MARKET HIGHLIGHT, DECEMBER 2007

THE INLAND EMPIRE
Douglas McCauley 

The Inland Empire’s demand drivers continue to be impressive. All sectors of the two-county market remain active based on employment and population growth figures that rank among the nation’s strongest.

Multifamily

The Inland Empire apartment market is poised to record solid growth through the second half of the year and should post even more outstanding fundamental performance beginning in 2008.

In addition to the market’s usual demand drivers of rapid employment and household growth, elevated foreclosures are returning some homeowners to the apartment market. During the second quarter, a combined 4,000 homes foreclosed in Riverside and San Bernardino counties, accounting for more than 40 percent of all foreclosures in Southern California. Apartment demand from these displaced residents should cause already tight conditions in Class B and C properties to further improve. On the supply side, developers are growing more cautious and will reduce apartment deliveries by more than 1,000 units this year, down from 2006, with additional slowing expected for next year. With supply in check, existing owners will be able to improve vacancy levels, move rents higher and burn off concessions.

By the numbers, employers in the Inland Empire are on pace to add 50,700 new jobs to the market this year, a 3.9 percent gain. Many of these positions were delivered early in the year, however, and expansion in 2008 is forecast to be more restrained. Apartment developers will bring 2,350 units online this year, with many of the new properties coming online in the second half. Deliveries will slow in 2008, however, a trend that is expected to continue in the years ahead. With completions clustered toward the end of this year, vacancy is expected to increase 20 basis points to 5.6 percent. Beginning in 2008, completions will slow, allowing vacancy to ease lower. The delivery of new inventory late in the year should help to support healthy rent growth. Asking rents are forecast to jump 4.4 percent to $1,069 per month, while effective rents will gain 4 percent to $1,032 per month.

Apartment investors continue to add Riverside and San Bernardino counties’ properties to their real estate portfolios, despite some near-term uncertainty in the marketplace. While higher borrowing costs could lessen the number of buyers in the metro, many of the market’s existing owners have built up considerable equity in their holdings in recent years and may see the current climate as an opportunity to reposition assets to meet long-term goals. Cap rates, which have averaged in the mid- to high-5 percent range during the past year, will likely continue to push higher, although there will be enough capital in the market to keep valuations near their current ranges. While a flight to quality will support buyer demand for top-tier properties, investors will want to target the market’s Class B and C assets, where the most significant fundamental improvement is expected to occur in the next few quarters.

Office

Elevated office deliveries, due largely to the Inland Empire’s healthy long-range demand drivers, will result in a vacancy increase in 2007, although extended forecasts highlight the area’s strength. While office-using employment growth in Riverside and San Bernardino counties will rank among the highest in the country this year, builders will boost office inventory more than 9 percent, and deliveries will outpace absorption. This trend is expected to be short-lived, however, with early estimates for 2008 calling for accelerated absorption and more modest development.

Despite the rise in vacancy, owners have been able to implement aggressive rent increases throughout the market, and revenue growth should pick up early next year. In the near term, owners in the Colton/Redlands submarket are anticipated to record some of the region’s strongest NOI gains, as demand remains elevated and only a handful of projects are in the development pipeline.

By the numbers, the Inland Empire’s employers are on pace to create 49,900 new jobs in 2007, a 3.9 percent gain. Office-using employment will expand at a more rapid pace with the addition of 10,700 new positions, a 5 percent spike. Looking ahead, more modest employment growth is expected in 2008. Office completions will total 1.5 million square feet in 2007, approximately twice the amount of deliveries from 1 year ago.

However, construction is forecast to slow in 2008. In 2007, deliveries of new space are expected to account for a 9 percent expansion to overall inventory, and absorption, while positive, will not be able to keep vacancy from rising. Vacancy in the Inland Empire is expected to increase 200 basis points to 11.8 percent this year but should decline in 2008. Healthy tenant demand for new space will continue to drive rents higher. In 2007, asking rents are expected to advance 7.7 percent to $22.95 per square foot. Rising vacancy will result in a modest growth in the use of concessions to attract and retain tenants. Subsequently, effective rents are expected to increase 7.4 percent to $19.82 per square foot by year’s end.

The market’s healthy residential growth, which is projected to continue going forward, is driving investor demand for medical office properties. In the past 12 months, sales velocity has increased 61 percent. The median price has been fairly stable, dropping 3.5 percent to $205 per square foot. Cap rates are currently reflecting demand levels, declining 100 basis points to the low-6 percent range year over year.

Just as the recent rise in vacancy has not deterred builders, investors continue to pursue office properties throughout the Inland Empire. Cap rates in the mid-6 percent range are high enough to bring buyers to the region, while the market’s future rent gains offer upside potential for owners with a long-term outlook. Although REITs and other institutions are active, much of the recent transaction activity has occurred in properties priced below $3 million, and individual investors continue to hold a larger presence in Riverside-San Bernardino than in most other California markets. Additional activity may come from owner-users that choose to use still-low financing rates to acquire properties rather than risk being subjected to rising rent payments. Investors seeking the metro’s premium properties will focus on assets in the growing Rancho Cucamonga/Ontario submarket, where rent growth is forecast to be particularly strong in the years to come.

Retail

Retailers will continue to follow rooftops in Riverside and San Bernardino counties through the remainder of 2007 and into the coming years.

The market’s demand drivers, specifically employment and population growth, remain among the strongest in the nation. Household growth is expected to approach 3 percent annually during the next 5 years, a trend that is encouraging retailers to establish a foothold in the Inland Empire’s expanding population centers, such as Ontario and Rancho Cucamonga. Consumer spending will also spur space demand, as retail sales in the Inland Empire are forecast to increase 5.5 percent in 2007, well above the national rate, which is expected to come in at approximately 4 percent.

In response to steadily growing tenant demand, retail property builders are undertaking ambitious development projects, including a number of power centers, with only modest pre-leasing in place. As a result, market-wide vacancy is forecast to push higher through year’s end, although the delivery of new space should support strong gains in asking rents.

By the numbers, employers in the Inland Empire are forecast to add 43,500 jobs in 2007, a 3.4 percent increase. While the professional and business services, and trade, transportation and utilities sectors will produce the most jobs this year, job growth will be widespread with every sector expected to expand. Retail construction is expected to total 6.9 million square feet in 2007, up from 6.1 million square feet in 2006. More than 1.8 million square feet of new space is forecast to be delivered in the Rancho Cucamonga/Chino submarket.

Absorption should be steady this year, although increased development of new retail properties will produce higher vacancy by year’s end. Vacancy is expected to finish 2007 at 12.2 percent, 170 basis points more than at the end of last year. Strong tenant demand for Inland Empire retail space will drive up asking rents 5.3 percent to $22.78 per square foot this year. In an effort to attract and retain tenants, owners may choose to offer additional incentives, and effective rents are forecast to advance 4.9 percent to $20.14 per square foot by year’s end.

The retail investment market in the Inland Empire remains quite strong, as valuations continue to be supported by short-term revenue gains and the market’s prospects for long-term economic growth. Cap rates are averaging in the high-5 percent to mid-6 percent range for both single- and multi-tenant properties, and prices continue to push higher. Individual investors are expected to target single-tenant assets, particularly fast-food restaurants with national credit tenants in place. In addition, the area’s growing inventory of new, large-scale lifestyle and power centers and relatively affordable prices should attract institutions and REITs. For buyers seeking upside potential, well-located retail properties in downtown San Bernardino could benefit from the city’s proposed extensive redevelopment efforts.

Industrial

The economy in the Inland Empire is expanding at twice the national rate, as the gross metro product (GMP) is currently at the annually adjusted rate of 4 percent.

Job creation in Riverside and San Bernardino counties is expected to spike in 2007, with the addition of approximately 49,900 jobs after 35,000 jobs were created last year. The professional and business services sector is expected to have an annual growth rate of 5 percent, after increasing 6 percent in 2006.

Employment sectors important to the industrial real estate industry, such as manufacturing, trade and warehousing, have displayed strong growth thus far in 2007. Employers in these groups have added nearly 3,700 employees to their payrolls in the last 12 months and are forecast to create an additional 1,000 positions by the end of the year.

After declining nearly 34 percent in 2006 to 11.2 million square feet, construction is on pace to rebound approximately 20 percent to 13.4 million square feet by year’s end. One of the largest projects currently under construction is Kline Ranch. Totaling 930,000 square feet, the two-building development near Riverside Avenue and Agua Mansa Road in Rialto is scheduled to be completed by the end of the year, with construction costs estimated at $55 million.

Builders will continue to add to inventory during the next 15 months, as approximately 4.4 million square feet is under construction and scheduled to be completed by the end of 2008. For example, the Interchange Business Center will comprise six buildings and nearly 2 million square feet just two miles northeast of the Interstate 10 and Interstate 215 interchange in San Bernardino.

Developers are expected to reduce construction output in the next few years, as only 950,000 square feet is currently in the planning stages.

Demand for quality industrial space is continuing to outpace supply in 2007, as the rate of absorption is on a clip to exceed new deliveries by roughly 25 percent, resulting in a vacancy improvement of 40 basis points by year’s end to 4.8 percent.

With vacancy expected to trend lower, rents are on the rise, and the reduction of concessions is estimated to persist through the end of the year. Asking rents are on pace to finish the year up 4.3 percent to $5.06 per square foot, while effective rents are projected to climb 4.7 percent to $4.87 per square foot.

Despite forecasts calling for the rate of absorption to slow through 2008, the effect on vacancy will be minimal during that time, as vacancy is expected to increase only 10 basis points to 4.9 percent. The slight up-tick in vacancy, however, will cause concessions to be reintroduced into the marketplace, as asking rents are anticipated to advance 4.3 percent to $5.28 per square foot, while effective rents gain 4.1 percent to $5.07 per square foot.

Lack of for-sale inventory has accounted for sales velocity to decline roughly 38 percent during the last 12 months; however, investors have maintained their interest in the market’s properties, as the median sales price has increased approximately 12.3 percent to $128 per square foot year over year.

Douglas McCauley is a sales manager in the Ontario, California, office of Marcus & Millichap Real Estate Investment Services.

©2007 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.