Experts foresee good times in Southern California

Our roundtable says Los Angeles' fundamentally strong real estate market will prosper in 1999 and beyond.

This is Southern California's time. After emerging later than the rest of the country from the real estate recession of the early 1990s, it's time for the region to shine, to get its just rewards. That is of course, unless the capital markets crunch - which showed signs of improvement at press time - robs Southern California of its glory. Still, the fundamentals are fine, and the area should shine.

National Real Estate Investor recently got the region's top real estate experts together at The Peninsula in Beverly Hills, where they shared their thoughts on what's happening in Southern California. Here's what they had to say about the region's real estate market.

NREI: Lew, can you offer an overview of leasing activity in the Southern California area?

Lewis Horne: For the most part, fortunately, even with some of the activity on the investment side, our leasing is very strong still, both with the office and the industrial marketplaces - even the retail areas. In fact, looking at the numbers for all of our offices in Southern California, we really saw an up tick in leasing overall in the month of September, in which it remains over and above everything in 1997. Obviously, the dramatic change was the retrading happening, especially in September, within the investment side. We saw a tremendous amount of activity, not so much in canceled deals, but just in renegotiated deals - really postponing deals on the investment side. We didn't see that much canceled or go away, but we did see a lot of retrading. Overall, though, we saw a slight down tick in rates in certain marketplaces. We frankly still see a very, very strong fundamental in the marketplace. Frankly, the back off of some of the investment community is probably a positive overall. We really see it as more of a governor in terms of preventing overbuilding like you saw in the early '90s. So overall, we see a very, very healthy community, office and industrial, especially, and hopefully, the investors come back within the next 30 to 60 days.

NREI: Todd, can you tell us what's happening in downtown L.A.?

Todd Doney: I think I'm the only guy - there's maybe a handful of guys - that are bullish on downtown right now. And it just sort of comes from my observations of when I look at the value downtown, and I say that downtown has the highest quality real estate at the lowest prices in America that I see. These are all $300 and $400 a sq. ft. buildings that you can get for half of a Century City rate - $20 to $25 a foot. And so, we keep seeing these articles in the L.A. Business Journal - ARCO downsizing and everything else - and people seem to be so pessimistic on downtown, and our vacancy still is 22%. My observation is you just wait 24 months, and you wait until Staples Arena is done - if you don't know anything about Staples Arena, it's a $350 million project that's going to be active 230 nights a year, the Kings, the Lakers and the Clippers make up 123 nights a year; the Downtown Convention Center loses $41 million a year now. When the arena gets built, now they're going to start building some hotels. So now you're going to get more conventions vs. trade shows at the Convention Center. Then you're going to get more people wanting to eat downtown, so you get more restaurants going on. And then we have more residential prospects downtown, people looking to develop apartments and residential. I think downtown has a lot of positive things, but like you and I were talking, perception sort of becomes reality. People's perception is that downtown is a bad place to be. Until that changes, it's always going to have some challenges.

Greg Schultz: I agree with you completely, and maybe I'm singing to the choir here. I had an opportunity to develop a building in Ohio in the early 1980s. I went into Cleveland, and I saw what Cleveland was like. I mean, downtown Cleveland was a very, very unique spot in the early '80s. They built that center in downtown Cleveland, and the retail went in. It was remarkable what happened. So, we're not Christopher Columbus here. It's happened before; it's going to happen again. You can already see the excitement that's happening with the sales in the restaurants starting to go up. The cultural aspects are there. You're absolutely right, the quality of the buildings downtown rivals those anywhere in the country.

NREI: Shifting the focus, Dwight, can you tell us what's happening in Orange County and San Diego?

Dwight Merriman: Orange County is enjoying the best statistics it has had in recent history. The vacancy rate is hovering around 10%. Most of that vacancy is concentrated around central Orange County, around the Orange Crush - the merge of the 55 and the 22 freeways. The airport market is 5%-6% vacant, as well as Irvine is 5%-6% vacant. So these are legitimate office markets with rental rates that have been growing at about anywhere between 18% and 22%. So, Orange County is in very good shape. There is a good bit of construction on the horizon for Orange County. We're watching that very carefully. The new capital crunch that has come upon us in the last 120 days, we think, will constrain some of that upcoming supply, which will keep the market in its current health. We're optimistic about the future of Orange County - technology-driven for the most part.

San Diego is the first Southern California economy to regain all of the jobs that were lost during the Southern California and national recession. In San Diego, QUALCOMM was the first major player to seed the technology growth in San Diego. That's been followed on by many other high-tech companies. We just recently completed the new corporate headquarters for Gateway Computers in La Jolla. They moved out here from Sioux City, Iowa, taking advantage of the labor pool in San Diego. Technology companies have had great success recruiting talented engineers to the lifestyle of San Diego. San Diego's enjoying a vacancy rate of 9%, despite the downtown, which has a vacancy rate in the high teens. So, San Diego, on the other side, relative to its size - it's about a 50 million sq. ft. market - has a good bit of construction on the horizon, and we're hoping that the capital constraints coming forward will crimp the supply pipeline that we have right now, which approached 5 million sq. ft. in the next 24 months.

NREI: You mentioned the credit crunch. Ned, maybe you can give your perspective on what's going on in the capital markets.

Ned DeLorme: I think fundamentally it's very interesting to see what happened. I think everybody looked to Wall Street and looked to the capital markets as sort of the salvation after the S&L debacle and the RTC, sort of, meltdown, which precipitated, I think to a large degree, the meltdown in the real estate markets. But, I think, fundamentally there's a disconnect between the short-term Wall Street-trader mentality and the long-term real estate mentality. Real estate is primarily a kind of long-tale asset. In California by the time you find dirt and then you're ready to build, it could be a year or two years or three years. By the time you're built and then hopefully, leased, you could be in a different market completely in terms of the macroeconomic situation. I think what Wall Street is reacting to, obviously, is a capital crisis of global proportions, and it is sort of unfairly impacting real estate. There was certainly a frenzy on Wall Street amongst many of the large mortgage banking and credit companies to jump in with both feet to the conduit and structured-finance business. A lot of different players came in; a lot of capital got thrown at the market. Spreads got to the point where it was tremendous to be a borrower. But in the long run, obviously, it wasn't something that could stay where it was. You all know the story: Capital crunch, spreads are back up. I don't even think people are quoting spreads any more; they're just sort of quoting 'rates.' If you're in the multifamily market, it's probably a great place to be because you've got the agencies basically behind that sort of capital flow, Fannie and Freddie, still, on a relative basis, for a cheap financing. But for the rest of us doing industrial or office or whatever, there is some concern out there. I think that it is probably a short-term phenomenon and that things will shake out once the inventory of fixed-rate product that's sitting on the balance sheets of various investment banks and mortgage banking companies goes through the pipeline and is able to get liquidated in some normal fashion. I think we're back, in terms of the conduit business, to a 1992-93 in terms of spreads and in terms of returns, but that's necessarily what has to happen. It has to get back to the point where you can make some reasonable money on a risk-adjusted basis for taking the risk of funding and holding a fixed-rate loan. Now we're back to the point where it will be a profitable business again, we just don't know when.

Mark Cassidy: To me, this thing got overheated, too much money chasing too few goods. I'm glad for it because, from a buyer's perspective and other developers' perspective, it reminded me of the S&L days a little bit where you had 100% financing with people who weren't necessary capable of making that kind of thing. So, what's it's done, it's put a governor on it. So people have to come to the table with real equity. You've got to build a building with real tenants going. From a California perspective, the rest of the economy came through their real estate recovery - occupancies went up, rents went up, building came up - and then this whole capital markets crunch came right when Southern California was starting the building thing. To me, this is probably going to be one of the healthiest markets on this recovery of anywhere in the nation because of that.

Mark Van Ness: Ned, could you address where rates are going?

DeLorme: I think we're in for lower rates because I think we're in for sort of a global economic slowdown. We have incredible overcapacity in Asia. Fortunately, the United States is chugging along, but I think the economy, in a sense, is sort of in the Goldilocks phase of the stock market, and we're seeing good growth. And it's interesting to hear that we're still leasing buildings and that things are still coming out of the ground. I think in general rates are going to trend down fundamentally because there's not that demand for capital on a global basis. We're needing to get in Asia and in Japan, in particular, and even in China; we need to crush some capital over there to crush the production capacity rather than build it. I think there's going to be opportunities over there, but that's going to force things down.

NREI: You mentioned the Asia crisis, and David and Chris are in close touch with that part of the world. Can you tells us how the crisis is affecting things here. Also, Chris, can you tell us about the Japanese owners that you represent?

Chris Yamada: In the big picture, you talk about Japanese capital markets, definitely, there's a downward spiral with credit shrinking down there. So far with Japanese capital, there is a tremendous amount of personal savings back there, but they they're only earning 1% on their saving accounts. Definitely, I think there's a big flow of capital from private savings to pension funds and life companies and through investment bankers that then flows into U.S. market and buys Treasuries. I think that the low interest rate of the Japanese market is helping the U.S. economy, so far, in supplying low-cost capital. American investment bankers are getting those Japanese funds and bringing them back to Tokyo to buy underperforming loans over there. I am hearing a rumor that some investment bankers who have been active in Tokyo are now backing out. My concern about Japan is that not too many Japanese buyers are buying assets over in Tokyo; only American investment bankers were active. If they are backing out of the market, there's nobody buying the real estate loans over there, and there's going to be downward pressure and property values will go even farther down. That's going to be a major downward spiral of values.

David Doupe: If I could add to that: The much touted Asia contagion - the ultimate solution and then part of the cause of it really rested at the doorsteps of the Japanese banks. And the reason for that is if you just take a look at Asia, and you take all of these countries, 2 billion people, and you exclude Japan - the Japanese economy exceeds the rest of Asia in total - if you look at the capital providers, those that have provided all the great growth that's occurred in Asia - it's been predominately fueled by the Japanese banks. So if Japan at long last, through this bank restructuring, can start to mark assets down to market-clearing prices - which I hope they will do, similar to what the RTC did - that economy will turn around so quick - and I'm not speaking of Japan but the rest of Asia, - will turn around so quick, you'll be amazed. I go every five weeks. I use a very simple standard to sort of value commodity pricing - you know, what does it cost to go out and buy a dinner, what does it cost to stay at a hotel, what does it cost buy a suit, tie, whatever. Asia today is cheaper than the United States for the first time, and I've been going for 12 years now. Asia will turn around. I'm not a believer that the economic problems in Asia are going to have a severe, detrimental effect upon the U.S. The U.S. dropping interests rates is a good first step. Hopefully there will be a couple more rate cuts. Not that the economy economically needs it, but it's more the psychology of it. This whole credit crunch issue was nothing more than something growing at such an excessive, rapid rate that the world was waiting for something to happen. So, when there was this flight to quality, which was triggered by Russian default on sovereign debt. My god, Russia is sixth-tenths of the world's economy; it's nothing. But that caused this whole flight to quality. Nobody wanted to buy any of the non-rated pieces. That's affected the REIT stocks. It will turn around, no doubt about it. But Japan's the key. That's the weather vane to watch.

NREI: Let's switch our attention to REITs. Has the downturn in REIT stocks forced Arden Realty to reposition itself?

Diana Laing: My brief pontification on the market is that we do have a bit of an oversold situation. We lost first the momentum players, the growth players out of these stocks because they rightly determined that REITs couldn't continue to grow from external sources as real estate across the country was in equilibrium. When supply and demand are at equilibrium, it's very difficult for a company that can't retain earnings to grow. So, sure they dumped the stocks, and then the mutual fund shareholders saw what was happening to the market prices. And we all know how you buy mutual funds, you buy them based on past performance. So, we show a couple of quarters of lackluster performance, and then the mutual funds have huge redemptions. Talking about a downward spiral, we've certainly seen one over the last six months. We can't help but believe there is a bit of a disconnect in the capital markets vs. the real estate markets, particularly in Southern California because our real estate fundamentals are still so good. But, as far as Arden is concerned, it has given us an opportunity to move to the sidelines on the acquisitions front, which was our bread-and-butter business for two years since we went public and to take our precious capital - which we still do have a bit of, with balance sheet capacity for additional debt - to take our precious capital and really study and wait for very smart, strategic opportunities to buy real estate or develop real estate. We bought the Howard Hughes Center, the 75 acres that's entitled for 1.3 million sq. ft. of office,. We're very excited about that. We believe it will compete very well in the West L.A. marketplace. We're starting a spec building in the first part of 1999. We hope to have space ready to deliver in early 2000. So, we've shifted our strategy a bit from acquisitions into development and redevelopment. We still have five properties that we are renovating, and those will be coming back on the market in '99 and 2000. And then we're also taking this breather in the acquisition game as an opportunity to continue to evolve our infrastructure so that we can efficiently manage the assets and put downward pressure on expenses and enjoy increasing rental rates and opportunities for additional revenues from our tenants.

NREI: As REITs stand on the sideline and slow down their acquisition levels, who are the buyers now?

Van Ness: Well, it's gone much more private, which I think has created a short-term buying opportunity. The investors we're dealing with, although they're more tentative than they were six months ago, are seeing a window of opportunity where they don't have to compete with the REIT buyers. So, we saw a market correction very quick, in a matter of weeks, of between 5 and as much as 20% in valuation when this hit. The high end would be with owners that had to close by year end, and they had a very real motivation. In some of those cases, those were actually Asian sellers, and that would be the high end. The low end was kind of everybody else. But certainly a very quick correction that I had never seen happen that quickly in our market.

Horne: We saw it in September. I mean, it was dramatic. Literally in 30 days, we saw the correction. Usually there's a gradual downturn and a gradual upswing, and we just saw it in September. I mean it was the most reactive thing I've ever seen, and that was across the board in a number of different offices.

Vicky Schiff: What I'm seeing is some of the deals that we're going after Storage USA was beating us out earlier in the year. Owners wanted stock instead of cash. Now, they're stepping back from the market. I use Storage USA for example, but there's the Shurgards, and Storage Trust is now coming out here from the Midwest. Either they're not aggressively pursuing assets anymore, and they're sitting on the sidelines. Or people don't want stock anymore; They'd rather take the cash, because they've seen what happened. We, even last week, have had the opportunity to step in to some of the deals that REITs have dropped and also some of the deals that, for instance Heller was financing, that two days before they were going to close, they've either increased their spread by double or triple, or they've just stepped away. So, we're seeing a real buying opportunity for our company right now.

NREI: Entertainment plays a huge role in the L.A. area. Peter, what's up at Playa Vista?

Peter Denniston: Clearly, we probably have one of the longest positions riding on the health of the Los Angeles economy and the real estate markets given that we have put over $100 million of fresh capital into Playa Vista. We are bullish both short term and long term. If you look at the fundamentals, the commercial and residential markets we're dealing with are very healthy. On the commercial side, we've been seeing well in excess of a million sq. ft. of net office absorption for probably the past 35 years. On the residential side, if you look at our competitive housing market area, there are well over a million jobs within a 7.5-mile radius of Playa Vista and less than 600,000 homes, which is obviously what exasperates the problem with traffic and congestion. So there's a significant shortfall relative to the number of housing units that needs to supply people who are working in the area. Those jobs continue to grow beyond the traditional finance, insurance and real estate sectors. Over the past five years, there's been very healthy growth in the technology and especially entertainment on the west side. Playa Vista provides, we feel, a phenomenal opportunity to respond to that opportunity; we've got an 1,100-acre project. Build-out is proposed to include more than 13,000 residential units and well in excess of 6 million sq. ft. of commercial, retail, office and sound-stage space. The majority of the notoriety of Playa Vista focuses around the entertainment industry, given that there are several major entertainment companies that we are dealing with for locating their headquarters facilities at Playa Vista. The one that's in the forefront today is DreamWorks. We had recently signed a term sheet with them which was a fairly long and difficult process. I thank the important thing is that DreamWorks clearly shares a vision about what Playa Vista's about from a sustainable development perspective, what it's about from a perspective of New Urbanism, the village atmosphere we're trying to create, and the very important jobs-housing link. I have found in talking to some of the major firms on the west side e or firms targeting the west side for occupancy that one of the key concerns has been the ability to attract and retain key employees. They need to offer more than just space in an office building. They are looking at the ability to be part of an environment where they can offer lifestyle, where they can offer vibe, especially in the entertainment industries. We feel that with the mix of product on the residential side - from very affordable apartments to single-family detached that are well in excess of $1 million a year - coupled with the retail and office and sound-stage component, that that's critical. I think Dream Works will add some significant momentum to the opening of the project. Another comment I had about Playa Vista that a lot of people seem to miss, given the focus on Dream Works, is that project has been under way for the past six months. We have moved 1.2 million cubic yards of dirt relative to Phase I residential, and we are six months into a program of deconstructing the former Hughes plant site. So the project is well under construction.

NREI: Are entertainment companies fueling the need for space?

Merriman: While the entertainment sector is still active, it's not as active as it was 24 months ago. The whole entertainment industry is under earnings pressure, and it's going to be and is in a cost-sensitivity mode at this point to deliver. I think you're going to see the entertainment companies taking lower-cost campus-style developments like the one Disney has done with the Grand Central Industrial Park in Burbank. Basically, Disney has encapsulated its real estate requirements for the next five to six years by converting industrial buildings into creative space for less cost, and they're owners.

Laing: We're definitely seeing entertainment demand for the Howard Hughes Center. But again, it's going to have a real campus feel with large floorplates and a lot of amenities.

NREI: One last question. It's pretty widely accepted that now is the time for California, which was last to come out of the recession, to reap the benefits of the current upswing. However, with the capital markets crunch, is there a fear that Southern California will miss out on its turn to reap the benefits of the current upswing?

Denniston: What's interesting for me to watch that the regulator, or the governor, of real estate development very often has been the capital markets cause that's what fuels what you can do. And maybe we're blessed that we've only been in the recovery for a year and a half and haven't done some really stupid deals. The lack of discipline in the underwriting with some of the conduit CMBS product absolutely amazed me. We're looking at deals that I said to myself in the late 1980s, 'How could somebody do this?' or in the early '90s, 'How could somebody do this?' All of a sudden I started seeing those same kind of deals coming back on the screen. And I think one of the positives is that this has knocked those kinds of deals off of the screen, and it's really forced us all to be much more disciplined.

Merriman: Yes, and much faster than before. It changed like that. Boom!

Doupe: The capital crisis, or whatever everybody wants to call it, it's added - I don't know when this great parade's going to come to an end in California - a good two years to when it would have [ended]. Southern California, we never really got started.

NREI: With that, we'll end NREI's 1998 Los Angeles roundtable. Thank you all for offering your views on the local real estate market.

Roundtable Participants

Mark H. Cassidy Executive Vice President Summit Commercial

Dwight Merriman Senior Vice President CarrAmerica Realty Corp.

Edward R. "Ned" DeLorme Partner Bridge Capital Ltd.

Vicky L. Schiff President StorAmerica

Peter B. Denniston President Playa Vista

Gregory W. Schultz Vice President First American Title Co. of L.A.

R. Todd Doney Senior Vice President Cushman Realty Corp.

Mark E. Van Ness CEO Sperry Van Ness

David B. Doupe President/ North America The Greenwich Group

Nobuyuki Chris Yamada Senior Vice President Sonnenblick-Goldman Co.

Lewis C. Horne Senior Managing Director CB Richard Ellis

Diana M. Laing CFO/Executive Vice President Arden Realty Inc.

Moderator: Tony Wilbert Editor

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