MARKET HIGHLIGHT, AUGUST 2008

INLAND EMPIRE
Jill Luna and Bob Patterson

Despite some economic hiccups, the Inland Empire shows many signs of stability during this transition stage in the market.

Retail

The Inland Empire retail market remained relatively stable during second quarter 2008 despite rising costs for fuel and energy, and the sluggish housing and stock markets. Riverside and San Bernardino counties added 1.7 million square feet of new construction to the existing base, while also experiencing a positive 1.3 million square feet of absorption. Of the recent completions, one of the most notable projects is Opus West’s The Shoppes at Chino Hills, an approximately 375,000-square-foot lifestyle center with a tenant mix that includes the Yard House, Trader Joe’s, H & M and Barnes & Noble. Another notable project recently delivered to the market is the Riverside project, Canyon Crossings, which is now home to Chapman College and John’s Incredible Pizza.

On the development front, there were 6.8 million square feet of product in the construction phase as of the end of second quarter. When compared to the 13.5 million square feet of construction noted in the prior quarter, it is clear that developments that were once considered “under construction” have been moved to the “proposed” stage as developers wait for market conditions to improve before breaking ground.

Vacancy for the entire market rose in the second quarter, but is still tracking below 6 percent. The latest rate of 5.71 percent represents a 2 percent increase from the prior quarter, generally due to newly constructed product where vacant space exists. The East End, South Riverside County and West End submarkets posted increased rates, while the High and Low Desert submarkets experienced a decline in vacancy rates. All center types — community, neighborhood, power, specialty, strip, free-standing and regional – experienced increased vacancies with strip centers posting the highest at 14.23 percent and specialty centers exhibiting the lowest rate of 1.30 percent.

Average asking rates in the Inland Empire increased $0.08 to end the quarter at $1.91 per square foot. At a time when many landlords may lower asking rates or offer incentives to attract tenants, newly completed projects are helping boost the market’s overall rental rate. The Low Desert and West End submarkets reported the highest rate of $2.48 per square foot and $2.06 per square foot, respectively, while the East End ended the quarter with the lowest rate of $1.68 per square foot. Power centers hold the highest average asking rate at $2.27 per square foot.

The second quarter demonstrated an increased demand for Inland Empire retail space by posting a positive 1.3 million square feet of net absorption. Collectively, all submarkets in the Inland Empire experienced positive absorption rates, with the East End, Low Desert and West End submarkets all showing absorption rates exceeding 300,000 square feet. With respect to center type, power centers experienced the highest amount of demand with 1 million square feet of absorption at the end of the first half of 2008. Strip and specialty centers both experienced an increase in the amount of space delivered back to the market, experiencing negative absorption of 57,283 square feet and 15,222 square feet, respectively.

— Jill Luna is director of research at CB Richard Ellis’ Ontario, California, office.

Industrial

In the midst of a slowing economy, the Inland Empire industrial market remains stable, with continued positive net absorption for second quarter 2008, although this represents a decrease in net absorption for yet another quarter. Overall net absorption in the second quarter was down roughly 1.2 million square feet from last quarter’s 2.1 million square feet. These figures can be attributed to both the maturing Inland Empire West submarket and the steady addition of new product to the Inland Empire East submarket as sale and leasing activity slows.

The Inland Empire West submarket experienced the majority of activity this quarter with nearly 2.3 million square feet of gross activity. The Inland Empire East submarket has become a tenant market due largely to the abundance of state-of-the-art product being offered at competitive rental rates, while the Inland Empire West continues to offer landlords a greater demand for product.

The availability rate in the Inland Empire increased from first quarter 2008 to 12.82 percent, which can be attributed to two factors: new buildings that have completed construction but remain unoccupied, specifically in the east submarket, and the addition of available space returned to the market. In the most extreme cases, some Inland Empire businesses have been forced to close facilities and vacate properties as a result of the slowing economy.

Land prices in the Inland Empire East have seen a major decrease in asking rates, and developers are being more scrupulous over potential development sites. Demand for smaller sites in the east submarket is declining, with sites able to accommodate buildings exceeding 500,000 square feet generating the greatest interest. In fact, the amount of inventory currently under construction in the Inland Empire has decreased sharply since first quarter 2008. Today, developers are much more hesitant to build speculative big-box manufacturing and warehouse space given the number of completed speculative buildings that currently remain unoccupied, and want a pre-committment before beginning the construction of a facility.

— Jill Luna is director of research at CB Richard Ellis.

Office

As the U.S. national economy continues to slow, the Inland Empire economy is also experiencing a downturn resulting from the mortgage meltdown, housing market crisis and rising unemployment rates. Despite the overall poor performance of the Inland Empire economy in the first half of 2008, its office market has experienced stable leasing activity highlighted by two significant transactions: the 30,813-square-foot Jacuzzi Brands Corporate lease at The Shoppes at Chino Hills and the 20,446-square-foot Regus lease in the Tyler Area submarket of Riverside.

Although leasing activity has remained stable, major corporate tenants are beginning to consolidate multiple locations in response to the recent economic uncertainty. This tenant consolidation contributed to the office market’s negative net absorption of 175,861 square feet year to date. Absorption, however, did improve slightly in the second quarter, posting a negative 81,816 square feet, down from the negative 94,045 square feet witnessed in first quarter 2008.

According to Torto Wheaton Research, office employment is the primary determinant of demand. Office employment is defined as certain categories within the financial and service employment sectors in which workers typically occupy space. Inland Empire office employment has grown by 4.9 percent during the last 5 years, however office employment has declined by 2 percent in the last 12 months. The financial activities sector has experienced a 6.3 percent decrease in job growth, whereas the professional and business services sector experienced a 0.1 percent increase and is expected to experience a 3 percent increase — or 6,000 jobs — during the next 2 years.

The construction pipeline remains strong with nearly 2.1 million square feet under construction in the second quarter. Newly completed construction increased with 240,475 square feet delivered to the market in the second quarter. The significant amount of new construction in the past five quarters, combined with the current trend of major tenants consolidating locations, has contributed to the overall increase in vacancy rates. The overall vacancy rate for the Inland Empire increased from 13.78 percent in first quarter to 15.08 percent in the second. The availability rate is currently 18.23 percent, which includes sublease space in the market.

The economic slowdown in the Inland Empire has created a tenant-driven marketplace, one where tenants can take advantage of abundant leasing opportunities with additional concessions and lower asking lease rates.

— Jill Luna is director of research at CB Richard Ellis.

Multifamily

While the reasons for the credit crunch may or may not be valid, the effects on investors’ perceptions, and consequently sellers’ ability to achieve returns that were prevalent only little more than a year ago, are unquestionable. In many ways there are parallels between today’s investment climate and that of the early 1990s, not in the least because many of the lessons of the past remain unlearned.

For the past several years, the Inland Empire was widely touted as one of the most desirable places in which to invest, resulting in unprecedented demand. Although rent increases could be driven by renovation programs at multifamily properties, the reality is that an investor often had to do little more than hold onto an asset for a short period in order to reap significant returns.

Post-credit crunch, however, demand has dramatically slackened. Many institutional investors that drove acquisitions by either buying assets for their own accounts or providing capital to investors have taken the Inland Empire off of their radar screen for investments or are demanding returns that sellers are generally uninterested in meeting. Various reasons are given by the institutions for the pull back, including the so-called shadow market of homes available for rent, the reduced cost to buy a home and low expectations for rent growth.

The effects of the lack of capital are compounded by lenders having increased equity requirements by reducing maximum loan-to-value ratios, increasing debt-coverage ratios and limiting or eliminating interest-only loans. These requirements have resulted in dramatically escalated equity requirements for buyers, pushing many to the sidelines and creating a buyer’s market for those who remain.

Overall, cap rates are expected to increase for all product types, although certain asset types in particular are expected to be heavily impacted. These include:

• Class C and lower assets. Given the perception of risk for these types of assets, cap rate increases have the potential to be substantial.

• Assets with no “story.” Assets which have been renovated by multiple ownerships or have been fully renovated lack an enticing story for value-driven investors.

• Core assets. The vast majority of Class A assets are sold to institutional investors. With these investors having largely pulled out of the Inland Empire, motivated sellers of these types of assets will have to meet the market. Class A assets in secondary markets of the Inland Empire (e.g., the Coachella Valley, Temecula/Murietta and the Moreno Valley) may be particularly affected, both in the short and long term.

That said, cap rates for all product types in the Inland Empire are shifting upwards for the moment, giving investors who have the equity available an enviable opportunity to acquire assets at returns substantially higher than those pre-credit crunch. At the current time, nearly all, if not all, transactions taking place involve private investors with the wherewithal to complete a transaction without institutional equity, and those transactions are happening at cap rates substantially higher than pre-credit crunch rates.

— Bob Patterson is first vice president at CB Richard Ellis’ Ontario office.

©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.