COVER STORY, SEPTEMBER 2004

L.A. COMPREHENSIVE
Demand for all types of Los Angeles real estate remains high despite
the increasing cost of debt.
Bob Safai and Chris Houge

Real estate professionals were a little nervous last month when the Federal Reserve took the long-anticipated step of increasing the Federal Fund Rate by 25 percent, after having maintained the cost of funds to lenders at just 1 percent for the preceding year. Some people feared that rising rates would pour cold water on a real estate market that had just heated up after nearly 3 years of recession or slow recovery. In retrospect, it turns out there was little cause for hand wringing, at least as far as the Los Angeles area market is concerned. Every type of commercial real estate is in high demand as the insatiable appetite of capital for real estate vehicles has outstripped the modest increase in the cost of debt.

Despite rising interest rates, commercial real estate in the greater L.A. market remains at top levels in terms of sales activity, price per square foot and overall values.

Commercial values in the greater L.A. market may be at top-of-the-market levels in terms of sales activity, price per square foot and overall values. For sellers, in particular, there has not been a better time in recent memory. Tishman Speyer’s sale of Colorado Center — formerly MGM Plaza — in Santa Monica is a fine example. After owning the property for little more than a year, the real estate firm sold the complex to Equity Office Properties for $75 million more than what it had paid in 2000. In the competition for the coveted asset were former owner Maguire Properties, Douglas Emmett & Co. of Los Angeles and Shorenstein Company LLC of San Francisco. (It has been a busy past month for Maguire, which just spent $314 million to acquire the Park Place mixed-use project in Irvine, California.)

Another example of spiraling values in Los Angeles: an area landowner spent $30 million in August 2003 to buy a 12-acre site in West Los Angeles. Scrapping the original plan to develop the entire site, the owner is in the process of selling half of it for a price per square foot nearly double what it paid a year ago. The buyers are likely to be multifamily developers, which are able to make sense of the more than $200-per-square-foot land pricing.

Safai

The perception that the top of the market has been reached will prompt certain institutions to be net sellers for the remainder of the year. With pension funds, real estate investment trusts and quiet entities or high net-worth individuals continuing their quest for stabilized real estate assets in all categories, including industrial, there may ultimately be no shortage of buyers looking to acquire stabilized core assets.

After the wild ride in the next 6 to 12 months, investment activity is likely to simmer down, a development not new to the Los Angeles market. It is worth observing, however, that the high level of investment activity is a sign that Los Angeles is a maturing market where investors have a sense of scarcity and growing value, even when the underlying economic performance of the assets themselves continues to be flat. In terms of actual leasing activity, the Los Angeles office market posted a moderate but healthy 12 percent vacancy rate, with Class A buildings about 16.6 percent vacant, Class B at 10 percent and Class C at 5 percent. The average rental rate for Class A space was slightly less than $30 per square foot annually. Combine the speculative fever with moderately performing assets and the result is rising prices and compressed cap rates.

Houge

Beyond that timeframe, it is difficult for anyone to predict the behavior of the market. The first up tick in interest rates barely registered a hiccup in commercial real estate, but a similar increase may have more of an impact. The anticipated increase in domestic interest rates could serve to level the field of buyers between private and institutional capital, eventually giving the advantage to private, low-leverage purchasers. However, it could have the reverse effect, causing buyers to avoid leverage altogether in favor of all-cash deals. Interesting possibilities abound, but real estate players are not spending much time thinking about them as transactional activity is at an all-time high and liquidity has never been so great.

Bob Safai and Chris Houge are principals at Los Angeles-based Madison Partners.

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