This article is republished with permission from REITCafe.
With no sign of a break in California’s four-year drought, Governor Jerry Brown on April 1 ordered a statewide reduction in water use. The executive order mandates a 25 percent cut in water use for the state’s 400 local water supply agencies that serve 90 percent of California residents. What does the worsening drought mean for the state’s economy, real estate, and real estate investment trusts (REITs)?
At a minimum, less water will be available to keep landscaping green, and water will likely become more expensive. In some areas, utilities are already paying residents to replace grass with native plants and drought-tolerant shrubs. New restrictions on lawn watering are also expected. Some cities and water districts have implemented moratoriums on swimming pool construction, restrictions on draining and refilling pools, or requirements that pools be covered to limit evaporation.
| TREPP-i Survey Loan Spreads (50-59% LTV)* |
| This Week | Previous Week | Prev. Month | End 2014 | End 2013 | |
| Industrial | 151 | 148 | 146.6 | 138.5 | 170 |
| Retail | 154 | 150 | 146.6 | 139.8 | 175 |
| Office | 156 | 155 | 154.8 | 148 | 175 |
| Multifamilty | 146 | 145 | 144.6 | 139.8 | 166.7 |
| Average Spread | 151.7 | 149.5 | 148.2 | 141.5 | 171.7 |
| 10-year Treasury Yield** | 1.95 | 1.95 | 1.8 | 2.17 | 3.04 |
California’s housing market will be hit particularly hard by the drought. Construction permits may be limited, and new homes and developments will be required to meet strict water efficiency standards, including use of drought-resistant landscaping and low-flow toilets, faucets, and showers.
Commercial development will also be affected. Legislation introduced in San Francisco last week calls for new buildings larger than 250,000 square feet (23,000 sq m) to create piping systems to capture and clean greywater from baths, sinks, and other kitchen appliances for use in toilets and landscaping. The San Francisco Planning Department notes that about two dozen new projects in the permitting process will be affected. Proponents of the legislation contend that flushing toilets or watering landscape with fresh water is a poor use of a scarce resource. Opponents, however, note that the legislation will add millions of dollars to construction costs and believe that similar results can be achieved more economically through other methods.
More than 30 REITs are based in California, and many others have significant investments in the state. Just how the drought will affect their bottom line and that of other real estate owners cannot be quantified, but water will certainly become a bigger expense that attracts more attention. REITs involved in real estate sectors that use more water, such as apartments and golf courses, will be affected more than those with interests in warehouses, for example. REITs may face capital expenses related to changing landscaping and refitting buildings to make them more water efficient. Construction may also be curtailed in some areas for lack of available water to serve the project long term.
The nation is watching California, which is at the forefront of developing methods to deal with the drought. Desalination of seawater is being considered, although many water districts have rejected the idea because they believe recycling and conservation programs will be more cost-effective. A desalination plant in Carlsbad in San Diego County, which will generate 50 million gallons of potable water a day, is 85 percent complete and will begin operating in several months. The San Diego Water Authority has contracted with the private plant’s owner, Poseidon Water, to buy up to 56,000 acre-feet of water per year, which will account for about 7 percent of the county’s water supply. Another facility at Camp Pendleton in San Diego County is currently in the planning phase, while Santa Barbara is considering a $40 million plan to modernize and restart a desalination plant that was shuttered in the early 1990s.
For real estate owners, the biggest concern is how the drought will affect the state’s economic growth. Will industries move away or stop adding jobs because there is not enough water or because it has become too expensive? Although some water-intensive manufacturing operations such as semiconductor manufacturing have largely moved elsewhere, it seems unlikely that the drought will derail the economy, given the state’s strong growth in recent years. Instead, Californians are likely to conserve more, find new and innovative ways to increase supply, and absorb the costs associated with the drought.
* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com. ** - 10 yr. Treasury Yield as of 3/27/2015
