MARKET HIGHLIGHT, MAY 2010

LOS ANGELES
Christopher Bonbright, David Toomey, David Landau and Richard Abdulian

With the recession behind it, L.A. will see its real estate lights continue to brighten. Find out which players and sectors in the City of Angels are already set to fly high.

Retail

A flurry of activity has hit the market as retailers have gotten off the sidelines to rummage through the abundant vacancies. Local tenants are the most active as the national credit tenants are taking a more measured approach.

The majority of recent lease transactions has been for smaller spaces, with rent concessions such as free rent and tenant-improvement allowances being common. Rental rates are being driven down by the increased competition for the tenants seeking the growing amount of space. The average asking rental rate is $2.35 per square foot with a 6.4 percent vacancy rate for Los Angeles County. Service-based retailers that do not compete with online shopping, such as restaurants, banks and value-priced retailers are the most active.

A couple of recently completed projects are helping to transform retail districts and generate both local traffic as well as tourism. LA Live is a $2.5 billion entertainment complex, with the Ritz-Carlton Hotel/Residences and J.W. Marriott Hotel just opening to add rooms for the adjacent Los Angeles Convention Center and Staples Center. The W Hotel/Residences is part of a $600 million complex surrounding a public plaza that leads to the Hollywood and Vine Metro stop.

The tight capital markets are impacting the ability of the REITs to operate/refinance their malls. The lack of options has trickled down to reorganization plans for companies like General Growth Properties. Sales transaction volume has been low, especially for investment sector. Retail cap rates for Los Angeles county stood at 7.2 percent the first quarter closed, although investors are keeping an eye on the cash flow. Overseas buyers are seeking properties, a trend that should continue to grow.

With the recession in the rear-view mirror, retail is expected to slowly regain its footing as tourism and consumer confidence edge up. Inflation has been in check as the area is experiencing stabilizing unemployment and housing prices. A number of major government-sponsored defense projects are underway in California, including satellites and unmanned aerial vehicles that can help to stimulate spending.

According to the Federal Reserve, business spending on equipment and software has risen significantly, and the labor market is stabilizing. This is an encouraging sign for a true recovery as the city endures the twists and turns along the way. The proverb says that the three most important things in real estate are location, location, location. Los Angeles continues to be the place to be for retailers given the strong demographics, traffic counts and, of course, the beautiful weather.

— Christopher Bonbright is CEO of Ramsey-Shilling Commercial Real Estate Services in Los Angeles.

Office

The good news for commercial real estate in Los Angeles is that the office market is now declining at a slower rate. But with real estate recovery lagging the economic recovery, the city faces a steep climb back to pre-recession levels as continued job losses fuel vacancies and rents continue to fall. In fact, a full commercial real estate recovery may be at least 2 years away.

Overall leasing activity increased by 25 percent in the last quarter, but is still 10 percent below the quarterly average during the past 5 years. Demand is expected to remain weak for the rest of 2010.

Now at 14 percent, vacancy is up 5.5 percent from its peak in 2007. However, in the last quarter, vacancy only increased 0.3 percent. If vacancy remains flat for several more quarters, which is likely if job growth in L.A. mirrors the projection for California —landlords will become more and more aggressive in trying to attract new tenants and renew existing leases.

Currently, many landlords are offering generous rental concessions, tenant-improvement allowances and discounted parking rates in order to fill empty space or to prevent tenants from moving when leases expire. Rents continue to decline in each submarket except South Bay, with quoted rents falling 9 percent from their peak in 2009. Yet actual, fully negotiated deal rates are much lower than statistics indicate.

There is no new office development in west Los Angeles except for projects that were underway in 2008. The owner of a large site at Olympic and Bundy in that submarket is working through the entitlement process for a mixed-use residential and medical development.

Major recent news at the Westside Media Center involves Shopzilla recently renewing its lease of 53,000 square feet after the city reclassified Internet companies, previously considered to be “multimedia,” into the “business and professional” category. The new ruling results in a five-fold tax rate decrease for companies like Shopzilla and may be a major incentive for an estimated 1,400 additional Internet companies to remain in the city when their leases expire. Many of these companies had threatened to relocate if the tax wasn’t lowered.

Current active tenants in the market include E! Entertainment recently renewing a more than 200,000-square-foot lease, Game Show Network evaluating options for 50,000 square feet, Activision in the market for 250,000 square feet for headquarters space and Northrop Grumman also looking to move its headquarters.

In selective instances, now may be a good time for tenants to negotiate longer-term leases to take advantage of soft market conditions before this window of opportunity closes. Those tenants with leases expiring in 2012 and 2013 should consider early lease renewals to lock in at today’s favorable terms, if their current and future space needs are adequately met in their existing facilities. As always, tenants entering into new or renewed leases should negotiate non-disturbance agreements to secure their leases in the event of foreclosure.

The worst may not be over for commercial real estate in Los Angeles, but as the market faces the steep climb back to pre-recession levels, proactive tenants can exercise their leverage.

— David Toomey is a principal at CresaPartners in Los Angeles.

Multifamily

Multifamily has been one of the safest asset classes to invest in throughout the recession for the simple reason that people need a place to live. Therefore it has held up much stronger than retail, office and industrial. Yet, rental unit vacancies are rising to approximately 8 to 10 percent across the board, and rents are down about 10 percent, so investor returns are declining.

Multifamily investors are also not able to get the same leverage that they were a couple of years ago, so deals are requiring more cash thus hurting their potential cash-on-cash returns. Buyers are also concerned about rising vacancies and further rent declines due to continued levels of high unemployment, so they are not meeting seller’s expectations on pricing. These market fundamentals have reduced multifamily sale transaction volumes substantially in the last year, and sales prices of multifamily properties are down about 15 percent year over year.

There are some signs that investors are returning to the market in 2010, but they are still looking for deals. An up-tick in notices of default for multifamily properties is evident, even in the urban-infill markets. Many of these owners simply over-paid during the bubble and are not meeting interest payments either because they are having difficulty refinancing their properties, their vacancies are rising or both.

Move-in specials are common to attract the tenants in the market. Concessions include free rent, lower security deposits and an easier credit-application process. Many owners are aggressive on lowering rent or giving free rent to get the space leased up as quickly as possible with the philosophy that some income is better than none.

Pockets of new housing inventory are slowly being absorbed in areas such as downtown Los Angeles, Hollywood, Mid-Wilshire and Pasadena. Condo developments are coming to market and being leased out to wait until a more favorable sales market returns. Another competing force is the residential portions of developments like the Ritz Carlton Hotel at LA Live and the W Hotel in Hollywood.

Developers are marketing small groups of condos to create the illusion of limited supply, while others are going the auction route. Financing is available for well-qualified buyers, with FHA loans being the most prevalent. Foreclosures are increasing on multifamily properties with the shifting fundamentals and lack of equity in many properties.

Home prices have increased for the first 3 months of the year, and home affordability fell back in line with historic averages seen prior to the run up. The high-end market has shown some signs of life, although most of the activity comes from value-priced properties. Owners are being left out of the bidding as investors are swooping in and paying all cash on these short sales. Home ownership is expected to continue its decline, which should bode well for the multifamily market.

Major construction projects will help spur jobs and spending, including several terminal expansion projects at the two ports, Bradley International Terminal expansion at LAX, plus highway and transit projects funded in whole or in part by Measure R, the county’s new half-cent sales tax.

— David Landau is an associate at Ramsey-Shilling Commercial Real Estate Services  in Los Angeles.

Industrial

Throughout the economic downturn, the Los Angeles industrial market has remained the tightest compared to any other area in the nation. Although the market’s vacancy rate has increased since the recession began, it was still a low 3.4 percent at the close of first quarter 2010. The warehouse/distribution property segment posted the highest vacancy rate at 4.2 percent. This was primarily due to the fact that consumer spending decreased, causing many companies to allow their inventories to run down. This reduced the volume of goods flowing into the market from the ports, lowering demand for space in the port-dependant Los Angeles warehouse market.

Many of the large lease transactions that have taken place in 2010 have come in the form of renewals or extensions. Landlords are continuing to lower asking rental rates and offer more concessions to entice new and existing tenants to lease space. At the close of the first quarter, market-wide asking rental rates stood at $0.53 per square foot per month NNN.

The Los Angeles north submarket fared the best during the first quarter with the completion of approximately 150 lease transactions, although the majority were less than 15,000 square feet. Owner/user sales continue to dominate: the north submarket recorded 15 owner/user industrial property sales during the first 3 months of 2010, 10 more than during the same period last year. In the largest transaction, Topaz Distribution purchased the 202,000-square-foot warehouse/distribution property at 2280 Ward Ave. in Simi Valley from Cinram International for $14 million.

Looking forward to the remainder of 2010, vacancy will likely inch higher as port activity struggles, unemployment remains high and retailers fight to regain a footing in a still uncertain economic climate. The increased availability of industrial product will continue to affect asking rental rates, as landlords lower expectations to sign tenants. Roughly 285,000 square feet of space remains under construction in Los Angeles – property such as Canord Industrial Park, a 45,000-square-foot master-planned property in the San Fernando Valley slated for delivery by M.W. Ossola and Associates in June. However, as the economy stabilizes, which is expected in the latter half of the year, market conditions will likely begin to put tenants and landlords on a more balanced playing field.

— Richard Abdulian is a senior vice president, Industrial Group, at Grubb & Ellis Company.

Urban Industrial Infill: It’s What’s Inside that Matters the Most

The economic and environmental benefits of all types of urban infill development are well-documented: reduced sprawl; optimized use of urban land supplies; improved access of people to jobs and jobs to labor force; enhanced economic diversity; neighborhood revitalization. And the list goes on. More importantly, amid the ongoing tumult of today’s commercial real estate landscape, infill development is playing a vital role in driving economic recovery on a market-by-market (or even submarket-by-submarket) basis.  The power of infill development to fuel micro-recoveries is especially apparent in the industrial real estate sector, where overarching economic trends have created a climate that favors smaller projects in key urban markets over large-scale complexes in outlying areas. 

First, it is important to note that according to industry analysts, industrial real estate tends to be more stable and less volatile over time compared to office, hospitality and retail product types. However, as the steepness or depth of the downturn has been uneven across product types and across geographies within product types, it is also expected that an ultimate recovery may be equally uneven. In general, high-barrier infill markets serving large, growing populations (driven by consumption and/or distribution of goods and services) with a diversified underlying base of industries and businesses will tend to fare better during the downturn and may recover more robustly. Such markets have typically benefited due to the limited development of new product in decades combined with relatively favorable forward-looking tenant demand, as opposed to low-barrier markets that may be suffering from over-supply.

In major markets like Southern California, infill sectors continue to fare substantially better than non-infill markets both in terms of vacancy and rental rates. Key industrial markets within greater Los Angeles have seen vacancy top out at 3 to 5 percent on average. Conversely, vacancy hovered around 9 percent in the western Inland Empire, even reaching up into the mid-teens in the eastern Inland Empire, where there is a proliferation of large-scale industrial complexes.  Reasons for this trend may have to do with over-building in low-barrier markets such as the Inland Empire, compared to land and economic constraints limiting development in infill Los Angeles. Additionally, Southern California is favorably positioned with the largest growing regional population, consumption and manufacturing base in the nation, driven by a diversity of industries that fundamentally set it apart from other regions. Locally and regionally-based businesses in infill industrial markets tend to disproportionately serve the growing regional population, which contrasts with big-box industrial tenants that tend to disproportionately service super-regional or global trade. which have taken the brunt of the reduction in containerized imports. Consequently, rental rates in big box industrial markets are off by as much as 40 percent as compared to about 10 to 25 percent in the infill markets.

Michael Frankel is managing partner and Howard Schwimmer is co-founder and senior managing partner at Rexford Industrial.

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