MARKET HIGHLIGHT, JUNE 2005

ORANGE COUNTY IN DEMAND
John McDermott and Joe Vargas

The incredible demand for commercial real estate in Orange County has depressed cap rates, led to a myriad of conversions and caused owners to ponder selling their coveted properties. Do market investors continue to ride the wave or cash in on the perceived peak values?

Retail

Retail continues to be one of the darlings of commercial investment real estate in Southern California generally and Orange County specifically. In the transition from 2003 to 2004, investment sales of retail product experienced an incredible 1.25 percent reduction in cap rates (the greatest change among the four traditional core property types), and 2005 appears to be taking cap rates to an even lower level for retail product. This year, expect fewer transactions and smaller deals trading, and expect to pay a significant premium for the right to acquire retail in Orange County.

What continues to nourish this frenzy is the alignment of the retail stars in the marketplace for the commercial buyer and seller — plentiful capital; low long-term interest rates; multiple lenders competing for loan business; significant first-time buyers in the market willing to pay more for the right of entry versus the return on investment; exchange buyers returning from Arizona and other markets that attracted them away from California 2 to 3 years ago; and, of course, the institutional/professional buyers such as REITs, TICs, pension funds and the like that must participate because it is why they exist.

Another phenomenon that has boosted the values and sales prices of retail is the incredibly low cap rates in the multifamily sector. Many of the sellers of apartments still desire to own in Orange County, and in order to sell at a 4.36 percent cap rate (Orange County’s average so far this year) and stay in the market with a better return, the apartment investor needs to crossover to another product type. Retail is the next lowest cap rate available in the same geography (improving their return by as much as 250 basis points on average) from their apartments. Industrial returns are even above retail, and office returns are above industrial and so on.

Some of the retail investment sales of particular interest that typify the market for 2005 include:

• 2121 W. Imperial Highway in La Habra – 6,169 square feet at $567.35 per square foot at a 6 percent cap

• 4678 Campus Dr. in Newport Beach – 6,200 square feet at $612.90 per square foot at a 6.6 percent cap

• 1011 Avenida Pico in San Clemente – 9,219 square feet at $607.44 per square foot at a 6 percent cap

• 26711 Aliso Creek Rd. in Aliso Viejo – 24,500 square feet at $428.98 per square foot at a 6.5 percent cap (This $10.51 million price tag is the largest pure retail deal published to date in 2005.)

In a market population of more than 1,000 retail centers — comprising nearly 50 million square feet of space — being tracked today, only 3 percent is available for lease, making Orange County one of the tightest retail markets in the country. Retail development has consisted of two major trends in the market: repositioning older or obsolete projects with new tenants and modern appeal or building mixed-use projects with high-rise condos and significant apartment densities at the heart and adding retail, office and entertainment for value, appeal and popularity, particularly among the emerging generation Xers and the echo boomers. California continues to lead in many innovations in a country that has 20.2 square feet of retail for every one of its citizens (with the next highest country being Sweden with only 3.3 square feet for every person).

In retail, 2005 should be characterized by slower investment sales velocity, scarcer product available for acquisition, continued demand by a buyer pool fueled by readily available capital competing at low long-term rates and a growing sense among sellers that it might be the time to sell high in California and look to the Midwest, East Coast or Florida for a retail replacement product with higher returns, lower price per foot and essentially the same tenants they have in their centers here in California.

— John McDermott is a senior vice president and national director for Sperry Van Ness in Orange County.

Multifamily

Orange County apartment owners and investors themselves are now beginning to ask, “How low can cap rates go?” Transactions today are closing at even or negative cash flows just like 1989 at the very peak of that cycle’s rise. Deals are being underwritten with hugely conservative expense numbers in an inflationary market (energy and insurance being the biggest wild cards of concern). Even with vacancy factors having been all but taken out of the underwriting process, lenders are still lending.

Currently, the Orange County multifamily market maintains an overall occupancy of approximately 95 percent with rents averaging $1,100 for one-bedroom and $1,500 for two-bedroom units. It appears that everyone is betting that rents will continue to climb and demand will flourish. All of this is bolstered by recent predictions that the three major population boom states between 2000 and 2030 will be California, Texas and Florida. History may provide some insight into the current market.

Apartment investments have always been a leading economic indicator in the rise and fall of a market. They serve well as a telltale sign of change for the commercial investment sector. Today in Orange County, these sails continue to be full of air and navigating well for owners and sellers. The key reasons today are plentiful capital; multiple lenders competing to finance purchases; aggressive underwriting to get a deal financed; creative financing vehicles like the interest-only conduit loan; aggressive start rates and teaser rates (often interest only); the emergence of seller-carry shortfalls or seller-financed deals; multiple buyers for every deal; a significant amount of first-time buyers (apartments are the first choice for most first-time buyers of investment real estate).

The trend for apartment investments in Orange County from 2003 to 2004 points the way toward what to expect in 2005. Fewer apartment transactions exceeding $1 million occurred in 2004 than 2003 — 192 to 240, respectively. However the dollar volume stayed relatively flat — $1.018 billion in 2004 and $1.192 billion in 2003. As one would expect, the price per unit had to go up from $127,700 in 2003 to $149,527 in 2004 — with 9,332 units changing hands in 2003 and only 6,811 in 2004 — to keep that dollar volume of total sales so close.

Look for 2005 to be characterized by fewer transactions, smaller properties selling (especially four to 12 units) and very few significant major Class A properties being available. Also look for condo conversions to be a major influence in our marketplace, much like San Diego has been experiencing for the last 2 years.

Finally, the mystery of what drives our investment market in Southern California and specifically Orange County may have less to do with what investors are physically buying today and more to do with what cannot be purchased in the future. The barriers to entry into our market for new development are extremely high and often cannot be overcome. This is a market that is arguably the best climate in America and the world, where the quality of life and lifestyle is highly coveted, home prices are well beyond the national average and out of reach of most workers (thus increasing the number of renters) and replacement costs continue to soar for all real estate driven by the world’s demand for increasingly scarce resources. 2005 should prove to be a whole new ride on the roller coaster of real estate.

— John McDermott is a senior vice president and national director for Sperry Van Ness in Orange County.

Office

The Orange County office market remained strong through the opening quarter of 2005 with continual decreases in the overall vacancy rate tightening the market. The economy remains robust as the unemployment rate fell to a preliminary figure of 3.8 percent in March, down 1 percentage point from March 2004. Job growth is likely to stabilize, however, as the employment market nears equilibrium. Throughout the county, corporate profits and retail sales continue to grow, and tourism will have a large impact on the economy in 2005.

In the first quarter, more than 3.4 million square feet of office space were leased throughout the county. This amount is the largest figure witnessed in the previous six quarters. As a result of a lack of large, contiguous blocks of space, many of the larger transactions in first quarter were preleases in proposed and under-construction buildings. Highlighting this activity were Broadcom Corporation’s lease of 685,584 square feet at University Research Park and Impac Funding Corporation’s deal for 200,000 square feet in Irvine. These transactions helped increase the county total to more than 1 million square feet of preleasing activity, which is the largest amount witnessed in recent years.

The greater airport area continued to perform well, accounting for nearly 65 percent of the total leasing activity in Orange County. The overall vacancy rate fell to 11.1 percent, down from 13 percent in fourth quarter 2004 and 16.1 percent in first quarter 2004. The continual decrease in available space has created upward pressure on asking rental rates in the area. In addition, with little speculative construction activity taking place, rental rates are expected to increase further throughout the remainder of 2005.

The residential mortgage industry, the major driver of the heightened demand for office space recently, has not demonstrated any signs of slowing, and continues to have a dynamic impact on much of the county. Impac Funding’s prelease in Irvine prompted construction activity to commence on the only Class A development project in the greater airport submarket. The remaining office project in Orange County is located in Brea, where another mortgage firm, ResMAE Mortgage Company, will occupy the entire 129,924-square-foot building. Due to high preleasing requirements in order to obtain construction financing, there is little relief expected in the short term. For developers that have the capability to respond quickly, preleasing transactions and subsequent construction activity will continue to increase.

The market’s performance the past several quarters and the strength of the regional economy have attracted a large amount of capital to the county. In the first quarter, more than 3 million square feet of investment properties were purchased in Orange County. The majority of the high-profile transactions were recorded in the greater airport area. Maguire Properties, which has quickly become a major owner in Orange County in the past 18 months, purchased Pacific Arts Plaza as part of a $1.5 billion portfolio acquisition from CommonWealth Partners. 

The Orange County office market maintained its momentum following an extremely positive 2004. As demand has exhibited no signs of weakening and new construction is limited, vacancy rates should continue to fall and asking rental rates will likely be increased. The recent residential overlays in Anaheim and Irvine and the continuing trend of converting office-zoned land to high-rise condos will further constrain new office development. The strong tenant demand and limitations on new supply will continue to attract capital throughout the remainder of the year.

— Joe Vargas is senior managing director of Cushman & Wakefield’s Orange County office.

Industrial

The Orange County industrial market continued to perform well in early 2005, and many indicators suggest this trend will last to the end of the year. Overall vacancy rates for all product types have increased to the current rate of 5.1 percent, up slightly from the fourth quarter 2004 rate of 4.9 percent. However, there are no signs that would indicate a major slowdown in the market as this figure remains significantly lower than 12 months ago when vacancy rates peaked at 7.1 percent. The average overall asking rental rate has remained stable at $0.65 per square foot per month. However, asking rents have increased in the more efficient state-of-the art buildings.

The demand for industrial space in Orange County is strong, as evidenced by year-to-date leasing and sales activity totaling nearly 4.65 million square feet. Significant 2005 transactions include: Bedrosian Tile & Marble leasing 375,000 square feet of warehouse/distribution space at 1515 Winston Road in Anaheim and Overton Moore Properties’ purchase of a 255,200-square-foot warehouse/distribution building, located at 6300 Valley View Avenue in Buena Park, from Ultra Wheel Company. Additionally, deRegt Development purchased a 20-acre development site at 1075 North Patt Street from BKM Development.

Sales of single-tenant buildings continue to gain popularity throughout Orange County due to the diverse and entrepreneurial nature of the economy. The benefits of ownership continue to outweigh leasing for small business owners due to historically low short-term interest rates and rates on SBA-sponsored loans. Most smaller industrial users perceive that they will not only save in terms of occupancy costs, but the underlying appreciation of small industrial buildings will outperform alternative investment options.

Strong economic conditions have fueled business growth and expansion in Orange County, resulting in a continued demand for industrial space. The market has experienced a number of industrial building conversions as well as complete redevelopments of existing buildings. Owners and speculative investors are converting older and functionally obsolete industrial buildings into for-sale industrial condos ranging in size from 3,000 to 60,000 square feet. A total of 215,670 square feet of conversions is currently in progress, which is similar to the surge in conversion and renovation activity experienced in 2004. Demand for these units exceeds $200 per square foot, which will spur additional industrial condo conversions in the future.

The industrial market will continue to improve throughout the county. As demand increases, rental rates on high-quality buildings will rise. Despite the rising cost of construction materials, developers are scouring the market for available land and redevelopment opportunities. In addition, investors will continue to acquire property in spite of increasing interest rates and cap rate compression.

— Joe Vargas is senior managing director of Cushman & Wakefield’s Orange County office.

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