MARKET HIGHLIGHT, APRIL 2010

ORANGE COUNTY
Jack McNutt, Greg Osborne, Edward Hanley and Jerry Giglio

While there are some positive signs in Orange County’s commercial real estate sectors, the market will likely look to the rest of the year for more stability. Healthy tenants and investors can pick their spots in an area whose solid fundamentals mean a blossoming is just a matter of time.

Office

After months of companies downsizing or stalling real estate decisions, the Orange County office market experienced an increase in activity during fourth quarter 2009 that has carried over into 2010. Although there is optimism among businesses in the market that the economy will improve this year, the office market is expected to continue to struggle as vacancy rates and job losses continue to rise.

Focused on reducing occupancy costs, tenants are either negotiating inexpensive renewals — earlier than their lease expiration in several cases — or are looking to relocate to high-quality properties available at very attractive rates. The reduced rental rates and concession packages offered by landlords have created a flight to quality. Class A buildings such as the Irvine Company’s 18100 Von Karman and 3 Park Plaza, as well as Hines’ 2211 Michelson, have all seen increased leasing activity lately, as tenants have taken advantage of the excellent value opportunity these properties provide. Lower-quality product that are very basic are largely passed over by prospective tenants. The lower-quality product will likely suffer in the next 12 months, regardless of how low landlords price this space, as tenants are focused primarily on the value opportunity that exists in higher-quality space.

In most transactions, effective rents have been cut significantly below asking rents, which averaged $2.43 per square foot per month for Class A properties at the end of fourth quarter 2009. With the current vacancy rate of 19.9 percent, the projected 25 million square feet of additional negative absorption and the expectation of more employment reductions in 2010, landlords are eager to complete transactions at virtually any cost in order to mitigate vacancy.

New owners are contributing to the downward pressure on lease rates by offering aggressive concession packages and low rental rates in order to get their properties leased up. The stability of an office asset and its ownership has also played a crucial role in attracting tenants. For example, the Irvine Company, which has considerable financial strength, has been extremely successful keeping its properties leased. On the flip side, tenants and brokers have been cautious in pursuing properties that are in the hands of a receiver or lender, or in the process of being sold, until a new owner is in place.

Although no new office projects are under development in Orange County, the investment market appears to be picking up compared with 2009, when only eight transactions closed in the first 3 quarters combined. Nine sale transactions have taken place so far in 2010 for buildings sized 20,000 square feet and above with a total dollar volume of $12.2 million. The average price per square foot was $121.80.

The sales and leasing market will continue to bounce along at what can be considered the bottom for the next 12 to 18 months. Still, there will be activity as tenants move from one building to another or renew their existing leases. The bottom line is that if tenants can save money via reduced occupancy costs, it will help landlords succeed long term. Ultimately, these tenants will grow and absorb space, which will decrease the vacancy rate and drive rental rates up.

— Jack McNutt is executive vice president, Office Group, in Grubb & Ellis’ Newport Beach, California, office.

Industrial

Orange County’s industrial market seems to be off to a better start than 2009 with the velocity of lease and sales transactions having picked up. There are more direct deals being completed, providing precedents for where lease and sales values should be. Additionally, users have seen enough of a drop in lease rates and values to spark interest in buying and leasing new space. On the sales side, both SBA and conventional financing is very attractive for buyers that can qualify.

However, the market is still dealing with significant overall negative net absorption and vacancy is still climbing. Moreover, there is still downward pressure on lease and sales values, a trend that will continue throughout 2010. There is a large delta between Class A product and B and C product. From a tenant and buyer perspective, there are favorable terms and concessions to be had. Unfortunately, from a landlord and seller’s perspective, most deals incorporate ample free rent, a fair amount of tenant-improvement dollars, and discounted rates and sales values.

Throughout 2009, most landlords primarily focused on tenant retention, causing more renewals than new direct deals. That trend will continue throughout 2010, but with less disparity. Furthermore, the gap between tenant/buyer expectations and the expectations of landlords and sellers has gotten smaller, which should translate into more deals being done.

Orange County’s investment market remains quiet, with very few quality industrial investment opportunities in the past 6 months. Most sellers in today’s market won’t sell unless they have to. There are a number of buyers and a lot of money on the sidelines waiting to capitalize on distressed opportunities, but there have been far fewer distress opportunities than anticipated. Expect to see more bank-owned opportunities in the smaller and medium-sized properties because of the number of users that purchased at the height of the market that are now overwhelmed by their debt service. Cap rates will continue to rise, a trend that is expected to continue during the next 18 months.

Orange County’s industrial development market also remains quiet, largely because construction financing is extremely difficult to acquire, and there is not enough lease or sales demand to warrant construction. In addition, most developers are still struggling to unload product built within the last couple of years.

The hope here is that the market is closer to the bottom, but it’s certainly going to take more time to recover. Expect to see more positive net absorption this year, as well as a gradual flattening of lease rates and sales values toward the end of 2010 and the beginning of 2011. Landlords will continue to offer ample concessions and low rental rates to get deals done. Vacancy, which was estimated at 6.7 percent at the end of fourth quarter 2009, is anticipated to climb higher throughout 2010.

— Greg Osborne is a vice president in Grubb & Ellis’ Industrial Group in Anaheim.

Retail

Despite negative forces impacting the market, Orange County still remains one of the most desirable places to own retail property. Although there is an abundant amount of both private and institutional buyer interest, there is a low supply of product. Shopping centers, especially those anchored by quality grocery stores, are still at the top of most investors’ lists and are the preferred asset class for the few lenders remaining in the market. Single-tenant, fast-food and drug stores are highly sought after by investors, who are typically purchasing them on an all-cash basis. Watch for cap rates on most Orange County retail product types to slowly begin to stabilize as investors feel the market beginning to reach its low point.

After a quiet first half of 2009, the market picked up some momentum with several large shopping centers trading hands, including the 81,000-square-foot Tustin Courtyard in Tustin for $18.5 million and 70,000-square-foot Plaza del Rio in San Juan Capistrano for $12 million, both sold by Donahue Schriber Realty Group. In Lake Forest, a private partnership sold the 44,000-square-foot Bell Tower Plaza for $16 million, and in Seal Beach a southwestern-based partnership sold the 255,000-square-foot Old Ranch Town Center for $45.3 million.

The large number of foreclosures predicted have not occurred, however, Orange County retail properties are not immune. A prime example was the REO sale of the 277,500-square-foot South Coast Home Furnishings Centre in Costa Mesa for $37 million to Burnham USA Equities in first quarter 2009. In first quarter 2010, the 219,000-square-foot Kaleidoscope lifestyle/entertainment retail center in Mission Viejo was offered as a receivership sale, which, once sold, will be a significant indicator to market values on distressed properties in the area.

Increasing approximately 5 percent from the previous year, Orange County retail vacancy rose to 8.3 percent by fourth quarter 2009 and shows no signs of declining as retailers wait for consumer spending to return. Average rental rates for the county at the end of last year were $2.55 per square foot, which was 8 cents below recorded asking rents a year prior. Consumer confidence has increased slightly in the past months, but still has a substantial way to go from the previous highs reported back in 2007.

Orange County’s long-term barriers to entry are so strong that the retail market is well positioned for future success once new tenants start to enter the market and fill existing vacancies. A watchful eye is being kept on unemployment, inflation and housing prices, which will continue to be factors that impact consumer spending. There is also some talk about lenders beginning to offer investors more attractive financing products, which should help increase the number of transactions in the retail marketplace. 2010 will be a very interesting year for Orange County retail property values as the industry sees some positive signs that hopefully the worst has passed. 

— Edward Hanley is president of Hanley Investment Group Real Estate Advisors in Irvine, California.

Multifamily

Multi-housing investment sales throughout Orange County have slowed dramatically since the economic downturn, largely due to uncertainty in the market and a freeze in available funding. Although sales and rental rates continue to decline, occupancy rates are on the rise due to the significant number of homeowners facing foreclosure needing a residence.

Rental rates, currently averaging $1,473 per unit per month, are predicted to decline 4 percent by year-end 2010 to $1,414 per unit per month. Occupancy rates, currently 93.6 percent, are anticipated to increase 20 basis points to 93.8 percent. This continues a similar trend that took place during 2009, when rental rates declined 14.5 percent from year-end 2008 and occupancy increased 20 basis points during the year.

Very little development is currently taking placing, with the majority of new construction in the north Orange County submarket. In Anaheim, The Related Companies is constructing a 146-unit affordable rental complex at the intersection of East Street and Lincoln Avenue, and the SARES·REGIS Group is building a 312-unit multifamily property on East La Palma Avenue. In Orange, C&C Development is building a 57-unit affordable rental complex on Lemon Avenue. All three developments should be completed by year-end 2010.

During 2009, only 19 multifamily sales took place involving properties of 20 units or more. Through the first 2 months of 2010, sales activity remained almost non-existent with no multifamily properties exceeding 20 units trading hands. This trend is likely to continue throughout 2010 unless buyers and sellers can close the gap on expectations and financing becomes more readily available. One factor that could fuel an increase in sales would be a spike in foreclosures. So far, foreclosures have been limited to broken condominium properties (those projects where developers owe more money than they can make on the venture) or four-unit and smaller multifamily buildings.

Cap rates are currently averaging 6.34 percent, and sales average $139,382 per unit and $173.90 per square foot. Private investors make up the bulk of buyers of the five properties currently in escrow. It is believed that Essex Property Trust is nearing the completion of the acquisition of Skyline at MacArthur Place, a planned 349-unit condominium complex located in the Hutton Center that will likely be operated as luxury rental units.

— Jerry Giglio is a vice president in Grubb & Ellis’ Multihousing Group in Anaheim.

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