MARKET HIGHLIGHT, SEPTEMBER 2004

ORANGE COUNTY'S REAL ESTATE BOUNTY
John McDermott

Orange County continues to attract residents and investors despite high prices, low cap rates and low cash-on-cash returns on investments. Added to this momentum are the market’s favorable demographics and strong economy, all bolstered by great weather and a high-quality lifestyle.

Single-family home prices are still off the charts in both price and affordability (as a percentage of available income for housing expense). A danger looms ahead: nearly 70 percent of all residential financing has been adjustable, versus 30 percent in more typical markets. The only way a working couple can get into a $600,000 starter home is to pay interest only with zero down and utilize an artificially low start rate to make the monthly payments. Orange County’s single biggest risk in its real estate economy is increasing interest rates, which could lead to both defaults and foreclosures. These would come first in residential and then in commercial investments as loans adjust and rates and payments increase.

The residential MLS can be viewed as a leading economic indicator that Orange County has reached the peak of value. Acknowledging this, many owners are now seeking to take still-record profits from their properties. “On-market” residential inventory is up 84 percent and “time-on-market” figures are expanding. For-sale commercial product is seeing a significant, though less dramatic, rise in inventory as well. As a result, buyers are finally beginning to feel some power in the process.

Multifamily

Orange County apartment vacancy is at 4 percent overall and may improve slightly by year’s end. Some availability, especially in Class A product, is evident, primarily due to the high rents for units in the new and fully loaded properties. Occupancy is being bolstered by the fact that affordable housing is non-existent and interest rates have kept many would-be buyers in the rental game.

Multifamily developers have been focusing predominantly on condominiums and condo conversions — the rave in San Diego County the past 2 years — versus apartments. The 535-unit Watermarke project in Irvine, California, is the most significant new addition.

Apartments have long been a leading economic indicator in commercial real estate investment. The multifamily buyer pool is the largest of all of the core product types, and demand has been artificially supported by the fact that most renters in Orange County cannot go out and buy a home, condo or townhouse due to high prices and the potential for rising interest rates.

Class A apartments should benefit accordingly as even fewer residents consider ownership. Class A apartment communities attract more amenity-focused residents with the financial capacity to pay significant rent while B and C properties will continue to do well capturing tenants more concerned with price than amenities.

The 12-month numbers through first quarter 2004 rank Orange County behind only Los Angeles and San Diego counties in multifamily sales volume. In the same timeframe, 51 percent of apartment buyers of properties worth $5 million or greater were private investors, a trend that should slow for the rest of 2004 as rates for private investors climb faster than they will for the public sector and institutions. Larger properties have been trading at 6.4 percent cap rates this year with smaller properties closing at rates 100 basis points lower on average.

Comparing $10 million-plus multifamily sales from the first half of 2003 versus the same period this year, the number of closings (nine) is the same but the average price per sale dropped nearly 54 percent, to $16.53 million. The average price per unit in that same period increased to $130,466, versus $122,101 last year. This indicates that many multifamily owners took advantage of the market in 2003 to sell their large properties.

Profit taking is on the increase in the Orange County multifamily marketplace because of the belief that apartment values have peaked, the looming capital gains tax issue leading up to the November elections and the continued attractiveness of 1031 exchanges. Apartment properties should continue to be solid investments for their owners. For owners wishing to sell, it’s wise to explore crossover product types — office, retail or industrial — within the market or seriously consider looking outside California should they desire to buy apartments.

Industrial

Orange County’s mid-year industrial vacancy rate was 7 percent, and absorption continues to be impressive following the 233,475-square-foot performance in the first quarter. Industrial zoning and land availability in the county remains tight with no change in sight. The average industrial lease rate remained unchanged at $8.39 per square foot per year, with flex and warehouse space being quoted at $11.67 and $6.86 per square foot, respectively. American Sports Centers signed the largest lease at 242,290 square feet, followed by Cardinal Logistics for 184,413 square feet at Fullerton Crossroads and CPU Protocol for 160,491 square feet at Foothill Ranch Distribution Center.

Orange County’s total industrial inventory exceeds 291 million square feet in 10,468 buildings.

Investors continue to seek out industrial real estate in Orange County. Owners are reluctant to sell or exchange these properties, which explains its scarcity in the market. Industrial product has always enjoyed a reputation of stability, lower rents than most other investment options, more tolerant tenants than most leased investments and lower prices per square foot than other core real estate types in the market. The scant increase in sales price — from $91.37 to $91.76 in the past year — indicates that stability. Many industrial sellers are selling high in Orange County and purchasing in markets with very low costs per square foot such as Salt Lake City; Sacramento, California; Portland, Oregon; Seattle; Dallas; and Phoenix.

Private investors continue to represent nearly 60 percent of the industrial buyers in Orange County, with users representing a very significant 33 percent of that buyer pool. Southern California, as a whole, accounts for 20 percent of all industrial sales transactions in the United States. With conditions as they are in Orange County, the balance of 2004 should present prime opportunities for those reluctant sellers of industrial product, delivering them cap rates 50 to 75 basis points lower for their properties.

Office

The office leasing market continues to rebound. Demand for space is exceeding new product delivery with first quarter 2004 absorption the best in the country at 448,937 square feet. Market-wide vacancy is down to 12 percent, nearly 50 percent below what it was a year ago. Sublease space is still a factor with almost 1.5 million square feet available.

The three largest leases this year occurred in what could be the most challenged industries as interest rates increase and refinance business comes to a near halt. They were the IndyMac Mortgage Holdings Inc. (70,000 square feet), Ameriquest Mortgage Company (36,220 square feet) and Commercial Capital Bank (32,066 square feet). The average rental rate for office space is $23.25 per foot per year, with the gap between Class A and C space narrowing — $24.75 to $20.15 per square foot.

The largest recent office completion was the 107,000-square-foot Kaiser MOB building, which was 100 percent pre-leased before its June 2004 opening. Little or no speculative office building is taking place in Orange County currently.

The true value-added buyer and the long-term investor both see office as a very significant arena for real estate profitability and stability in Orange County. Several factors are contributing to the office product’s positioning. They include the lack of any major speculative building in the market, the continued absorption of a glut of sublease space during the past 12 to 24 months, the significant time line and expense of bringing new product through the approval and entitlement process, the ever-increasing construction and materials costs — steel is up 60 percent in the last year while concrete has doubled — and slowly improving job growth.

As China continues to emerge as a global manufacturing marketplace, it will demand more and more of the world’s supply of steel, oil and concrete. The effects of this will be felt in all commercial real estate circles, but especially in the office and industrial sectors. The positive effect of this development on Orange County is that demand for office space is greater than that for new product, which has reduced vacancy figures.

One potential bump in the office road may be the impact that rising interest rates have on the residential loan production business, a very significant component of office tenancy in Orange County. As rates rose for residential home loans, refinance requests were reduced to nearly a trickle, and as rates rise, new loan activity will surely drop. Consolidations, layoffs and downsizing can be expected in the mortgage and banking industry, resulting in sublease space or dark space in Orange County office buildings.

Because of both demand and interest rates, office product offered at less than $10 million and that which is more than $30 million have enjoyed similar drops in cap rates in early 2004, achieving approximately a 15- to 75-basis-point reduction. However, the products priced in between are too big for local or smaller investors and too small for institutions, foreign buyers or REITs. This seems to impact the suburban office market more than other areas as pricing typically falls into that middle range. Office is one of the few core products where cap rates continue to fall mid-year 2004.

Orange County office investment sales ($1 million plus) nearly tripled from the first half of 2003 to the first half of this year. The resulting rise in average office values from $146.98 to $156.69 per square foot indicates bigger deals at good prices. In 2003, only seven properties closed at more than $10 million versus 20 such closings in the same time period this year. The largest office transaction in Orange County occurred in February when Maguire Properties bought a portion of the Park Place Office Campus at $148.69 per square foot, a bargain by today’s standard for Class A space. Look for the real players to continue their accumulation of office product throughout 2004 and beyond.

Retail

Retail occupancy continues to keep strong pace with apartments. Retail vacancy, which should improve slightly before the close of the year, is less than 4 percent countywide. A healthy slowing of retail construction will keep occupancy levels high. A little more than 1 million square feet will be added to the entire Orange County marketplace. Emerging trends in the Orange County retail market include the addition of mixed-use properties and the repositioning of infill locations. Examples of this are The Ezralow Companies’ $170 million redevelopment of Huntington Beach Mall into Bella Terra, an open-air lifestyle center, and the $90 million makeover of Buena Park Mall into Buena Park Downtown by The Festival Companies.

Trying to catch up to industrial activity, retail is still a favored asset class for investors in Orange County. Retail assets are priced 50 basis points higher on average in Southern California and Southern Florida than the rest of the nation and 2004 should finish strong in the Southern California marketplace.

Private investors, as well as some REITs and institutions, are beginning to shed many of their retail assets because profits are just too significant to hold them any further.

There was a 40 percent increase in retail sales volume from the first half of 2003 to the first half of this year. In the same period, 2003 had only six properties close over $10 million, totaling $129,110,000 (37 percent of the dollar volume closed) versus 11 first half closings of more than $10 million in 2004, totaling $296,210,000 (61 percent of the dollar volume closed) for an average of nearly $27 million per deal.

Orange County is still where retail investors want to buy and apartment sellers in the market have often elected to remain, increasing their returns by crossing over to retail, office and even industrial when they can find it. With regard to average price per square foot of retail space — the most important measure for retail sellers in Orange County — only Las Vegas; San Jose, California; San Francisco and San Diego have posted higher values. Orange County retail space is more expensive per square foot than Los Angeles, Sacramento, Seattle, Portland, Salt Lake City and the Inland Empire.

John McDermott is national director of office and industrial properties in Sperry Van Ness’ Irvine, California, office.

ORANGE COUNTY INDUSTRIAL: GOOD IF YOU CAN GET IT Industrial product continues to be hot in Orange County, California. While retail and multifamily product types are strong across the country, industrial is only solid in certain markets. Orange County’s industrial sector is at least 5 years into a cycle featuring an all-time high level of competition for both development and acquisition of buildings and business parks. Demand for industrial space is strong due to the market’s diverse base of small and large corporations in the services, technology and biomedical industries. The demand is driven upward even more by the large and growing population and Orange County’s position as part of the Southern California distribution chain. Tustin Gateway Business Park in Tustin, California, will appeal to all sizes of industrial users. The result is that companies are buying and using industrial buildings for more than just industrial purposes. Industrial space in the market is being used for distribution, warehousing, research and development, and back-office operations as well as for firms desiring a more casual or cost-effective location for their company headquarters. With the supply of raw land so low in the Orange County market, every developer, owner and broker is trying to identify properties they can acquire and renovate/redevelop or vacant land on which they can build new industrial product. When a site or property does become available, there are often literally dozens of parties bidding on the opportunity. To be successful in this cut-throat market, one needs the vision to see if the deal is viable, a strong track record of quickly closing on properties and a history of developing those properties into product that meets public approval. The acquisition and redevelopment of the 1 million-square-foot former Steelcase manufacturing and distribution facility in Tustin, California, gives insight into the industrial market forces at work in Orange County. Finding a single buyer or tenant for that size and kind of space would have proven very difficult. Instead, the first half was sold to Bedrosians Tile and Marble while the remaining 500,000 square feet was demolished and is being redeveloped into Tustin Gateway Business Park, a new state-of-the-art facility. The redevelopment and downsizing of this large building will allow the developer to not only capitalize on the current market demand but also appeal to the range of industrial users and their different sizes and needs. An industrial market will always exist in Orange County. Whether the market is stronger in sales or leasing, prime opportunities will continue to arise. James Camp is a senior vice president for Voit Development Company in Newport Beach, California.

INVESTORS GO FOR THE GREEN IN ORANGE COUNTY Marked by an abundance of capital and a lack of available quality product, the Orange County investment market has remained strong through the first half of 2004. Among all categories of buyers, demand is greatest for industrial properties, followed by retail and office. Private capital investors — mostly 1031 exchange buyers — are the most aggressive, paying prices that are prohibitive to institutions and real estate investment trusts. Almost all players are utilizing financing in an effort to lock in low interest rates for as long as 10 years. The boost in interest rates has had little or no effect on the pricing of assets. Many sellers believe that cap rates have peaked while a good portion of buyers think rental rates will increase, enabling them to acquire properties at high values. Vacancy rates are declining across all sectors, fueling investor optimism in the Orange County market. In addition, many assets are being sold well below replacement cost as land values rise and construction prices escalate. In the industrial sector, there were approximately $209 million of transactions through the end of May. On average, price per square foot was $78, with a cap rate of 8 percent. However, assets located in south Orange County or having long-term, high-credit tenants commanded cap rates in the 7 percent range. Industrial properties, if they can be found, are the most sought after assets in Orange County. The retail sector can be summed up in one word: hot. The economy has picked up, fueling retail sales, while the much anticipated housing market slowdown hasn’t yet arrived. In the first 5 months of the year, eager investors have poured approximately $125 million into this sector, with an average price per square foot of $141. The average cap rate was 7.5 percent. However, there are currently 19 retail properties for sale at an average price per square foot of $274, with cap rates hovering around 6.7 percent. Sales volume in the Orange County office sector has been excellent this year. Approximately 27 assets were sold totaling $871 million. The average price per square foot was $172 and cap rates averaged 7.9 percent. Investors are bullish as vacancy rates dropped by a full percentage point from the previous quarter and rental rates are beginning to rise. Some investors are wondering if the bubble will burst. A number of investors believe prices will drop significantly in this cycle as many buyers have taken on variable debt. With rising interest rates, there is a feeling that the income from properties will not service the debt. If that is the case, those assets will be taken back by the lending institutions and sold again at much lower prices. This was the scenario during the last down cycle, and many investors are waiting on the sidelines for these potential value-added properties. That should not be the case this time. On a broad basis, investors over the past 5 years have exercised caution, even while paying all-time high prices. Instead of borrowing as much as 75 to 80 percent of the purchase price, today’s investors are putting more capital into the acquisition, reducing the loan-to-value ratio to a level of approximately 60 to 65 percent of the purchase price. Even with floating debt rising, owners will be able to service the debt and wait for increasing rents to attain the cash-on-cash returns they previously enjoyed. Mark Larson is a senior vice president at Grubb & Ellis’ Newport Beach office.

©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.