MARKET HIGHLIGHT, OCTOBER 2008

ORANGE COUNTY
David Pinsel, Jereme Snyder, Chris Houge, Hunt Barnett and Louis Tomaselli

Vacancies are tight in most commercial sectors in Orange County, but so is available financing. The prime Southern California market certainly has the fundamentals to prosper when the economic fog lifts.

Multifamily

Orange County is home to one of the most prominent multifamily markets within Southern California. Its constant blue skies, desirable coastal location and strong demographics earn it a well-deserved reputation as a wonderful place to live, do business and invest in sound real estate.

Despite slowing in every sector of the commercial markets, multifamily fundamentals in Orange County remain strong with a healthy overall vacancy of approximately 4 percent and cap rates remaining relatively low at 4.9 percent, according to Real Capital Analytics, Inc.

“Although transaction volume has decreased in the region, for now, multifamily properties in Orange County continue to fare better than surrounding areas in the Inland Empire and North Los Angeles,” says Michael Soto, regional analyst with Colliers International.

Multifamily investors actively seeking to place capital are focusing on Class A properties, that are often upgrades from Class B property holdings, or Class C properties that hold value-add potential, which is an old trend that is slowly coming back. This flight to quality tends to happen when a market slows. Quality properties in strong submarkets are likely to sustain occupancy rates and experience rental growth, which provides the groundwork for solid investment for both private and institutional investors.

In regards to the development climate, there are a few high profile projects like Anaheim’s Platinum Triangle, but overall, little development is taking place in Orange County’s multifamily market. This is due in large part to high construction costs and the lack of affordable land in the area. Several projects were completed during the second half of 2007 and many of those, once for-sale condos, are being converted to multifamily properties due to the dismal housing market. This is a trend the market may see more of in the coming year.

The final trend is investment in multifamily properties in close proximity to public transportation systems. High gas costs will significantly impact low- to middle-wage earners and will cause a greater need to be near public transportation for daily commutes.

Though not immune to the macroeconomic difficulties plaguing a majority of the country, the Orange County multifamily sector is holding up well in most key metrics. Once this down cycle plays itself out, look for the multifamily market in Orange County to once again be highly sought after and, most importantly, profitable for investors.

— David Pinsel is director at Colliers International in Irvine, California.

Retail

Several factors leave the near-future fate of the Orange County retail market largely unknown. With the current environment of little to no access to commercial financing, pullback from national and regional tenants, and one of the most monumental presidential elections in our history taking place in November, consumers, tenants, landlords and investors are uncertain about the economy and its direction.

Retailers are closing stores and rethinking expansion efforts, investment sales have stagnated, and maintaining tenant occupancy has become quite the challenge for many landlords.

Fast-food tenants and drug stores are still fairly aggressive in expanding into new locations, mostly for strong, high-traffic, corner real estate. However, even for the best of locations, it has become a struggle for many owners to lease inline shop space to quality tenants and also achieve the healthy rental rates the co-tenants already pay. Mid-size box space for tenants in the 15,000- to 30,000-square-foot range has also been a challenge to lease.

Both national and regional retailers that were rapidly expanding this time last year have halted plans to open new stores, and a number of them have claimed bankruptcy or are closing store locations. Tenants such as Linens ‘n Things, CompUSA and Levitz Furniture have filed for bankruptcy, while tenants such as Starbucks Coffee, which is closing more than 600 locations, and Mervyns, which is closing 26 stores, are reacting to consumers tightening their wallets.

Investment sales transactions will continue to be stagnant, mainly due to the large delta between seller and buyer expectations, and the lack of available financing. Commercial transactions are down more than 75 percent this year compared to the transactions closed in 2007. The majority of transactions being closed are with all-cash buyers, buyers with in-place financing or with seller financing, which is becoming a welcomed alternative by many sellers. A substantial amount of money waits in the wings from overseas funds to private investors. Active buyers are all scouring for distressed opportunities and looking to rescue developers, lenders and over-leveraged investors. 

Retail vacancy is currently at approximately 4.2 percent, which is one of the lowest in the country. This rate is expected to increase to 5 to 6 percent by year’s end. However, compared to neighboring areas of Los Angeles and the Inland Empire, Orange County has remained relatively healthy. As the 2008 holiday season approaches, it will become clearer as to where the retail market stands in Orange County.

On the bright side, the market remains fundamentally solid. With its strong demographic profile and its dense coastal location, Orange County is among the most desirable retail markets in the country for investors and retailers alike.

— Jereme Snyder is vice president of Private Capital Advisors for Colliers International in Irvine.

Office

The Orange County market is passing through a period of temporary difficulty, due to the sudden shrinkage of the residential mortgage industry, as well as the corresponding growth in sublease space. Don’t be fooled, however, major tenants are still looking for space in the O.C.

Major leases include Raytheon’s 78,000-square-foot deal at the Brea Financial Commons in Brea. In the airport area, notable leases included Memorial Care’s 98,000-square-foot deal at Fountain Valley Centre 1, Bryan Lang LLP’s 48,000-square-foot lease at 3161 Michelson and Medical Capital Corporations’ 48,000-square-foot deal at Pointe Red Hill.

The vacancy rate was 13.1 percent in the second quarter, 2 points higher than the level at the end of 2007 and nearly the same as the national average, according to CoStar. When 1.7 million square feet of sublease enters the picture, the combined vacancy rate may approach 20 percent.

Construction slowed down to 490,000 square feet of new space in the second quarter, while another 328,000 square feet remained under construction, according to CoStar. That level of construction is 90 percent lower than it was a year ago and speaks well to the discipline of Orange County investors who have been careful to avoid overbuilding. Even so, it may be several years before some of that space finds tenants.

For investors, the good news is that some institutional grade properties are trading at discounts. In May, Maguire Partners sold Main Plaza to Shorenstein Properties for $211 million, subject to the buyer’s agreement to assume a $161 million in project-level financing.

Orange County can also expect a surge in the number of new jobs in 2009, according to the Chapman University economic forecast. Those new hires make up for the job losses incurred this year, while adding another 4,000 new salaried positions. The O.C. will come back, and the demand for new office space will eventually match, and possibly exceed, the level of supply of new office space.

— Chris Houge and Hunt Barnett are principals at Madison Partners.

Industrial

The commercial real estate market has been slowing due to the substantial amount of uncertainty regarding the future direction of the economy. This uncertainty has created a growing hesitancy in the marketplace, prompting a reduction in development, a slowing of investment and industrial space sales, and a relative increase in short-term leases in Orange County.

Market reports indicate the total space under construction during third quarter 2008 was 310,536 square feet, a third of the amount that was under construction the same time last year.

Through August 2008, only three significant industrial developments in Orange County have been completed or are nearing completion. Already close to 50 percent pre-sold, the largest building expected to be completed in fourth quarter 2008 is Lowe Enterprises’ Kimberly Business Center, a 285,401-square-foot industrial park in Fullerton. The second property, completed in February 2008, is Magellan Groups’ Valencia Business Center, a 221,253-square-foot industrial park in Fullerton, which is approximately 60 percent sold. Completed in March 2008, the third project is Koll Center 3, a 188,374-square-foot industrial park in Irvine, which is 40 percent sold.

The lack of industrial development can be attributed to three major factors. There is currently a disconnect between buyers and sellers regarding the price of land. The lack of available land in Orange County has pushed prices beyond what developers are able to pay to make a new development profitable. Secondly, developers are waiting to see how quickly the available product coming on the market is purchased before committing resources to developments that may not be purchased or leased in a reasonable amount of time. Thirdly, the limited availability of financing and greater equity requirements have limited the viability of new industrial development.

Due to the credit crunch, loans are subject to much more scrutiny than they were only a few years ago, making them nearly impossible to obtain. Lenders want to underwrite loans based on the expected income a property could yield at stabilization rather than the expected gross sales income a property will yield, which has been the norm in the past. This requirement greatly increases the equity requirement and reduces the developer’s ability to generate the returns necessary to risk new development. For these reasons, in the short term, larger REIT or institutional companies less dependent on financing are more likely to remain active in Orange County industrial development. These companies include ProLogis Corp., AMB Property Corp., TA Associates Realty, First Industrial Realty Trust, RREEF and Opus West.

Despite this decrease in industrial development, buyers are still active in the market, but tend to be small industrial entrepreneurs rather than large investors. Sales are still closing at market price, although they are closing at a slower pace than the market has seen during the boom of the last few years. Most buyers in the current market are expanding into large spaces or moving to newer properties.

A large number of potential buyers are signing short-term leases and watching the market to see what happens in the next year. Despite lease rates remaining flat and vacancy rates remaining in the low 4 to 5 percent range, the county is still witnessing an increase in short-term leases with tenants reluctant to make long-term commitments. Landlords are subsequently forced to either accept short-term lease renewals at market rates or to provide concessions in order to encourage longer-term lease commitments.

The industrial market will exhibit similar characteristics for the next 12 months. With the high price of land in Orange County, there is limited opportunity for new development, especially for large, Class-A distribution buildings for which there is still a growing need. The “sit back and wait” mentality will continue into 2009, even though the market remains stable and still has the strong fundamentals throughout all four submarkets to rebound.

— Louis Tomaselli is a senior vice president in Voit Commercial Brokerage’s Anaheim Metro office.

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