FEATURE ARTICLE, JUNE 2004

OFFICE OUTLOOK
Investors and renters provide most of the office activity in the West’s coastal markets.
Bill Younce, Rhyne Brown, Michael Miyagishima, Morgan Emmett, Deborah Tauberg, Andrew Martin and Ian Lopez

With the help of brokers and commercial real estate specialists, Western Real Estate Business offers a coastal compendium of office markets from the Puget Sound to Southern California. In general, absorption is up in this renter’s market. Factors such as excess sublease space have kept new construction to a minimum. In addition, low interest rates have increased the incentive for investors to find properties with upside but have also allowed small tenants to purchase their space rather than lease.

Portland, Oregon

The 120,000-square-foot Cornell West complex in Beaverton, Oregon, is among the premier office developments in Portland's Sunset Corridor.

Though the overall office vacancy rate still looms around 16 percent, many Portland submarkets are showing long-awaited signs of recovery from the high-tech bust of the early 2000s. Since first quarter 2003, net absorption in Portland’s 58 million-square-foot office market grew from negative 688,000 square feet to positive 67,048 square feet.

Among the healthiest areas are the downtown central business district (CBD) and suburban Interstate 5 corridor. Along I-5, new construction rents range from $14 to $23 per square foot, depending on location and type of office product, with vacancy at 8.4 percent for 2.8 million square feet of inventory. Downtown, rents average $18 to $22 per square foot, and vacancy is 11.7 percent for 10.2 million square feet. Unfortunately, a large segment of this inventory is being subleased for as little as half its market value, which plagues landlords and makes development financing almost impossible without a 50 percent pre-lease guarantee.

This sublease trend has slowed construction significantly — from 275,000 square feet of new space completed in fourth quarter 2003 to 160,000 square feet in first quarter 2004 — and volume continues to fall. On Portland’s west side, the 78,000-square-foot Peterkort Centre III is one of the only new developments scheduled to come on-line by year’s end.

The Sunset Corridor on Portland’s suburban west side remains the hardest hit. Once a thriving hub for high-tech companies with vacancies in the 2 percent range, the Sunset Corridor today is struggling with most of its previous tenants dissolved or relocated overseas and its 6.8 million square feet of inventory as much as 20 percent vacant. Fortunately, many still consider this area a mecca for good deals and are prepared to wait out a market recovery.

In mid-April, a two-building, 126,800-square-foot property in the Sunset Corridor sold for $153 per square foot. The largest transaction in the last two quarters was the $38.1 million — or $100 per square foot — sale of the 379,900-square-foot Woodside Corporate Park in Beaverton, Oregon. Most Portland office buildings of less than $5 million in value sell at a 7.5 to 8.5 percent cap rate with larger buildings selling for 8.5 to 9.5 percent caps.

Institutional investors still stalk Portland’s few large office opportunities in what remains a seller’s market, but private buyers drive transaction volume. Many are small companies who become buyers/users to take advantage of financing rates. About 90 percent of all deals are 1031 exchanges.

The remaining critical factor in Portland’s commercial real estate market is jobs. Since peaking at 8.7 percent in July 2003, Portland’s unemployment rate has fallen to 7.2 percent and continues to drop, according to the Oregon Employment Department. And as the job outlook improves, there is little doubt that this resolute office market will respond in kind.

— Bill Younce is the senior advisor for Sperry Van Ness in Portland.

Seattle

Repositioning is the watchword in the Seattle/Puget Sound office market. The area continues to struggle in the wake of the recent downturn in Washington’s two largest industries: software and aviation. The sudden decline of the dot-com industry and past layoffs at Boeing Aerospace produced an enormous amount of vacant office space. At 7.5 percent, Washington continues to have one of the highest unemployment rates in the nation. Economic forecasts project limited job growth (0.1 percent) and economic expansion (0.5 percent) this year.

Regional office market rental rates have declined for the 10th consecutive time through third quarter 2003. Seattle’s CBD vacancy is hovering around 15 percent with full-service lease rates averaging $28 to $32 per square foot. This represents a 30 percent decrease from its peak in 2000. The suburban eastside office market has experienced a 50 percent decline in rental rates since 2000. Current full-service rates are in the $18 to $22 per square foot range. This quarter, vacancies have remained stable at 22 percent.

Regionally, office tenants have been actively blending and extending. However, growth and overall absorption have been flat to slightly negative. Historically a major influence in the market, Microsoft continued to expand in owned facilities at the expense of leased buildings. Among the transactions Microsoft completed in the past year is the purchase of land in the Highlands master-planned community in Issaquah, Washington. The global employer plans a 150-acre campus of up to 3 million square feet. The strongest tenants in the market are now biotech and medical firms. Actual new construction of office product remains limited mainly to the Lake Union submarket.

Speculative office development is nonexistent in the region. Proposed projects such as the 500,000-square-foot Lincoln Square (office component) and the Technology Tower are on hold until the market improves.

— NAI Senior Vice President Rhyne Brown, in association with Pacific Real Estate Partners, contributed this report.

San Francisco

The 770,000-square-foot Market Center, located at 555 and 575 Market St. in San Francisco, sold for $79.5 million in late 2003.

From an office tenant’s perspective, the golden city of San Francisco is showing a renewed shine. Rents continue to fall from already low positions and leases are being re-upped.

Many companies who left in the mid- and late 1990s — when dot-coms were booming and rents reached as high as $80 per square foot — are returning to take advantage of Class A lease rates that average $30 per square foot. Many are also seizing the low-rent opportunities to move into the high-status financial district of downtown San Francisco from other parts of the city and the Bay area.

Despite the influx of new tenants, San Francisco is still reeling from the dot-com corporate exodus, which left a mountain of pent-up office space that could take up to 5 years to fill. At year-end 2003, the overall office vacancy rate was 24 percent — 20.1 percent in the CBD and as high as 35 percent in the non-CBD “South of Market” submarket, where dot-com groups once flocked.

Fortunately for owners, leasing activity in all areas of San Francisco is slowly improving. During the last half of 2003, positive net absorption of office space exceeded 500,000 square feet. In recent quarters, companies like Gymboree, Pacific Gas & Electric, Deloitte & Touche, the Culinary Academy and California Pacific Medical Center have leased or renewed space.

Rent for Class A CBD space averages $30 per square foot while non-CBD, Class A office leases go for $26 per square foot. Class B rents average $18 to $22 per square foot.

Because of the high costs of land and labor, as well as the availability of existing office space, new office construction is all but non-existent. There is, however, significant investment capital waiting in the wings with private investors and opportunity funds looking for value-added properties while others seek, and will pay for, the well-secured building.

For example, in late 2003, the 80 percent vacant Market Center, totaling 770,000 square feet at 555 and 575 Market St., sold for $79.5 million or $103 per square foot. Conversely, a 125,000-square-foot leased office property at 90 New Montgomery St., one block south of Market Street, sold for $25 million or $200 per square foot, and the 233,000-square-foot Foundry Square IV at Howard and 1st streets sold for $119.4 million or $512 per square foot.

Together, these transactions create a picture of recovery, albeit a slow one that will require patience. For those that understand this and are willing to accept the pace of the market, opportunities do await.

— Michael Miyagishima is a vice president for Sperry Van Ness in San Francisco.

Los Angeles

Downtown Los Angeles saw moderate office leasing activity in the first quarter, especially when compared to a very robust fourth quarter in 2003. Despite moderate leasing activity, the market remained stable, with the overall vacancy rate for the CBD at 18.3 percent, down more than half a percentage point from the end of last year. Several sizeable leases in Class A buildings kept the market moving, including the law firm Brown, Winfield & Canzoneri’s expansion into 48,104 square feet at Cal Plaza I. Also of note was Great American Insurance’s 47,982-square-foot relocation to Ernst & Young Plaza at 725 S. Figueroa.

Downtown L.A.’s amount of sublease space continues to decrease as many large subleases are either expiring or being expanded into by tenants already in the building. In the first quarter, the total amount of available sublease space was reduced by nearly 100,000 square feet.

Though overshadowed by the influx of large banking firms such as City National Bank and US Bank in 2003, a continuing trend is the consolidation of office space by banking and accounting firms in the downtown area. One noteworthy example was Bank of America’s relocation into 190,000 square feet at BP Plaza. At one time, Bank of America occupied more than 400,000 square feet in Arco Plaza.

Investment activity remained strong throughout the first quarter as large Class A and B properties changed hands. Significant transactions included the sale of 660 South Figueroa St. to Milbank Real Estate for $62.4 million, Jamison Properties’ purchase of the World Trade Center for $52 million and the sale of 800 Wilshire Blvd. to the Ratkovich Company for $29.2 million. The growing faith in the downtown area as a revitalized residential center will keep investor interest high. More than 3,200 residential units, many of which are loft apartments, are currently under construction with nearly twice that amount proposed through 2007. CIM Group’s $247 million mixed-use South Village project, which will include the downtown’s first supermarket in nearly 50 years, is a key factor in this CBD momentum.

An improving economy and decreasing rental rates boosted leasing activity in west Los Angeles in the first quarter, as several large lease transactions pushed direct vacancy rates to 14.1 percent, down from 14.5 percent in the previous quarter. Landlords continue to decrease rates and increase concessions as a means to attract new tenants to the once tight and vibrant market. Direct average rental rates fell another few cents to $31.56 per square foot, down from $32.88 a year ago.

Highlighting the quarter was Creative Artists Agency’s highly anticipated deal to occupy 180,000 square feet in a 15-year, $150 million transaction at the new 790,000-square-foot retail and office project to be located at the former ABC Entertainment Center in Century City. Other large lease transactions include Fremont General’s lease of approximately 62,000 square feet in a 10-year deal at the Water Garden in Santa Monica and Crystal Stairs’ lease of approximately 100,000 square feet at the Wateridge campus in Culver City.

Following several trophy-building sales in 2003, investors continued to take advantage of low interest rates in the active west L.A. investment market. Contributing to the momentum were Decron Properties’ $14.5 million purchase of the 86,000-square-foot office building at 6222 Wilshire Blvd. in Miracle Mile and Bebe Studio Realty’s $11.9 million acquisition of a 50,000-square-foot Class A facility at 10345 West Olympic Blvd. in Century City.

In the South Bay area of Los Angeles, overall office vacancy fell slightly in the first quarter to 19.9 percent. However, with a more diverse tenant base than in the past, the 30.9 million-square-foot South Bay office leasing market has been slow to respond to positive economic indicators.

The El Segundo submarket, which contains 37 percent of the Class A space in the South Bay, remains soft despite the completion of one of the largest leases in the area. Real Estate Management, an executive suite operator, signed a 10-year, 33,610-square-foot lease at 5959 W. Century Blvd. worth more than $5.3 million. With more than $1 billion in revitalization projects in residential and retail properties nearing completion, those in the downtown Long Beach market remain optimistic. The first quarter showed a noticeable improvement as more than 100,000 square feet of office space was leased up.

Investors continue to find attractive opportunities in the South Bay office sector. Younan Properties purchased Pacific Pointe for $35 million or $140 per square foot. The 12-story building located at 879 190th Street in Gardena, California, had a 6.2 percent cap rate with only 65 percent occupancy at the time of the sale. Other transactions included the Copeland Group’s $6.8 million purchase of the Xerox Building at 2355 Utah Ave. in El Segundo and Snyder Partners’ acquisition of a 38,000-square-foot building at 400 S. Sepulveda Blvd. for $7.4 million.

— Morgan Emmett, Deborah Tauberg and Andrew Martin are research specialists for Cushman & Wakefield in Los Angeles.

Orange County, California

The Orange County office market continued to progress confidently during the first 3 months of 2004, ending the first quarter with positive absorption. Vacancy in the greater airport area submarket decreased for the fourth consecutive quarter to 16.1 percent. However, certain office parks within Orange County continue to struggle to lease available space. The Irvine Company’s University Research Park and Irvine Business Center currently have a combined total of more than 360,000 square feet of available space. Law firms have shown a lot of movement this quarter, yet this activity is spurred by their growing efficiency with space requirements, resulting in the downsizing of their space needs. However, technology and insurance companies, the traditional tenants of the greater airport submarket, continue to create a steady base of market activity.

In central Orange County, there are few opportunities for tenants requiring more than 40,000 square feet due to the lack of large contiguous space. However, leasing activity remains strong for small- to mid-size tenants as direct vacancy rates in the submarket declined 1.2 percentage points from the 12.8 percent figure a year ago. With decreasing vacancy rates, landlords are looking to increase rents and minimize the amount of concessions. This suggests that the area is changing from a tenant market to a landlord market.

With interest rates at historically low levels, prospective tenants are seeking to purchase suitable buildings as an alternative to leasing. This is evident in the south Orange County area, as market activity continues to focus on the sale of small office buildings. An example of this trend is BreNexus in the Irvine Spectrum, which has sold 20 of its 35 buildings to date. The buildings range in size from 4,900 to 9,900 square feet and are being marketed from $260 to $275 per square foot.

Only 89,065 square feet of new office product were delivered to the market during first quarter 2004, less than half of the 201,685 square feet delivered at the beginning of 2003. Since 2000, there has been a steady decline in the construction of new office buildings throughout Orange County.

— Ian Lopez is a research specialist for Cushman & Wakefield in Orange County.


©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.