Southern California

Dramatic improvements transform region's real estate market from a laggard into a trend setter.

It's baaacccck. After an economic downturn lasting several years -- and made worse by natural disasters including fires, floods and earthquakes -- the Southern California real estate market has been transformed from a laggard into a trend setter.

Dramatic improvements in almost every property type in terms of both occupancy and rental rates are being reported, with some markets beginning to justify new development.

"During the last six months, we have witnessed the return of the office buyer to levels approaching the late 1980s pricing," says Tim Ballard, regional director of Belgravia Capital Corp. "It was reported that Douglas Emmett, one of West L.A.'s biggest office players, is in contract to buy the Landmark II Tower in Brentwood for approximately $320 a sq. ft., a level not seen in the 1990s."

Well-financed, conservatively leveraged REITs flush with cash are increasingly looking at Southern California, adds Ned DeLorme, a partner in the Newport Beach office of Bridge Capital, a direct lender specializing in financing for acquisitions and "opportunity" real estate projects.

"They target some of the best properties in the market, at prices that our shell-shocked developers never thought they would see again," he explains. "In fact, cap rates have been driven close to 8% on trophy properties with the REITs betting on increasing rents and an ability to grow their portfolios to keep their stock up."

Such buying has transformed the Southern California investment market. "It's on fire," says Kevin Shannon, director of the investment group at The Seeley Co. in downtown Los Angeles. "Appreciation can be seen every couple of months instead of every six months. We sold a 200,000 sq. ft. building for $9.5 million a year ago and it's going to trade at double that now. Investors have forgotten about earthquakes, fires, floods and riots. Hot pockets of activity include the O.C. airport area, West L.A. and the Tri-cities -- Pasadena, Burbank and Glendale. Emerging pockets include El Segundo and Culver City, among others."

With such a strong market, rates are rising fast, reports J.D. Cook, senior vice president and managing director of Cushman Realty Corp. in West Los Angeles. "The entertainment industry, in particular, continues to lease space at a rapid pace," Cook says. "Over the past 12 months, Santa Monica and Century City experienced rental rate hikes of approximately 20% to 30%. Rental rates are anticipated to continue rising until the completion of new construction brings more opportunities on the market, stabilizing the supply and demand for westside Los Angeles office space."

Improving economy benefits market >From Los Angeles to San Diego, Orange County to the Inland Empire, the Southern California real estate market is benefiting from a rapidly improving economy with real demand generators for space, historically low interest rates that allow positive leverage and the capital markets seemingly endless supply of money to lend, analysts say.

At the same time, diversification efforts in Southern California are bearing fruit. Once heavily dependent on the defense industry, the economy is more global, with a heavy concentration on the growing technological and entertainment sectors. Says Ballard of Belgravia Capital, which expects to fund more than $500 million of debt in the Southland next year: "Although, I don't expect to see the incredible absorption levels and boom times of the 1980s, I believe that Southern California's real estate markets will experience a much less volatile future as a result of the economy's diversification."

L.A. vacancy down, rents rising Perhaps the biggest news in the Los Angeles area is that the long delayed start of Playa Vista, the 1,087-acre development project near Marina del Rey is expected to begin soon. A master-planned community adjacent to the Pacific Ocean between Marina del Rey and Westchester in West Los Angeles, Playa Vista's first phase includes approximately 3,200 residential units and 3.6 million sq. ft. of office and studio space. Dreamworks SKG is expected to call Playa Vista home in the near future, but the project has been bogged down for several years. No more.

"Now that both the entitlements and financing are securely in place for the first phase, we are prepared to move forward immediately on the Playa Vista development," says Jeff Dritley, West Coast director for the Morgan Stanley Real Estate Funds, one of the project's participants. "Playa Vista (now) has the commitment and financial wherewithal of an ownership group that is able to see this project through to its completion."

According to Cushman & Wakefield, the overall vacancy rate for the Los Angeles office marketplace decreased to 23.7% in the third quarter of this year, a drop of 1.6 percentage points. Year-to-date leasing activity stands at 4.6 million sq. ft., compared to 3.3 million sq. ft. at the end of the third quarter of last year.

Mickey Isen, vice president of leasing for Heitman Properties Ltd. in Century City, which oversees nearly 1.8 million sq. ft. of office space, notes that vacancy rates in West Los Angeles, for instance, hover around 12%, with lease rates continuing to rise for direct and sublease space.

"These rising rates are an unavoidable result of increased demand with no new construction -- but the lack of new product is about to change," he adds. "Several proposed projects bear watching, such as the Arboretum Courtyard and Arboretum Gateway in Santa Monica, with a combined 325,000 sq. ft., as well as Water Garden Phase II, also in Santa Monica, which will be a 600,000 sq. ft., two-building project.

The desirability of West Los Angeles has not been lost on investors, either. Recent and upcoming purchases by Marvin Davis, Beacon Properties, Arden Realty, J.P. Morgan and others, he adds, "have helped to reinforce the feeling that the time to buy in this area is now."

At the same time, West L.A. has seen the return of the apartment developer as rents have increased and occupancy levels have approached almost 100% in some locations. Lincoln Property Co., Essex Property Trust and EMC Financial are all proceeding with significant apartment projects to meet the pent-up demand that has resulted from the dearth of construction over the past five years.

John Kerin, senior vice president and Los Angeles division manager of Marcus & Millichap, notes that multifamily values have generally stabilized and are beginning to trend upward. "Rents have also stabilized and have begun to move up in response to falling vacancies," he adds. "Currently, the countywide apartment vacancy rate is 7.8%, down from 11.7% in 1993."

Glendale is hot office market One of the hottest office markets in Southern California is Glendale, notes Doug Marlow, vice president of CB Commercial. Currently, the Glendale office market, with Class-A vacancies below 5%, is achieving rental rates between $25 to $28 per sq. ft. annually, he adds, and new building has begun. PacTen Partners, in a joint venture with Morgan Stanley Real Estate Fund II LP, has started construction on Glendale Plaza at Central Avenue and the Ventura Freeway. Billed as the first speculative high-rise office building to be developed in Southern California since 1991, Glendale Plaza will offer 520,000 rentable sq. ft. upon its completion in early 1999.

"Commercial development is a strong indicator of the health of a local economy," says PacTen Partners CEO Nyal Leslie. "The growth of the entertainment, insurance, finance and health industries in the region has driven office vacancies to new lows. The development of Glendale Plaza addresses the need for new office space in the Tri-Cities area."

Industrial sector healthy The Southern California industrial markets are very healthy as well, reports Jack Cline, co-manager and senior vice president of Lee & Associates in the City of Commerce. "The L.A. industrial market is hot as heck and we expect it to continue because of a dwindling supply of space and the availability of capital for development," he continues. "We think we're a third of the way into the development cycle, so we have two thirds of the cycle still left. Land prices have gone up 10% to 15%."

In Los Angeles County, the industrial vacancy rate is 5.9%, but real estate brokers note that a large part of that may be obsolete or a candidate for demolition. Among the significant lease transaction in the third quarter: M.C. Distribution's sublease of 392,000 sq. ft. in the City of Industry and Burnham Services Corp.'s lease of 230,000 sq. ft. in La Mirada. Also during the third quarter, Cargill, Inc. purchased 475,000 sq. ft. in Commerce from Pillsbury and Hathaway Enterprises Inc. bought a 290,000 sq. ft. facility in Los Angeles.

Santa Fe Springs, on the L.A.-O.C. border is reporting tremendous industrial activity, both completed and slated, adds Cline. "We could start to see some spikes in vacancy, since it takes some time to move hundreds of square feet from market," he explains. "Orange County industrial is very solid; it has more land to develop than L.A. and all the big institutional players are already down there, looking to secure large parcels for development."

Retail construction in the L.A. basin is also strong. Six new centers are planned or under construction in L.A.'s South Bay area, including an 800,000 sq. ft. power/community center in Torrance and a million sq. ft. center in Long Beach.

"We find the current retail market in Southern California beginning to emerge from the doldrums experienced in the early part of the decade," says Doug Brown, a partner at Beverly Hills-based Regent Properties Inc., an active retail developer in Southern California. "Retailers are experiencing increased sales volumes, and future sales volumes are projected to continue to escalate. New shopping centers are coming out of the ground and more are planned; however, most developers are proceeding cautiously to avoid the painful lessons learned in the early 1990s. New project are significantly preleased with long-term credit leases and are financed only with considerable equity investment."

Among the more active buyers: The Macerich Co., which acquired Stonewall Mall, a super regional in the L. A. suburb of Downey. The 927,000 sq. ft. mall is anchored by Sears, J.C. Penney, Robinsons-May and Mervyn's. A joint venture of The Macerich Co. and AMB Institutional Realty Advisors Inc. also acquired Manhattan Village, a multi-use center in the affluent L.A. suburb. Manhattan Village has 468,000 sq. ft.

Orange County has renaissance Like the L.A. area, the Orange County real estate market is experiencing a renaissance. Over the past year, for instance, the countywide direct average rental rate has increased 9%, with the airport area and south county sub-markets posting 17% and 22% increases respectively, according to Grubb & Ellis. Office space net absorption totaled 1.7 million sq. ft. at the end of the third quarter and was expected to exceed 2 million sq. ft. by the end of the year.

Sandy Fleschman, executive vice president of senior housing at Birtcher Senior Properties of Laguna Niguel, notes that there is increased competition for product even in the health care sector. "Acquisitions are so overheated that, economically, it makes more sense to develop for us rather than acquire a congregated care facility," he adds. "Much of this is due to the 16 companies that have gone public. In order for those companies to achieve earnings growth, and because development can take up to three years, they have to grow through acquisitions. But many are chasing a finite supply, which is driving up prices."

Birtcher's strategy is to continue to develop purpose-built projects in Southern California. It has two projects under development and is negotiating on another half dozen sites. "We're incredibly excited," he adds. "We have a great pipeline of product to come."

On the industrial side, O.C.'s prime location in Southern California translates into some of the highest rental rates in the state. The third quarter vacancy rate of 6.6% was down 1.6 percentage points from a year ago. Some 3 million sq. ft. of speculative industrial space is under construction in O.C.

Demand for new retail construction is especially high in Orange County's south and central coast submarket, analysts add, where virtually all new space built during the past three years has been occupied upon completion. According to Grubb & Ellis, more than 2.5 million sq. ft. of retail is slated for completion this year.

Inland Empire is stronger Neighboring Inland Empire is also reporting a much stronger real estate sector. Office leasing activity during the third quarter in the Inland Empire, was the strongest it's been in two years. However, the vacancy rate increased slightly, to 24.6%, as a result of some 70,000 sq. ft. of space being vacated by state agencies in San Bernardino. In the third quarter, Ontario reported its lowest direct vacancy rate in the past seven years -- 17.4% -- according to Cushman & Wakefield. Among the notable transactions: AEW/LBA Acquisition Co. purchased the 84,400 sq. ft. Havengate Business Center in Rancho Cucamonga and the 110,700 sq. ft. Centrelake Plaza in Ontario.

The retail sector in the Inland Empire is also showing some signs of life, although the vacancy rate is 14%. New construction is under way in selected markets. Lease rates for good space in good locations are on the rise, but second-tier centers continue to struggle. On the industrial side, the Inland Empire has some 4 million sq. ft. of speculative space under construction. Why so much new building? Land is available for development at reasonable prices, state-of-the-art product, a solid labor base, excellent freeway access and rail service and a solid labor base are some of the reasons.

San Diego displays slow growth Not to be outdone, nearby San Diego is also displaying slow, solid, steady growth in office, retail and industrial, with vacancy rates at their lowest levels in five years. The area has become a landlord's market, with space tightening in nearly all areas and rents increasing.

Richard Caterina, senior vice president in the San Diego office of Johnson Capital, notes the real estate market is very strong -- and much saner than the 1980s. "Now it's largely demand driven," he adds. "It depends on the product type and specific location. Most of the recovery has been driven by the expansion of companies. There's been limited new development, and it's difficult to add new supply as quickly as demand has increased."

In the Sorrento Mesa market, for instance, rents for Class-A office space has gone from $1.70 per month per sq. ft. to over $2, within the last year. "It's inching up still, and eventually what will happen is new product will come on line. Rents have really spiked southeast of the Carlsbad airport area. Downtown San Diego is slower. The suburban market places are a little more attractive because they are closer to where people live. The CBD markets will come back, but it'll probably be a function of price. They will have to be cheaper than the suburbs."

On the industrial side, 1996 was a record year for land sales, so this year was one for construction. Speculative developments were planned in Carlsbad, Vista, Rancho Bernardo, Poway, Sorrento Mesa and Otay Mesa, according to CB Commercial.

There's no question the Southern California real estate market has recovered from the early 1990s, when overbuilding combined with economic reductions produced a surplus of space. Today, falling rental rates and empty buildings are but a faint memory as the area's economic engine roars, powering an energized real estate market.

Mike Sheridan is a Houston-based writer who contributes frequently to NREI.

West L.A. Office (overall): 13.6% Central L.A. Office (overall): 23.4% Central L.A. Office (direct): 18.6% South Bay Office (overall): 20.5% North L.A. Office (overall): 15.9% Orange County Office (overall): 14.3% Orange County Office (direct): 12.1% South Bay Industrial (est. overall): 7.5% L.A. Industrial (overall): 5.9% Orange County Industrial (est. overall): 6.6%

Source: Cushman & Wakefield

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