COVER STORY, APRIL 2005

CENTERS OF ATTENTION
Conversions, job growth and new infrastructure alter the makeup of many of the West’s downtown office markets.
Craig Coppola, Mark Tarczynski, Gary Lucas, Dan Gaston and Adam Christofferson

Western Real Estate Business recently contacted several brokers to see how downtown office sectors in the region are performing. Adaptive reuse ordinances, public works projects and long-awaited job growth are dynamics creating interesting market opportunities from Phoenix to Portland.

Phoenix

Downtown Phoenix’s office sector currently holds the advantage over its midtown counterpart. Photo courtesy of Todd Photographic.

While the two submarkets have competed for their CBD tenants since the early 1990s, other tenants have migrated away from the area to the more suburban financial districts in the Valley (the Camelback Corridor and North Scottsdale submarkets) and office buildings closer to executive housing. No new speculative office construction is scheduled for the foreseeable future in either CBD submarket while developers Opus West and Ryan Companies wait for demand and rental rates to rise. In the CBD’s latest lease transaction, Arizona Business Bank signed a $4.55 million, 21,000-square-foot lease at 2600 North Central, taking advantage of the low rental rates.

On the other hand, several investors have already taken a bet on improving conditions by purchasing more than 10 mid- and high-rise buildings in the past couple of years. Many of these properties sold to local and out-of-state private investors at less than $100 per square foot, which is well below replacement cost.

Looking to the future, the health of Phoenix’s CBD will hinge upon the success of almost a billion dollars worth of infrastructure being invested in the area. Momentum will be built on the new Light Rail Project, expansion of the Phoenix Civic Center, a new Sheraton hotel, Arizona State University’s downtown campus, a proposed high-end boutique hotel and numerous residential developments.

— Craig Coppola is a founding principal with Lee & Associates in the firm’s Phoenix office. 

Los Angeles

Downtown Los Angeles is continuing its powerful renaissance that began in the year 2000. With the city council’s passage of the Adaptive Reuse Ordinance (ARO) in 1998, housing developers saw an opportunity to profitably acquire pre-1974-built office and industrial buildings and convert them into live/work apartments and condominiums. Additionally, large pension funds like CalPers and CalStrs began to target a larger portion of their real estate investments toward urban redevelopment or “smart growth.” The convergence of pension fund investment into urban redevelopment and the passage of the ARO, combined with Los Angeles’ chronic under-supply of housing, all contributed to the current explosion of housing development in downtown.

Just how big is the explosion of new housing development? In 1988, downtown Los Angeles boasted a mere 2,400 housing units available for a work-force population of nearly 500,000 people. Today, there are nearly 10,000 housing units available for downtown’s work-force population. Nearly 5,000 of those housing units were brought on line in the last 5 years. Another 5,000 new housing units are expected to receive their certificates of occupancy in the next 24 months, and an additional 10,000 new housing units are in the planning and permitting stages and are expected to be added to the CBD’s housing stock by 2009.

Will converting all those former office buildings into housing product reduce downtown Los Angeles’ office space supply? Not likely. The largest supply of office-conversion-to-housing has occurred in the Class C category. Most of these Class C buildings were not up to current building codes and thus were unoccupied. In 2004, Los Angeles’ first Class A office tower, 1100 Wilshire, was acquired by the partnership of RAD Management, TMG Partners and Forest City Enterprises to be converted into housing condominiums. 1100 Wilshire’s conversion from office to housing removed 326,000 square feet of office supply from a market that measures nearly 32 million square feet of Class A and B office space. Additionally, the partnership of CIM Group and Lee Group are converting into condominiums the upper half of the Class A office tower at 801 South Grand Avenue. This conversion removes an additional 200,000 square feet of office supply from the market — hardly a tsunami of conversion from useful office supply to housing.

That said, it is widely believed that downtown Los Angeles’ 300 percent growth in available housing stock will attract a highly affluent and educated pool of workers. The explosive growth of highly educated employees downtown will be attractive to companies that are smart enough to recognize that transportation will become a key issue for business in the next 20 years. Hence, it is expected that downtown L.A.’s annual net office space absorption will begin to markedly improve as companies relocate closer to where the available work force is living.

In Los Angeles it takes nearly 6 years to acquire land, entitle it for an office building, plan and obtain the necessary permits, and then build it. Hence, it is quite possible that in the not-so distant future, downtown Los Angeles will see demand for office space eclipsing existing supply, thus driving an increase in rental rates somewhat beyond normal inflation.

— Mark Tarczynski is a first vice president at CB Richard Ellis in Los Angeles.

Portland

Improving economic conditions in the Portland office market will continue to stimulate solid leasing activity. After 3 years of losses followed by minimal growth in 2004, the outlook for office employment is positive. Job growth in the Portland market will outpace the national average at 2.4 percent, translating into 22,770 jobs. The market will see broad-based improvement in the economy throughout the year, but manufacturing, health care and retail trade will lead the recovery.

The urban office market will remain stable in 2005. Leasing will remain strong downtown, although much of the activity will be movement of firms from one property to another within the submarket. Expect vacancy in the CBD to remain at approximately 14 percent this year. Asking rents in urban areas will remain relatively flat, though mild gains in effective rents during the year are expected. Asking rents reached $20.31 per square foot by year-end 2004, and effective rents were $16.13 per square foot. The downtown’s vacant stock totals more than 2 million square feet.

Completions will increase across the metro area by 75 percent in 2005 to 700,000 square feet, although the downtown submarket saw zero completions last year. For the second year in a row, the absorption rate will outpace new supply with 1 million square feet expected to be leased in 2005. Only one office property is in the pipeline for downtown Portland, the Madison Tower. This 32,500-square-foot property is estimated to cost $5 million and will be located one-quarter block from the Museum Place site.

— Gary Lucas is a managing director and senior vice president at Marcus & Millichap, as well as regional manager of the Portland office.

San Diego

The San Diego office market is one of the top sectors in the country, just shy of the No. 1 market in Washington, D.C. Revitalization of the downtown district, the diverse economy, low unemployment rate and the city’s world-famous climate have all contributed to San Diego’s ability to weather the commercial real estate storm in the past and remain a healthy market. Nearly every major office building has sold in the past 2 years, including trophy properties such as Emerald Plaza, Golden Eagle Plaza and Comerica Building, which sold for a total of $270 million. In addition, the Wells Fargo Plaza sold for $148 million, SBC Plaza for $116 million and the NBC building for $95 million.

The outlook for San Diego remains bright while developers scramble for available land. Most of the developable land is in Otay Mesa near the Mexican border and Oceanside, one of San Diego’s northern neighbors. With interest rates remaining low, there is still a lot of owner/user demand that has been difficult to satisfy. Not unlike residential real estate, developers have embraced the condominium approach to office projects to fill the pent-up demand and give smaller users the benefits of ownership. Although the current supply is estimated in the hundreds of thousand square feet, there has been an increased desire by smaller office developers to jump into the market. Some noteworthy recent projects are the Balflour Corporate Center in Carlsbad, Oberlin Park and Cornerstone Court in Sorrento Mesa, and Park Place in San Marcos.

This is good news for landlords, specifically large multi-tenant landlords who have been withstanding a sluggish leasing market. Vacancy rates for San Diego are hovering around 10 percent. Some areas had vacancy rates near 30 percent in 2001. The tide is slowly turning toward the landlord, which has stabilized rents and in some cases even pushed up rents.

— Dan Gaston is a principal with Lee & Associates in San Diego. 

Denver

Denver’s office market will benefit from improvement in market fundamentals across the board in 2005, including job growth, declining vacancy and a slowdown in construction. The Turnpike and Tech Center areas, which were hit hard by the high-tech and telecommunication downturns, will post declining vacancy and rising rents as job growth in the information sector rebounds.

The employment and construction forecasts both bode well for the office market. Denver can anticipate employment growth of 2.5 percent in 2005, which will mark the second consecutive year of expansion. Office employment will grow by 2.6 percent, and the information sector, which began showing renewed signs of life in 2004, will have a robust 2005, growing by 4.6 percent. In addition, completions will decrease in 2005 to 500,000 square feet. The 47 percent drop in activity comes on the heels of a 62 percent decrease in 2004.

Despite flat asking rents, effective rents will register modest gains this year of 0.9 percent to $13.94 per square foot, as owners slowly reduce concessions, halting 4 consecutive years of decline. Led by downtown Denver, seven of the region’s eight submarkets will have effective rent increases ranging from 0.5 percent to 1.1 percent in 2005. Vacancies will decline 150 basis points to 19.6 percent during the year.

Office investment activity will rise in the next year. Cap rates, while still healthy, have fallen 80 basis points since 2001 to 8.9 percent. Investors, both large and small, are more concerned with prices per square foot than current occupancy levels. Buyers are optimistic that as the local economy improves, they will be able to lease space at higher rates. In 2005, additional investors will enter the Denver market, trying to take advantage of the comparatively low prices and favorable lending environment. The increase in demand for office assets is expected to encourage existing owners in the marketplace to offer their properties for sale.

— Adam Christofferson is a vice president and regional manager of Marcus & Millichap’s Denver office.

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