FEATURE ARTICLE, MAY 2006

THE MILD, MILD WEST?
The commercial real estate market in the West might be abating a bit, but there’s still plenty of capital coming in.
Kevin Assef

Assef

Job Growth Fuels Retail Sectors

Throughout the western region, demand for both strip and anchored retail shopping centers will increase this year. Robust economic growth is driving expansion in several major metropolitan areas in the western region, particularly in the Southern California and Phoenix retail property sectors.

A thriving economy and continued high levels of demand for space will keep the San Diego retail market among the top performing markets in the country. Increased job growth in nearly every sector will help keep retail sales humming at a 5.5-percent growth rate, a slight decrease from last year that can be attributed to the expected moderation of home refinancing. Sales growth will be strong enough for retailers to continue expansion efforts, resulting in higher occupancy and lease rates across the metro area.

Investors remain bullish on San Diego retail properties, as is evidenced by the more than $700 million in single- and multi-tenant property transactions last year, an increase of nearly 50 percent from 2004. While institutional investors remain far more prevalent in the multi-tenant sector, investment in single-tenant, net-leased properties showed significant growth last year due to the liquidation of several Mervyn’s locations throughout the county. In all, institutional sales involving single-tenant properties increased to more than three times the level reported the previous year. Institutions were most active within the southern San Diego County submarket where investment more than doubled and prices for multi-tenant properties increased to $175 per square foot.

The Westfield Group recently announced they will be purchasing five Federated department stores within San Diego County. The company plans to completely redevelop the University Towne Center (UTC) in San Diego and the Plaza Camino Real in Carlsbad into upgraded shopping centers with a new lineup of higher-end stores. The overhaul of the centers will turn these traditional malls into open-air, mixed-use lifestyle centers. The $100 million renovation of the UTC will incorporate 500 new residential units and more than 160 stores and shops, including anchor tenants Macy’s and Nordstrom.

In the burgeoning Phoenix retail property market, job growth continues to attract new residents. Population growth of 2.7 percent and income growth of 6.1 percent will push retail sales up 10.5 percent in 2006, the fourth straight year of double-digit growth. Builders are rushing to bring retail to new suburban residential communities. While big box stores will anchor most of the large centers, smaller grocery-anchored neighborhood centers are being built on nearly every major intersection not served by a larger center. Vacancy continues to tighten, with near-full occupancy in new suburban areas while vacancy in established urban malls is slightly higher at 6.9 percent.

Urban Lifestyle Centersto Dominate

Mixed-use, urban lifestyle projects throughout the West will enjoy a high degree of success this year, depending, of course, on their location. Los Angeles, Orange County, San Francisco, San Diego, Las Vegas, Portland and even Boise will attract developers interested in constructing lifestyle centers, which is the next hot development wave. Developers have started to embrace these lifestyle centers for a variety of reasons, including their profit margins. In terms of cost effectiveness, the developers look at their overall returns and exit strategy. With a hotel, they usually flag it or sell it to a larger chain. These actions add value to the overall development. A number of developers are even outsourcing some of the construction; if they don’t have the expertise in multifamily construction, they bring someone in as a joint-venture partner to build the apartment units. That way, they are able to maintain complete control.

Office Market Heats Up

Turning to the office sector, vacancies are at the lowest levels in 10 years, and the sector is an attractive alternative for many apartment and retail investors used to lower cap rates. Office properties also offer more of a recovery play, as retail and apartment fundamentals have been strong for the past several years. As the economy continues to grow, more people are starting their own businesses, and existing firms are expanding aggressively after several years of lackluster growth. This is driving the need for more urban and suburban office space, particularly since companies will be facing higher rents in a tightening market. To access a larger workforce and reduce commute times, a growing number of companies are moving their operations further out geographically, which is benefiting suburban areas and resulting in the development of growth pockets such as the Inland Empire in Southern California and the greater East Bay in Northern California, as well as the Central Valley. Unlike most previous cycles where a battle raged between the suburbs and downtown markets for companies, there is plenty of economic and demographic growth to go around this time. Urban markets are benefiting from the growth in the “empty nester” segment of the population and professional adults who choose the amenities of central cities.

Looking at specific urban areas, San Diego features some of the tightest office market conditions in the entire country. Demand will outpace new supply in the San Diego office market this year as area employers continue their expansion efforts. Led by strong leasing activity in the downtown area, net absorption in the metro area is expected to total 2.1 million square feet in 2006. Development activity is expected to reach a 5-year high in 2006, but will continue to fall short of demand.

Strong fundamentals will keep investors interested in San Diego office properties, despite relatively low returns. Local buyers continue to dominate the investment scene and are still competing with one another for deals. This is especially true in the Uptown/Hillcrest submarket, where private buyers are paying an average of $446 per square foot for single-tenant properties, an increase of more than 40 percent over the past year. The downtown submarket continues to be a popular location with institutional investors, highlighted by the sale of the NBC Building and SBC Plaza. Those office properties, which total more than 730,000 square feet, sold for a combined $265 million or $362 per square foot.

The Riverside/San Bernardino office market will continue to thrive due to another year of healthy job growth. Strong office-using employment gains translated into record construction levels last year. Responding to robust demand, developers have filled the planning pipeline with more than 4 million square feet of office space. Despite the increase in construction, heightened demand from companies expanding inland to serve the growing population will keep vacancy rates low. Rancho Cucamonga, in particular, will remain popular with expanding businesses due to the growing list of high-end retail centers and restaurants, as well as its proximity to the Ontario airport.

Gains in the office sector are not limited to California’s metropolitan areas. Arizona has been a focus among investors, as pricing and cap rates move beyond reach in the Golden State. Inexpensive land and development-friendly policies have always sparked concerns about overbuilding in the metro. Approximately half of the new space coming on line this year is in Scottsdale, including the 165,000-square-foot second phase of the Portales Corporate Center. Some areas, though, could record a decline in inventory. Investors seeking to convert for-rent offices to office condos have recently purchased more than 380,000 square feet of space in the Camelback Corridor.

West’s Multifamily Market Expected to Again Outperform Nation

Fundamentals in the apartment market will remain strong due in large part to immigration and strong renter household formation. A sharp deterioration in housing affordability has made rental apartments a good target for investors throughout the region.

All market indicators suggest that most Western markets will outperform the nation in 2006, with owners benefiting from the combined effect of healthy job growth, record home prices and shortage of new supply. However, apartment sales activity will slow this year, although prices will be supported by high investor demand. The drop-off in activity will be due in part to declining cap rates, which fell below 5 percent in 2005, higher interest rates and a drop-off in apartments being sold for condo conversion. Strong rent growth is expected to offset the effect of higher interest rates, but a market transition should be expected during the process. Orange County, Los Angeles and the Inland Empire will lead in terms of supply-demand fundamentals while the recoveries in Seattle, Portland and the Bay Area continue.

Investor demand for Las Vegas apartments remains strong. Purchases for condo conversions have pushed prices and volumes to new highs over the past year. The market has become extremely heated, with conversion buyers paying as much as $120,000 per unit for high-end apartments. The reduction in rental inventory has been extreme in some submarkets, which has allowed remaining owners to dramatically improve cash flows. For example, a total of 4,000 units were converted in the Spring Valley and University submarkets, and existing owners posted gross revenue growth in excess of 10 percent during the last year. Despite the expectations of a substantial cooling in the condo market this year and a growing inventory of condos put on the market as rentals, the Las Vegas apartment market should post another strong year in rental growth and investor demand.

Strategy for Growthin the West

The real state industry has transitioned from a local business to a national, mainstream capital market asset class with institutional investors and private capital converging. As the market becomes more transparent, the main challenges to investors will be accessing investment opportunities and executing transactions with sufficient knowledge. Partnering with a brokerage firm with national coverage, extensive research capabilities and knowledge of capital markets is always a good idea.

The Future

2005 boasted the best transaction volume on record, and a transition to a more normal market has begun in 2006. More inventory will be placed on the market which, together with higher interest rates, poses the biggest short-term challenge. Cap rates are expected to rise from current lows in response to higher interest rates, but are unlikely to revert back to long-term averages in the foreseeable future. This is driven by a healthy and improving supply-demand balance, still low interest rates, and strong domestic and international investor demand.

Kevin Assef is senior vice president/managing director and regional manager of Marcus & Millichap’s Ontario, California, office.

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