MARKET HIGHLIGHT, FEBRUARY 2006

LOS ANGELES LOOKING GOOD
Jonathan Weiss

Strong economic development boosted all sectors of Los Angeles' investment market in 2005. The apartment market has been buoyed by healthy job growth and low housing affordability, and the outlook for 2006 remains solid. Healthy consumer spending has encouraged retailers to expand, making the L.A. retail market one of the strongest in the nation. Growth lies ahead for the office sector as well, as local office expansions, based on growth in office-using employment, continue and vacancy drops. Industrial sector activity is also surging, predicated on improved property fundamentals and eased construction. Busy ports continue to boost the market.

Multifamily

Los Angeles apartment owners are poised for yet another strong year in 2006 with continued low housing affordability and job growth boosting the sector. Housing affordability is likely to remain at a historic low through 2006, keeping renter demand on the rise. In addition, local employers will add 57,000 workers to payrolls in 2006, a gain of 1.4 percent over 2005. Nearly one-quarter of these jobs will be in the higher paying professional and business sector, which will result in increased demand for luxury apartments.

After ending 2005 at 3.4 percent, vacancy is expected to improve to 3.2 percent in 2006. Even the priciest areas are posting improving fundamentals. In the desirable west side cities, vacancy is expected to drop below 4 percent in 2006 despite the area's asking rents being 50 percent more than the county average. Another area benefiting from growing tenant demand is the east San Fernando Valley, where the entertainment industry is rebounding. This will lead to strong absorption in Glendale and Burbank, with vacancy forecast to end the year down 60 basis points at 2.8 percent. Owners in the submarket will attain more pricing power, allowing them to push asking rents up 4 percent this year to an average of $1,355 per month.

Apartment builders will add 5,100 units in 2006 with the majority concentrated in the west side cities and the greater downtown area. Demand will continue to outstrip new supply, though, as multifamily development remains focused on the condo market. The expanding renter pool has been able to absorb the large number of new units delivered in recent years. As a result, owners are expected to raise asking rents 5.2 percent in 2006 to an average of $1,350 per month. Effective rents are forecast to increase 6.2 percent this year.

Investors will remain bullish on L.A.'s apartment market. Competition for properties remains heated among investors, which will keep upward pressure on prices this year. While private investors will remain the dominant players in the market in 2006, institutional activity has started to pick up, especially since annual average revenue growth is approaching 5 percent. Over the past year, transaction velocity and dollar volume for properties selling in excess of $10 million more than doubled. Prices will continue to appreciate in nearly all areas of the county, though the greater downtown area is expected to post the largest gain due to condo conversions, redevelopment efforts and a limited number of sellers.

Retail

Los Angeles' retail market continues to be one of the strongest in the nation as the strengthening economy stimulates healthy consumer spending growth and encourages retailers to expand. Bolstered by rising disposable incomes resulting from job creation in high-paying sectors, retail sales growth was expected to reach 5.2 percent in 2005. Vacancy remains minimal, and owners are capitalizing on tight market conditions by raising rents. Investors are clamoring for properties, putting upward pressure on prices.

Retail construction in Los Angeles County was on track to increase slightly in 2005 with developers set to deliver 2.3 million square feet, compared to 2.1 million square feet in 2004. A significant amount of retail product remains in the pipeline, including 16 million square feet of retail space either underway or in the planning stages. Most of the current construction activity involves single-tenant properties. Albertsons is one of the more active retailers this year and is building two new grocery stores and adding five drugstores to existing locations. The growing opposition to big box retailers has led to a decline in development of discount retail locations, with Lowe's Home Improvement Warehouse, Wal-Mart and Kohl's adding only one new store each during 2005.

As a result of retail expansion, shopping center vacancy is expected to have dropped 20 basis points by year-end 2005 to 3.9 percent. Measured by vacancy, Los Angeles is one of the strongest retail markets in the nation, surpassed only by San Diego. The best performers are the west side cities and east San Gabriel Valley, where vacancy has dropped to 3.5 percent and 4.2 percent, respectively. Areas to watch include Burbank/Glendale and Long Beach.

Low vacancy and strong demand have allowed owners to push rents higher in 2005 with a 4.5 percent increase in the average asking rent to $2.11 per square foot projected for year-end 2005. Submarkets posting better-than-average growth include downtown and west San Gabriel Valley. Downtown was expected to see asking rents up 6 percent by year-end 2005 to $3.06 per square foot. Owners on the west side expected a 5 percent increase in rents by the end of 2005 to $3.62 per square foot. In addition, owners in the San Fernando Valley hoped to raise asking rents 4 percent to $2.10 per square foot in 2005.

Solid fundamentals and leasing activity are motivating retail property investors, but price growth was projected to slow at the end of 2005. Private investors remain the dominant players in the market as evidenced by transactions under $5 million accounting for 90 percent of all shopping center transactions. While the velocity of these deals slowed over the past year, the number of transactions for $5 million-plus properties hit an all-time high. Competition for higher-priced assets remains fierce. Institutions are paying a premium for quality properties with some large centers selling for as much as $350 per square foot. Large deals include the sale of the 180,000-square-foot Promenade at Town Center in Valencia for $365 per square foot and the 123,000-square-foot Hacienda Center in Hacienda Heights for $313 per square foot.

Office

Los Angeles' office market is clearly entering a growth phase with prospects for stronger economic expansion, allowing investors to maintain a positive outlook. Many of the thousands of new jobs entering the market are in office-using industries, leading to an expansion that has resulted in increased absorption of local office space. The rapid drop in vacancy has nearly returned the market to what many consider to be healthy territory with conditions forecast to tighten further in the coming months.

Development of new office buildings remains limited compared to inventory, yet speculative building activity appears to be gaining momentum. Builders are on pace to have added a total of 1.3 million square feet of competitive office space in 2005, down slightly from the 1.4 million delivered in 2004. The majority of space coming online consists of small, multi-tenant, low-rise office buildings that average around 60,000 square feet in size. The only project completed downtown in 2005 was the 55,000-square-foot One Union Station Plaza, which was 100 percent leased upon completion. Completions in the west side cities were expected to total 180,000 square feet in 2005, down from the 215,000 square feet delivered in 2004. In the San Fernando Valley, new office space hit a 5-year high in 2005 with developers on track to add 525,000 square feet.

Leasing activity continues to ramp up as local businesses enter expansion mode. As a result, vacancy was forecast to end 2005 down 160 basis points from 2004 to 11.5 percent. While the central business district has been garnering all the attention with building conversions and numerous redevelopment projects, the west side submarkets have posted the best absorption numbers as of third quarter 2005. A number of suburban submarkets, including San Fernando Valley, Tri-Cities and San Gabriel Valley, had stronger leasing activity than downtown in 2005. Vacancy in these submarkets is down anywhere from 200 basis points to 700 basis points during the last 12 months.

Rapid declines in the vacancy rate over the past year have produced a rise in asking rents, which were expected to end the year up 3.5 percent to $2.19 per square foot. Effective rents were expected to rise 3.8 percent during 2005 to $1.83 per square foot. Most of the gain came from Class B/C properties, which were up 3.5 percent on a year-over-year basis to $1.75 per square foot. Areas posting strong rent growth include the west San Fernando Valley (6.8 percent), Santa Monica (6.8 percent) and Santa Clarita Valley (7.6 percent).

Investment activity is expected to slow as the cost of capital starts to rise. Investors continued to push prices higher in 2005 with the median price for office buildings up 14 percent over the last year to $195 per square foot. Private investors continue to dominate the investment scene with deals priced less than $10 million accounting for nearly 80 percent of all transactions in first half 2005. The median price for properties selling for less than $10 million increased by 21 percent through the third quarter to $200 per square foot. The median price for institutional level deals held steady at $198 per square foot in 2005.

Industrial

The Los Angeles industrial sector remains a solid performer. Property fundamentals have improved with construction easing and absorption picking up. Industrial completions were forecast to total 5 million square feet in 2005, down slightly from 2004. Most new construction consisted of speculative projects, and only 20 percent of space underway is pre-leased.

If combined, the Los Angeles and Long Beach ports would be the third-busiest in the world. The volume of goods passing through is expected to increase as the economy improves and the dollar remains relatively weak. Los Angeles ports are capitalizing on increased trade with eastern Asian countries, but an increasing amount of the goods arriving at the Los Angeles ports are being transported to the Inland Empire. As a result, the South Bay submarket may not realize a significant increase in warehouse demand from port activity; however, increased defense/homeland security spending will continue to have a positive effect in the area. In addition to Northrop Grumman, Boeing and General Dynamics, there are many other aerospace and defense-related companies in South Bay.

All of this has led to expectations of a 15 percent jump in absorption for the city in 2005 to 8 million square feet. The vacancy rate for industrial properties was expected to decrease 60 basis points to 5 percent by the end of 2005 thanks to an improving local economy and a slight decline in development. Rents were forecast to rise 3.5 percent to $6.95 per square foot in 2005 after a 3 percent increase in 2004. Concessions still exist in some submarkets but will be employed less frequently as demand strengthens over the next 12 to 18 months.

Industrial investment activity continues at a strong pace. As competition for assets has intensified, the average cap rate has fallen to the low-7 percent range, about 50 basis points below the average reported in 2004. The median price per square foot has soared to approximately $100 per square foot, up from $90 per square foot in 2004. Some very large institutional transactions have occurred over the past year — a few at prices in excess of $100 million — but the majority of deals involved private buyers.

Jonathan Weiss is a managing director and regional manager of Marcus & Millichap's Encino, California, office.

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