MARKET HIGHLIGHT, MAY 2007

LOS ANGELES MARKET HIGHLIGHT
J.C. Casillas and Tom McLeod

Population and job growth are boosting Los Angeles’ commercial real estate market, while the city’s ports, paucity of developable land and lack of housing affordability have sent industrial and multifamily occupancies through the proverbial roof. Also, Los Angeles’ office sector has transformed into a landlord’s market with the vacancy dipping into the single digits. It is good to own commercial real estate in the City of Angels.

Industrial

The Los Angeles County industrial market continues to shatter occupancy records in 2007, posting the highest occupancy rate in the nation. Occupancy has exploded to an unprecedented 98.2 percent as of first quarter 2007. This heightened space crunch presents a multitude of issues for the largest industrial center in the United States, an industrial market that is 1 billion square feet strong. The main driver of industrial activity is brisk national and regional economic growth, which is directly manifested in the large number of cargo-TEUs (20-foot equivalent units, which is the size of the containers) moving through the ports of Los Angeles and Long Beach.

Containerized trade volumes at the ports of Los Angeles and Long Beach set another record in 2006 with a combined 11 percent year-to-date growth rate over the prior year. Trade has grown by 147 percent in the last 10 years, and trade volumes are expected to double in the next 10 years. Given that more than 40 percent of all containerized cargo in the nation moves through the Los Angeles and Long Beach ports with 50 percent of that cargo staying in Southern California, it is no surprise that warehouse/distribution space is in extremely high demand but in short supply. The enormous growth and sheer volume of goods being shipped from Asia — primarily China, Japan and Korea — has created an explosive demand for warehouse/distribution space, especially in those markets that are within the ports’ reach. The counties of Los Angeles, Orange, Riverside, San Bernardino, San Diego and Ventura collectively represent 1.8 billion square feet of industrial space with a vacancy rate of just 2.6 percent. The Los Angeles basin is home to a tremendous consumer base with 21.5 million people living within a 2-hour truck trip from the ports.

Nationally, of the top five largest industrial markets in terms of square feet, Los Angeles County continues to command the highest rents for warehouse/distribution facilities. The average asking industrial rate in first quarter 2007 was $0.61 per square foot per month NNN. While the rate of growth appears to have leveled off (a function of new supply), rents have grown by 20 percent during the past 2 to 3 years. Other issues affecting the true cost of occupancy are net charges. For rents quoted on a triple-net basis, the tenant is responsible for the taxes, insurance and common-area maintenance. Some recently sold buildings have a higher tax base, which is passed on to the tenant. Many net leases have a $0.10 to $0.15 charge tacked on per square foot.

This condition of extremely low vacancy is a situation that will not end soon. It will put tremendous pressure on rents, property values and redevelopment opportunities throughout the region in 2007. The Los Angeles industrial market cannot escape the growing pains associated with the ports’ projected growth. Demand for new state-of-the-art industrial space is widespread, however, half a billion square feet or 55 percent of the total inventory is more than 30 years old. As the gap in rents between Class A, B and C space widens, landlords will take notice. Redevelopment will provide the next wave of growth for the Los Angeles industrial market with the strongest demand along the ports’ cargo distribution paths.

— J.C. Casillas is client services manager in Grubb & Ellis Company’s Los Angeles office.

Office

In first quarter 2007, vacancy in the Los Angeles office market dipped to 9.8 percent, the lowest level since Grubb & Ellis began tracking the market in the mid-1980s. Los Angeles is the nation’s fourth largest office market, with much of its growth coming in the period of economic expansion that occurred between 1985 and 1995. The market grew by 50 percent as developers went into a building frenzy. However, the economy then slowed and supply soon outpaced demand. Many new buildings remained unoccupied and the vacancy rate soared to 20 percent. The period from 1995 to 2000 was considered the Tech Boom, another period of expansion largely driven by tech companies anticipating “growing into their space.” This helped push occupancy and new construction once more. The office inventory grew by 11 percent, while vacancy dropped to a then record low of 12 percent. However, by 2001, the tech bubble burst, the economy floundered and vacancy was on the rise again. By year-end 2002, vacancy hit 17 percent, the high for that downturn.

The slowdown of the late ‘90s proved to be different than that of the ‘80s. Whereas the latter slump left many new buildings unoccupied due to developers anticipating demand, the tech bust left mostly existing buildings unoccupied due to tenants not “growing into their space.” The majority were technology-related, start-up companies that had leased more office space than they needed. As these tenants found themselves unable to meet their obligations, the bubble began to burst and a glut of sublease space was put on the market. While much of the space vacated went back to the owner, a significant portion of the space available was for sublease.

Today a different set of dynamics is at work. Office space occupancy in Los Angeles County stands above 90 percent, and demand is not projected to let up anytime soon as the result of a steady economy and a diverse tenant base. From 2001 to 2006, new construction has increased a moderate 9 percent, resulting in a lower level of new office supply on the market. Land is limited for new development, and developers with entitlements have selectively held back on new projects. Tenants in the market have based their occupancy on real needs, making efficient use of existing space and expanding only when necessary.

The demand-supply imbalance has caused Class A and B rents to rise 14 and 11 percent, respectively, from a year ago. This has translated into sticker shock for tenants looking to lease or renew office space. What’s more, tenants renewing in recently sold buildings received an even bigger shock as new rents reflected the hefty purchase price paid by the new owner. Expanding tenants are having a difficult time securing additional contiguous space — especially in prime locations — and in many cases must factor in additional moving costs to secure available space.

The Los Angeles office market is now a landlord’s market. Healthy net absorption, decreasing vacancy and rising rent levels are in part due to the consistent economy, which will continue to drive office leasing and investment activity producing steady growth for 2007. Office sales activity will continue, with steady to moderately rising prices for commercial property. Demand for Los Angeles office product stems from constrained supply and a large amount of investment capital chasing a limited number of properties available for sale.

— J.C. Casillas is client services manager at Grubb & Ellis Company.

Multifamily

The future looks bright for owners of Los Angeles County apartment properties. The market remains incredibly tight with vacancy at just 3 percent, the second lowest in the nation after New York City. Population continues to grow, particularly through immigration, which is adding approximately 90,000 residents a year, the majority of them renters. The economy continues to grow, generating more jobs and attracting more residents.

Single-family homes and condominiums are among the most expensive in the nation (only 11 percent of Los Angeles residents can afford the median-priced home), which pushes more people in the direction of apartments. The gap between renter and homeowner has always been wide in Los Angeles and it’s becoming wider. When interest rates were low, the number of homebuyers rose, but now the tide has turned and interest rates are increasing. Add to that the subprime meltdown, which has left even fewer individuals able to qualify for financing to buy a home. Even those that can afford to buy are taking a wait-and-see approach to see where the sales market is headed. Many will wait on the sidelines in rental housing.

On the supply side, there is some new apartment construction, but not nearly enough to keep pace with the demand generated by a population that exceeds 10 million. A major limiting factor is the lack of available land in Los Angeles. According to the USC Lusk Center Casden Forecast, downtown Los Angeles accounts for much of the product that is under construction with 2,430 new units scheduled for completion this year. One of the largest downtown projects under way is GH Palmer Associates’ 566-unit Orsini II, which will be competed this year. Also generating new rental opportunities are the West Los Angeles, Hollywood and the San Fernando Valley submarkets, with more than 6,000 units under construction, according to the forecast. The apartment inventory has also been reduced as existing rental units have been converted to condominiums, but that activity has slowed with the slowdown in the housing market. Some new projects that were planned as condominiums may instead be built as apartments.

 Persistent demand coupled with minimal supply will translate into higher rents for landlords. Rents in L.A. County averaged $1,470 last year, and an increase of 5 percent is expected this year. West Los Angeles commands the highest rents in the county with Santa Monica leading the market. The average rent in Santa Monica exceeds $3,000 per month, an increase of 16 percent from a year ago.

The number of apartment sales transactions has slowed, but sale prices have continued to increase. The average price per unit in Los Angeles is approximately $200,000, nearly double the national average, and the average cap rate is 5 percent.

— J.C. Casillas is client services manager at Grubb & Ellis Company.

Retail

The economy in first quarter 2007 was moderately healthy. Consumer confidence during this period stayed high, increasing in the Pacific region by 11.4 points from May 2006 to February 2007. According to Chapman University’s mid-February survey, consumer confidence among Californians was at the highest level in 3 years. In March, leading apparel retailers throughout the nation reported bullish earnings.

While consumer spending has been healthy, the average price of regular gas in Los Angeles has risen to $3.25 per gallon. Increasing gas prices and decreased disposable income, combined with the slowdown in the residential housing market, are expected to slow down California’s economy. However, according to the UCLA Anderson Forecast, this will not be enough to cause a statewide recession.

Retail leasing trends for Los Angeles County in first quarter 2007 show a slight increase in vacancy by four basis points to 3.3 percent, as well as increases in direct and sublease rates. Among the areas seeing increased retail vacancy rates is Glendale, which has also seen double-digit office vacancy rates. Richard Caruso’s Americana at Brand in Glendale, a $324 million, 15.5-acre mixed-use development, is slated to open in spring 2008. It is expected to be a major draw to the area but may cause turnover for local retailers.

Another Los Angeles County retail development project is the Westfield Group’s plan to expand the Westfield Valencia Town Center to 1.3 million square feet and to build more parking for shoppers. In addition, Westfield is proposing to expand the Westfield Fashion Square in Sherman Oaks by adding 280,000 square feet and 80 stores. On the east side of Los Angeles County, Atlantic Times Square, a mixed-use development in Monterey Park, is currently being constructed. This development will offer more than 200,000 square feet of retail/entertainment space integrated with 210 high-end condominiums.

Perhaps the most notable retail investment transaction in Los Angeles County in the first quarter was the sale of a portion of Sierra Center, a 100,112-square-foot retail center in Baldwin Park. The property sold for $23.5 million or approximately $234 per square foot. Other notable deals include Lemon Creek Village, a neighborhood shopping center in Walnut that sold for $11.8 million and 2000-2012 Long Beach Boulevard, a neighborhood shopping center in Long Beach that traded for $8.7 million.

The retail investment trends in Los Angeles for this period have been difficult to analyze because of the lack of product on the market. During the first quarter, the total sales volume for retail investment sales was $85.8 million with 109 transactions. With an average cap rate of 6.2 percent, cap rates remain relatively the same as last year. The general consensus among retail investment brokers is that there are many principals looking to place their money but they are unable to find suitable product on the market. With the product shortage, cap rates remaining relatively stable and the increasing price per square foot, it is a seller’s market.

— Tom McLeod is vice president in the west Los Angeles office of Grubb & Ellis Company.


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