MARKET HIGHLIGHT, DECEMBER 2008

INLAND EMPIRE
Ron Washle, John Ewart, Dain Fedora and Skip Crane

New economic realities in the Inland Empire are reflected in the area’s commercial real estate trends, but its fundamentals will anchor the two-county market until the storm clouds dissipate.

Industrial

The desire to streamline transportation and operating costs has been a recurring theme in 2008. For tenants already in the marketplace, consolidations provided an answer with companies such as MGA Entertainment Inc. vacating numerous buildings in favor of one large facility. This trend drove healthy leasing activity in cities along Interstate 215, the market’s development corridor. However, it also added available sublease space to the market as tenants vacated older buildings in cities west of Interstate 15 to relocate east to larger, newer product.

The east, however, has been saturated with new speculative construction just as the national economy has taken a turn for the worse and consumer spending plummeted to record lows. With 22.1 million square of new speculative construction added during 2008, and only 22.6 percent absorbed, the Inland Empire is now contending with buildings staying vacant longer as landlords vie for tenants. The vacancy rate, which has held below 5 percent for 14 consecutive quarters, rose in 2008, ending the year at 9.1 percent. Absorption, meanwhile, was down 61 percent from year-end 2007.

With the changing economy, the desire to reduce costs is now driving many business decisions. In the case of industrial users, one way to do that is to reduce transportation costs. As a result, expect the region’s western submarkets to see increased activity, given their closer proximity to Los Angeles and Orange County. Eastern cities such as Moreno Valley, San Bernardino and Riverside may receive notable activity in 2009 from intra-market consolidations and out-of-state distributors that rely on Southern California’s port system to funnel goods to the rest of the nation. The I-215 corridor, while often viewed as too far removed for many Southern California distributors, may be desirable for Arizona-based firms who use the ports as a gateway to ship goods throughout the country due to its available first generation space and highly competitive asking rental rates.

Though 2009 will pose numerous challenges to the local industrial market, the region’s long-term outlook is good. The Inland Empire is Southern California’s last stop for companies looking to establish massive distribution centers within reasonable proximity of one of the world’s busiest port systems, where more than 40 percent of all containerized cargo enters the country. With local port traffic potentially exceeding 42.5 million TEU containers by 2030 and Los Angeles County’s built-out industrial markets, West Coast distributors will be hard pressed to find an alternative to the Inland Empire.

— Ron Washle is a senior vice president at Grubb & Ellis Company in Ontario, California.

Office

On the heels of a declining housing market, the Inland Empire office sector recorded its first negative absorption since the mid-1990s, as the vacancy rate surpassed the 20 percent mark, sublease space rose and new construction completions were met with slack tenant demand. With job losses mounting in the finance/real estate-related industries, 2008 has been a bleak year. And yet a paradox exists: while new construction completions have saturated the market, there is a gap between the market’s population of 4.2 million and available office tenants to serve this base.

Expect landlords to become more flexible with their rents to lure tenants. The financial crisis affecting mortgage companies and banks has resulted in a surge in Class A sublease space, which is competing directly with new construction. This space can be had at a discount, which will exert downward pressure on rents at newer buildings. Tenants will also benefit from higher tenant-improvement allowances, free rents and effective rents that will be dramatically lower than asking rates. Ontario and Riverside are expected to see a quicker recovery than other inland cities, a function of being the area’s central business districts and offering available amenities, surrounding demographics and an array of newer construction that will present opportunities for tenants.

Insurers, credit unions, for-profit educators, medical and law-related firms will constitute the next wave of office tenants when a recovery does occur. They also led tenant activity in the second half of 2008. For example, the Riverside County District Attorney purchased a 260,000-square-foot building in Riverside, while SchoolsFirst Federal Credit Union committed to 22,009 square feet. Other leases included Corvel Corporation, Wachovia, Parsons, Personnel Concepts and GE Corporation in Ontario.

To minimize losses, many builders will put larger developments on hold, while current developments will be phased with construction beginning on planned buildings once pre-leasing reaches the 40 to 50 percent mark. Overall, construction will dramatically decrease in 2009. Despite job losses in companies linked to the subprime lending industry, such as mortgage firms, title agencies and home builders, the Inland Empire has established a diversified tenant mix in recent years. This will help drive the office market once the local housing sector begins to show signs of recovery and consumer confidence improves. Class A asking rates will decrease 12 percent as landlords vie for tenants.

— John Ewart is a senior vice president at Grubb & Ellis Company in Ontario.

Multifamily

The Inland Empire has been hit hard by the slowdown in the housing market as evidenced by the fact that the two-county area has one of the highest foreclosure rates in the nation. While the vacancy rate for apartments in the Inland Empire stands at 6 percent, the weakness in the for-sale housing market has created a shadow market as foreclosed houses and condominiums flood the market as rentals. Apartments now have to compete with all of these foreclosed properties for tenants.

Newer submarkets, such as the High Desert and the Banning/Beaumont areas, are reporting significantly lower occupancy rates than their counterparts in more established submarkets such as Rancho Cucamonga, Ontario, Chino Hills and Riverside, cities that are in or near the market’s central business districts.

Looking ahead, developers will scale back on new construction due to difficult construction financing, a projected inland job loss of 17,700 positions by year-end 2008 and additional rentals from the region’s shadow market. Rental growth will be flat at best, averaging a 1.8 to 2 percent gain in 2009. The market’s average rent of $1,162 per month as of third quarter 2008 was a 2 percent gain from 2007.

The apartment investment market has been impacted by the credit crunch, which has stalled investment sales nationwide. Through third quarter 2008, 24 investment properties with a sale price of $5 million or greater changed hands in the Inland Empire. This was a decline of 55 percent from last year’s numbers. Transaction volume totaled $842 million, off 42 percent from last year. The average price per unit was $133,149, a decline of 12 percent from 2007, while the average cap rate was 6 percent. Sales activity was fairly evenly split between the two counties with San Bernardino recording 10 sales valued at a total of $445.9 million and Riverside posting 12 sales with a total value of $379.4 million.

Leading investment sale transactions in 2008 included the $45 million Grand Marc at University Village, a 212-unit complex in Riverside; the $44 million Archstone Woodsong, a 262-unit complex in Rancho Cucamonga; The Lexington, a 165-unit complex in Montclair, for $29.2 million; Magnolia Park, a 268-unit complex in Riverside, for $20.9 million; Hillside Park, a 177-unit complex in Hemet, for $11.6 million; the $10.8 million Corona Village, an 83-unit complex in Corona; and Serenade, an 79-unit complex in San Bernardino, for $8.9 million.

— Dain Fedora is client services manager for Grubb & Ellis Company in Ontario.

Retail

Nationwide layoffs, plunging home prices and tumbling investments pushed consumer pessimism to record levels in 2008 as the consumer confidence index fell to 38 in October, the lowest level since tracking began in 1967. And with household expenses outpacing income growth, particularly in Southern California, consumer spending has dramatically changed. The question is now discretionary versus necessity, and which retailers can expect growth in 2009 amidst a national recession.

Though many national retailers expect reduced earnings, they continue to target the Inland Empire to expand their market share. For instance, Target opened three SuperTargets in the Inland Empire; Tesco is moving forward with 48 Fresh & Easy store openings; Kohl’s opened its 17th inland location; and Wal-Mart continues to seek expansion in the two-county area. The dollar’s devaluation in 2008, high gasoline prices and rising cost-of-living expenses were positives for discount retailers and grocers as shoppers focused more on staple necessities rather than luxury purchases. However, even these tenants will only expand after careful research and evaluation, leading to a more conservative rate of growth than witnessed in prior years.

Luxury lifestyle centers are bracing for flat sales in 2009. However, the steepness of sales declines will vary by location and surrounding demographics. In Chino Hills, where the median household income is among the highest in the market, The Shoppes at Chino Hills are expected to record higher sales than Corona’s Dos Lagos, located at ground zero for home foreclosures in the area. Traditional malls will struggle in 2009; General Growth Properties, owner of Galleria at Tyler in Riverside, Moreno Valley Mall, Redlands Mall and Montclair Plaza, may be forced to divest some of its more than 200 national assets, as the company struggles to pay down debt amid the worldwide credit crunch.

The local population reached 4.2 million people in 2008, a 22 percent increase from 2000. With the ailing housing market, select discount retailers, pharmacies and grocers will enjoy moderate sales growth. A recent increase of sublease space will present opportunities for aspiring franchise operators to lease at discounted rents. The majority of developers will put future groundbreakings on hold as tenant downsizing puts vacant space back onto the market, consumer confidence remains lackluster and construction financing remains difficult to secure. By the close of 2009, the market will post $40.6 billion in total taxable retail sales, the lowest level since 2004.

— Skip Crane is a senior vice president for Grubb & Ellis Company in Ontario.

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