MARKET HIGHLIGHT, AUGUST 2011

ORANGE COUNTY
Donald MacLellan, Tim Joyce, Joe Vargas, Bill Mongtomery and Alan Reay

Orange County seems poised to lead the way for a comeback post-recession. Nearly across the board, this county is showing positive signs and promise as we look to 2012.

Retail

With a lower than national unemployment rate, and an educated and skilled workforce, the Orange County retail market for both investment sales and leasing remains one of the best in the country. To that end, the year-to-date retail vacancy rate is around 5.7 percent for all of Orange County, with the Airport Area submarket faring the best at a 4.4 percent vacancy and the North County submarket coming in at the highest at 7 percent. Year-to-date net absorption was 440,200 square feet. The North County submarket led the pack with a much welcomed 231,000 square feet, while the West County was the only submarket to lose a modest 5,100 square feet, according to Costar. Rental rates have been impacted since their peak of 2007 but they are beginning to slowly creep up again.

Orange County has also seen its share of retailers close their doors. However, it has also seen new brands come in and take their places as the market adjusts for the changing demand for products and services. There has been a growth of gourmet burger establishments that are coming into Orange County such as Five Guys Burgers & Fries and The Counter.

Similar to other markets, Orange County has not been immune to the loss of larger format retailers like Mervyns, Circuit City, as well as Borders Books’ and now Blockbuster Video’s demise. However, the strength of the county’s consumer base and low unemployment at 8.5 percent ensures that the region is viable for new and expanding tenants looking to fill those empty boxes.  We have seen retailers such as Forever 21, Kohl’s, Burlington Coat Factory, Ashley Furniture and  LA Fitness backfilling these former empty anchor spaces. Other out-of-state retailers looking to expand into Southern California include Hobby Lobby and Winco Foods. 

All investor types see the Orange County market as one of the strongest retail investment options. We  have seen grocery-anchored retail and well-located centers receive multiple offers from both private and institutional buyers at pricing levels last seen in 2007.  Based on our recent assignment to dispose of 13 former Mervyns locations consisting of four net leased investments and nine vacant sites — several of which are Orange County locations — we have seen significant interest ranging from the income-driven investor profile to the value-add buyer and the owner-user. 

— Donald MacLellan, senior managing director, Faris Lee Investments

Office

The Orange County office market has shown significant signs of a recovery over the past few months.  In the second quarter, more than 575,000 square feet of positive net absorption was experienced — the highest amount since the third quarter of 2006. On average, overall asking rental rates dropped $0.04 during the second quarter, with rates for Class A and B space averaging $2.16 and $1.77 per square foot per month.  In terms of vacancy rates, Class A properties closed the second quarter at 22.3 percent and Class B at 16.6 percent. 

The Airport Area and South County submarkets have been the most active, with the Airport Area accounting for 50 percent of overall positive absorption in the second quarter.  Additionally, the majority of the vacant space remaining in the Airport Area is the best Class A office space in all of Orange County.  On a limited basis, owners of Class A office space offered at depressed rental rates have seen an increase in tenant activity from those companies wishing to move to higher quality space at rates that are hard to pass up.

In terms of business sectors, loan modification companies, services companies and healthcare-related firms have been the most active recently.  In South County, LoanDepot leased 70,000 square feet of space in Foothill Ranch and Wonderware, a part of Invensys, took occupancy of 152,000 square feet of space in Lake Forest during the second quarter.  In July, CashCall moved into 127,000 square feet of space at the Anaheim Arena Corporate Center.  

In addition to tenant activity, Orange County has seen a significant increase in investment activity during the past 12 months, where nine transactions closed with a combined value in excess of $400 million for Class A and B space.  One of the largest investment transactions to take place during the second quarter was the sale of 4 Hutton Drive in Santa Ana, which was purchased by an Asian investor for $37 million.  In July, Ocean West Capital Partners purchased 2600 Michelson in Irvine for about $70 million, or $225 per square foot.  TA Associates Realty also purchased 3 MacArthur Place in Santa Ana, a nearly 250,000-square-foot building, for roughly $54 million, or $220 per square foot.  Orange County now has limited office product to sell and a capital market that has reached a shallow bottom in available financing.

Looking forward, central Orange County will be an area to watch for in the near future in terms of active capital coming into the market.  In the Airport Area submarket, look for tenants able to take advantage of soft asking rental rates with competitive concession packages.  Additionally, the limited job growth in Orange County will have an effect on the pace of the market’s recovery, as new jobs are needed to create significant demand from companies. 

— Tim Joyce, senior vice president, Office Group, Grubb & Ellis Company

Industrial

Orange County arguably appears to be among the first of the Southern California markets to pull out of the recession. For the past few quarters, the industrial market has been on a slow recovery trajectory despite a slight dip in the economy in the first half of 2011.

Though this recession adversely affected Orange County’s industrial property values, which bottomed in 2010, by mid-2011, early signs of recovery were fueled by increased investor interest and returning tenant demand. There are stumbling blocks, however. Real GDP grew at an estimated annual rate of only 1.9 percent in the first quarter, a meager level below most forecasts, and unemployment dropped just 10 basis points to 9.1 percent, down from 9.6 percent a year ago.

The key indicators of improvement are rent growth and occupancy gains. Despite modest job growth among industrial employment sectors, positive growth in trade volume at the ports (4.3 percent year over year and 13 percent quarter over quarter) drove demand for big box warehouse/distribution product. Third-party logistics companies vigorously sought 100,000-plus-square-foot buildings, spurring rental rate growth over the past six months.

In the second quarter, the average direct asking rental rate for all product types, of $0.63 per square foot, per month, marked a year-over-year increase of 1.6 percent. Rents for warehouse/distribution properties stabilized at $0.53 per square feet, per month after a market low of $0.51 per square feet, per month in the second half of 2010. Overall absorption of industrial properties at mid-year totaled 995,533 square feet, marking the fourth consecutive quarter of positive absorption. Over the past 12 months, approximately 1.7 million square feet of inventory absorbed as tenant demand returned. Consequently, overall vacancy fell 40 basis points from the first quarter to 6.1 percent. Overall vacancy among warehouse/distribution product fell as well by 80 basis points to 6.7 percent down from a peak of 8.8 percent in early 2010.

Orange County remains a tenant market for now. Landlords, driven to increase occupancy during the recession, attracted tenants by offering competitive concession packages. These concessions will diminish as leasing activity picks up, but activity slowed in the first half of 2011, down 25.4 percent from the same period last year, to five million square feet leased. The largest leases included eCosway’s five-year, 112,944-square-foot lease in Fullerton and Incipio Technologies’ 110,399-square-foot lease of warehouse space at the Irvine Spectrum.

Expectations for recovery have been tempered by national and global setbacks. Despite this, Orange County’s recovery is underway with improving market fundamentals. Employment growth this year will also contribute to declining vacancy and could lead to a significant upturn in asking rents in the next 12 to 18 months. The region is forecast to add more than 20,000 jobs in 2011 and 30,000 the following year. The Cal State Fullerton business index measured 34 percent of Orange County employers intending to add employees in 2011, which will strengthen the warehouse market and stimulate rental rate growth across all property types. Speculative development has all but shut down with nothing slated to break ground this year and limited construction is expected in 2012, which will keep vacancy in check.

— Joe Vargas, executive managing director, Cushman & Wakefield

Multifamily

Orange County occupancies have firmed up over the past 18 months and stand at 95 percent countywide — the highest since 2008. This is driven chiefly by Gen “Y” residents. Surveys say this group accounted for the largest number of new hires in the past year, enabling them to move from their parents’ homes or shed roommates. Also, fewer people are seeking to buy or cannot qualify.

With virtually no new apartment product being delivered in Orange County, increased demand is starting to push rents, which were up $50 a month last spring, to $1,532, reports RealFacts.

The largest gains are in-fill sites closest to jobs and in newer projects that are burning off leasing concessions offered during the downturn. Stronger rent growth will occur as job growth climbs. We are seeing this now as forecasters project 2.5 percent new jobs this year.

Demand for core apartments in OC has been strong with little product available for purchase. In the first half of this year few transactions have occurred but pricing has been strong on assets acquired by REITS. Most active is Essex Realty Trust, which bought three busted condo projects last year, converting them to rental. Private groups with dedicated funds include Western National, which has closed two transactions for existing rental projects in the past eight months here. Private developers such as SARES•REGIS Group, Mill Creek and others are processing apartment developments. MG Properties of San Diego purchased a project in Garden Grove in December of last year. The balance is the core group of long-term local, regional and institutional groups that have historically valued this market for its opportunity.

Demand is also heating up for value-add acquisitions and development projects as capital seeks out non-core acquisitions due to the limited supply available.

Development projects are now starting to pencil as yield requirements have fallen from the low to mid-7 percent return to high 5 percent and low 6 percent metrics depending on location and entitlement status. Institutional owners and investors are increasing their allocations to development projects. The highest demand is for entitled projects.

Little new development is in the pipeline. The City of Irvine recently completed approvals on a new specific plan allowing developers to reconsider several planned apartment projects, however, all are at least 18 to 24 months from delivery.

Acquisition activity is heating up in most of Orange County’s submarkets, with interest in projects closest to employment centers where job growth is highest. There is similar heightened development activity but it’s limited by site availability.

Generally most sub-markets are in the 94 percent to 97 percent occupancy range for stabilized assets. Rental rates vary significantly by submarket. For example, rents of $1.85 per square foot to $2 per square foot are being achieved in northeast Anaheim and in Irvine rents are $2 per square foot to $2.40 per square foot.

Most development will occur first in the central business markets as rents drive feasibility. This also is the submarket to watch for greatest rent growth. Infill locations near jobs, transportation and shopping will seek the quickest growth in rents, supporting values and development. Unique upside is offered in the airport area, Anaheim’s Platinum Triangle, which is near three freeways and northeast Anaheim.

— Bill Mongtomery, president, SARES•REGIS Group, Multifamily Acquisitions & Investments Division

Hospitality

One word sums up the Orange County hotel market: resilient.

Despite one of the most dramatic hotel room revenue declines since the Great Depression, Orange County hoteliers have weathered the storm quite well.

In late 2008, with the financial markets on the verge of collapse, Orange County was unceremoniously thrown into the national spotlight. Just days after the Federal Reserve Bank of New York gave American International Group (AIG) an $85-billion handout, the company threw a lavish retreat at the St. Regis Monarch Beach Resort & Spa in Dana Point.

The outrage that ensued became known as the “AIG Effect.” As a result, companies quickly canceled planned meetings and curtailed travel spending. Luxury resorts were suddenly off-limits.

The dramatic drop off in corporate travel, combined with the pullback by leisure travelers, put many hotels into a tailspin. Notices of default and foreclosures rapidly increased. At the start of 2010, we estimated that almost 2,500 California hotels had no equity. The future was looking bleak.

Fast-forward to July 2011. We aren’t completely out of the woods, but Orange County has fared better than any other county in the state, as illustrated in the following table.     

A number of factors help explain why the Orange County hotel market doesn’t show the same level of distress as its neighbors. These include the little new supply of room inventory and fewer sales refinancing during the peak years of 2006 to 2008.

It doesn’t hurt that Orange County is home to many tourist attractions and some of the best beaches in Southern California. The county attracts more than 40 million annual visitors who spend in excess of $7 billion.

Orange County hoteliers are now enjoying healthy revenue increases. Although we are not yet back to the 2007 peak, we’re getting close. Smith Travel Research (STR) figures from May show Orange County’s average room revenue at 85 percent of the peak numbers enjoyed in 2007. At the current pace, Orange County is on track to match those numbers by mid-2012.

Investors and lenders alike can see how well Orange County weathered one of the worst hotel downturns ever and know that it is a great place to own and lend.

— Alan Reay, president, Atlas Hospitality Group

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