MARKET HIGHLIGHT, AUGUST 2007

THE INLAND EMPIRE
John Oien, Janet Valentin, Brian McDonald and Bob Patterson

Topping the list of California markets with the greatest population and job expansion, the Inland Empire offers seemingly endless real estate opportunities. It can be seen in an active office market, a high-demand industrial sector and a retail market that continues to plug away despite the residential slowdown.

Office

As the leader in population and job growth in California, the Inland Empire boasts an office market that has never been stronger. With a base of approximately 19 million square feet throughout the two-county market and more than 1.7 million square feet of space under construction, consensus among those active in the office market is that new space coming online is balanced and can be absorbed based on strong population and job growth projections, active migration from coastal counties and the continued expansion of homegrown companies, all of which are expected to negate the effects of the recent slowdown in the housing market.

Development continues to be the big story in the Inland Empire office market, particularly in the cities of Corona, Riverside, San Bernardino and Rancho Cucamonga, each of which boast anywhere from 150,000 to 700,000 square feet under construction. In the last 3 years, the Inland Empire has been absorbing office space almost as quickly as it’s been coming online, and this trend is expected to continue. With increased land values and construction costs now creating barriers to entry for new development, the amount of additional new construction is expected to slow, which should help keep the market balanced for the foreseeable future.

Today’s asking rents in the Inland Empire demonstrate how far the market has come in the past few years. In the last 24 months alone, asking rents have increased 16 percent, and 9 percent from the same time last year. Following a 3 percent gain in the second quarter of this year, asking rents in Corona are now at $2.26 a square foot, while the Ontario/Rancho Cucamonga market is commanding asking rates of $2.20 per square foot. Projections estimate that the market will soon be positioned to command as high as $2.50 to $2.60 per square foot, while maintaining vacancy rates at or below 10 percent.

As significant as the volume of new office space is the type of space. The Inland Empire is one of the only markets in Southern California offering brand new, Class A office space, a significant factor that is expected to support the market’s increasing rent structure. New space with flexible, rectangular floor plates that can be tailored to a user’s needs is proving to be an enticing alternative for tenants comparing older space in more mature markets such as Anaheim and Brea.

In addition, mixed-use office developments that incorporate retail, high-density residential and hotel are experiencing some of the highest success rates. For example, HavenPark, a mixed-use project in Rancho Cucamonga featuring on-site retail and a full-service hotel, was fully leased 6 months prior to construction completion.

Another significant sign of change in the Inland Empire office market is the relatively new institutional investment market for Class A office buildings. Bolstered at the end of 2006 by RREEF’s purchase of a three-building Ontario portfolio, investment activity has changed in that major institutional players that hadn’t been in the market before are now becoming very active and focused on ownership in the Inland Empire, due in large part to continuing strong fundamentals across the market.

— John Oien is first vice president at CB Richard Ellis in Ontario, California.

Industrial

The Inland Empire industrial market has maintained its strength throughout the first half of 2007, and market indicators are showing no signs of a slowdown. While the market remains strong for the two-county market as a whole, varying maturation stages from submarket to submarket are indicative of unique market trends and dynamics affecting owners, users and developers today.

2006 was a banner year in the Inland Empire industrial market with approximately 18 million square feet of net absorption and 32 million square feet of positive gross absorption. Of particular significance, it was also the first time that the Inland Empire East and Inland Empire West submarkets experienced equal absorption rates. Net absorption has continued at a steady pace in 2007, with year-to-date net absorption at 9 million square feet and gross absorption at 15 million square feet.

Vacancy remains incredibly tight, particularly in the Inland Empire West where big box vacancy is at 1.5 percent. The Inland Empire East big box vacancy is slightly higher at 10 percent, which can be attributed to the fact that development is just starting and there is no base to spread over the amount of new construction.

The most active growth paths in the Inland Empire can be found to the east along Interstate 10 freeway in Redlands, where new, state-of-the-art, big box product has attracted users such as Payless Shoe Source, Lamps Plus, Discount Tires and PrimeLine; and along the Interstate 215 Corridor in Moreno Valley, which is home to March Global Port, one of the region’s most dynamic new industrial projects offering 350 acres of land for commercial air cargo and distribution development, located on the south end of the March Air Reserve Base.

With all that said, land — or the lack of it — continues to be the big story in the Inland Empire industrial market. Until recently, the West Inland Empire, consisting of Ontario, Rancho Cucamonga, Fontana and Mira Loma, was one of the fastest growing industrial development markets in the country. Today, consensus is that the West has transitioned into a bona fide infill market. While the land that is developable is off market in the West, estimated improved land values are at approximately $20 per square foot.

By comparison, growth paths in the East Inland Empire are seeing land values anywhere from $8 to $14 per square foot, and the newest growth area, the High Desert, is commanding $5 to $6 a square foot. Land in Redlands, which is one of the newest big box frontiers, is already effectively sold out to developers planning to develop themselves.

Increasing land prices notwithstanding, the biggest factor driving development decisions in the Inland Empire today is not the cost of the land itself, but the cost to finish the land. Developers are giving heavier consideration to the cost and length of the entitlement process and infrastructure improvements, noting that the farther out development goes, the more costly each of these factors becomes. Furthermore, with real estate costs at only 10 percent of the development cost structure, developers are evaluating opportunities with a heavier emphasis on inbound and outbound dreage costs, which represent 10 percent and 60 percent of the total cost structure, respectively.

— Janet Valentin is a senior associate for CB Richard Ellis in Ontario, California.

Retail

The retail construction boom in the Inland Empire continues because the pipeline is so long, even though residential growth has slowed down tremendously. Driven for the past several years by an explosion of new rooftops in the two-county market, developers, owners and tenants continue completing projects that have been in the pipeline for the last few years.

Leading the Golden State in job, population and retail growth, the Inland Empire is the most active and unique retail development market in Southern California. While the marketplace is experiencing some repercussions of the housing market slowdown of the past year, retailers continue to see opportunity to grow their company and market share.

The Inland Empire boasts an existing retail base of 572 retail centers that are 50,000 square feet or larger, totaling more than 92 million square feet, with vacancy at 5.42 percent. Proposed and under construction centers at 50,000 square feet or more could increase the base by almost 50 percent, with another 46 million square feet slated to come online. As of first quarter, 14.8 million square feet of that was in the pipeline.

Tenant demand remains strong. Not long ago considered an underserved market, absorption has been strong enough to affect a significant increase in rental rates, which continued in the first quarter in spite of negative absorption. With that said, potential shifts in consumer spending as a result of the slowing housing market and increased gas prices will be watched closely by both developers and tenants in the foreseeable future.

Rental rates remain competitive in comparison to Orange, Los Angeles and San Diego counties. In first quarter 2007, average asking lease rates increased to $1.92 per square foot, compared to $1.70 the previous quarter. Grocery-anchored shop space lease rates for new construction range from $2.75 to $4 per square foot, while co-anchored space lease rates for new construction range from $1.25 to $1.75 per square foot. Continued rental rate increases are contingent on absorption on new space coming online.

The most active development markets in the Inland Empire are the High Desert cities of Victorville, Hesperia and Apple Valley, where the new 700,000-square-foot Jess Ranch Marketplace power center achieved 90 percent pre-leasing in its second phase. In Riverside County, retail continues to forge its growth path to the south in the high-growth cities of Temecula, Murrieta, Hemet and the French Valley area.

One of the most unique market trends in Southern California, big box retailers Wal-Mart, Target, The Home Depot and Lowe’s Home Improvement Warehouse are taking down their own land for development in the Inland Empire as a way to increase control over the location of their store on the site and to lower their land basis in the site.

The other big story of 2007 thus far is, of course, the impact of the housing slowdown. Tenants are taking a much closer look at housing studies when evaluating opportunities, comparing housing sales in addition to construction in the proposed trade area. As an example, some supermarkets are going as far as requiring “rooftop contingencies” in their pre-commits in order to inoculate against any further slowdown in the market.

Finally, lifestyle centers that include retail, office and high-density residential continue to be among the most successful center types in the market, a trend that continues to be fueled by the massive success of Victoria Gardens in Rancho Cucamonga, now more than 2 years after it opened.

— Brian McDonald is a vice president at CB Richard Ellis in Ontario, California.

Multifamily

Slowly but surely new fundamentals are asserting themselves in the Inland Empire as investors change their underwriting requirements to reflect the desirability of different submarkets and, most recently, significant changes in interest rates.

Underwriting changes due to submarket fundamentals have been due for some time. Even given comparable assets, investors are making adjustments for perceived risk in similar markets. There are reports that newer construction multifamily assets in Moreno Valley are trading at per-unit pricing that would be more reflective of 1980s’ constructed assets in Rancho Cucamonga or Chino Hills.

Interest rates are also impacting transactions and creating concerns on both the buying and selling side of transactions. The 10-year Treasury rate has increased by approximately 50 basis points — more than 10 percent — during the past 60 days. This has dramatically affected investor returns and is expected to increase the going-in cap rates demanded by multifamily buyers, particularly for non-core assets. It is also resulting in purchase price re-trades as buyer’s lenders are forced to re-evaluate loan terms.

Equally as important from the debt markets is the turmoil in the CMBS market. Loans which are bundled for resale are being rejected totally or having select loans with low debt coverage ratios or excessively high loan-to-value ratios rejected on the secondary market. There have been a number of incidents where loan proceeds have been dramatically affected by changes in the secondary market.

Changes to the debt market will undoubtedly filter into apartment developer’s plans and affect land values as well, although currently developers are still enjoying heady times as the downfall of the single-family and condominium markets have made them competitive for land development opportunities. With a dearth of new land opportunities in the premier markets of Corona, Rancho Cucamonga and Chino Hills, developers are looking further afield for opportunities.

The High Desert cities in particular are showing activity, although institutional capital has not shown any substantial interest in opportunities in that market, leaving it to private capital investors to get the ball rolling — much as the Lewis Companies did a quarter century ago in Rancho Cucamonga. Although most of the deals in the development pipeline currently are in core and near-core locations — Riverside, Temecula and Ontario’s New Model Colony — developers are contemplating or are already moving forward in Beaumont, Perris and Lake Elsinore, tertiary markets to be sure.

In spite of some of the changes to the debt markets and overall Inland Empire market fundamentals, there’s an increase in assets being brought to the market. More importantly, both institutional and private capital investors show unshakable, persistent optimism about the future of the Inland Empire — an opinion shared by many.

— Bob Patterson is a vice president for CB Richard Ellis in Ontario, California.


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