MARKET HIGHLIGHT, JUNE 2009

ORANGE COUNTY
Chris Deason, Mike Hefner, Joseph Cesta and Thomas Shelton

Vacancies are rising and rents are falling across the board in Orange County as companies look for positive signs.

Office

Vacancy is rising and rents are falling in Orange County’s office market. To maintain occupancy, landlords are lowering their rent rates and reducing lease terms. 

The total amount of office space available in Orange County was 22.41 percent at the end of first quarter 2009, which is an increase of 3.72 percent from the vacancy rate at the end of first quarter 2008. Many tenants are either downsizing or consolidating due to the declining economy and shrinking job market.

However, as demand drops off and lease rates decline, some companies are capitalizing on some of the opportunities arising in Orange County’s office market. Orange County’s popularity with businesses and its strong labor base has always made it a popular destination for companies to expand into, but its high rent rates prevented many from doing so. In the current economic climate, businesses such as loan modification companies and call centers have actually expanded and are moving to the area. Now that rents have fallen, these companies that would previously have been uninterested in office space within Orange County due to its high prices are opting to move to the area.

While there are some great opportunities for tenants in the current market, the same cannot be said for buyers. The combination of buyers’ inability to obtain financing, coupled with the unrealistic pricing set by sellers, has frozen sales activity. While some sales are occurring, either because exchange buyers need to purchase property quickly or through unique financing for owner/user buyers, there are very few transactions closing. However, as more office product begins to foreclose over the course of the next 12 months and is returned to lenders, there will be a resurgence of sales activity as sellers will eventually lower their pricing in the wake of increased competition.

Development has also halted due to the fact that most of the product that was completed within the last 2 to 5 years remains vacant. The only significant office development to be completed in 2009 is the 30,000 square-foot property located at 1401 Dove St. in Newport Beach.

— Chris Deason is a senior vice president in the Irvine, California, office of Voit Commercial Brokerage, a member of CORFAC International.

Industrial

The national and global recession continues to take its toll on the Orange County industrial market, creating a wave of business failures, corporate downsizing and consolidations. This has increased the industrial vacancy rate by nearly 20 percent in the past 12 months to 4.97 percent.

On the surface, this vacancy level appears very healthy, however the increase in the industrial availability rate (occupied space on the market and sublease opportunities) has increased to 10.39 percent, which is nearly 54 percent higher than the availability rate of a year ago, posing a significant threat to the health of the market.

These recent changes have created a tenant’s market, and landlords are now offering lease rate reductions, free rent and other concessions in order to retain existing tenants and compete for the few tenants in the marketplace. The net impact of these factors has been a 19 percent decrease in the county’s average asking lease rate during the past 12 months.

In the sales arena, a combination of the poor economy and uncertainty about future property values has buyers sitting on the sidelines in anticipation of more attractive purchase opportunities in the future.

On a slightly brighter note, some newly completed projects like Valencia Business Center in Fullerton, North Anaheim Industrial Center in Anaheim and Bacchus Signature Series in Irvine have recently implemented aggressive price reductions, which range from 25 to 30 percent of their original asking price and, as a result, are generating moderate sales activity. Additionally, recent interest rate reductions and lower origination fees for Small Business Administration Guarantee financing have further improved already attractive owner/user financing programs.

The capital market meltdown has severely impacted new development activity with no new industrial construction currently underway in Orange County and only a meager 550,000 square feet of product in the planning phase. Investment sale transactions are also at a standstill, as investors demand premium yields in order to deploy capital. The limited investment sales activity witnessed this year is at cap rates of 250 to 350 basis points higher than a year ago.

In the near term, anticipate an increasing vacancy rate and further lease rate reductions. Sale price reductions will also continue as distressed assets become lender owned and lender-driven sales apply further pressure to prices. It may take another 1 to 2 years to fully cycle through these distressed assets and to see a meaningful recovery in property values. Key variables in market recovery will be a rebound in the residential sector and a return to employment growth. A rapid recovery in these sectors will accelerate a return to stability in the Orange County industrial market.

— Mike Hefner is a senior vice president in Voit Commercial Brokerage’s Anaheim metro office.

Retail

As 2009 began, the effects of reduced consumer spending, rising store closures and fewer startup retailers became more apparent in Orange County and will result in the second straight year of negative net absorption. Since first quarter 2008, retail space demand in the county has contracted by 1.7 percent. This movement largely stems from the volatile local job market, which was disproportionately tied to the subprime mortgage debacle. As this trend persists in the coming months, the metro’s vacancy rate is set to exceed 7 percent, the highest level since 1991. With building expected to slow this year, however, the greatest threat will be store closures by regional and national tenants near office corridors that have recorded steep job cuts. As the challenges of backfilling vacant space escalate, rents are set to fall even further in 2009 to attract the few tenants still signing leases.

Metro area employment is forecast to decrease for the third consecutive year. In 2009, employers are expected to cut 42,000 positions, reducing head counts by 2.9 percent. Last year, 56,800 jobs were eliminated. Retail construction will total 730,000 square feet this year, an inventory expansion of less than 1 percent. In 2008, developers completed 843,000 square feet. In 2009, a drop in retail spending will result in a rising number of store closures, while delayed expansion plans among retail chains will slow the rate of lease-ups, leading to a 290 basis point increase in vacancy to 7.2 percent. Vacancy rose 160 basis points last year. Asking rents are expected to slip 3.4 percent to $30.50 per square foot this year, and effective rents are expected to decrease 4.7 percent to $27.01 per square foot. In 2008, asking and effective rents fell 0.1 percent and 2.4 percent, respectively.

Ongoing economic concerns will suppress retail sales velocity this year in Orange County and dampen competition, trends that may benefit some cash-equipped investors. Deal flow slowed to a near standstill early in 2009, as some investors have been unable to divest assets in other states, limiting 1031-exchange activity. Single-tenant discount retailers and quick-service operations that cater to local residents’ daily needs are poised to record steadier performance as consumers reduce spending. Concerns surrounding tenant retention, meanwhile, may prolong marketing times for some retail property types such as unanchored strip centers in blue-collar areas. With more big-box national chains announcing bankruptcy, however, even anchored shopping centers, particularly those that have lost major traffic-generating tenants, will receive fewer offers due to challenges filling large space in the current environment.

— Joseph Cesta is the regional manager of the Newport Beach office of Marcus & Millichap Real Estate Investment Services.

Multifamily

Demand for Orange County apartments is soft due to the current state of the job market, the sector’s chief driver. Since job growth is down, there is an immediate and profound effect on the multifamily industry.

Multifamily development in Orange County is down 15 to 20 percent due to deflated demand. There are only approximately 3,000 units set to come online in 2009 with the majority of the properties located in Irvine and the Anaheim Platinum Triangle. These projects were committed and financed 2 years ago, prior to the meltdown of the financial markets. In Irvine, the newest properties to open for leasing include Lincoln Properties’ 448-unit Main Street Village, the 280-unit Avalon Irvine and two large communities by the Irvine Company — the 528-unit Palmeras complex and The Park, which comprises 762 units near Irvine Spectrum. In the Platinum Triangle, both the 265-unit 1818 community and the 320-unit Park Veridian community recently opened.

At 92.2 percent, Orange County’s apartment occupancy rate is approximately 2 percent better than the national average, but the market has experienced its first rent cut in years due to the state of the economy and struggling job market. Residents are doubling up in units, which is causing the occupancy levels to drop and vacancies to rise. According to M/PF Yieldstar, Orange County apartment occupancy decreased by 1.5 percent in 2008 alone. With these rising vacancy levels, owners and property managers are being forced to lower rents as residents are more price-conscious and willing to shop around for the best rental rates. M/PF Yieldstar recorded a 1.9 percent drop in effective rents between late 2007 and late 2008. This decline has continued during first quarter 2009.

There are still a number of 1031 exchange buyers in the Orange County multifamily market, making up the majority of the investment activity. Motivated to purchase a multifamily property to avoid paying income or capital gains taxes, these exchange buyers often overpay for a property or purchase something they would not buy otherwise.

The Orange County multifamily market will continue to experience downward pressure on rents, and residents will continue to be driven by the lowest rates. There are many investors sitting on the sidelines, waiting to see where the pricing will settle and what cap rates will be established before they dive into a market with a substantial amount of risk.

— Thomas K. Shelton is president of Western National Property Management.

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