MARKET HIGHLIGHT, JUNE 2010

SACRAMENTO
Ken Reiff, Jim Gray, James Teare, Blair Wheatley, Amar Cheema, Dylan Herrick and Nahz Anvary

Like most markets around the country, the Great Recession has severely impacted the overall state and morale of the Sacramento area in all facets and in some aspects even more so. Some of the effects have been dramatic job loss, wage losses, soft tenant demand, increased vacancy rates, plummeting rental rates, depressed housing values, rising residential and commercial foreclosures and tightened credit practices to a decline in consumer confidence and spending. Unemployment exceeded 13 percent in March 2010 from the mid-5 percent range pre-recession as a substantial number of jobs, more than 80,000 wage and salary jobs, have reportedly been lost in the area since mid-2007. Commercial real estate vacancies have climbed to new highs as rental rates have plummeted. It was reported in early 2010 that for every six businesses open, one was closed in greater Sacramento; this is a very staggering statistic.

New construction projects, namely office-oriented, that were funded a few years ago during the last market recovery were still being completed through 2009, which continued to add further strain to vacancy rates. Many retailers, from small shops to big box, have been forced to close their doors as a result of the difficult economic climate that has resulted in depressed consumer confidence and a drop in retail sales. Some large and small retail tenants have recently begun to emerge or re-emerge in the marketplace, but there still remains a lot of vacancy to fill.

Additionally, home prices have plummeted from their pre-recession levels, while foreclosures have climbed, with the latest figures showing more than 56,000 foreclosures since the start of 2007 in the Sacramento area. The city’s housing sector has been one of the most negatively impacted statewide although there are signs that it is beginning to right itself. In the commercial sector, a significant amount of foreclosures have been realized and a sizable number more are expected. In recent reports, the Sacramento metro area ranked No. 3 in the nation in terms of bankruptcy filings. However, the problems in the commercial sector are not anticipated to be as significant on the metro economy as the residential market.

— Ken Reiff is a managing partner with Cassidy Turley BT Commercial’s Sacramento office and Jim Gray is a leasing and sales specialist.

Retail

The Sacramento Valley shopping center vacancy rate remained in double digits at year-end 2009, experiencing a modest increase from 11.1 to 12.5 percent since close of 2008. Rapid shopping center development in the past 5 years, coupled with an overall retail softening, has led to an excess in supply of both shop and anchor space on the market. Retail has been among the most impacted for the Sacramento area.

Sacramento, like most metros, has lost some of its largest, most well-known and once flourishing national tenants due to the recessionary period. Retailers such as Sam’s Club, Gottschalk’s, Circuit City, Mervyn’s, Office Depot, Linens & Things, Comp USA, Tower Records, Albertson’s, Shoe Pavilion and Levitz have all either shut down or have announced that they will shut down stores throughout the Sacramento area. The auto industry has also taken a hit, with many dealerships shutting down along the Florin Road auto row. Additionally, in downtown, Hard Rock Café has closed its doors.

On the positive side, many of the larger store closures have actually become opportunity for many other retailers, which have already back-filled many spaces, although a lot still remain vacant. The back-fillers include Signature Furniture Gallery in the former Levitz space in Sacramento; Henry’s Farmers Market in the former Circuit City space in Elk Grove; Burlington Coat Factory in the former Mervyn’s space, also in Elk Grove; SR Entertainment to take the place of a Mervyn’s with a new multiplex cinema in Rocklin; and 99 Ranch Market will fill the former Alberston’s space in Sacramento. (Raley’s has also filled some of the former Albertson’s locations in recent years). Additionally, Kohl’s purchased four Mervyn’s locations in the area last year. Recently, another major retailer, Sam’s Club, found a tenant to back-fill its big box space in Sacramento, as Shop$mart leased its former 108,263-square-foot building in Sacramento. Shop$mart will be a unique indoor mini-mall that will feature hundreds of professional retailers that sell predominantly new products at bargain prices. And last month, Gottschalk announced plans to re-open one of its stores in Auburn. It was not disclosed if the Fresno-based department chain plans to re-open any other of its sites in the area.

Other national and regional retailers have opened new stores in order to take advantage of the discounted rents and concessions landlords are willing to negotiate. The retailers include Forever 21, Bed Bath & Beyond, Ross (two new sites) and Pinkberry. In addition, California Fitness, Strikes Bowling Alley, and US Furniture struck big deals last year. New deals transacted in 2010 have come from Crunch Fitness, Grocery Outlet, Dollar Tree, Ulta and Citi Trends. Meanwhile, notable tenants actively looking to expand in the area include CVS/pharmacy, Jiimboy’s Tacos, Sizzler, 7-11 (making a major push), Freshii, Marco’s Pizza, Auto Zone, T-Mobile and The Lasher Automotive Group (a Subaru auto dealership).

The retail market has been hit hard by the market downturn. In the latter part of 2009, the Sacramento area ranked as the 9th worst in the country on a distress index. Fortunately, a number of the larger spaces vacated by popular, large tenants have already landed new tenants; otherwise things could be much worse. After helter-skelter-like activity in 2009 and into 2010, retail vacancy may begin to show signs of stabilization by year’s end assuming projections for improved consumer confidence and sales volume ring true.

Additionally, there are active tenants in the market looking for space. Frugal has become a very popular term as a result of the recession, and the benefactors have been and will remain bargain and discount stores, which will continue to thrive during these tough economic times. Fast-food chains and casual dining restaurants should continue to dominate the eatery sector, as fine-dining and upscale restaurants will continue to struggle. Second-generation restaurant spaces are a big trend right now, mostly with mom-and-pop eateries taking them. Grocery still remains very competitive, with several newcomers joining the Sacramento market. New retail construction will remain obsolete the remainder of this year, as vacancies remain very high and demand is far too soft to warrant any additional building. In 2009, only 250,000 square feet of new construction projects broke ground, compared to more than 2.1 million square feet that broke ground during 2006. This market has seen a steady decline in new construction since that year, partly because developers have experienced trouble with funding and have had low expectations of active tenants filling their centers.

— James Teare and Blair Wheatley are senior vice president/partner and senior associate, respectively, at Terranomics Retail Services, a division of Cassidy Turley BT Commercial.

Multifamily

With a challenging job economy, bank-owned apartment offerings will increase. Private investors are showing signs of activity.

Apartment properties of 99 units or less in the greater Sacramento market posted a 7.6 percent vacancy rate during first quarter 2010. Once again, Yolo County multifamily properties reported the area’s lowest vacancy rate at 3.4 percent. During first quarter, Placer County’s vacancy increased 30 basis points to 5.1 percent, while Sacramento County’s vacancy decreased 10 basis points to 8.7 percent. During this period, the average monthly rental rate for properties of 99 units or less in the greater Sacramento market was $861, down from $870 in fourth quarter 2009. At $1,207, Yolo County posted the highest average rental rate in the area. Placer and Sacramento counties showed significantly lower average rental rates than this at $957 and $787, respectively. Only Sacramento County experienced rental rate losses during this time, shrinking 2 percent. The midtown/downtown submarket is healthier than other submarkets in Sacramento. Its shows 3 percent vacancy, with cap rates trading around 5.5 percent with more traditional sales than bank-owned.

Vacancy for properties of 100 units or more was down 30 basis points to 7.5 percent in first quarter 2010. Large Sacramento County properties reported a 7.8 percent vacancy rate, the highest local level. The vacancy rate in Placer County decreased during the first quarter, while it increased 60 basis points in Yolo County. Properties in this size range had an average rent of $928, remaining the same from the previous quarter. At $884, Sacramento County rents were 24 percent lower than Yolo County and 15.5 percent lower than Placer County.

Sale activity in the greater Sacramento apartment sector ended first quarter 2010 with a total dollar volume of $86.2 million in 16 transactions. The total number of units traded during the quarter was 1,112 compared to 870 units in the previous quarter. Pricing for multifamily properties in the greater Sacramento market experienced an increase in both metrics. Average price per unit ended the quarter at $80,129, up from $60,818 in the previous quarter, while price per square foot increased by $13 to $83. Capitalization rates fell below the 8 percent level during first quarter 2010 to 7.89 percent, down from 8.43 percent in the previous quarter. The greater sacramento market Gross Rent Multiplier (GRM) also decreased from 7.42 in the previous quarter to 6.81.

The largest sale transaction in the first quarter was the 612-unit State Creek at Johnson Ranch for $54.3 million to the Prime Group. Apartments have been difficult to sell in this challenging and uncertain economic climate. While some private investors are pursuing value-add and long-term hold strategies, institutional investors seem bearish on the capital area. Currently, sales activity appears focused on distressed assets and bank-owned properties where intrinsic value is more apparent. Sales activity of quality, well-located apartments will remain low until the area witnesses an improvement in economic fundamentals. 

Some of the Class B/C properties face challenges in some Sacramento area submarkets. With a staggering job economy, landlords are having a difficult time leasing out units. They are pressured to give more rent concessions, decrease rents and decrease rental deposits. 

— In Sacramento, Amar Cheema is an associate in Cassidy Turley BT Commercial’s Multi-Family Group and Dylan Herrick is a senior associate.

Office

The Sacramento Valley office vacancy rose to 16.3 percent in first quarter 2010, as total availability increased 300,000 square feet for a total of 13.9 million square feet. Sublease space remained constrained, representing less than 3 percent of the total availability. The overall average asking rate for office space slid another $0.03 per square foot quarter over quarter to $1.85 per square foot full service in first quarter 2010.

Gross absorption was a mediocre 1 million square feet in first quarter 2010, about 25 percent less than its quarterly average in the past year and 40 percent below since 2005. Large tenants remain very scarce in the market, with most of the activity being dominated by smaller tenants less than 10,000 square feet. Net absorption, the change in occupied space, was a negative 368,000 square feet in first quarter after having reported positive 117,800 and 213,000 square feet in fourth and third quarters of 2009, respectively. Notably, during the past year, net absorption (which excludes new vacant construction) has actually held stable with just negative 50,000 square feet. The heavy dose of new unoccupied construction has really been a primary cause for the large increase in vacancy and availability in the past year.

The larger leases in first quarter 2010 included California State Board of Equalization for 76,502 square feet in Sacramento; ITT Technical Institute for 27,020 square feet in Rancho Cordova; Principal Financial Group for 24,645 square feet in El Dorado Hills; and Brown & Caldwell for 22,126 square feet in Rancho Cordova. There were also a handful of notable sales, led by CSAC Excess Insurance Authority’s acquisition of a 48,591-square-foot building in Folsom.

Office construction continued to trickle at the start of 2010 as projects funded more than 1 to 2 yearsr ago are now finally being completed. One building was delivered in first quarter: the 141,210-square-foot Sutter Health Facility in east Sacramento. This pace is already drastically cooler than last year when 1.9 million square feet were delivered and caused a massive swelling to the area’s vacancy rate. The development pipeline, however, is quickly diminishing as developers wait on the sidelines until market conditions become favorable. This slowdown is a double-edge sword, as it will help alleviate rising vacancy, but it will also take away construction jobs, a historical key source of job growth for the market.

The climate continues to remain favorable for tenants as there are still a lot of rental rate discounts being offered, plus concessions such as free rent and higher tenant-improvement allowance dollars from landlords. Lease terms also remain shorter, with the typical leases ranging between 1 and 3 years. The office sector will continue to battle the effects of the economic recession. The services and tech sectors lost a reported 10,000 jobs, and the job outlook ahead remains pretty grim. The forecast is that there will continue to be growing vacancy, slightly lower rents and very little new construction. The bright spots in the local office market have been and will likely continue to be owner-user sales financed with SBA long-term, low-interest loans and growth in healthcare and education.

Notably, the heavy majority of the 10 largest office leases transacted in 2009 were from the state’s government. Government is at risk as revenues from property and sales taxes continue to shrink, as the deficits become increasingly structural. Employees are being furloughed. Services are being cut back, and capital expenditures are being frozen. A great deal of the federal stimulus funds found their way to state and local government last year, but who knows what the political future holds? What happens to state and local government will have profound impacts. There is reason to be more optimistic, but being able to avoid a “double dip” is not certain.

— Jim Gray is a partner and Nahz Anvary an associate in Cassidy Turley BT Commercial’s Sacramento office.

Industrial

The effects of the economic recession and the housing crisis have understandably resulted in negative trends across the board in the Sacramento Valley industrial sector, as occupancy loss, rising vacancy and reduced rental rates continue.

With a total building base of 136 million square feet for warehouse, light industrial and manufacturing buildings, the Sacramento Valley industrial market ended first quarter 2010 with a vacancy rate of 11.6 percent, a 40 basis-point increase from the close of 2009. Vacancy rates were pretty widespread throughout the Sacramento Valley, with about half in single digits and the other half falling between 10 and 18 percent.

Total availability at end of first quarter was 15.8 million square feet, an increase of roughly 550,000 square feet quarter over quarter. (Total availability has grown a monstrous 2.8 million square feet or 21 percent since the recession began). Sublease space accounted for a still-comfortable 8 percent or 1.25 million square feet of the total availability. Sublease space has, however, increased nearly nine-fold from less than 150,000 square feet at the end of 2007.

The average asking rate for industrial space at the end of first quarter 2010 was $0.35 per square foot NNN, down $0.04 or 10 percent from year-end 2009. The average asking rate has deteriorated by more than 25 percent since the start of the recession.

At 1.65 million square feet, gross leasing activity was modest to begin 2010, which was slightly higher than the start to 2009. However, it is still a low statistic historically. The most noteworthy lease transactions signed in the first quarter included N Solar Inc. for 116,727 square feet in McClellan; Blue Diamond Growers for 80,000 square feet in McClellan; HP Hood LLC for 64,885 square feet in Sacramento; and Prison Industry Authority for 50,200 square feet.

There were a few notable sales that transpired in first quarter 2010, mainly from users. The three largest sales occurred in Sacramento proper: West Fork Construction for 48,000 square feet, DFP LTS LP for 27,574 square feet and Soutgate Glass for 22,000 square feet.

The industrial sector continues its battle with occupancy loss. During the past 2 quarters combined, the industrial market has reported a loss in occupancy of 1.35 million square feet through negative net absorption, and in the last year it has lost roughly 2 million square feet.

The overall forecast for 2010 is looking hopeful to end with non-negative absorption. Lease rates have seemed to have found the bottom with rents going from net to gross in order to make the deals stick. Rents will continue to bounce on the bottom until some net absorption happens. There is currently half a million square feet of net demand looking for space to lease in the Sacramento area. The majority of leases are short term, with few exceptions, as a handful of manufacturing-related companies are looking for long-term deals. The housing-related industry accounted for 35 to 40 percent of the industrial demand in the area, and with that industry not expected to return to its previously levels, manufacturing and traditional warehousing will have to pick up the slack. Also, expect a downward pricing pressure on sales to remain through the remainder of the year with primarily owner-users taking advantage of the lower prices and buying opportunities.

— Ken Reiff is a managing partner with Cassidy Turley BT Commercial’s Sacramento office.

Conclusion

Looking ahead, the Sacramento market faces many challenges. An overbuilt commercial market during the recent boom and then simultaneous with the recession has become very problematic. The current high rate of vacancies and number of business closures will hamper this market for years to come. In a report by bizjournals.com, the Sacramento area recently ranked as one of the worst in the nation for small-business owners, finishing 95 out of 100. Unemployment is projected to remain elevated in the Sacramento metro throughout the remainder of the year and possibly showing tempered declination thereafter. Meaningful job growth is not anticipated until early 2011 or even beyond, but a return to pre-recession levels is not projected until at least 2013.

Slow growth definitely appears to be the consensus moving forward. Even still, there are many hurdles the area will face along the way. First, the state’s budget crisis, with many projecting massive job cuts in the government arena, which could result in the state’s capital area feeling even more pain in 2010 and beyond depending on how many jobs may be cut. Second, companies still remain cautious in their hiring practices due to the fragile state of the economy, resulting in minimal tenancy. Additionally, new companies in the market remain scarce. This all culminates in soft tenant demand, unless driven by renewals. Third, credit remains very tight, and banks struggling with a list of foreclosures are hesitant to provide new loans. And last, but certainly not least, is the deterioration in construction activity due to high vacancies and the housing market collapse. One of the main contributors to the heavy growth in employment in Sacramento during the last market recovery was construction-based. A report by the Sacramento Business Review stated that the last time the Sacramento metro added as many as 80,000 jobs (equivalent to the job loss since the start of the recession) it took roughly 3.5 years and was fueled mainly by the real estate boom. However, with new home and commercial development currently evaporating and likely to remain faint for some time — some experts even call for a continued decline in this sector near-term — the area will more than likely have to rely on other means this time around to help spring job growth. One sector being coveted for such a role is clean technology, which is also being viewed, both optimistically and pessimistically, by many across different industries as a hopeful source of jobs statewide as California has taken the role as an emerging leader in this effort. In a report from the Sacramento Regional Alliance, the Sacramento area was the statewide leader for job growth in the clean-tech sector between 1995 and 2008; it stated that the area had a total of 13,000 clean-tech jobs. Though the recession has certainly hindered some of the ability for growth in the sector, a return in venture-capital funding and government financial assistance is helping re-charge the effort.

The state hiring freeze and furloughs are expected to continue, and coupled with decreasing property tax revenues, governmental agencies in the area will be forced to make additional budget cuts. Job losses and monies flowing through the local economy will only get worse before getting better.

Sustained recovery in Sacramento Valley’s commercial markets will be a very slow process. Much of the activity will be likely driven mainly by renewals and/or relocations as companies shuffle around in search of the best deals for the best spaces they can find, while landlords compete hard for tenancies. Certainly, specific sectors and areas in the market will see improvement before others. Once jobs return and the fragile economic climate strengthens, it is expected that Sacramento will re-emerge as a strong and dynamic marketplace, but as to exactly when that will be remains unknown. Until then, the Sacramento area will continue its trend along the bottom.

— Ken Reiff is a managing partner with Cassidy Turley BT Commercial’s Sacramento office and Jim Gray is a leasing and sales specialist.

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