MARKET HIGHLIGHT, APRIL 2008

INLAND EMPIRE
Robin Treen, Scott Ostlund, Ken Jones, John Oien and Paul Runkle

Despite any short-term market wavering, the Inland Empire’s population growth continues, making the market an attractive one for real estate players.

Retail

Riverside and San Bernardino counties’ retail absorption rate slows as supply outpaces retailers’ demand for space in early 2008, which is projected to continue throughout the second quarter. The market’s continued population growth sends a strong signal that the current malaise will be short-lived; it’s an opportunity for the strong players to gain market share over their weaker competition.

In response to growing vacancy, landlords are lowering rental rates and offering concessions not seen in the last 5 years. In contrast, retailers are willing to pay even higher rates for the newer, nicer centers coming online.

Retail developers are undertaking ambitious projects, including a number of power centers such as Pacific Developments new 1 million-square-foot phase of the Colonies Crossroads in Upland featuring Best Buy. As a result, market-wide vacancy is expected to push higher through the year, although the delivery of new space should support modest gains in asking rents.

Absorption in the Inland Empire should be steady this year, although increased development of new retail properties is producing higher vacancy rates. Vacancy is expected to grow to 15 percent in 2008. Strong tenant demand for premier Inland Empire retail space will drive up asking rents to $24 per square foot this year. In an effort to attract and retain tenants, owners may choose to offer additional incentives, and effective rents are anticipated to advance 4.9 percent to $20.14 per square foot by year’s end.

The Inland Empire retail investment market has slowed as buyers lack interest in paying higher prices, and sellers have not yet adjusted to the declining market trend as valuations continue to be supported by short-term revenue gains and the market’s prospects for long-term economic growth. Cap rates are averaging in the 6 percent to low 7 percent range for both single- and multi-tenant properties as prices stay flat or decline. Individual investors are expected to target single-tenant assets, particularly fast-food restaurants with national credit tenants in place. In addition, the area’s growing inventory of new, large-scale lifestyle and power centers at relatively affordable prices should attract institutions and REITs. Buyers waiting for the sector to move lower may be disappointed as they may not get a chance to act before the market correction ends.            It’s an old story made new, the new high-end retail is in demand and the old low-end retail is trying to compete with the one thing it has going for it — price. So in this turning of the market, we will see new highs in the new projects and new lows in the old projects prompting owners of older, well-located retail centers to redevelop and jump the gap. 

— Robin Treen is a senior vice president for RBI Retail Brokers in Riverside, California.

Industrial

The most distinguishable difference that has arisen in the industrial real estate market in the Inland Empire West during the last 12 months is the challenge of pinpointing the price at which a building will sell. It is not an issue of whether or not buildings are selling; the issue becomes pricing the buildings at a price buyers will pay.

There is no question that the market has changed; however, convincing sellers of this notion has been far from easy. Many sellers continue to price their buildings by simply looking at other buildings on the market comparable to their own. In these cases, they face a lack of activity because there is an enormous disparity between the asking prices of available buildings and where these deals are selling. 

Following the trends of the real estate market in recent years, it would seem obvious to price a building 20 percent higher than what a comparable building sold for in the previous year. In a rising market, it is not only common but justified to price above market, holding the assumption that the market will eventually climb to that price. The problem occurs when prices flatten or, in our current situation, drop 10 percent below the comps of the previous year. This statistic, accompanied by building owners who continue to increase prices at the historical pace of 20 percent, creates nearly a 30 percent gap between where buildings are priced and where they will sell.

That is the negative side to a falling market. The positive news is that these current sales prices are only 10 percent under the all-time high prices at which buildings have sold. Industrial prices in the Inland Empire West have only rolled back to early 2006 levels.

Absorption is still in a manageable range; however, the downside is that more cracks are beginning to appear and vulnerability is increasing among tenants. The gross absorption in the market has maintained a consistent pace, and the vacancy rate is still at a historical low.

On the development side of the equation, the most eye-opening change has occurred among the construction of buildings less than 50,000 square feet. In this size range, development has essentially become non-existent, excluding the eastern cities in the Inland Empire. At a closer look, there are virtually no industrial buildings less than 25,000 square feet being constructed in the cities of Rancho Cucamonga and Ontario, which is something that has not occurred since 1998. These factors can be attributed to the obvious lack of available land and moreover to high construction costs, which would exceed the value of the building upon completion.

— Scott Ostlund is a principal and Ken Jones an agent in Lee & Associates’ Ontario, California, office.

Office

With continued population and job growth in the Inland Empire, the office sector continues to show activity, despite any short-term market adjustments due to capital compression or the trickle-down effect of the subprime meltdown. In the investment arena, the market is still experiencing capital market interest in well-positioned, well-leased assets. That said, deal flow in the office market has experienced a slowdown in pace or activity levels in one form or another.

For the past decade, the Inland Empire’s office growth has been directly correlated to population growth. Today, the two-county area’s population exceeds 4 million, which makes the Inland Empire larger than 24 states in terms of the number of people who live there. By 2020, the area’s forecasted population growth is expected to surpass that of 44 states (U.S. Bureau of Census). During the same period, the Inland Empire’s job growth forecast far exceeds that of the surrounding counties. This suggests that even if the unemployment rate experiences some upward fluctuation in the short term, the long-term prognosis for the Inland Empire is strong.

As important to the office market as the population increase is the changing make-up of the Inland Empire’s workforce, which is continuing to shift from blue collar to white collar. According to the 2000 Census and 2005 American Community Survey, the percent of college-educated workers in the market grew by 41.4 percent from 2000 to 2006. In short, population growth and the shift to white-collar workers are the two most important factors driving business migration to the Inland Empire.

Net absorption for 2007 was positive at approximately 1.3 million square feet. In total, fourth quarter 2007 saw 61,936 square feet of positive net absorption, while the vacancy rate at the end of the quarter increased to 11.85 percent as 240,830 square feet of new space completed construction.

With respect to pre-commits and speculative land development plays, the Inland Empire is seeing a slowdown due to lender constraints, which is affecting the smaller players in particular. In addition, some new development projects are being put on hold, given other projects that are in further stages of development.

Ontario has been at the forefront of office growth with a significant amount of new development in office high-rises. The speed with which the subsequent phases of these developments will be delivered will be directly proportional to the speed with which the first phases lease. This is good news for those developments that are actively marketing and pre-leasing, and it also speaks to the sophistication of the market’s developers, which are only going to build when the market is ready for new product. This approach will help avoid a situation similar to that experienced in past cycles where overbuilding was a significant problem.

— John Oien is first vice president for CB Richard Ellis in Ontario.

Multifamily

The Inland Empire apartment market like most other real estate sectors is in a state of flux. The two indicators that predict the health of the apartment market are job creation versus new apartment starts. The Inland Empire has not witnessed negative job growth since 1980, but a state agency recently reported that the two-county area lost more than 14,000 jobs in 2007 as a result of the slowdown in the housing market. While some experts predict these numbers may be revised upward, it is clear that even California’s most robust economy in the past decade is being affected dramatically.

During 2007, developers began to pull back from the development of new projects in tertiary markets within the Inland Empire as their equity partners began to suggest that they focus on the western edges of the market bordering Orange and Los Angeles counties. That being said, apartment communities were recently approved for development in Moreno Valley (256 units by Lincoln Property Company) and Temecula (232 units by Dinerstein Companies).

In certain submarkets and for specific product types, the apartment fundamentals are strong and real economic occupancies are in the 90 to 95 percent range. In other pockets, a preponderance of development in initial lease-up has spurred rental concessions, which has impacted older existing product. New product lease-up is being exacerbated due to the current economic slowdown. Expect rental growth in 2008 to be nominal — in the 2 to 4 percent range. The slowdown in the condo market has had the greatest effect on the apartment market in the Coachella Valley, where two recently developed condominium projects totaling 469 units were transitioned to apartments.

Apartment transactions for the market in 2007 tallied 27 sales of properties 100 units or greater, which is down about 35 percent from typical sales volume. Only 4 of these 27 sales closed after the capital markets meltdown of August 2008. While recent sales in the Inland Empire have witnessed continued strong prices per unit — 212 units in Moreno Valley built in 1989 for $133,000 per unit and 180 units in Temecula built in 2007 for $205,000 per unit — investors are being much more selective about the submarkets and types of properties they are willing to offer on. In addition, the pricing range of offers received can vary by up to 10 to 20 percent.

The strength of the Inland Empire job market in 2008 will define the strength of the area’s apartment market. With a strong expanding industrial market, a rapidly growing office market and continued population growth, the foundation is set for swift recovery. The key questions for the apartment sector — when will the real estate market stop contracting and will a national recession be prolonged?

— Paul Runkle is an associate partner with Hendricks & Partners in Temecula, California.

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