The Golden RE Years

After going through an economic dip in the early-1990s, the California economy is enjoying its sixth year of economic expansion.

"The statistics really support our business today," says James C. Watson, president of the western division for Koll Development Co. in Newport Beach, Calif. The state has experienced a tremendous amount of job growth and business expansion in recent years. As a result, demand is on the rise for existing real estate facilities and new development. Koll has been active in the California market for more than 25 years. "We've developed 60 million sq. ft. over the years and invested north of $10 billion," Watson says. "As a whole, the markets in California are as strong or stronger than they have ever been."

While California-based firms such as Koll have a long track record in California, the state's growing economy is attracting renewed interest from investors scattered across the country. "California is a major investment market for any institutional investor looking to hold a diverse core portfolio of real estate," says Andrew Friedman, an executive vice president for Lend Lease Real Estate Investments Inc. in San Francisco.

California has a robust economic base with the size and diversification of a good size country. "If California were a nation unto itself, it would be one of the 10 biggest economies in the world," says Hugh F. Kelly, chief economist with Landauer Associates Inc. in New York. "We're really seeing in the work we do with commercial investment institutions that California, over the last two and a half to three years, has solidly displaced the growth markets of the Southeast as the hottest investment locale in the country," Kelly says.

One of California's strengths is a relatively young economy. Unlike most of the states along the eastern seaboard, California's economy is still largely influenced by significant net increases in population growth year after year. The population base was expected to grow by nearly 1 million residents from July 1995 through July 2000, according to the U.S. Census Bureau. In addition, much of the state's technology industries are young and growing. California is home to "future-oriented" industries, Kelly says. "These growth industries themselves are early in their life cycle," he says.

The economy California is in a good economic position, largely due to the diversification that took place in the early 1990s. Although some experts refer to that period as a recession, a more accurate description is a "very painful economic restructuring," says Hessam Nadji, senior vice president of research for Marcus & Millichap Real Estate Investment Brokerage Company in Palo Alto, Calif. "That restructuring is now paying off and will continue to pay off for several decades to come," Nadji says. The restructuring provided an essential departure from the state's heavy reliance on industries such as defense and aerospace, and allowed it to grow new industries that include entertainment, high-tech and exports. The high-tech industries in particular have expanded well beyond Silicon Valley to permeate the state with concentrations in areas such as San Diego, Los Angeles, Orange County and the Bay Area.

"It's real easy to say the diversity of our economic base helps us. But contrasted with 10 years ago, we didn't have the same diversity," says Glen Esnard, senior managing director for investment properties, western region at CB Richard Ellis in Los Angeles. For example, the Los Angeles market in the 1980s was driven primarily by the aerospace industry. "That has really realigned to a condition where we now have a host of different industries," Esnard says. Some of those industries include medical device manufacturing, entertainment and tourism. "I think we truly have a diverse economic base that energizes us and gives us greater stability," he says.

Investors have a variety of submarkets to choose from in northern and southern California. "All the markets in my view have their own positive attributes," Friedman says. Southern California has grown more robustly in the last year. The Inland Empire area, which is comprised of Riverside and San Bernardino, added 52,767 jobs in the last year for a 4.1% job growth rate. Orange County added 39,833 jobs at a rate of 2.9%. Northern California, despite last year's declining growth rate in the San Francisco area, is still growing at a healthy pace. The Bay Area added 72,533 jobs at a growth rate of 2.1%, according to the California Trade & Commerce Agency.

California has two primary economies - northern California and southern California - and they are both doing well, says Ray Torto, president of Torto Wheaton Research in Boston. "However, you have to look at northern California and southern California a little differently," Torto says. >From an investment point of view, northern California has matured a bit, while southern California has more growth potential. Additionally, northern California recovered faster than southern California from the recession, and now that market is seeing slightly slower economic growth.

"What's interesting about northern California is that it's starting to hit its capacity. There's not many more people around for [companies] to employ. As a result, there's not much more you can grow from a real estate point of view," Torto says. "I would look at northern California as income investment and southern California as growth investment," he says. "By that I mean that there is still some growth potential relative to prices and rents and occupancies," he says of southern California. Meanwhile, rates and occupancies in northern California have started to flatten out, he adds.

Job growth & labor supply The California investment market is much hotter than it has been in recent years. Significant job growth is one of the primary factors driving the investor and developer interest. California experienced a net job loss in the early 1990s when the real estate market slipped into a severe recession. However job growth returned in 1995 and 1996, and now it is back with a vengeance in 1997 and 1998.

The California economy outpaced the nation in the first quarter of 1999, with jobs increasing in almost every industry and region of the state. Nonfarm employment - not seasonally adjusted - was up 3.5% from the first quarter of 1998, adding almost 462,000 jobs. Nationally, jobs grew 2.2% during the first quarter, according to the California Trade and Commerce Agency. "That's a big driver for real estate in all respects," says Mark Van Ness, CEO of Sperry Van Ness Investment Real Estate in Irvine, Calif. More people and more jobs means greater demand for office and industrial space, retail space and housing.

Job creation attracts people. California learned that lesson the hard way. The state lost thousands of residents to other states that were adding jobs while California jobs declined during the early 1990s. The L.A. Basin alone lost more than 1 million residents during that period, Nadji says. Now the dilemma for California is that while there is an abundance of jobs, the state many not have the skilled workers to fill the high-tech positions. That shift is putting California's education system under the microscope. "The big question is whether California's existing residents are being prepared well enough for high-tech jobs and jobs of the 21st century," Nadji says.

"I find it ironic that we have tens of thousands of high-tech jobs that are unfilled right now with our fast growing and large population base," adds Nadji. "The discrepancy between population and skill base is going to cause some problems in the future." One such problem is that if the state has to recruit skilled workers, both domestically and internationally, it will place an added strain on an already strapped transportation infrastructure and housing market, he says.

However, the state's university system is one of its educational strengths. "I don't think that you can discount that we have an abundance of high-quality education institutions, which makes southern California a very attractive location for industry of all types," Esnard says. Not only are the schools churning out educated workers, but in many cases, they are collaborating with the business community. Stanford University has partnered with businesses in Silicon Valley to further technology innovations. UCLA features a business incubator program, and two of the finest film programs in the country can be found at USC and UCLA.

"One of the great resources the state has is its University system. Like most excellent university systems, it attracts people from all over the country and all over the world," agrees Kelly. Students who attend USC, UCLA, Stanford and Berkeley often end up living in California. So while California - along with the rest of the United States - is experiencing the squeeze of the labor shortage, the state's ability to grow its population base is a positive attribute. "The labor situation in California, if anything, is more favorable than places like the Midwest, where you have stagnant or declining populations," Kelly says.

Negative aspects California does have some trouble spots in its economy. The crisis in Asia has had a significant impact on the California economy. Fifty one percent of all California exports go to Asia, compared to the national average of 29%, Nadji says. Those exports have taken a hit because of the drop in demand from Asia. However, the good news is that the struggling Asian economies have bottomed out and are beginning to recover, he says.

High business costs are another factor affecting California's economy. "California is an expensive place to do business," Kelly says. The cost of doing business in California does make businesses think twice about what types of businesses to put there. Distribution firms, for example, tend to locate on the outside boundaries of California. Areas such as Reno, Nev., and even Las Vegas have become "staging areas" for warehouse and distribution firms serving the California market, he says.

During the early 1990s, many companies woke up to the fact that the cost of doing business in California was restrictive, Nadji agrees. Relocating to Nevada or Oregon saved them a considerable amount in business taxes, labor and regulatory fees. "We went through a period of losing companies as well as people," he says. The state bounced back because there are a number of advantages to doing business in the state - factors which have become more apparent since California has continued to strengthen and diversify its economy. "However, [migration out of the state] could become an issue again in the future if we're not careful," Nadji says.

Businesses are paying premium wages largely due to high housing costs. California has the highest housing costs in the country. The state average home price in first quarter 1999 was $205,000. "It's an expensive place to own a home, which is why the rental apartment investment market is always so great in California," Kelly says. Because of the expense of owning a home, apartment rents can be high and still compete with the single family housing market.

New investors "There is still a high demand for California product, the shift is in who the investor is," says Barry Saywitz, president of The Saywitz Company in Newport Beach, Calif. Eighteen months ago, most of the heavy buying was done by the REITs. REITs' access to cheap capital and hefty appetite for properties prompted a feeding frenzy that pushed sale prices to excessive levels. "That aspect of the investment market has pretty much dried up," Saywitz says. These days REIT buyers are almost non-existent. "They're all in the process of building rather than buying," he says.

So who is buying in the current market? The higher profile projects are trading hands largely among the institutional investors - the pension funds and insurance companies. As REITs backed up, institutional investors have stepped up to satisfy their pent-up demand for properties. The small- to medium-size transactions are taking place largely among private investors. Many of the local investors are "trading up" on properties that they have owned for several years, Saywitz says. The private investors are selling existing properties and rolling those profits into larger acquisitions.

The strong economy also is attracting some first-time investors. U.K.-based Regus Business Centre Corp. expanded into the California market with its business center operations in September 1998. The company enters into long-term leases to create its business center formats, which essentially are subleased to companies as turnkey offices. Regus currently operates 200 business centers in 40 different countries. The company currently has 12 offices open or committed in California, and Regus expects to grow by 100% each year.

"At the moment, California is on par with probably two or three other regions of the United States from our perspective," says Matthew Stubbs, vice president of the Western Region for Regus Business Centre Corp. "It is similar in demand for our products and services to New York and the Washington, D.C. metro area and Boston," he says. Regus selected California because a number of the international clients they work with in Europe also have California operations.

Another reason why Regus favors California is that many businesses located in the state are receptive to new, flexible working practices. "They're more interested in finding more efficient ways of working," Stubbs says. That is the type of clientele that Regus caters to with its business center model. The company also values the concentration of high-tech firms due to the rapid changes that many firms in that industry experience. "They are increasingly looking for property solutions to match their changing business needs," he says.

Investment opportunities California's healthy economy is fueling investor and developer interest across all product types. Sperry Van Ness recently held a sealed bid offering on Bristol Park, a 106,000 sq. ft. Class A office building in Irvine. The property received 24 offers, and sold for $13.8 million in June. The sale price was well above the $10 million to $11 million that many in the industry expected as the sale price, Van Ness says.

The crowded field of investors makes it difficult to find and close on desirable properties. "It is a challenge to find a good value," Van Ness says. What happened was that the REITs overbid the market a couple of years ago. But while REITs have left the acquisition market, sellers' expectations are still at that same level. So now there is a broader gap between asking prices and what buyers would like to pay, he says.

It is more difficult to find investment properties with the same amount of upside that existed several months ago. Properties are still appreciating, but it is not the same fervor that there was 12 months ago, Saywitz says. Buyers that are out there are taking a closer look at the properties and the price they are paying. Sellers in 1998 were able to pick a number and get the asking price. That is not the case in 1999, Saywitz says. However, there are some buyers out there that are more concerned with trading up than they are spending money. "So that is still continuing to fuel activity and hold the property values where they are," he says.

"Multifamily is probably the safest and strongest market with vacancy rates below 5% and rents that are going up substantially," Van Ness says. The multifamily market is experiencing tremendous demand along with a significant undersupply. "There has been virtually no building in the southern California market since 1994," he says. Although developers are returning to the multifamily market, the majority of new construction is focusing on high-end Class-A product.

"It's harder to find the opportunities that we found through the bulk of the 1990s as we were recovering," Esnard says. In addition, it takes more work to find those good deals. "The market is not going to make you look smart anymore. Through most of the 1990s, whatever price you paid, the market was recovering so aggressively that whatever you paid, six months later it looked attractive," he says.

The competition for investment grade product depends on the product, market and timing. For example, three downtown San Francisco office buildings sold this year - all to German investors, Friedman says. German investors have seen some recent tax breaks that make it more favorable for them to come in and buy U.S. properties. They also have access to lower cost debt financing. That competition is prompting some investors to look for new opportunities such as submarkets further out from CBDs or other niche markets.

One hot new investment market just south of the San Francisco CBD is Multimedia Gulch. Three years ago rents in that area were $15 to $18 per sq. ft. Now those rents are in the high $30s to low $40s. The boom is due largely to Internet growth of local companies. Those firms depend on young, generation X employees who don't want to live in the suburbs.

They want to live and work in the city. As a result, entrepreneurs came in and redeveloped older Class C buildings. The recent rent spikes have prompted institutional buyers to take a look at opportunities in that submarket, Friedman says. Although there is some volatility in the high-tech sector, many investors have targeted it for its strong growth potential, he adds.

Future outlook Many industry observers remain optimistic about the continued growth of the California economy and the investment outlook. "This is the best of times for consumers. Interest rates are very low, wages are going up, prices are flat and the stock market is going up. I don't think we've ever seen it so good from the consumer's point of view," says Torto.

The babyboomer population, which is moving through its peak earning and peak spending years, will continue to fuel the economy. "That doesn't necessarily mean that the real estate market will remain stable, but the economy will remain relatively prosperous," Esnard says, adding that stable development activity is another factor that bodes well for the real estate market.

"One of the unique features of this particular economic cycle, which is very different from the prior economic cycle, does seem to be a healthy restraint on capital, which is causing us to reach a point of equilibrium vs. massive overbuilding," says Esnard. "I think the capital is a little smarter this time around."

"From an overbuilding standpoint, we really don't have that risk yet in the cycle. I think there's more caution now than there has been in previous boom cycles," agrees Van Ness. However, the investment market could be headed for a dip similar to fall 1998. "We're anticipating some disruption in the market similar to last year," Van Ness adds. One factor that could influence potential volatility is concern over Y2K. "We're advising our clients not to be in a selling mode in that last quarter," Van Ness says. Last year, sale prices dropped in value by as much as 20%. Instead, Sperry Van Ness is encouraging its clients to be in a position to buy in case those depressed prices reappear.

With an improved job force and hot investment market, California appears to have learned a critical lesson about the importance of skilled workers. However, this state is not out of the economic woods yet. Only time will tell if the Asian crisis and high business costs will force California to learn the hard way once again.

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