MARKET HIGHLIGHT, DECEMBER 2006

INLAND EMPIRE MARKET HIGHLIGHT
Brad Umansky, Walt Arrington, David Waggoner and Bob Patterson

The Inland Empire market continues to rank high nationally in commercial real estate performance. Its location near Southern California’s ports and population centers combined with the area’s cheaper land make it a favorite among developers, investors and tenants.

Retail

Shoppes at Chino Hills

The fundamentals of the Inland Empire economy remain quite strong. Unemployment across San Bernardino and Riverside counties is approximately 4.7 percent, and the market continues to be California’s largest generator of new jobs.

Retail sales in 2005 increased by 12 percent, and double-digit sales growth was expected again this year. Vacancy rates continue to remain in the 5-percent range, and lease rates have continued to trend higher.

Expect development to slow during 2007 as developers complain about rising constructions costs, longer and more costly entitlement periods, rising land prices, concern about the national economy, and worries that lower cap rates and interest rates will no longer be able to “cure” mistakes.

Furthermore, many landowners seem to believe that their properties are the next pot of gold. Not long ago, the best 5- to 10-acre parcel of land may have been priced in the $8 to $12 per square foot range. Now it is difficult to find a marginal parcel of land for less than $10 per square foot, and the higher quality properties have asking prices in excess of $25 per square foot. As a result, developers are citing that there is not much room for error; having had much success during the past 5 years, many companies are trying to avoid making bad deals and are waiting on the sidelines for equilibrium to return.

In the Inland Empire’s retail investment sector, equilibrium has definitely returned. With the exception of institutional-grade real estate, most properties are on the market for much longer and receiving far fewer quality offers than last year. Private capital is definitely taking a more cautious approach and 1031-exchange buyers have many more choices in the market, although most of these buyers will tell you that much of the product they are seeing is not very desirable due to real estate quality and pricing.

Although cap rates are still at almost unprecedented levels, they are trading about 50 basis points higher than in the summer of 2005. Actual selling cap rates on newer-constructed, multi-tenant product are generally in the 5.75- to 6.5-percent range; existing product is in the 6- to 6.75-percent range, although older, lower rents and lower price per square foot are substantially mitigating factors for buyers of this product. Single-tenant product is likely to trade in the 5.5- to 6.5-percent range depending upon lease terms, credit quality and location. Cap rates are likely to continue to trend higher as cash-on-cash returns that are below CD rates are not likely to continue.

Unlike a few years ago when it seemed like Southern California operated in a vacuum, many investors have hopped on the out-of-state bandwagon to achieve better returns. As a result, Inland Empire sellers now have more competition for their product. Motivated sellers have been reducing their prices, and those that are unmotivated are starting to take their properties off the market. The fact that the 10-year treasury slid back below 4.75 percent certainly helped boost investment activity during the third quarter of this year.

In summary, market fundamentals remain strong, and the investment market has softened, but the outlook for 2007 remains quite positive for owners of retail properties in the Inland Empire.

— Brad Umansky is a senior vice president for Sperry Van Ness in Ontario, California.

Industrial

The Inland Empire industrial marketplace continued to see vigorous development and user activity across all product sizes through third quarter 2006. Driven by the continued growth of the Los Angeles/Long Beach ports, the Inland Empire continues to lead the nation in new industrial building construction and user activity. Primarily known today for its mega-size distribution warehouses (buildings exceeding 500,000 square feet), the market continues to see developers maintain their aggressive pace of development of large, medium and smaller warehouse product as well.

Industrial vacancy in the market is averaging a low 3.2 percent, allowing lease rates to rise during the last year. Lease rates are currently at 43 cents per square foot, while gross activity remains strong at more than 25 million square feet through third quarter 2006. Year-to-date, nearly 20 million square feet of space have been completed in the Inland Empire, with another 11.2 million square feet anticipated to be completed before year’s end. This is the largest amount of new industrial construction annually dating back to 2001, which saw more than 18 million square feet come online.

The sheer size of warehouses in the Inland Empire differentiates the market from the rest of Southern California and from other cities in the West. Mega-sized distribution warehouses continue to appeal to large retailers such as Target, Wal-Mart and Walgreens, as well as to third-party logistics operators that want to consolidate goods into a large distribution center. With big box-sized land parcels hard to come by in the West, large mega-sized distribution warehouse development has quickly migrated east along the Interstate 215 corridor through Redlands and, to a certain extent, north to the High Desert (although this market is waiting on rail service in order to really take off). Developers such as Panattoni, Oakmont, Sares-Regis, Hillwood, Watson, Majestic, RREEF and Alter are all active in the market, with major projects including Majestic’s 80-acre Meridian project at the former March Air Force Base and Hillwood’s Alliance California in San Bernardino.

Smaller, privately held niche manufacturing and Asia-based import/export firms have played a significant part in the absorption and subsequent development of small and mid-size buildings as well. While not on a scale to match the overall square footages of large and mega-sized distribution warehouses, these smaller users have leased or purchased well over 500 buildings, accounting for more than 10 million square feet of absorption in the Inland Empire in 2005. This trend has continued in 2006. The western Inland Empire, specifically the greater Ontario Airport area, has seen the most growth from the small to medium-size building user, which has generally preferred to purchase a building rather than lease.

Due to the continuing supply of industrial product in the pipeline, demand will be critical to maintaining the historically low vacancy rate and continued strong absorption for the area in first quarter 2007. However, certain size segments, especially in the extreme western Inland Empire, are already seeing limited supply of available product being brought to market. This will definitely keep upward pressure on lease rates and sale prices in those size ranges, and help keep overall vacancy low in the Inland Empire.

— Walt Arrington is a senior vice president at CB Richard Ellis’ Ontario office.

Office

The Inland Empire office market has come into its own during the past 2 to 3 years. With an office base of more than 19 million square feet and more than 3.5 million square feet under construction, it is gaining traction as a legitimate Southern California sector. The Inland Empire posted the biggest 2005 job growth in Southern California with 56,658 new jobs (the second highest gain in the history of the area), and economic forecasts through 2020 call for continued job growth that will outpace its coastal counterparts. The cities of Murrieta, Temecula and Corona were recently ranked as the Nos. 5, 6 and 7 spots on Money magazine’s 2006 “Top Cities for Job Growth” list.

Market drivers for office development continue to be comparatively low housing costs, population growth and an increasingly educated workforce. The U.S. Census Bureau ranks San Bernardino and Riverside counties 13th and 14th, respectively, by population. The two-county region leads 44 states with respect to projected population growth through 2020. In addition, the Inland Empire currently represents 54 percent of new home construction in Southern California, a response to demand from people migrating from the coastal counties in order to find more affordable housing. And finally, with a 38.2 percent increase in the college-educated workforce from 2000 to 2005, the demographics of the market are changing along with its perception.

Office activity spans both the eastern and western halves of the Inland Empire, including hot submarkets such as Ontario, Rancho Cucamonga, Riverside, Corona and Chino Hills. Another burgeoning office market is the High Desert, where at least 11 new office development projects are planned. Overall, vacancy remains at a low 8.81 percent across the market, while year-to-date net absorption has exceeded 700,000 square feet. A major deal in the western Inland Empire was Fremont Investment & Loan’s 50,000-square-foot lease at Sterling Center in Ontario.

Despite the Inland Empire’s strong fundamentals, there is still a watchful eye on the market to see where the next few deals will land among all of the new developments.  Active players in the market are watching to see what lease rates will do, although lack of supply and increasing land values and construction costs continue to suggest further increases. Currently, rents are around $2.40 per square foot for all new Class A developments, going as high as $2.80 per square foot in Corona.

Like any Southern California market, there is a lot of capital looking at few opportunities in the Inland Empire. Because of the national attention it has received, the market is seeing a different kind of capital from private and institutional sources. RREEF’s investment in Ontario Airport Towers (up to 800,000 square feet) represents the first major institutional investor in the Inland Empire, a signal to the institutional investment community about the legitimacy of the office market.

The big question — can the area absorb all the new development and sustain its current momentum and growth? — will likely be answered in 2007. Still, positive net absorption in the last 5 years and current space constraints indicate that demand is strong enough to absorb the new space that is coming online in the next 12 to 24 months.

— David Waggoner is a broker in CB Richard Ellis’ Ontario office.

Multifamily

Ontario Town Square townhomes

Inland Empire investments are driven by the same factors as other Southern California markets. Currently, one driving fundamental is a substantial disconnect between buyers and sellers regarding a fair rate of return and, consequently, the values of Inland Empire apartment buildings.

Until fairly recently, the multifamily market had downplayed the link between risk and return: regardless of location and asset class, cap rates were, on the whole, somewhere between 4 and 5 percent. For the most part, everything worked out fine as significant rent growth and historically low cap rates drove asset values consistently higher.

With negative leverage driven by higher interest rates and a convergence of other factors, multifamily buyers have become more discriminating, resulting in decreased transaction volumes and increases in cap rates. The ongoing asset-value disconnect between sellers and buyers means a healthy return to investment fundamentals. With the likely exception of Class A assets in core locations — e.g., Chino Hills, Rancho Cucamonga, etc. — and select offerings with substantial upside, expect to see a modest increase in cap rates, resulting in a return to differentiation between Class A, B and C assets as well as between A, B and C locations.

In the new construction corner, one developer’s famine is another developer’s feast: Inland Empire’s apartment development community is thrilled to be back in the game after years of being outbid for land development opportunities by for-sale developers. Per-unit prices for land slated for rental development are lower than those of for-sale product, but unquestionably an increase in the supply of rental communities is a beneficial occurrence. Despite their relatively high rents, new rental projects provide relatively affordable housing for those who are unable to or choose not to make the leap to owning their own home.

Although the Inland Empire condominium conversion market was never as frothy as that in San Diego, recently acquired condominium conversions may be considered an exception to the above generalization about how everything worked out fine. The San Diego market is already seeing broken conversions being quietly shopped to potential investors, and it is entirely possible that some condo converters are going to take losses or only break even as they bulk-sell their unsold inventory to other converters at a discount. Alternatively, select apartment operators have an interest in broken conversions, provided that they are able to own more than 50 percent of the community and thus control the HOA, though at substantially higher cap rates than condo conversions have been sold at.

For 2007, many sellers are going to have to decide if they are sellers at the new market equilibrium or not. For non-core assets and assets without a substantial upside, cap rates should stabilize north of 5 percent. Demand for assets with renovation/rehab potential will continue to be a focus for many investors, developers will still be seeking out well-located development or redevelopment opportunities and institutional investors will still aggressively pursue core investment opportunities. Fundamentally, the Inland Empire multifamily market remains healthy and a desirable place to invest.

— Bob Patterson is a broker in CB Richard Ellis’ Ontario office.

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