MARKET HIGHLIGHT, JULY 2009

THE INLAND EMPIRE
Paul Earnhart, Erik Hernandez, Thomas Pierik, John Kalmikov and Brian Bielatowicz

The Inland Empire commercial real estate market is in the process of a demand and price correction like many major commercial markets in the country. Institutional de-leveraging, decline in port traffic through the Los Angeles/Long Beach harbors, consumer retrenchment, higher vacancy rates and new economic realities are all having an impact on the marketplace.

Industrial

In the best tenant and buyer’s market in years, lease rates have retreated to late 1990s levels. The overall vacancy rate for the western Inland Empire stands at 6.47 percent through May 2009. However, the actual availability rate (which includes sublease space, space available but currently occupied and available under construction space) stands at 13.2 percent of the total inventory. To battle vacancy, landlords are providing lease rates and incentives today that some would have never dreamed of 2 years ago. Free rent? Check. Moving allowance? Maybe. Lease assumption on another property? Let’s sit down and talk.

To recap 2009 to date, new construction is down dramatically — forecast at about 80 percent off of 2008 levels — with only a handful of new projects underway. Sales activity is off dramatically, as buyers seem to be waiting for the proverbial bottom in prices. Many sellers have become very aggressive this year to move standing inventory. Prices are therefore adjusting, as buyer and tenant activity slowed dramatically in the second half of 2008 and first quarter 2009. What does this all mean?

Sales activity was anemic in first quarter 2009. Through May 2009, there were only eight sales (closed escrows) of industrial properties exceeding 5,000 square feet in the western Inland Empire. That’s not a typo. Annualized, that would mean that sales volume for 2009 on a transaction basis could be off by as much as 70 percent, possibly more. Interestingly, however, leasing activity is not off by that much. Through May 2009, there were 113 leases exceeding 5,000 square feet executed in the western Inland Empire. Annualized this number would come to approximately 271 lease transactions. If the trend holds, this number would only be off approximately 16 percent from 2008’s total of 323 transactions.

In what would seem to support the trend of steady demand from tenants to lease space, in the last 90 days there has been a noticeable increase in activity of companies reviewing the market to consider their alternatives. Some perhaps are reviewing the market so they may go back to their existing landlords and cut a better deal on a lease renewal. Others are making the choice to consolidate other locations and/or relocate operations from adjacent, more expensive markets in Los Angeles and Orange counties to reduce operating expenses by a considerable margin.

Mass relocation to the Inland Empire was the trend in the 1990s as companies in Los Angeles and Orange counties reduced operating costs by taking less square footage, but higher cubic square footage (read: taller, more efficient buildings) in the Inland Empire that was less expensive. This trend in the 1990s stabilized the Inland Empire industrial market, providing a floor for rents and sale prices. We are beginning to see anecdotal evidence of this happening again today.

There are, however, for the next 12 to 18 months, great deals for tenants and buyers to be had for state-of-the-art, Class A industrial facilities in the Inland Empire. As usual, the best will go first and fast. The pendulum will swing the other way. In the meantime, buckle up!

— Paul Earnhart and Erik Hernandez are senior vice presidents at Lee & Associates in Ontario, California.

Office

Corporate consolidations and tenant move-outs have combined with record levels of new office construction to create some of the highest office vacancy levels in the history of the Inland Empire market.

As of the end of first quarter 2009, office vacancy in San Bernardino and Riverside counties exceeded 23 percent on a base of more than 23 million square feet.

Since mid-year 2007, almost 4.5 million square feet of new office space completed construction, representing an approximate 25 percent increase to the market’s base. This new supply entered the market just as both the regional and national economies began their slide.

In 2008 alone, the Inland Empire lost more than 32,000 jobs, and the office market gave back space with negative office absorption exceeding 115,000 square feet. This negative job growth was the first time Riverside and San Bernardino counties did not post positive job growth since 1964.

Markets such as Corona and Ontario saw the greatest number of new office buildings built. Their locations on the western edge of the Inland Empire have been experiencing some of the region’s strongest growth due to their close proximity to both Los Angeles and Orange County. Now, their newest Class A product has vacancy levels exceeding 40 percent.

Positive news, however, is on the horizon. With the beginning signs of a strengthening economy, the Inland Empire’s current vacancy levels offer advantages for those tenants who have delayed corporate relocations to the market. Significant opportunity exists due to the number of high quality buildings available to accommodate future expansions in the two-county area. In addition, these opportunities are available at economics that offer attractive concession packages and low rental rates. When combined with the market’s competitive wage advantages — a large, well-educated, available labor pool willing to work for wages 5 to 15 percent lower than other job markets closer to the coast — Southern California’s Inland Empire offers forward-looking companies reduced occupancy and labor costs that positively impact long-term corporate profitability.

— Thomas Pierik is a senior vice president in Lee & Associates’ Riverside, California, office.

Multifamily

The Inland Empire is still positioned to be one of the greatest opportunities to grow a strong portfolio of multifamily investments in the long run. However, apartment sales have somewhat stalled with a lack of jobs being created, lack of financing in the market and the softening of rents. As cap rates rise along with economic uncertainty, there has been value deterioration for owners, yet many of them have not experienced much of an impact on cash flow, especially for buildings closer to Los Angeles and Orange counties.

The farther east one gets from those counties, the market gets softer in terms of decreasing rents and more concessions to attract tenants. These cities have vacancy rates that have climbed as the unemployment rate has risen from the mid-8 percent to 13 percent. Beacon Economics had estimated last September 2008 that unemployment would hit 12.4 percent. Now unemployment is hitting 13 percent, and its new projections are that it could rise to 16 percent. This new unemployment projection will continue to impact rents, concessions and vacancy rates.

There are a few transactions in the marketplace that have closed in 2009. Most owners are not in trouble so they choose not to sell at today’s market values. Those owners that are having difficulty with high levels of debt are getting concessions from their lenders with discounted payoffs or some type of modification of their loan terms. Lenders prefer to do concessions rather than foreclose or take a hit on their principal balance.

Many of the outlying areas will be greatly impacted from the shadow housing, which consists primarily of single-family homes that have been foreclosed. An area like Moreno Valley and the Interstate 215 corridor had tremendous construction of new apartments in the last 7 to 10 years and are now seeing the largest vacancy rates.

Projections are that the unemployment will hit bottom in the next 12 months. Meanwhile cap rates are rising above the 7 percent range from a low of sub-5 percent a few years ago. This is going to present tremendous opportunities for those who are positioned with liquidity and able to take advantage of these acquisitions. The upside of these acquisitions will create tremendous wealth for those who take advantage of it and use positive leverage for great cash flow.

— John Kalmikov is a senior vice president in Lee & Associates’ Riverside office.

Retail

In most areas of the Inland Empire, the erosion of core retail property fundamentals persists due in part to the continued retail store closures sparked by bankruptcy and poor sales. Add in the lack of available capital, billions of dollars of looming debt set to mature in the next 24 months, much tighter underwriting, deteriorating net operating incomes, historically low space demand and declining property values and you now have a recipe for disaster.

For most landlords, the focus has shifted to tenant retention, cash flow preservation and offering creative incentives to attract new tenants to fill these spaces.

According to CoStar, the Inland Empire’s retail vacancy went from 7 percent in fourth quarter 2008 to 8.1 percent in first quarter 2009 and is expected to increase throughout the balance of 2010. Market rents are continuing to decrease at an alarming rate, making this purely a tenant’s market. Most segments of the retail industry continue to report lower same-store sales, adding to the continued uncertainty in the sector. However, value-oriented retailers are posting sales increases, translating into limited expansion of these brands throughout most of the Inland Empire.

Behind the scenes, retail properties are being forcibly pushed into a black hole as cash-flow preservation is nearly uncontrollable due to tenant instability and uncertainty. The catalyst in all this is the mounting vacancies and reduction of rents. Many 20-year-plus industry veterans purport that this is the worst they have ever seen the market and that their crystal balls have all but shattered. However, with the correction being seen, rent levels and asset values are receding to levels that offer good opportunities for investors and tenants alike to secure acquisitions that have not been a part of the market since the late 1990s.

— Brian Bielatowicz is principal and senior vice president at Lee & Associates as well as director of its Retail Services Group.

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