MARKET HIGHLIGHT, NOVEMBER 2006

COUNTING GREEN IN THE COUNTY OF ORANGE
Mike Meisenbach, Chuck Noble, Edward Hanley and Shane Shafer

Investment transaction volumes may have slowed in some sectors of Orange County, but the market still boasts top-notch commercial real estate fundamentals.

Office

Demand for office space in Orange County is steady with a vacancy rate of 6 percent. Average lease rates have gone up since the end of the second quarter from $2.43 to $2.49 per square foot, with the highest gains in the John Wayne Airport submarket, which increased from $2.55 to $2.76 per square foot. The area’s waning residential market has enabled office developers to secure prime land parcels that would have been used for condo or apartment projects 6 months ago.

Investors are becoming discouraged with the market as prime investment opportunities — generally $30 million or more — have quickly disappeared. Most investors looking at Orange County already own real estate in the market, which is considered the third best investment market in the country. Many are also looking for additional opportunities in Phoenix, Las Vegas and secondary markets such as the Inland Empire, which now has significantly more institutional investors than it did just 3 years ago. The most active investors at the beginning of this year, pension fund advisors are not as visible today because they typically purchase quality Class A properties in excess of $30 million.

At the beginning of 2006, Orange County saw several Class A trophy office transactions, including the Irvine Company’s purchases of Irvine Center Towers for $400 million and Newport Gateway for $215 million. Now, investors with properties of this caliber are holding on to their assets. Although they would be able to make a large profit due to the demand, they would be incapable of making an exchange. The largest recent transaction was the $58 million sale of Cypress Corporate Center, a Class B property comprising approximately 550,000 square feet of office and industrial space. The demand for medical office buildings is high also because of the projected need for healthcare as a result of the county’s aging population. 

Office development is heating up in the airport and south county submarkets. In fact, they are the only two markets in Orange County currently pegged for development. In the last 6 months, more than 1.7 million square feet of space broke ground in those areas, including Maguire Properties’ 20-story, 530,000-square-foot office tower on Michelson Drive and Irvine Company’s two buildings totaling 624,000 square feet at the Irvine Spectrum. Northern markets like Anaheim do not support increased construction costs, and building in Newport Beach is difficult because of the recent slow-growth initiative, which caps projects at 40,000 square feet.

There is some uncertainty in Orange County, but the market and interest rates should stay steady during the next couple years. Therefore, the success of Orange County’s office market in 2007 will rely heavily on consumer confidence, home prices, the pace at which interest rates may increase and the possible rise in cap rates. The Inland Empire, with its new office product and affordable housing, will continue to draw traditional Orange County investors, though these investors will be adding to their portfolios, not replacing their Orange County properties.

— Mike Meisenbach is senior vice president of Lee & Associates’ Newport Beach, California, office specializing in the sale of office investment properties and business parks.

Industrial

The ever-tightening industrial and R&D market in Orange County shows no sign of easing. Virtually all construction is for smaller buildings, which limits options for mid- and large-size users. In view of the nation’s economic jitters, prices are holding and lease rates are continuing to rise as vacancies drop.

Although lease rates have increased 5 to 10 percent in the last two quarters, it still makes sense for most companies to lease rather than buy. Some business users are inclined to buy their buildings, even at record prices, in an attempt to take advantage of low interest rates while they last. The situation causes a dilemma for potential buyers: to buy or not to buy? A market shift from owning to renting has begun. Industrial buildings can be rented for about 50 to 60 cents less per square foot per month than payments on a purchased property. This may not seem like much, but when an owner is paying an additional $60,000 per year for a 10,000-square-foot building, that owner will begin to consider leasing.

Absorption continues to slip because there’s little space available. In addition, much of the 14 million square feet of available space is obsolete. In the third quarter, gross absorption was approximately 4.64 million square feet, up from the 3.2 million identified during the second quarter. However, it’s still down from an average of 5.85 million square feet for the previous 12 quarters, including the 8.55 million square feet absorbed in second quarter 2004.

Even though there are reports showing more than 4.1 million square feet of new construction, it hardly makes a dent in a total county inventory of 309 million square feet. Developers have few places to go in this mature market. Much of the current construction involves redeveloping older North Orange County properties, which are being converted to smaller buildings or residential housing.

Some industrial projects, particularly in Irvine and Anaheim, have been rezoned to allow development of apartments and condominiums. Earlier in the year, this had been reducing industrial development opportunities; however, with the residential construction boom coming to an end, the space may revert back to industrial.            

Major local developers are moving away from industrial and R&D projects. The Irvine Company, which had been developing R&D buildings with larger floor plates, has abandoned those projects due to the high number of R&D subleases. Two predominantly residential redevelopment projects — Lennar’s 3,700-acre El Toro Marine Corps base and Tustin Legacy’s 1,000-acre Tustin Marine base — have the capacity for industrial use. The focus, however, is on office, retail and build-to-suit opportunities for corporate headquarters.

As these developers suspend industrial construction and older properties shrink through redevelopment, large industrial users will be unable to find properties to fit their needs. This unavailability, combined with high purchase prices and lease rates, may cause companies to relocate to the Inland Empire. Potential buyers and owners continue to watch the market to gauge whether leasing, buying, expanding or contracting is the right move.

— Chuck Noble, president of Lee & Associates’ Anaheim office, specializes in the sale and leasing of industrial, R&D and office properties.

Retail

Orange County remains one of the most desirable markets in which to own retail property and continues to boast a high demand from investors, although there is a scarce selection of available properties. Shopping centers, especially those anchored by quality grocery stores, are still at the top of most investors’ lists and are the preferred asset of choice for many lenders. Watch for cap rates on most retail product types in Orange County to remain unchanged for the next 6 to 9 months. However, there is a growing separation between buyers and sellers. Sellers still want last year’s prices while buyers are more cautious and slower to act than a year ago. Buyers are now taking a wait-and-see attitude with a belief that prices will be coming down in the near future.

There have been record sales in Orange County to date in 2006, but velocity has certainly decelerated. According to Co-Star Comps, 45 transactions had closed for approximately $534 million at the end of third quarter 2005. In third quarter 2006, only 28 transactions have closed for approximately $228 million. Significant transactions this year have been the sale of the 63,000-square-foot Bristol Place in Santa Ana for $25.1 million or $400 per square foot at a 6 percent cap rate; the 70,000-square-foot Marbella Plaza in San Juan Capistrano for $29 million or  $415 per square foot at a 5.75 percent cap rate; and the 47,000-square-foot Shops at Aliso Viejo Town Center in Aliso Viejo for $39 million or $830 per square foot at a 5 percent cap rate.

Significant new projects to watch in Orange County include the District at Tustin Legacy, Vestar/Kimco Tustin LP’s 1 million-square-foot lifestyle center in Tustin featuring Whole Foods Market, AMC Theatres, Target, Costco and Lowe’s Home Improvement Warehouse; the 56,000-square-foot, two-story boutique lifestyle center Bel Mare in Newport Beach, being developed by Allied Retail Partners and Red Mountain Retail Group; the 450,000-square-foot neighborhood center Woodbury Town Center in Irvine, featuring The Home Depot, Staples, Trader Joe’s, Ralphs Fresh Fare, Walgreens and LA Fitness; the Irvine Company’s 125,000-square-foot upscale neighborhood center Orchard Hills Village in Irvine; and the 103,000-square-foot neighborhood center Talega Village Center in San Clemente, featuring a Ralphs and being developed by Hopkins Real Estate Group and Rockwood Capital.

Overall, 2006 has been another record-breaking retail year for Orange County in rent growth and occupancy. Tenants continue to pay premium rental rates between $3.50 and $4.50 per square foot and, in some cases, in excess of $5 per square foot at high-end projects. Developers are keeping a very watchful eye on profit margins as construction costs continue to rise. If there is any downturn in the market and sales for retailers diminish, developers must be prepared to withstand potential vacancies left by tenants unable to pay record-high rental rates in new developments.

Over the long term, the barriers to entry are so strong in Orange County that the retail market is well positioned for future success. Gasoline and housing prices will continue to be factors that impact consumer spending, but the demand to live in Orange County combined with future residential development will drive retail growth and fuel the Orange County economy.

— Edward Hanley is president of Hanley Brown Group Real Estate Advisors in Irvine, California.

Multifamily

Orange County apartment sales velocity, considered by many to be the leading economic indicator for the local commercial real estate market, has experienced a 47 percent reduction in transaction volume so far this year and a 30 percent reduction in dollar volume compared to the same period in 2005. While apartment sales velocity may be returning to normalcy in terms of volume (versus its peak in 2005), apartment investments are still trading at even lower cap rates and higher gross rent multipliers than just 1 year ago.

Living proof that the “market is in the eye of the beholder,” last year’s biggest deal, the $106 million Coronado at Newport sale from REIT giant Essex to United Dominion, consisted of 715 units and traded at $148,251 per unit or $212 per foot. Based on its location and the huge barriers to entry into Newport Beach, particularly if Measure X passes this November, these figures today look like a bargain.

For an example of this, just contrast the Coronado sale with the largest deal so far in 2006, The Bascom Group’s $123 million sale of Creekside Meadows to Security Properties Inc. The 628-unit property sold at $195,859 per unit or $293.39 per square foot and 11.23 times gross. One conclusion might be that the professional buyers and sellers in this market just need to buy and sell, and that they do not necessarily time their transactions to the market as much as their own internal strategies, opinions, desires, needs or investor/stockholder demands.

They also are operating in an intrinsically valuable marketplace, where at present county apartment vacancy rates are just 3 to 5 percent on average, with very few signs of getting higher as first-time buyers of homes, condos and condo conversions are relegated to renting. This is in large part due to the rise in interest rates on home loans and down payment requirements having jumped up to the more traditional levels of 10 to 20 percent, versus the 100 percent financing at artificially low start rates (1 percent typically) with negative amortization that was so very popular just a year ago.

Presently, the top buyers in Orange County’s apartment market are the typical bigger players with an over abundance of already raised capital and the need to buy. They include such notables as United Dominion Realty Trust, Montecito Investments, Merrill Lynch, Blackrock Realty, Pacific Property Company, Essex Property Trust, Sares Regis, Archstone and Equity Residential.

In the near future, Class A product will continue to be in high demand, and Class B and C owners will want to sell to move up to newer and nicer properties (or move out of state for higher yields). Private investors will remain on the sideline and public/institutional investors will continue to invest as capital is plentiful and must be spent.

— Shane Shafer is vice president for Sperry Van Ness in Irvine, California.

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