MARKET HIGHLIGHT, JANUARY 2006

ORANGE COUNTY: SURF AND PRIME TURF
Alex Pavich, Damon Wyler, Don Keena and John Read

Upper-end demographics, prime location and easy access to Southern California's major markets help to put Orange County commercial real estate in great demand. Just ask developers, tenants and investors.

Multifamily

After several years of strong demand and increased pricing for Orange County apartment properties, the red-hot investment market is now cooling. Although the apartment market continues to outperform other major markets, properties are no longer snapped up the moment they come to market because buyers are increasingly unwilling to pay the high prices.  

More than $600 million worth of Orange County apartment assets traded hands during the third quarter, the highest volume since the late 1990s according to New York-based research firm Real Capital Analytics Inc. Moreover, 42 properties totaling $1.5 billion were acquired from July 2004 to October 2005.

The price per unit continued to increase over the quarter, reaching an average of $166,178, which is significantly higher than the national average of $86,396, according to Real Capital Analytics. For example, the 40-year-old Seashore Apartments in Huntington Beach recently sold for $214,000 per unit, while the 59-unit Villa Mesa Apartments in Costa Mesa sold for $184,915 per unit. Along those same lines, cap rates for Orange County apartment deals reached record lows during the third quarter, averaging 5.4 percent versus the national average of 6.4 percent.

Overall, there's a feeling that apartment pricing in Orange County has reached maximum value. The increasing interest rates are also having an impact, causing some concern among investors. Quality apartment properties are sitting on the market 5 to 6 weeks longer than they did just 1 year ago when the seller's phone just wouldn't stop ringing. Looking forward into 2006, the price gap between buyers and sellers is likely to widen despite strong apartment fundamentals.

At the end of the third quarter, the vacancy rate had dropped to 3.5 percent from 4.1 percent a year ago, according to REIS. The vacancy rate is expected to decrease even more over the next few years. Absorption during the past 12 months has been strong, outpacing the number of new units completed. During the past 12 months, 3,582 units were absorbed, while 3,356 new units came online, according to REIS.

The strong absorption is allowing apartment owners to push rental rates. In the past 12 months, rental rates have increased 4.7 percent, outpacing the national rate of 2.2 percent, according to REIS. The research firm expects rental rates in Orange County to increase 4.4 percent annually over the next 5 years. However, rents are getting to the point where it may be difficult for owners and landlords to keep pushing.

Next year, roughly 2,000 units are expected to be completed — a number that won't come close to satisfying demand. Apartment developers are competing with condo developers for sites. Canadian firm Bosa Development, for example, recently dropped $40 million on a parcel in the Park Place development in Irvine. The firm plans to develop four 18-story condo towers totaling 566 units.

Most of the new apartment development occurring in Orange County is part of mixed-use or high-rise projects situated in infill locations. Windstar Communities, for example, is developing 390 loft apartments near Anaheim Stadium. The units will be part of a larger project that includes roughly 12,000 square feet of retail and restaurant space.

— Alex Pavich is a senior advisor for Sperry Van Ness in Irvine, California.

Retail

Affluent demographics and a consumer-oriented culture have enticed almost every retailer in the country to expand into Orange County. Retailers — and investors — want to be where people can't wait to get the newest car or fill their houses with the nicest furnishings.

In fact, investor demand for mall and strip center properties has been out of control for the past 3 years. Over the past 12 months, investors have scooped up $1.1 billion worth of retail assets in Orange County, according to Real Capital Analytics. The properties traded at an average cap rate of 6.8 percent and an average price per square foot of about $200.

The market during the third and fourth quarters slowed somewhat because of high energy prices, natural disasters and rising interest rates. However, a strong holiday season should kick investors back into high gear in early 2006, particularly since there are no signs that Orange County's retail market will not continue to outperform the rest of the nation.

Orange County continues to be one of the healthiest retail markets in the country. The vacancy rate for neighborhood and community centers was 1.8 percent and 2.4 percent, respectively, according to REIS. Throughout the county, there's just not enough space to meet demand. During the first three quarters of 2005, only 9,000 square feet of retail space were delivered, compared to 99,000 square feet of absorption.

Demand is pushing up rental rates for both community and neighborhood centers. During the third quarter, asking rental rates for community and neighborhood centers increased 1.6 percent and 2.2 percent, respectively, according to REIS. The average asking rent is $2.40 per square foot per month — rather expensive when compared to the mid- to late 1990s when $2 was rent seen only on the coast or in brand centers.

Orange County is so land constrained that developers are bypassing new development for redevelopment opportunities and rehabbing older centers into urban, mixed-use properties. Nearly 2 million square feet of retail space — either new or redeveloped — is under development in Orange County. A prime example is the Aliso Commons at Town Center in Aliso Viejo, which is the redevelopment of a former vacant Kmart building into 25 acres of new urbanist lifestyle use with 140 residential condos. Phase I was completed earlier this year with the next two phases to begin in spring 2006. This will be the first high-rise residential property in south county.

Additionally, in Huntington Beach, prominent developer J.H. Snyder Co. recently completed Bella Terra, a $170-million, 1 million-square-foot, open-air lifestyle center. The center was created through the extensive renovation of Huntington Shopping Center, Southern California's oldest enclosed mall. The “demalled” center offers 71 shops and restaurants and a 20-screen, 4,000-stadium-seat Century Theatres multiplex.

Moving into 2006, buyers will have a lot of options because many owners are trying to sell at the top of the market. Prices are not likely to appreciate much next year, although a lot of out-of-state money and international money have recognized the intrinsic value of Orange County retail real estate. In mid-November, for example, United Kingdom-based Grosvenor acquired the River, a 227,550-square-foot outdoor lifestyle center in Rancho Mirage from J.H. Snyder. The purchase price wasn't disclosed, but industry experts estimate it to be worth about $70 million.

— Damon Wyler is a senior advisor for Sperry Van Ness in Irvine, California.

Office

Orange County's office market is no longer a tenant's market — the tables have turned, and landlords are back in control of the sector. In fact, vacancy in Orange County dipped to a record-low 6.8 percent at the end of the third quarter, and asking rental rates have finally started to increase.

Due to the market's bright long-term forecast, projects like 2211 Michelson, the new 261,000-square-foot office tower in Irvine, are sprouting up. Hines and Crescent Real Estate Equities have joined forces to develop the 12-story, Class A building. Los Angles-based Maguire Properties is developing a new 600,000-square-foot, Class A office building in the Park Place campus. The 20-story tower, which is scheduled for completion in 2007, will have little impact on the market's vacancy rate since it's already more than 50 percent pre-leased to mortgage lender New Century Financial Corp. (190,000 square feet) and Los Angeles-based law firm Gibson, Dunn and Crutcher LLP (80,000 square feet).

During the third quarter, nine buildings totaling 237,320 square feet were completed, bringing the total office inventory in Orange County to 92 million square feet. Currently, there is 2.4 million square feet of office space under construction in the county. Nonetheless, absorption far outpaced new supply, with all Orange County office submarkets posting positive absorption of 1.6 million square feet during the quarter, a performance that brought the year-to-date total to 3.7 million square feet.

The average asking lease rate increased to $2.14 per square foot per month during the third quarter, compared to $1.99 a year ago. Concessions such as free rent are just memories today and will be for some time to come.

The strong market fundamentals are driving prices and cap rates to record levels. In particular, the airport and Fashion Island submarkets are attracting huge amounts of investor interest, although there is strong demand for office properties throughout the county and across the quality spectrum. In fact, the deal volume during the second and third quarters was at near-record levels. During those two quarters, nearly $2 billion of office properties was sold at an average price per square foot of $235 and an average cap rate of 7.2 percent, according to Real Capital Analytics. The better-quality properties are trading at cap rates in the mid- to high 6 percent range.

One of the biggest deals in the county was AEW Capital Management's acquisition of 100 Bayview, a 317,376-square-foot trophy office project, for $117 million. The property, which was purchased from a partnership of the Laguna Hills-based Muller Co. and Rockwood Capital of San Francisco, is situated in the Orange County airport submarket in Newport Beach.

Private investors like Muller and Rockwood Capital are still driving the market and will continue to do so in 2006 as long as interest rates don't increase too much. However, buyers next year will be less likely to pay top dollar for Orange County office assets and will force sellers to come off their prices just a bit, ending the compression on cap rates and allowing them to return to the 7 percent range.

— Don Keena is Sperry Van Ness' sales manager in Long Beach, Irvine and San Diego, California.

Industrial

Owners/users are driving Orange County's industrial market today, scooping up smaller industrial buildings and industrial condos, some for $200 per square foot or more. Demand from owners/users is expected to be strong in 2006 as Orange County's population continues to grow, and small business owners seek to purchase buildings close to where they and most likely their employees live.

During the first 9 months of 2005, roughly $230 million of Orange County industrial assets were acquired, according to Real Capital Analytics. That volume represents a 35 percent increase compared to the investment activity in 2004.

Moreover, the average price per square foot for Orange County industrial properties has outpaced the national average — $101 compared to $74, according to Real Capital Analytics. Similarly, cap rates have been decreasing for the past several years and recently reached a low of 5 percent.

Orange County investors are chasing a scarce commodity when it comes to industrial property, and industrial users that need large distribution and manufacturing buildings are forced to look to the Inland Empire because land for new construction is hard to come by, especially for this larger type of product. In fact, many of the industrially zoned sites have been rezoned for residential use, and industrial developers have turned to redevelopment of existing buildings and infill sites.

For example, Lowe Enterprises plans to develop 260,000 square feet of small industrial buildings for sale on the 15-acre former Johnson Controls site in Fullerton. They plan to build 24 buildings ranging from 7,500 square feet to 15,000 square feet after the leaseback period ends. These new buildings will be designed to accommodate office, warehousing and light manufacturing uses with grade-level doors and 18- to 24-foot clear heights. Lowe expects to start construction in fall 2006 with completion estimated for fall 2007.

At the end of the third quarter, 20 buildings totaling 1 million square feet were under construction with most of the new development catering to the owner/user. BKM Development, for example, is constructing Red Hill Business Center in Costa Mesa. The project consists of for-sale buildings ranging from 5,000 to 24,000 square feet. The firm also is working on another for-sale industrial project in North Anaheim.

Of the submarkets, west Orange County will bring on the most new construction next year with nearly 415,000 square feet of industrial space under construction currently, while north Orange County also has a significant amount of development activity with 314,000 square feet of industrial space going up.

However, as construction costs increase, the question is how much of the expense can be passed along to the end-user, whether it is a tenant paying rent or an owner/user buying a building. There could be a backlash from owners/users if prices continue to rise along with interest rates. Industrial properties could sit on the market longer than expected if this happens.

Nonetheless, new development is not expected to have much of an impact on rental rates, which have increased 3 percent during the past 12 months to an average of more than $9 per square foot per year. Absorption during the third quarter was 876,489 square feet, a significant improvement from the negative net absorption of 581,254 square feet during the second quarter. This pushed the vacancy rate down to 3.6 percent at the end of the third quarter from 4 percent during the previous quarter.

Demand for Orange County industrial space is not expected to wane, and industry experts forecast that prices will increase another 5 to 10 percent, and vacancy rates will continue to decrease in 2006. Next year will be another good year for sellers and landlords.  

— John Read is an advisor for Sperry Van Ness in Irvine, California.


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