COVER STORY, JUNE 2010

WESTERN OFFICE REPORT
Unique market traits and common economic forces combine to direct the office performance paths of three key subregions.
Michael Hoffman, Dana Howland, Barry Saywitz, Rod Keefe and Mark Fraser

Investment vs. leasing, downtowns vs. the suburbs, new industry vs. old — the interplay of these office factors and more are affecting the West’s major markets in different ways. Focusing on three different sub-regions, Western Real Estate Business relies on its expert broker friends to paint a picture of the path to recovery.

Mountain West

In May, Westfield Co. opened 500,000-square-foot 1800 Larimer, the first high-rise office building constructed in Denver's CBD in 25 years.

Driven by the clean-energy industry, the Denver office market is expected to stabilize in late 2010. Although the year will prove challenging for many local owners, the growing regional healthcare and energy industries support a positive longer-term outlook. Dialysis giant DaVita announced plans last year to relocate its headquarters to Denver. The company has yet to identify a permanent location, but recently leased interim space downtown. Also, Vestas Americas, one of the world’s largest wind turbine manufacturers, is nearing completion on two plants in Brighton, Colorado. While the facilities will not directly benefit office absorption, they will attract support and other energy-related businesses to Denver. In 2009, for example, Golden, Colorado, landed the North American headquarters of PMC, a Denmark-based maker of hydraulics for windmills.

Class A space availability and rent reductions continue to encourage tenants to upgrade, leading to softer fundamentals for the metro’s suburban Class B/C properties. The CBD, midtown and west central submarkets will register some weakening this year, but vacancy in these areas will remain 350 to 700 basis points tighter than the metro average. New development will total 980,000 square feet by year’s end, down from 1.4 million square feet in 2009. Despite easing construction, vacancy will increase 160 basis points by fourth quarter 2010 to 21.7 percent. Asking rents will slip 2.8 percent this year to $20.99 per square foot, while rising concessions will contribute to a 5.7 percent decline in effective rents to $15.84 per square foot.

As the year progresses, office investment activity will rise modestly as more distressed assets change hands and sellers adjust pricing to clear the market. More than 10 percent of local CMBS loans report debt-service coverage ratios of less than 1, which is likely to result in a growing number of lender-owned listings this year, assuming loan modifications remain limited in this segment.

The southeast suburban submarket, where approximately 900,000 square feet of new office space has been delivered since 2008, accounts for an outsized share of CMBS REO/foreclosure activity to date. Private, in-state buyers and investment funds will dominate transactions this year, with many already acquiring properties or actively searching for attractive opportunities. Between 2007 and early 2010, cap rates in the Denver market increased between 175 and 200 basis points to the low-9 percent range, and another up-tick is likely by year’s end. With plenty of capital circling the market for deals, owners considering selling, particularly those with near-term debt maturities or exposure to lease expirations, may generate better offers by doing so sooner rather later.

Salt Lake City’s long-term office market outlook remains strong despite short-term hurdles. Many office-building investors in the city are sitting on the sidelines waiting for major transactions to come to market. As the market tumbled in 2009, investors believed that there would be significant distressed/REO properties they could acquire for a substantial discount. However, banks have become more willing to work with borrowers to renegotiate terms, which has resulted in far fewer stabilized properties becoming available to purchase. Lenders’ willingness to work out loans has also caused a gap in buyer and seller expectations. Buyers hope that cap rates will rise, while sellers want cap rates to return to 2006-2008 rates in order to salvage as much of their investments as possible. Until this gap is bridged, the market will continue to lag. Transaction velocity in the Salt Lake City Metro Area fell 77 percent in 2009 compared to the peak in the market in 2007.

The northwest and central west submarkets of Salt Lake City market continue to suffer. Vacancy rates in these areas are averaging nearly 23 percent, with an anticipated increase in vacancy expected through 2010. The southeast and southwest submarkets have remained the most resilient. Vacancy rates are averaging only 14.6 percent in these areas. CBD numbers continue to be skewed by the occupancy rate at the 222 Main St. building. Recently, Goldman Sachs signed a 147,000-square foot lease for seven floors of the building, which represents approximately 33 percent of the building. Despite this lease, this asset, where asking rents are $32 per foot, remains 45 percent vacant. Until the vacancy is absorbed, the overall numbers for the CBD will be more difficult to analyze.

The Salt Lake City market faces additional challenges because procuring financing remains a hurdle to closing transactions. Loan-to-value ratios have fallen to 60 percent and 70 percent, depending on the deal. Banks are cautious and requiring investors to have more skin in the game.

As 2010 progresses, office investment will remain tepid. Absorption of vacant space, sublease space and shadow space will continue to be vital to the rebound of the Salt Lake City office market. Salt Lake City’s business-friendly environment, highly educated workforce, relatively low cost of living and aesthetic beauty will remain its strongest draws. Businesses will continue to relocate to the area and lease space in the long term, thus boosting vacancy and overall office-market fundamentals.

— Marcus & Millichap's Michael Hoffman and Dana Howland are first vice president and regional manager in Denver and senior associate in Salt Lake City, respectively.

Southern California

There is no question that the office sector in Southern California is one of the hardest hit in the country. While Southern California’s real estate has a tendency in the good times to escalate to even higher levels with greater returns than most other places in the country, it also has a tendency (in a downward spiral) to fall harder, faster and with more impact on the local economy.

The impact to the commercial real estate market, including declining property values, increased vacancy rates and reduced returns, have impacted investors of all types such as REITs, large developers and individual investors The name of the game right now is stabilization. Many landlords and property owners in the office market are looking to fill vacancies and create cash flow on their properties to reduce financial exposure. The values to those commercial assets will not return for some time, and savvy investors with significant capital are looking to take advantage of distressed asset sales.

Many of the larger office complexes that were developed and/or purchased at the height of the real estate market have now traded hands. This trading at current market pricing allows the new ownership to be able to lease the properties at an aggressive market rate that still provides for a return. While this does nothing to help the current rental rates in the marketplace, it does make a step at re-stabilization of the asset and will fuel leasing activity and absorption.

Certain submarkets will fair better than others. Those such as The Miracle Mile in Los Angeles, Beverly Hills, La Jolla and Newport Beach’s Fashion Island, which cater to high-end users with limited amount of space and as a result less vacancy, will retain higher rental rates and higher property values. Nonetheless, they all have taken significant hits in their position from the height of the real estate market.

Other submarkets such as Corona and most other cities in the Inland Empire, as well as Carlsbad in north San Diego County, have taken a significant beating with respect to rental rates and property values. The over-building in these areas and lack of depth of available tenants and businesses to absorb the vacant space creates a difficult situation for property owners. Office vacancy in Carlsbad is in excess of 30 percent, and buildings offer as much as 1 year free rent knowing that there are few tenants to lease a multitude of vacant space.

In the Inland Empire, rental rates have dropped as much as 40 percent, and those businesses tied to the real estate, finance and mortgage sectors of the economy, which previously occupied a majority of the office space in those areas, are virtually non-existent and at the moment. There are no new businesses to take their place. The recovery will be a long one and will be accomplished by making deals one at a time.

The good news is that the majority of companies and tenants in the marketplace who were severely struggling and on the brink of failure has either disappeared or stabilized their operations so that they can see somewhat into the future. This allows tenants to sign longer-term leases and have a better comfort level with regards to the outcome of their business. Those tenants who are stabilized and have the capacity to sign a long-term lease have the ability to take advantage of the lowest rental rates in a long time and will be able to curb their expenses for the long haul and hedge against future increases in rental rates down the road.

Investors with holding power and capital reserves will do extremely well as the market recovers. The forward-looking real estate professional and savvy investor view the economy as an opportunity. Remember that real estate is a cycle — it goes up and down — and those that can roll with the punches will be better off at the end of the day.

— Barry Saywitz is president of Newport Beach, California-based The Saywitz Company.

Pacific Northwest

In Seattle, leasing activity is much stronger than investment sales activity due to sellers, in general, not being ready to accept the new lower pricing that buyers/lenders are requiring. As a result, sales of office investment properties have dried up almost completely. Class A office leasing is the strongest due to the large drop in rates in the last 12 to 24 months, so tenants are locking in low rates for long terms where possible.

Despite recent leasing activity, Seattle is vacancy rate will continue to increase this year and in early 2011 due to planned moves by Amazon and the Bill & Melinda Gates Foundation. The market vacancy will top out at around 22 percent. Therefore, there will continue to be good leasing opportunities in Class A buildings for tenants for the rest of 2010 and into 2011. The Emerald City is not likely to see a real turnaround until there is some job growth.

The eastside submarket is doing better than downtown Seattle due to Microsoft having leased up several projects and Bentall mothballing a project. Beacon Capital Partners is working to sell a new project in downtown Bellevue that is fully leased to Microsoft. The south end is experiencing very little leasing or sales activity; there are very few prospects in the area other than the FAA’s demand for more than 500,000 square feet, the bid for which every developer is trying to get. In the north end, there are no sales and a difficult market for landlords as the few tenants there are looking for very favorable lease terms.

Local developer Martin Selig has kept busy, signing GSA for a 172,000-square-foot lease at 5th & Yesler and gaining another with Dendreon’s commitment to 191,000 square feet at 635 Elliott. Amazon.com has started to move into its new more than 1 million-square-foot campus in the South Lake Union district. The 500,000-square-foot West 8th office tower has seen its first two leases — Seattle Children’s Research for 50,000 square feet and Casey Family Programs for 75,000 square feet. The 1918 8th office tower has attracted four new leases from Parametric, RBC Wealth Management, Freestone Capital and Hagens Berman.

In Portland, the loss of office jobs during the last 8 quarters has produced a negative demand for 3.8 million square feet of office. During the same time, negative net absorption has only been 900,000 square feet. This would indicate a pent-up vacancy of nearly 3 million square feet. Market-wide, vacancies will rise, concessions will rise and pressure will be on landlords to retain and attract tenants. Landlords who adapt to this reality by crafting renewals prior to expirations and attracting new tenants on terms that wonít make sense until renewal time will outperform the market. Landlords who donít will under-perform in the market. Tenants will have a need to evaluate the credit of their landlord. In the sales sector, prices that don’t factor in flat or falling rents with higher vacancies don’t get a second look from investors.

The central business district is doing better than Portland’s suburbs as several large suburban tenants have recently announced moves downtown. Expansion of CBD-type tenants such as creative companies, law firms and government entities have kept downtown’s vacancy at only 9 percent versus 15 percent in the suburbs. (Favoring the “industrial chic” look, the creative tenant class doesn’t want traditional dropped-ceiling Class A space and will pay more for a gritty look). The GSA has committed to nearly 400,000 square feet across several locations, most notably 250,000 square feet at Shorenstein’s First & Main project.

As for Portland’s environs, Kruse Way, which has been the best of the suburban submarkets, was hard-hit by the mortgage meltdown, but will probably recover first because of the executive housing in the area. Beaverton/217 will be the next to bounce back with its strong local businesses. Unless Nike and Intel catch fire, the Sunset Corridor will be the last to recover with real office vacancies exceeding 20 percent.

— GVA Kidder Mathews' Rod Keefe and Mark Fraser are first vice president and partner in Seattle and senior vice president and partner in Portland, respectively.

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