FEATURE ARTICLE, JANUARY 2005

OFFICE OVERTURES
Southern California’s office investment market continues to show strength.
John McDermott

McDermott

Southern California’s office market continues to show its power on the local and national scene with high transaction volume and impressive per-square-foot prices. And though the Inland Empire and Los Angeles, Orange and San Diego counties are as diverse as the region itself, there are several major trends that occurred in 2003 and 2004 that also link them together as a leading market.

The first commonality is the high volume of attention that office product in each of these markets continues to attract from a wide variety of investors — from REITs to the individual “Main Street investor” and everything in between. This attention caused Southern California office values to climb across the board from 2003 through 2004, with significant average price-per-foot gains occurring in San Diego (25 percent), Los Angeles (20 percent) and the Inland Empire (17 percent). This equates to a year-over-year increase in Los Angeles from $168 to $203 per square foot; in San Diego from $183 to $227 per square foot; in the Inland Empire from $127 to $149 per square foot; and in Orange County, which represents the smallest value increase, from $178 to $179 per square foot. Orange County’s sluggish performance, it should be noted, is largely due to Maguire Properties’ acquisition in February 2004 of the 1.77 million-square-foot Class A Park Place Office Campus in Irvine for $260 million ($146.61 per square foot). The price is well below average and particularly low for the asset’s great location and quality.

The fact that cap rates in all of the counties have significantly improved for sellers — from the low 8 to 9 percent range in 2003 to the low 7 to 8 percent range in 2004 — adds fuel to the fire, encouraging owners to sell and leading to the volume of transactions exceeding $1 million to increase in all markets except the Inland Empire. In the remaining markets, Los Angeles rose from 386 transactions and $4.08 billion total volume in 2003 to 441 transactions and nearly $4.6 billion in 2004. San Diego and Orange County enjoyed nearly double the sales volume from 2003 to 2004. In San Diego, transactions rose from 123 closings totaling $1.18 billion in 2003 to 135 closings totaling $2.14 billion in 2004. Though Orange County reported a drop in transactions from 165 in 2003 to 158 in 2004, sales volume over the same period increased from $1.09 billion to $1.94 billion.

The major office real estate investment players in Southern California continue to be Equity Office, Maguire Properties, The Irvine Company, Metropolitan Life, RREEF, Wells REIT, Arden Realty, GREIT, CarrAmerica and Teachers Insurance and Annuity. Newer to the market are the tenant-in-common firms with Orange County-based Triple Net Properties closing on significant CBD acquisitions, particularly in San Diego.

Though Southern California office remains the weakest of the region’s core commercial investments, some interesting footnotes about certain markets again speak to the diversity and improvement of the sector in 2004. San Diego County currently boasts the region’s highest office price per foot at $227 and lowest cap rates at 7.25 percent. L.A. County has the biggest deal reputation, with 15 properties over $100 million trading hands in 2003-2004. This includes the area’s single largest deal, Equity Office’s $443.6 million acquisition of the Colorado Center in Santa Monica last August.

There is no doubt that the garden of opportunity for Southern California office players still looks ripe, and a number of factors are helping it steadily become a darling for many savvy investors. Acquisition costs today are far below replacement costs in all classes of Southern California office product. Barriers to entry are becoming more difficult to overcome, occupancy has been steadily improving across the board, and sub-lease space is becoming more scarce and with shorter remaining terms available. Existing Class A space can be filled immediately as opposed to the lead time required for new construction. Although the office market is showing signs of improvement, speculative construction in office has been virtually non-existent in the past few years.

Compared to last year, 2003 was a bargain year for office product. At this time next year, we will likely look back at 2004 as a similar year of bargains. All of the stars are aligned for 2005 to show even greater improvements in the office market. Promising areas to look to include the Inland Empire and Long Beach, which is probably the most undervalued coastal region in California. While the Inland Empire experienced the lowest number of transactions, lowest dollar volume and lowest price per square foot in 2004, it had the greatest cap rate improvement — from 9.0 percent in 2003 to 7.58 percent in 2004 — and may hold some treasures for the finding. Let us not forget the impact made by the many local investors who are now selling their apartments at 4 and 5 percent cap rates but want to remain in the region. They want higher returns and office is the best answer available to them today in Southern California.

John McDermott is a regional manager for Sperry Van Ness in Orange County, California.


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