In the year since we last visited with some of Southern California's top real estate executives in a formal meeting, the property markets, particularly the office sector, have continued to perform well. Recently we convened a group of top dealmakers from the area at the Park Hyatt in Los Angeles' Century City to gauge their latest opinions on the present state and future of this now-booming region.
NREI: The Southern California employment drives the area's commercial real estate markets. In the early-90s there was an exodus of people from Southern California, but in the last two to three years, there has been tremendous job growth here, particularly in the Los Angeles area. Why is that happening?
Phil Nichols: Los Angeles is still really appealing to the people who will be attractive to the high-tech companies. Employers traditionally go to where good employees are. One of those areas right now is Southern California. There will be pockets of this around the country.
Richard Allen: Certainly it's job creation and the Internet and Pacific Rim growth, but a lot of the reason business was leaving the state is the economy was terrible. But jobs go where it's competitive, and where business is, and business goes where it is competitive to do business. Jobs were leaving this state in droves in the early-'90s, going to Arizona, Washington, Idaho, everywhere. But that flight was, to a large degree, because California became non-competitive.
One of the greatest things about the United States is the states have a lot of sovereignty and because of that there is a lot of competition and as we know competition makes the world go 'round. Unless we put up barbed-wire fence and guard dogs around the state of California, it has got to be a good place to do business. I believe governor Wilson had done a good job of making California competitive in the early-'90s in order to attract the jobs back to the state. And in all fairness, Grey Davis (California's present governor) has not destroyed that, thank goodness. I think he understands the importance of keeping California competitive.
Dana Ostenson: If you look at the overall international drivers right now - trade, high-tech, biotech, entertainment - they exist in Southern California. The fundamental point here is California's technical intellectual infrastructure. With Cal Tech, Berkeley, Stanford and the aerospace and aviation industries, California already had an intellectual and technical underpinning for the drivers of the international economy, and that's what is powering our growth. It's nice to wake up in the morning in the winter and have nice weather, but it's the fundamental skills of California's population that are creating the growth and will continue to create long and stable growth as the infant industries of high-tech and biotech continue to grow.
Eric Olofson: California has always been a boom-and-bust economy. It's always had radical upswings and radical downfalls. In the early-'90s and late-'80s the economy just started transforming, especially in Los Angeles. We had a lot of the big banks and the oil companies and other major corporations that started transforming into a different type of economy where it was entertainment, Internet, high-tech and bio-medical based. There was a period within that cycle where people didn't see the opportunities that maybe they do today because these companies are growing much more quickly than people thought they would.
Jerry Feldman: On this side of the table we'll talk about the 'touchy-feely' stuff. It's the weather, it's the sun, it's the mountains, it's the water, and I think we attract the risk-takers. The people from around the country who have that entrepreneurial spirit and travel across country. Whatever reason they come up with because they were there watching the Rose Bowland it was sunny. The entrepreneurs fuel a lot of this.
Victor Coleman: I don't think the 'touchy-feely' is all so bad. I look at it in three ways. The touchy-feely is absolutely about quality of life. California has it and you see exodus and migration, exodus and migration.
If you look at the cycles, secondarily, in this marketplace in Southern California, you have to look at a few key indicators. First of all, healthcare. It's the home of healthcare, it started up here. Why? Because of the quality of life the mass population of people who wanted to be out here started it, from San Diego all the way up to West San Fernando Valley. You saw an exodus of aerospace. What happens to a marketplace when there's an exodus? This is not like Seattle in the late-'80s when they lost those people there was no infilling. We had the exact same issues, but high-tech came in. A lot of those engineers went to work for high-tech companies, they didn't all leave to go to Arizona.
I think statically, though, you're looking at a marketplace in Southern California that has always been the largest in entrepreneurial startups of any state in the United States. You have more startup companies here, and I think it is primarily because of quality of life, access to capital, access to the environments. Until something changes, I don't think the peripheral perils of horror, which are earthquakes or anything else like that, are going to indicate to people to leave in any kind of mass exodus. If the economy slows or the quality of life changes, which is education for your kids, which is the weather, which is the environments around here, that will consistently fuel this environment.
Scott Lunine: I think there are several reasons. One is every Jan. first when people look at the TVs and see the Rose Bowl game and it's 80 degrees in Southern California, that's a huge reason why they want to get out of there minus-30 degrees and come on out here. That will be a continual factor. The earthquakes are a minor thing out here. The two biggest places where people go to live long lives are probably Florida and California, and both have their own problems, whether it's hurricanes or earthquakes.
The other causalities are big reasons. We did a remarkable job of transitioning from the aerospace and defense industries to a high-tech environment, and that's going to keep on continuing. They are talking about getting out to other areas of Southern California. The Inland Empire is tripling the amount of population out there in the next few years, all driven by job growth out in that area. With the expansion of the airports around there, Ontario turning into an international airport, talking about building new airports at El Toro if that ever Orange County, it's going to keep on growing and you're not to see a stop for quite a long time.
Ostenson: Victor's point about small businesses is well taken. One of the interesting things with the Internet, if you look at the number of businesses just the number of pure small businesses there are in L.A., it's a huge number, and as a ratio it's a huge number compared to the rest of the country. Some people look at corporate exodus and the lack of L.A. being a corporate town, but part of L.A.'s strength in the future is going to be the fact that there are a lot of small companies, which are going to create enormous value going forward.
Coleman: If you looked back at 1991 to 1994, when all those companies left, how many actual employees went with the companies? It would be a very interesting statistic to see. A lot people stayed. It was a very high unemployment rate at one point and you had the aerospace fallout and now all of those jobs have been absorbed. A tremendous number of jobs have been absorbed, plus now this is one of the hottest job markets in the country. So we've gone to an all-time low in unemployment in a matter of just six years. That's a pretty impressive statistic. So not all those people left with the companies, and a lot came back.
NREI: How is all of this job creation affecting commercial real estate, particularly the office market? I note that L.A.'s downtown, in particular, has been slower to come back.
Coleman: When the cycle hit, it hit from east to west, so we were the last to be affected to be affected by this cycle. In 1992, the country was in a major recession. We really didn't hit that point until 1994. We were definitely the last in and now we are the last out. So the upswing is still absorbing, and it's showing in the areas of development. Two to three years ago these guys (Allen) weren't developing.
Allen: We weren't existing. The good news is we weren't in the development business in the late-'80s.
Coleman: That's exactly it. Now there is such a slow growth in development, it's picked up because of the demand. You can see this cycle is picking up and I think we're now at the peak of this cycle, in my opinion, in terms of growth. I don't know about rental rates.
Olofson: You mentioned downtown. As far as downtown, you almost have to treat it like an island. The economy's changed so much that those buildings don't have as much appeal anymore.
NREI: Hasn't it all changed around downtown, where the downtown core tenant base been consolidated or left?
Olofson: That's my point. It's gone. Everybody's moving out of downtown, west, and nobody, no matter how tight it gets, has any interest.
Feldman: Why won't they go there?
Olofson: It's the wrong type of product, No. 1. It's the quality-of-life issue. They don't perceive there being a good quality of life downtown. It's not close to where the executives live. There's no reason to be down there. It used to be all the banks were down there and the major institutions and it made sense for a corporate headquarters to be down there.
NREI: But all across America, CBDs are coming back. So why not L.A.?
Allen: I think it's transportation. It's getting there and to be able to afford to live in L.A., you've got to live in the suburbs, so you're going further and further away, be that the Inland Empire or the Central Valley. What first happened is the employees moved out to the hinterlands because that's where they had to move to be able to afford to live, and now they have to commute back to where the offices are. But what's happening now, you mentioned Ontario and that market, I think that's going to be a huge office market in the future because guess what? The offices are now moving out to where the employees are, be that going from the Bay Area to Sacramento or be it going from the L.A. basin to the Inland Empire.
Coleman: Also the point that Eric's making about downtown sort of ties into the first point that everybody made around this table. If you're dealing with quality of life, the employees are going to start dictating. It's not just where the senior guy lives anymore, it's where the employee workforce is to attract and to attain qualified individuals to work for these companies. They are going to dictate where these office environments will be.
We are an anomaly in Southern California. There are 45 different submarkets that are all viable submarkets. You have them up and down the coast, and these are all great markets to be in which all have workforces, which all have executive time, great housing and all the amenities. So why go downtown? I'm not saying downtown is over, by no stretch. I believe in cycles. There will be the opportunity when rates get higher in other markets. People will look for the economies, people will have to go downtown and ship people down there.
Allen: What kind of home is the reception that you're going to hire downtown live in versus Ontario or the Central Valley or any of the suburban markets? What are you going to have to pay a receptionist and what kind of home is she going to live in? If she works in downtown L.A., she's going to be living in a slum, for what she makes.
Lunine: One of the big problems, too, is that if people own a home, they'll drive. If people rent, they'll only rent in the neighborhood that they're working. I think downtown is coming back, though. The Staples Center is a good example of it. We just opened an office in Pasadena, and it's amazing that we're paying more rent in Pasadena than we are in our West L.A. office or if you're looking at downtown. That's where a lot of people are going, the outlying areas. The thing that's probably helped the most is the highway system. In Orange County, Corona used to be miles away from everything. Now with the 241, it's not that far away anymore. They're opening up the 30 in the Inland Empire now, which is going to make a Pasadena drive from San Bernardino 30 minutes instead of an hour and a half. That's the thing that's going to start driving the markets. Now it's feasible to live 30 or 40 miles away and not be two hours away.
Coleman: The biggest mistake that was done in the City of Los Angeles was the transportation corridor that would not go all the way through West L.A. Beverly Hills would not let any type of public transportation go through and as a result you could not get to Westwood, Century City, Santa Monica, and that changed the whole dynamics of that marketplace. As a result, downtown and Mid-Wilshire were left as an island. Look at San Francisco and the mass transit system they are doing. It's 18 minutes from downtown to the airport. That's phenomenal. That city's downtown is going to thrive. You just can't compare them.
Allen: People are getting sick of the commute. It takes me five minutes to get to work. I happen to live in the Central Valley. Down here, an hour and a half both ways is the norm.
NREI: Where are the hottest office markets right now?
Coleman: There are a number of them throughout Southern California. I think North San Diego County hasn't been this hot ever with the activity that's going on down there. If you come up the coast from North San Diego County, South Orange County and the Laguna area, you can't get real estate in that marketplace today. And there's a trend here. You skip up here to the West L.A. marketplace, our project at Howard Hughes. The reason it's a successful project is because there is nothing in the west side of Los Angeles. If you're a large tenant you can't go there anymore. Eric tried to do a deal with us, he was one step away.
NREI: And you're still speaking; I like this!
Coleman: He'll bring us somebody else. But West Los Angeles is as tight as it's ever been. The Westwood marketplace has a 7% vacancy factor. In Santa Monica it's 5%. These are some pretty tight areas, but there's not a lot of development growth. I think the biggest value you have in Southern California in the next wave is the San Fernando Valley. There is land, there is availability and there is a huge desire to be out there for quality of life. And that's from Woodland Hills all the way through Ventura County, in my opinion, and that will be North San Diego County in the years to come.
The next area could very well be Ontario and those markets in the Inland Empire. They already have the industrial infrastructure which is a safe, secure marketplace to start and run businesses.
Lunine: There's a big difference between what's hot and where the biggest growth is going to be. You're going to see a lot of growth in the West San Fernando Valley and also in the Inland Empire. There are three new high-rises planned in the Ontario area right by the airport in the next year or two, so you're going to see some huge growth out there. That's fueled by the hottest sector right now, multi-tenant industrial and the single-tenant industrial is doing phenomenal out there and that's driving the growth for everything else. They're doing build-to-suit high-rises now.
I think the San Fernando Valley will be the same, which still has the prestige factor over the Inland Empire. There's still a lot of negative attitudes towards the Ontario/Riverside areas. We actually had an Orange County forum that our company does and we started talking about the Inland Empire and several people wanted to know why we were talking about it since nobody goes out there. I think it's going to be five to 10 years out before we start eliminating that negative perception. But, I remember 25 years ago they were saying the same things about the [San Fernando] Valley.
Allen: If you look at the amount of land that existed in the late-'80s and the early-'90s, entitled infrastructure just sitting there going begging for tenants. Think of the millions of square feet of land and think how much of that has been absorbed. I think the biggest problem that we're going to have in the future, let's face it, it was a lot easier to get entitlements done back in the late-'80s than it is today. Right now, not only is land unavailable, but you've got environmental issues, you've got the Coastal Commission you've got to deal with, you've got the no-growth folks that are fighting you every step of the way. To entitle land in the future, the difficulty is going to continue to drive the price of land up, which is going to continue to move development into other markets.
Part of what we're doing from an industrial standpoint is we're doing a lot in the Central Valley right now because land prices are half what they are in the Inland Empire. So we see a big shift in the future. Try and get a half a million square foot industrial building on a class-one, rail-served site in California today in a master-planned park and you can't find it. Let's face it, there are a tremendous amount of barriers to entry in Southern California.
This trend toward big-box distribution centers: let's face it, everybody's consolidating their warehouses into 600,000 sq. ft. and 1 million sq. ft. facilities. You've got Sears with 1.5 million sq. ft. going to 2.5 million sq. ft. Wal-Mart is taking 1 million sq. ft. up in Porterville. Everybody is consolidating into big-box, high-tech, modern distribution centers. You're not going to put those in the L.A. basin. You can put them in the Inland Empire, but it will cost you dearly. So we see a big movement into the Central Valley.
Nichols: One of the big things the Inland Empire has going for it that we don't recognize enough yet is the reduction in air pollution. One of the real problems in the Inland Empire in the past is that it's been a real nasty place to live in terms of pollution, and that will be lessened in the future.
Ostenson: Part of the interesting story about the office markets in Southern California is just the supply question. If you look at Phoenix, Atlanta, Dallas, there has been almost as much new supply in office in those cities with 3 million populations as there has been in Orange County and in Los Angeles with 15 million people.
Part of that has been entitlements, part of that has been capital discipline, part of that has been that we're a little bit further behind in the cycle. But if you look at Orange County and L.A., we have maybe 5 million square feet total. Phoenix has built that much by itself. At the same time, we've had commensurate growth rates of 3% GDP very similar to some of those southern markets.
Part of the really great part about this cycle is we're at a point both in the business cycle and the real estate cycle in past times where we would have been overbuilt and we're not. There is more discipline and that is going to pay dividends to everybody going forward.
Olofson: We talked about lack of supply, and even when you can find product oftentimes it's obsolete. Certainly in the industrial arena that's been a huge factor. You talked about these new buildings being state-of-the-art and you look at a building that was built 10 years ago and it can't be used by a lot of companies today.
Allen: And now they're rehabbing the buildings, such as in the Santa Monica area, and turning them into offices.
Coleman: I think you're seeing the wave of these multitenant industrial buildings going into office and incubator spaces, and I think you're going to see the same thing with office buildings. You're going to see good located office buildings that are virtually obsolete. We're taking the ugliest, obsolete office building in West L.A. and turning it into a Class-A office building in a matter of a year and a half. We're signing deals at the highest rents in the market. I thinkyou'll find more of those opportunities in our markets.
We really haven't had new building in the last 10 years. The last wave was 1984 to 1989.
Allen: We've all landed at LAX at night. Where is the next big industrial development in the L.A. basin? There isn't any. It's just got to move, which is why the Ontario market is so hot.
Lunine: One of the things I think you're going to see is conversion, and we're seeing it on the retail side, where you're seeing a lot of these dead retail strip centers being converted into office.
Ostenson: L.A. can't go out any more. The commutes are too long and don't make any sense. We're urbanizing and building up. If you look at several recent projects, what you're seeing is L.A. urbanizing, it's going to become more dense and it's going to drive growth.
Richard S. Allen The Allen Group
Victor Coleman Ardem Realty Corp.
Jerry Feldman CallSource
Scott Lunine Sperry Van Ness
Phil Nichols, Esq. Pircher, Nichols & Meeks
Eric L. Olofson Cushman Realty Corp.
Dana Ostenson Johnson Capital