working in McClellan Park now. The majority of the tenants that we have here, you can point to a time and say, "I remember when they leased 10,000 square feet from us 15 years ago. Now they’re in 50,000."

That's really exciting, I think that shows the health of the region and the desire for companies to expand here. The nice part at McClellan Park is we can accommodate that organic growth. So that's a wonderful thing to see.

DENTON: I think the other thing is what Josh said with respect to the Railyards and 12 months from now, is being in a position where you can feel the momentum of where The Railyards and that whole area is going. It's what that momentum translates into in terms of the types of users, and the retailers that’ll start to have interest in the project That’ll help continue to form the vision of the overall Railyards project. Because you have to have some sense of momentum, kind of a "prove it up" moment before you’re really going to start getting interest from certain users.

That's really exciting when you start getting some real interest from the types of dynamic users that we aspire to anchor and merchandise the project with, I think that's going to be really exciting.