A blessing in disguise

Although Los Angeles definitely felt tremors from California's dot-com and energy quakes, the damage could have been worse. A lack of developable land prevented overbuilding, and municipally owned utilities have kept energy supply and prices in check in much of the Los Angeles area.

“We're fortunate it's been much more difficult to develop in Southern California than other parts of the country,” said Jim Proehl, senior vice president and director of the western division in the Newport Beach office of Houston-based PM Realty Group. “Vacancy is not super high, so no one is panicking. We haven't had a significant amount of development like other parts of the country.”

In the first seven months of the year, the Los Angeles area added more than 3 million sq. ft. of office space to the market and posted an increase in direct vacancy rates of 1%, according to Proehl. The amount of sublease space, however, increased by 2%.

The sublease space being dumped back on the market in the wake of the dot-com exodus is posing the biggest challenge in the region. More than 20% of office space currently available on the market is sublease space, according to a mid-year study released by Los Angeles-based Colliers Seeley. Vacancy rates in the first six months of the year climbed from 12.1% to 14.3%, the study indicated.

Many companies are delaying building decisions, which further weakens any market momentum. “The oversupply of sublease space and the present wait-and-see attitude of business decision-makers toward the economy has created a slow-motion marketplace for office space,” said Lewis C. Horne, senior managing director of the Los Angeles region for locally based CB Richard Ellis.

Southern California will narrowly avoid a recession in 2001, but the growth slowdown will be painful, according to a mid-year economic forecast published recently by the Los Angeles County Economic Development Corp. (LAEDC).

Population growth in California will ease in 2001, with a projected increase in non-farm employment of 2.2%, or 318,000 jobs. This projection is down from last year's 3.8% gain of 526,200 jobs, according to the LAEDC. The state's unemployment rate has increased slightly this year to 5%. But commercial real estate, especially the industrial sector, is in “good shape,” according to the report.

For one 30-year veteran of the Los Angeles market, it's just another familiar cycle. “We've done this before, and we'll do it again,” said Howard Sadowsky, vice chairman of New York-based Julien J. Studley Inc., who founded Studley's Los Angeles office in the early 1970s.

“It [the cycle] keeps the landlords a little more honest. They were starting to behave like this was going to go on forever,” Sadowsky said, referring to the economic boom of the late 1990s. “They tend to forget and were starting to get aggressive. It brings everybody back to reality.”

Dot-com tremors in office sector

West Los Angeles has experienced the biggest fallout from the dot-com crash, said Jack Kyser, chief economist for the LAEDC. “Some of those companies were signing leases with great abandon, actually banking space.”

Proehl, whose region covers all of California and the West, said the impact from the dot-com bust in the Los Angeles area is not nearly as significant as in San Francisco. “The dot-coms in the past few years gobbled up more space than they needed,” Proehl said. He calls 2000 an “aberration,” and said that 2001 actually is in line with market activity in 1999.

“But it's more than just the dot-coms now,” Proehl added. “There are a lot of technology companies that are concerned about which way the economy is going, so they've cut back and are holding off on decisions about taking additional space.”

The Westside submarket, home to many of the dot-com companies, added 1 million sq. ft. of sublease space to the market — the largest increase in sublease space of any of the submarkets — in the first seven months of the year, according to Studley. At mid-year, the Westside also reported a dramatic 63.6% drop in the total amount of square feet leased, compared with the same period last year.

The Westside also has the area's highest rents, and those rates have softened to the low $40s per sq. ft. for Class-A space, according to Proehl.

Price plays a big role in the selection of office space, especially in the Downtown, San Fernando Valley and South Bay/Long Beach submarkets, which will be among the top beneficiaries of the Westside's softened — yet still expensive — office market, the Studley report stated.

The number of large blocks of contiguous space on the Westside surpassed downtown for the first time in a year, according to Studley. The market now has more than 40 blocks larger than 50,000 sq. ft. on the market.

“I think we've seen the worst from the dot-coms, but we're still seeing the ripple effect and slowdown of the economy,” Proehl said. He predicted that activity in the third quarter will still be weak. “By 2002, things might start turning around, but a lot depends on the overall economy.”

Office tenants on the sidelines Observers of the Los Angeles office market agree leasing activity is on the decline. On the other hand, the market has created opportunities for prospective tenants. “It's brought down some of the prices and humbled some of the landlords,” Sadowsky said. “There definitely has been a flatness in rent rates. I think they'll continue to soften, and we may see improved amenity packages.”

Some tenants can't postpone decisions indefinitely. “There are tenants who can't wait much longer and have to make some commitment — either their lease expires or their business demands it,” said Sadowsky.

While there is a huge amount of sublease space on the market, leasing that space has its own challenges, according to Proehl. “If you're a prospective subtenant, you have to be concerned if a dot-com [original tenant] files Chapter 11 bankruptcy protection. As a result, their lease could be rejected, and you'll have to negotiate a new lease directly with the landlord of the building,” he said. “You might have negotiated a rate of $20 per sq. ft. with the original tenant. But then the landlord wants $30, and you're faced with accepting that rate or finding new space and disrupting your business. It's completely different if you're subleasing from a company that is solid financially,” Proehl continued.

Another 300,000 sq. ft. will be coming on the market in West Los Angeles this fall because of the consolidation brought about by the Walt Disney Co.'s acquisition of Fox Family Worldwide from The News Corp. Ltd., Australia, and Saban Entertainment, according to Sadowsky.

“They'll be consolidating in Burbank,” Proehl said. “That's a lot of space, but the positive thing about the West Los Angeles market is that we don't have a big overhang of space. It's still a fairly tight market compared with previous downturns. We've been restricted in our building. Consequently, the overhang is from sublease.”

New office construction has been scarce in Los Angeles County due to limited availability of land and caution among developers. At mid-year, new construction slated to come on line by year's end was a moderate 1.3 million sq. ft., according to research by Studley. The largest office project under construction is the 700,000 sq. ft. MGM Tower, which is slated for completion in 2003. New office construction remains brisk in Burbank with more than 800,000 sq. ft. of new product expected to be delivered through mid-2002.

The year-to-date absorption for Los Angeles County is a negative 1.8 million sq. ft., according to Colliers Seeley. In 2001, the area absorbed a record 11.4 million sq. ft.

Going downtown

Momentum downtown, especially in the office and multifamily markets, has been fueled by the completion of the area's light-rail system last year.

“All of a sudden people are paying attention to downtown,” said Kyser of the LAEDC. “The mass transit option has really increased interest.” He added there is notable activity in the Old Bank District as well as the Fashion District, where several million square feet of space is being converted into showroom and loft space.

The best deal for Class-A space is downtown, where the vacancy rate is still quite high, according to Proehl. “You can get some great Class-A office space for $30 per sq. ft.” Vacancy rates downtown decreased slightly, from 21.3% in mid-2000 to 19.6% at the same time this year, according to Studley.

In the multifamily market, construction and conversion activity have picked up in downtown Los Angeles. “In the past two years, we've seen a resurgence of interest downtown,” said Howard Levine, CEO of ARCS Commercial Mortgage Co., Calabasas Hills, Calif., which specializes in multifamily lending. “It seems to be mushrooming, building up momentum.”

Industrial forges ahead

“The hottest non-residential market in the second quarter was industrial,” Kyser said. Los Angeles County posted a stingy 3.9% vacancy rate. Even in the Tri-Cities submarket, which experienced a hefty amount of new development, the vacancy rate was only 7.6%.

“It's tight, and it's probably going to get tighter,” Kyser said. “It [development activity] has slowed slightly but is still running at a strong pace. New overall construction is off from the previous year, and both lenders and developers are being ultra-cautious.”

Available industrial space grew approximately 18%, while market activity fell about 31% in the second quarter, according to a survey of the Los Angeles industrial market by CB Richard Ellis.

Demand for industrial space was down in the second quarter — particularly in inlying areas — due to concerns about the economy, lack of available space and higher rental rates, according to research by Colliers Seeley. Construction activity slowed but remained significant, slightly outpacing growth. Average asking rents climbed slightly, and sales prices continued to increase significantly.

Net absorption in the second quarter totalled 4.9 million sq. ft., down significantly from the record-setting 11.2 million sq. ft. quarterly average in 2000. The pace of construction at mid-year was on par with last year's mid-year totals, with 30.6 million sq. ft. completed. This pace is expected to slow over the next 12 months.

Total vacancy at the end of the second quarter was 5% (including sublease), up from 4.4% at year-end 2000. At 3.7% vacancy, San Fernando Valley/Ventura County is the tightest submarket. Sale prices climbed to an average of $64 per sq. ft., up $1 from the first quarter, and reached as high as $80 per sq. ft. in Orange County.

The new 240-acre Centre Pointe Business Park in Santa Clarita received zoning approval for 3 million sq. ft. of industrial space. Spirit Properties, a Santa Clarita-based development firm, broke ground this summer on the master-planned business park. It will be the largest new business park to be developed in Los Angeles County in five years, according to Larry Rasmussen, president of Spirit Properties and owner of the property.

Multifamily stabilizes

The multifamily market is generally more in balance and stabilized than a year ago, according to Levine of ARCS Commercial Mortgage, who said the economy has slowed rent increases. “Rents had been going up 10% to 15% a year,” he said. “Now it's closer to 5%.”

The Los Angeles area continues to struggle with a shortage of affordable housing. The problem likely will persist because there's very little construction, Levine noted. “The process is very slow to obtain permits. It's very difficult to build and bring new product on line, both from a timing standpoint and cost. It's slow and expensive to get the land lined up, because the cities take their pound of flesh.”

Although demand outweighs supply, development obstacles discourage new construction. “Most developers here think it's wiser to take over older buildings and reposition them,” Levine said.

Multifamily demand has increased dramatically in Los Angeles County each year since 1990, according to research by Northbrook, Ill.-based Grubb & Ellis. At the end of the first quarter, rents averaged $1,200, and the vacancy rate averaged 3%.

Investment deals still churning

While the Los Angeles Basin is viewed as one of the best real estate investment markets in the country, investor demand has been restrained largely because of reduced demand for real estate by national investors, according to Colliers Seeley, which ranked apartments as the number one investment interest, followed by industrial, office and retail.

“Generally, in Southern California, we're outperforming the rest of the United States, though it is slower than last year,” said Michael Ross, managing director of the investment division in Colliers Seeley's Los Angeles office. Multifamily has been the most active investment market, but interest in industrial warehouse space has increased, Ross noted.

“There are more buyers than sellers right now,” he said. “Investors are looking for conservative investments, and multifamily and industrial have performed well over long periods of time. A lot of institutional investors over-invested in office, but we think that's one of the best investments right now because there are fewer buyers.”

Investment sales in the first half of 2001 reached their lowest point in 2½ years, according to Ross. The most attractive office investments are those properties with long-term leases and single tenants, he said. “They're selling close to the asking price.”

Too much retail?

While the general consensus is that the office and industrial markets have not been overbuilt, there has been an overdevelopment of retail, according to Kyser. “Retail in general has been banged around for a long time, though there's still tremendous interest in grocery- or drug-anchored centers,” Ross echoed. “And power centers in Southern California still do well because of the density of the population.”

Everybody is awaiting the arrival of Kohl's in Southern California, he said. Kohl's has been very low-key about it, but the retail chain has leased a site in San Bernardino for a 650,000 sq. ft. distribution facility. There also has been a huge push by both Target and Wal-Mart to develop store sites, Kyser noted. “This has put a lot of pressure on existing retail. The retail sector is the most competitive and the most under stress.”

Both retail sales and rents increased last year while vacancies remained fairly tight. Nearly 11 million sq. ft. of retail space is under development in the Los Angeles metro area, according to Grubb & Ellis.

One much-talked-about project is TrizecHahn's new $430 million retail and entertainment complex at Hollywood Boulevard and Highland Avenue, which will feature the new Kodak Theater, soon to be the permanent home to the Academy Awards and a venue for other events. A portion of the development will be a new Renaissance Hotel.

“If anything, Los Angeles County is under-hoteled,” Kyser said. “Tourism seems to be holding up. It's business travel that's falling off.”

The hotel industry has benefited from the completion of the Anaheim Convention Center expansion project in December 2000 and the opening of Disney's new California Adventure theme park earlier this year, said Jeffrey Dallas, hospitality practice leader for the western division in the Los Angeles office of Ernst & Young's real estate advisory services. The Disney project includes the 750-room Grand Californian, which is adjacent to the Disney parks.

Occupancy and average daily room rates (ADR) have increased in Anaheim, due in large part to the new convention center and theme park, he said. The overall occupancy rate in the Los Angeles area was 72% through July, according to Smith Travel Research of Hendersonville, Tenn.

In the luxury resort category, projects include the new $240 million, 400-room St. Regis Monarch Beach in Orange County, built at a cost of $600,000 per room, according to Dallas. Other projects include a 263-room Ritz-Carlton hotel planned in Laguna Beach and a 520-room resort adjacent to the Hilton Waterfront in Huntington Beach.

However, increasing difficulty in obtaining construction financing and a shortage of land have continued to hamper new development. Also, in the wake of recent terrorist attacks more and more projects will be either postponed or cancelled as already nervous investors and lenders try to protect themselves from additional losses, according to industry observers.

“The debt markets require a large percentage of equity, anywhere from 40% to 50% equity, which places pressure on returns,” Dallas said. Hotels also aren't changing hands as frequently, because the current owners have high expectations. “The buyers are looking for what they can afford to pay in light of investor expectations,” he said.

Weathering the storm

Fortunately, Los Angeles is a diversified market that doesn't rely on any one industry. That, coupled with a lack of new development, will help speed the recovery, according to Proehl and others. “Lenders have been a lot more conservative in their underwriting,” Proehl said. “Because of that, it will help us recover quickly.”

Los Angeles may have suffered more from the news reports about the energy crisis than from any actual shortages of power or increases in energy costs, because many of the cities have municipal utilities that haven't been affected, according to Kyser.

“A significant chunk of the county is sort of an interested bystander to the overall energy crisis,” he said. “People have worried about power, but so far we've had no brownouts and it seems to be a problem we've thwarted.”

Cynthia Mines is a Wichita, Kan.-based writer.

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