MARKET HIGHLIGHT, AUGUST 2004

EMPIRE BUILDING: GROWTH MOVES INLAND
Kevin Assef

Strong population growth is fueling economic expansion in Southern California’s Riverside and San Bernardino counties. Known as the Inland Empire, this market has zoomed to the top of the real estate charts. The region presents unique opportunities for both investors and developers as it is the last Southern California area with large amounts of undeveloped land along developed transportation corridors. Because dirt is cheaper in the Inland Empire, and the homes and buildings constructed on it sell or lease for substantially less than in neighboring Los Angeles, Orange and San Diego counties, the market has become one of the fastest growing urban areas in California.

Area employers are expected to add 30,000 jobs this year — an increase of 2.7 percent, nearly half of which is coming from sectors that cater to the growing population. These include the professional and business services, education and health services, and leisure and hospitality sectors. More than 100,000 new residents are expected each year for the next 5 years. This positive outlook, combined with improving real estate fundamentals, has made the Inland Empire one of the top markets in the country and fueled intense competition among investors.

Multifamily

Strong net migration from the coastal markets, along with the creation of higher-paying jobs and rising home prices, will continue to fuel tenant demand for Inland Empire apartments and keep the outlook bright for the multifamily market. The region’s apartment sector is among the strongest in the nation despite some weakened demand in the luxury sector. Absorption is improving in the Class A market, though, as fewer people have been able to purchase homes due to escalating prices. As a result of tight conditions, the Inland Empire continued to post rent growth during the recent national economic downturn.

Building activity has increased in 2004, but a possible cloud on the horizon may slow future development. Apartment construction will total approximately 3,000 units in 2004, up from the 2,150 units delivered in 2003. Class A projects account for the majority of construction as rising development and acquisition fees make it cost-prohibitive to build anything else. The largest projects continue to be built in the western portion of the Inland Empire. Lewis Apartment Communities is in the process of adding another 500 units in Mira Loma, while Fairfield Development is completing 588 units in Rancho Cucamonga. Thousands of units are planned for Moreno Valley, but the $6,000-per-unit Transportation Uniform and Mitigation fee imposed upon new residential projects may alter the type of housing units constructed. Condo development has started to increase due to the high demand for less expensive housing and the fact that developers can pass the fee on to homebuyers.

Slow absorption of luxury apartments caused vacancy to creep up during the past year, but renewed job growth and rising home prices will elevate demand and drop vacancy by 30 basis points to 4 percent during 2004. Vacancy increased by 30 basis points to 4.3 percent during 2003, as low interest rates allowed many residents to buy homes rather than rent. Class A properties experienced a vacancy increase of 90 basis points, to 6.1 percent. The average asking rent rose 6 percent to $870 per month in 2003 and has continued to register gains this year. Owners will achieve a 6 percent gain in asking rents in 2004.

The current multifamily investment climate is characterized by frenetic buying activity, with continued price appreciation expected during 2004. The median sales price has increased nearly 30 percent over the last year, to $77,000 per unit. Buyers continue to outnumber sellers and are aggressively competing for properties. In the past year, apartments with fewer than 20 units garnered tremendous interest, which has resulted in a 25 percent price increase, to $85,000 per unit. Aggressive investors drove up the median price in the airport area by 39 percent, to $95,000 per unit. Other active areas in the region include east San Bernardino, which recorded a 30 percent increase in the median price, to $65,000 per unit.

Retail

The introduction of new home communities throughout the region and strong retail sales growth are spurring retail development despite concerns that the area is becoming over-retailed. National discount retailers believe in the long-term potential of the market as evidenced by the rollout of new concepts. Wal-Mart opened its first Supercenter in California in the city of La Quinta. Sears is introducing a new 180,000-square-foot store in Rancho Cucamonga called Sears Grand, which will compete against the new Wal-Mart Supercenters and SuperTargets by offering a grocery component. Smaller grocers and underperforming locations will likely take a hit from the discount giants. Areas of concern include Coachella Valley, Moreno Valley and Hemet. Still, neighborhood and community shopping centers have been performing well. Owners maintained occupancy levels and increased rents by nearly 3 percent during 2003, which resulted in average property revenue levels rising by 2.5 percent.

Builders are on track to deliver 4.3 million square feet of retail space to the market this year, a substantial increase from 2003. Nearly half of the space is composed of large centers, such as the 1.3 million-square-foot Victoria Gardens in Rancho Cucamonga, with the remainder made up mostly of single-tenant properties, such as Wal-Mart, Target and The Home Depot.

While construction levels will increase dramatically in 2004, the average vacancy rate will post a noticeable decline due to new properties coming online pre-leased. The vacancy will drop 90 basis points during 2004, to 4.7 percent. Rent increases will resume at a more aggressive rate in 2004 as shopping center owners find more encouragement in the region’s economic outlook. Asking rents will increase by 4 percent during 2004, to $17.91 per square foot.

Economic strength, coupled with a rapidly expanding population, has created a robust retail market and is luring numerous investors to the region. The intense competition among investors has driven prices higher. Strip centers remain at the forefront of activity with a median price of $110 per square foot, representing a 10 percent increase from last year. The highest price growth was achieved in east San Bernardino, where investors are entering the market before redevelopment efforts take hold. The median price for shopping centers in the submarket increased by 15 percent in the past year, to $92 per square foot.

Sales activity will likely slow due to a lack of willing sellers, but prices will continue rising as revenue streams increase. South Riverside County serves as a solid investment location because the housing boom that is taking place in Temecula/Murrieta, Lake Elsinore, Menifee and surrounding areas is luring many retailers to the market and keeping demand for space at a high level.

Industrial

Economic expansion, coupled with the continued influx of companies leaving the high-cost coastal markets, will boost absorption rates and create a tight industrial market this year. The Inland Empire was one of the few metro areas to experience a rise in manufacturing employment last year — a job increase of 1.4 percent or nearly 2,000 positions. Developers have recognized the strength of the market and added nearly 9.8 million square feet of new industrial space in 2003 and are on schedule to complete another 7.2 million square feet this year. Most of the new construction has been large build-to-suits, which contributed to impressive absorption numbers being recorded within the region in 2003. The growing labor pool and accessibility of transportation, including rail and air, have kept tenant demand high with vacancies decreasing by 80 basis points to 9 percent over the last year. The large and still-expanding airport market has performed well for owners and investors alike, with average revenue growth exceeding 5 percent over the last year, and the median sales price up 11 percent, to $62 per square foot. The area surrounding the airport is the most active industrial development location, accounting for nearly 50 percent of the 7.2 million square feet slated for delivery this year.

Owners can look forward to a 50-basis-point vacancy decline this year, to 8.5 percent, as absorption continues to outpace construction. Increased leasing activity and longer lease terms will allow owners to raise rents by 4 percent this year.

Robust leasing activity will keep the industrial market on solid ground, allowing sellers to achieve healthy price gains this year. Competition for deals has pushed down the average cap rate from 8.9 percent in 2002 to 8.6 percent in 2003.The submarkets highest in demand among investors include the area surrounding Ontario International Airport and Corona. Tenant demand is high in Corona due to its proximity to Orange County and Los Angeles. The median price in the submarket has increased by 10 percent, to $66 per square foot, and the cap rate has declined by 120 basis points, to 7.5 percent.

Office

The Inland Empire’s population and employment growth have spurred office construction as investors and developers anticipate a jump in space demand. Development activity has increased to a decade high with approximately 515,000 square feet slated for delivery this year, up from 58,000 square feet in 2003. New projects are sprouting in nearly every corner of the region, including five projects in Temecula/Murrieta, four projects in Rancho Cucamonga and five in Corona. Most of the new space is speculative development; only 15 percent of the 515,000-square-foot total is pre-leased. Two of the largest projects include a 130,000-square-foot Class A building being constructed by Rexco and a 120,000-square-foot Class B project by Opus. Both spec developments are located in Corona.

Similar to the residential market, lower costs in the Inland Empire are attracting more companies from coastal locales. Plus, the expanding population is fueling significant gains in professional and business services, which should generate growing demand for office space in the near term. Currently the local office market boasts one of the lowest vacancy rates in the country at 9.7 percent. One of the most popular areas with tenants has been Rancho Cucamonga, which enjoys close proximity to the airport and features high-quality properties and ample retail destinations. Over the past year, this submarket posted positive absorption of 100,000 square feet, which pushed down vacancy to 7 percent. Corona also has fared well with its proximity to Orange County. Vacancy in that city is currently a tight 5.7 percent.

Healthy leasing activity and growing tenant demand are prompting rent increases. Last year, monthly asking rents climbed 4 percent, to $1.52 per square foot. Asking rents are projected to jump another 5 percent by year-end 2004. Gains are being driven by the Class A market, where rents to date are up 2 percent from 2003, at $1.85 per square foot. The more popular markets of Rancho Cucamonga and Corona have achieved even greater increases in the first half of 2004, with asking rents for all property classes rising by 7 percent and 6 percent, respectively, since 2003.

Office property values will continue to escalate as investors compete for a limited supply of for-sale product. The median sales price for multi-tenant office buildings recently hit a record high of $115 per square foot, which represents an increase of approximately 10 percent from last year. The intense competition among investors has compressed cap rates to an average of 7.8 percent. Much of the investment activity is focused on low-rise, multi-tenant office buildings, and, in many cases, the buyers have been private investors looking to complete the upleg in a tax-deferred exchange. Expect investor demand and pricing to remain strong as investors look to take advantage of low interest rates as well as a tight market with prospects for improved revenue streams.

Kevin Assef is a managing director at Marcus & Millichap and is the regional manager of the firm’s Inland Empire office in Ontario, California.

THE INLAND EMPIRE’s RETAIL INVESTMENT GROWTH Dollars & development follow demographics in San Bernardino and Riverside counties. The Inland Empire retail investment market remains one of the strongest in the country. Strong retail fundamentals, combined with the region’s rapid population growth, are attracting investors to this market. With more than 1 million new residents expected in the San Bernardino/Riverside (Inland Empire) trade area during the next 10 years, investors are seeing the potential for increased rents as densities continue to increase. Sellers continue to expect top dollar for their assets. This expectation appears realistic although the tide might be changing. During the past 2 years, the market has been very clear. If you were a seller you were going to get a higher price than the previous comparable, and if you were a buyer, you were going to have to pay it. Expectations may be starting to change. The potential for misaligned expectations appears more in the upper end ($10 million or more) of the market, where more sophisticated investors are purchasing. These investors are frequently investing other people’s money, and, therefore, must maintain minimum returns in order to commit. This end of the market also seems to be most affected by the rise in long-term interest rates given that their financial partners are primarily yield-driven. Depending upon the quality of the asset, cap rates for this type of product are in the 7 to 8 percent range. On the other hand, the $10 million-and-less retail market appears to be as strong as ever because less sophisticated investors are investing their own money and are willing to settle for lower returns. Cap rates for product in this segment range from 6 to 7.5 percent depending upon location, price, age and the quality of the asset. These investors frequently have no other place where they can obtain a similar yield on their equity. Many of these buyers are in 1031 exchanges, having recently sold apartments at sub-6 percent cap rates or vacant land from which they received no income. As a result of these two buyer pools, retail cap rates of 6.5 percent or more look appealing. This is especially true for the apartment exchange buyer, who now sees a less management-intensive asset with a NNN lease instead of a gross lease. In an effort to take advantage of the spread in cap rates between these two price ranges, Lewis Retail Centers recently put its Terra Vista Town Center in Rancho Cucamonga up for sale. It was divided into more than 20 separate parcels, resulting in a significantly greater return for the owner than if it had chosen to market the property to one investor. Sellers of Inland Empire retail assets are generally either developers taking a profit, long-term investors trading into larger or less risky holdings or arbitragers capitalizing on the cap rate spread. During the next 6 to 12 months, cap rates should stabilize and possibly trend higher. Currently, product is being listed at higher prices, producing lower cap rates than we’ve seen in the past 15 years. This is due to the fact that properties are being priced relative to the most recent closing and current listing values. Until buyers balk at these prices, brokers and owners will continue to push the envelope. A major driver of the Inland Empire’s retail investment market is the substantial amount of newly constructed product. The more than 5 million square feet of retail space that will hit the market during the next few years is producing two trends: developers selling new product to turn a profit (this product is very popular with small investors) and certain owners selling their holdings due to concerns about market competition. The next 12 months should be very interesting for retail investment in the Inland Empire as many believe that cap rates have no where to go but up. At the same time, as the population continues to grow and the economy remains strong, rental rates may continue to trend higher, and therefore property values could potentially sustain higher cap rates and still maintain their values. Brad Umansky is vice president of Sperry Van Ness’ Ontario, California, office.

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