MARKET HIGHLIGHT, JUNE 2008

ORANGE COUNTY
Brian Childs, David Knowlton, Roman Ciuni and Sheila Alimadadian

Orange County commercial real estate players are having to make adjustments in response to the current economic environment, but many opportunities exist in a market still boasting handsome fundamentals.

Office

The Orange County office market had been soaring since 2002. By year-end 2006, it was considered one of the top three office markets for investment in the United States due to its low vacancy rates, robust economy and constrained supply of developable land.

The story is quite different in 2008. The Orange County office market has been hit by a trifecta of market factors that have definitely slowed it down. Orange County was the scene of the crime in the subprime meltdown, being home to the largest subprime lenders in the nation including Ameriquest and New Century. The liquidation and/or downsizing of mortgage-related firms added an additional 2 million square feet of vacant office space back into the market. At the same time, more than 4 million square feet of new Class A office space was being delivered. These projects include the Irvine Company’s 20 and 40 Pacifica totaling 624,000 square feet, and Maguire Properties’ 531,000-square-foot 3161 Michelson, both in Irvine. The third market factor is that Orange County lost 21,800 jobs between March 2007 and March 2008.

The overall Orange County office market inventory is 142 million square feet. Current vacancy is 12.5 percent, which reflects a significant increase over rates in early 2007 of 8 percent. There is almost 1.8 million square feet of sublease space available, which increases the overall availability rate (vacant space plus sublease space) to 13.8 percent. Larger transactions include Memorial Care leasing 98,000 square feet in Fountain Valley and Pacific Life taking 245,000 square feet in their new building at 45 Enterprise in Aliso Viejo.

Needless to say, Orange County office market absorption has been impacted. There has been more than 2.8 million square feet of negative net absorption in the last year. Asking lease rates are on a slow decline with current rates at $2.57 per square foot, full service. This is down from $2.62 per square foot at year-end 2007.

There is 1 million square feet under construction to be delivered in the remainder of 2008. There are other projects in line for 2009 and 2010, but current office market conditions as well as capital market conditions may postpone their start dates.

Orange County office sales activity has slowed down. Investment sales over the last 12 months include the 230,000-square-foot 18301 Von Karman in Irvine for $485 per square foot (6 percent cap) and the 115,000-square-foot 4590 Macarthur in Newport Beach for $350 per square foot (6.5 percent cap). Small user office buildings asking prices are in the $275 to $425 per square foot range depending upon location.

The remainder of 2008 will be choppy. The pressure is on owners to find ways to entice tenants without reducing asking lease rates significantly. Buyers will continue to sit on the sidelines waiting for prices to drop. The question moving forward; is 2008 really 1991 or is it 2002? We can only hope it’s the latter.

— Brian Childs is executive vice president of NAI Capital’s Newport Beach, California, office.

Industrial

The real estate market may have already turned the corner, in Orange County anyway. The fundamentals point in that direction. In fact, those who continue to put off leasing or purchasing commercial real estate may be surprised to see industrial prices rising by the fourth quarter of this year.

It has been only 12 months since the Orange County industrial market began to fade. Activity in first quarter 2008 continued that trend. Building sales have gone down, construction activity has dropped and the vacancy rate has gone up. It sounds somewhat bleak. But there are good reasons to be optimistic.

The vacancy rate is very low. CoStar reports that the first quarter ended with an overall industrial vacancy rate of 4.3 percent. That’s only 0.5 percent higher than 9 months ago — an insignificant amount. Surprisingly, the vacancy rate for flex space is almost as low as it is for the warehouse/manufacturing segment. Generally, it is considered that an 8 to 9 percent vacancy is required to create a balanced market between buyers and sellers.

Net absorption for the past 3 months was negative (901,480 square feet). That reflects a slowly dropping trend since second quarter 2007, when it was a positive 789,741 square feet. Leasing activity actually grew in first quarter 2008, but that was offset by a significant slowdown in sales. Only 978,752 square feet of industrial buildings sold in fourth quarter 2007, compared to almost 3 million square feet in the third quarter. That’s a big hit. Last year’s sales numbers are not in yet, but one could bet they dropped again in the last quarter. User buyers have been on the sidelines, likely because of the recent general uncertainty of the national economy.

Orange County industrial values are holding. Lease rates are slightly up, and sale prices are slightly down. The average quoted asking rental rate climbed 2.6 percent during the last 3 months to $10.89 per square foot per year. The average sale price at the end of 2007 was $134.56 per square foot compared to $144.49 in the previous quarter and $128.34 per square foot at the end of 2006.

So why could the industrial market be on the rebound? In these “disastrous times,” the Orange County industrial market’s lease/sales activity has dipped, but not dramatically. Sale prices have dropped but not close to the defined “correction rate” of 10 percent. SBA lending is alive and well. Most buyers of industrial properties use SBA financing. Money for them is plentiful and cheap. Most important, it appears that the national economy is stabilizing. In 12 months, we’ll likely look back and say, “Oh yea...the Orange County market turned the corner in mid-’08.”

— David Knowlton is senior vice president with NAI Capital’s Newport Beach office.

Retail

Is this the right time to invest in and develop retail properties? The slowdown in the real estate market is making everyone uncomfortable. Developers, investors, owners and retailers alike are feeling uneasy about the apparent economic downturn. There’s been a surge of retailers, such as Wickes Furniture and Sharper Image, declaring bankruptcy. According to CoStar, the retail vacancy rate in Orange County is expected to rise to 4.2 percent by second quarter 2009. Adding to the unease are the national retailers that have scaled back, namely Starbucks Coffee, which plans more than 100 store closings nationwide, and Tesco, which has also slowed down U.S. expansion.

The credit crunch is making lending more difficult for those investors who are active. Loans are harder to come by as banks tighten lending standards on properties. Commercial mortgage-backed securities dropped from $47.8 billion in first quarter 2007 to $3.6 billion in first quarter 2008.

Yet despite the slowdown, there are also positive indicators in the market. Current retail vacancy is still at a low 3 percent. Lease rates have risen 2.5 percent since fourth quarter 2007. Unlike the overabundance of condo projects, the retail market has not suffered from overbuilding in recent years. As a result, retail properties have generally been better able to keep current on their mortgage payments.

Most retail players are working hard to take advantage of the market conditions, scrutinizing deals closer than ever before, looking for low-risk investments with higher returns. Most importantly, they’re getting smarter about what makes a good investment. But there’s more to exploit in the current market — specifically, timing.

A slowdown does not mean its time to sit on the sidelines. This is the time to change your perspective on the market and create your opportunities. It is a time to find the deals where a property owner may be in financial distress because their property is experiencing higher vacancy and might be unable to obtain financing. As some business owners need to close their doors, there may be opportunities in owner-user properties. Other opportunities exist in urban infill locations in cities like Santa Ana where Parrague Development is proposing a new retail center anchored by Rite Aid and Fresh & Easy. A down market is the time that investors can find the best opportunities.

— Roman Ciuni is vice president at NAI Capital’s Newport Beach office.

Multifamily

Orange County’s multifamily market has seen some changes thus far in 2008, caused by a slowing economy, the conversion of condo projects, the mortgage meltdown and rising gas prices. The economic slowdown could be pushing more tenants to double-up, reducing apartment demand. A shadow rental market of foreclosed properties or homes held by speculators desperate for cash flow may compete for multifamily tenants.

Low vacancy in the multifamily market can be attributed to the mortgage meltdown and the tightening of credit, which continues to contribute to the loss of homes, thus affording landlords the ability to obtain higher rents and high occupancy. In addition, there are those that sold their homes and rented — waiting for the housing market to turn — that are now a part of the renter pool. Landlords are seeing rent hikes with an average of 2 to 3.5 percent this year, which is lower than last year.

Notable conversion projects from condos to multi-family are: Avalon Bay Communities Inc.’s 251-apartment mixed-use project in the Platinum Triangle in Anaheim; The Hanover Co.’s 265-apartment project in the Platinum Triangle; 

Shea Homes’ 179-apartment project in the Irvine Business Complex; and John Laing Homes’ 248-apartment project in the Irvine Business Complex. Lennar is contemplating converting its A-Town Metro project near Angel Stadium to apartments. Converting to apartment rentals is better than having the condos sit empty, even though the return on rent is less than the sale.

As gasoline prices rise, demand increases for apartments in higher rental areas for shorter commutes, attributing to a 5 to 6 percent vacancy factor. Vacancy will most likely go up as rental pressure builds. Possibly due to higher paid, white-collar professionals that prefer being close to work and having the amenities that they demand will help keep the vacancy factor down.

Communities with the lowest vacancies are Huntington Beach, Buena Park, North Anaheim, and the cities with the highest vacancies are Placentia/Northeast Anaheim, Westminster/Fountain Valley and south Santa Ana. Higher vacancies are seen in Irvine and neighboring Newport Beach due to over build-out and inflated speculation.

The outlook for the apartment market this year is somewhat cautious as the area adjusts to employment contractions in the financial services and real estate industries. Health services and hospitality continue to grow, helping maintain multifamily demand.

— Sheila Alimadadian is a senior associate at NAI Capital in Newport Beach.

* All figures came from CoStar and REIS.

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