MARKET HIGHLIGHT, FEBRUARY 2005

LOS ANGELES’ RACE FOR SPACE
John Battle, Jeffrey Morgan, Laurie Lustig-Bower and Bert Abel

The Los Angeles commercial real estate investment market continues to exhibit a great deal of activity, with lots of dollars chasing a limited amount of properties. Low interest rates have produced a condo craze in the multifamily sector, and lifestyle centers are a hit in the retail market. Industrial space is in great demand in Los Angeles while the city’s office sector continues to recover.

Office

The office sector is slowly starting to recover and continues its slow transition from a tenant’s to a landlord’s market. This trend is due to the continued absorption of Class A office space and the lack of any new speculative office construction. In addition, there has been a tremendous amount of sales activity in the past year reaching price levels that have exceeded any true rent growth. These new office owners are going to be raising rents as soon as possible in order to increase the low returns they had to accept in order to purchase property in Southern California.

Every submarket of greater Los Angeles has seen major sales activity. For example, the following office sales: 1000 Wilshire, 333 S. Hope and 445 S. Figueroa are some of the major properties to have changed hands. Pricing levels were in the 6.5 to 7.5 percent cap rate range, which is near an all-time low for this market. The buyers were well known national players like Trizec Properties.

Another area that has experienced major sales activity is the San Fernando Valley. One of the most prominent transactions in this area is the first phase of The Pinnacle, M. David Paul’s new office development in the red-hot media district of Burbank. This fully leased project has generated a price in excess of $340 per square foot. Due to the fact that many properties have changed hands at these high valuations, the major impact on the market is going to be higher rents and less concessions on any new or renewal lease transactions.

On the new development front, we are seeing action in suburban areas like Ventura County, the Inland Empire and southern Orange County for many reasons. Number one, this is where the larger land parcels are located. Secondly, the population trends all indicate that these areas will continue to grow for the next 20 years. Also, there is a significant amount of infill development happening. These projects are generally much smaller than what is happening in suburban areas and many of the developments are mixed-use combining multifamily residential and retail.

The downtown Los Angeles market is very dynamic at the present time. This is primarily because of the activity around Staples Center and the significant amount of new housing units that have already been brought to the market (a total of more than 8,000 units). For example, AEG, the developer of Staples and the surrounding area, has announced the final details of the massive project around Staples Center. The project will include a 55-story, 1,200-room hotel with the top 20 floors being condominiums. Surrounding the hotel will be more than 200,000 square feet of retail shops, restaurants and entertainment venues such as the 7,000-seat Nokia Theatre. The developer is receiving assistance from the city of Los Angeles primarily in the form of tax rebates that will be generated by the use of the hotel. Due to the fact that this is such a high-profile project, it will continue to keep downtown at the forefront of the commercial real estate market.

Office leases in Class A properties in downtown Los Angeles range from $1.75 to $2.50 per square foot. The highest asking prices are in the Sanwa Bank Building (601 S. Figuerora) and U.S. Bank Tower. Both market available space on a NNN basis, which translates to $2.50 to $2.75 per square foot on a full-service basis. The overall vacancy rate downtown is hovering around 20 percent. The San Fernando Valley submarket has the lowest vacancy at 12.2 percent.

As 2005 progresses, the greater Southern California office market will continue on the road to recovery. The strength and diversity of the local economy, the lack of any speculative construction and the continued desirability of the area will all contribute to the recovery.

— John Battle is a principal at Lee & Associates-LA North/Ventura.

Industrial

The Los Angeles industrial sector is experiencing extremely strong leasing demand for high quality warehouse space. Occupancy rates are at their highest levels in 10 years. As a result, lease rates are firming up, sales prices are reaching ever-higher levels and lease concessions are diminishing.

The primary cause for the boost in warehousing demand is the increase in import volume coming through the ports of Los Angeles and Long Beach from the Far East. A pending elimination of several Department of Trade & Commerce import quotas on Chinese-manufactured woven garments could potentially flood these ports with a huge influx of these goods.

Most of the new development in the South Bay market has been confined to the Dominguez Technology Center in Carson and the Harbor Gateway Center project in the Torrance/Los Angeles area. In the Dominguez Technology Center, Carson Companies has one large spec building under construction while Watson Land Company is building three new facilities with three additional buildings planned after lease up. In the Harbor Gateway Center, Boeing Realty is slated to complete an additional facility in second quarter 2005. Lack of available land is the reason that industrial development has taken place almost solely in these two submarkets. The South Bay now is virtually out of developable parcels. Much of the existing inventory of older obsolete buildings is being converted to lighter industrial uses or torn down for adaptive reuses such as schools, residential or retail. Development opportunities in the future will continue to be elusive as there is a tremendous demand and almost no supply of viable development projects.

The industrial product that is being constructed, for the most part, is high-clearance efficient distribution centers with ESFR sprinklers, 3 percent skylights, large-truck courts, and adequate automobile and truck parking. This type of product draws third-party distribution warehousing operators, in-house warehousing and distribution tenants, and some light manufacturing and higher-end service center type of uses. The major tenants in the market are the third party logistics companies that focus on all manner of cargo but specifically garments that are manufactured in the Far East and imported through the ports for sale in Wal-Mart, Target, Kmart and other large retailers. Manufacturing tenants, on the contrary, are in decline as the local manufacturer’s cost basis does not compete favorably with goods made in China. Industrial rental rates range from $0.41 per square foot NNN for quality second-generation facilities to more than $0.65 per square foot NNN for new 30-foot clearance ESFR state-of-the-art buildings. Overall industrial vacancy in Los Angeles, including subleases, is 5.9 percent, which is down half a percentage point from the end of the third quarter 2004. The South Bay’s gross absorption in the fourth quarter was roughly 3.5 million square feet. Major investors in the market include AMB Property LP, The Carson Companies and RREEF.

Straddling the Alameda Corridor that runs north from the Artesia 91 Freeway, the Compton/Lynwood/ South Gate area is one to watch due to its redevelopment potential. The ever-increasing traffic burden on the transportation infrastructure in and around the South Bay will drive several changes in the industrial operations, in terms of hours of operation, cost per container, tightened security protocols, contingency planning and lead time. There’s a growing resistance by a number of the incorporated municipalities around the South Bay industrial ports against the expansion or addition of any new container parking facilities, cross-dock trucking terminals and container staging yards. The approximately 15 percent year-over-year compounded growth in the volume through the ports of Los Angeles and Long Beach have pushed many local municipalities to enact strict-use moratoriums and building restrictions, enforce noise and hours of operation ordinances and to harass trucking and heavy traffic users into conformity.

— Jeffrey Morgan is a senior vice president in CB Richard Ellis’ Torrance, California office.

Multifamily

Over the last year, low interest rates have had a significant impact on property values all over Los Angeles. Now that more and more people have been able to purchase homes, there has been a significant increase in demand for condominiums. In fact, from the last three quarters of 2003 to the first three quarters of 2004, we have seen condo prices rise more than 25 percent in A and B locations in Los Angeles. In a conventional real estate market, condo prices typically increase an average of about 3 percent per year. In a nutshell, an increase in value that would normally take nearly a decade to achieve has occurred in less than 2 years.

This trend has altered the makeup of brokers’ listing inventory as well as how they market multifamily properties. A large number of properties are apartment buildings being sold for their land, as they are worth more as condominium development sites than as existing apartment buildings.

As a result of the recent condo craze, developers are becoming encouraged by the high price per square foot that these condos are achieving. Many developers are converting existing apartment buildings to condominiums as well as building for-sale units from scratch. Apartment buildings with condo maps filed with the city are commanding premium prices such that the current income is essentially ignored in determining sales prices for properties. A big part of the conversion process is upgrading the individual units. Depending on the project, the renovation might include installing hardwood or tile floors, granite countertops, washer and dryer hookups and new appliances. For the converter, it is a balance between spending enough money to make the condominiums attractive to buyers while not spending more than the market can afford.

Sellers are just now starting to take advantage of the market, realizing that their existing apartment properties might be worth more as land for condominium development. However, the window that these sellers have to maximize the value of their properties may be closing as interest rates continue to rise. As interest rates rise, less people will be able to purchase condominiums, demand will decrease and therefore prices for condominiums will decline. As this happens, the underlying value of the condominium development land will consequently decline as well.

Meanwhile, although it appears as though interest rates are projected to increase, the increase is coming slower than expected and many developers believe that the condo market will stay strong. In fact, even if interest rates do rise, many people believe that given Los Angeles’ shortage of afßfordable housing, condominiums will remain the dominant affordable choice for Angelinos for years to come.

On the rental side, the average vacancy rate in Los Angeles is 5 percent. G.H. Palmer Associates is the most active multifamily developer in the market with five projects under construction or in the planning stages. Also, J.H. Snyder is busy building The Crescent, a $40 million mixed-use development featuring 88 luxury residences, which will be the first apartments built in Beverly Hills in more than 20 years.

— Laurie Lustig-Bower is an executive vice president and partner with CB Richard Ellis.

Retail

The “de-malling” trend was evident throughout 2004 and is expected to continue in 2005. According to the retail experts at an International Council of Shopping Centers conference, these so-called lifestyle centers — open-air shopping centers such as The Grove and Pasadena’s Paseo Colorado — will double in number in the next 5 years. One reason for the trend is that many traditional malls have become hulking eyesores that require a tremendous amount of land. In Southern California, land is a limited commodity and lifestyle centers usually require less property due to smaller or non-anchor stores. Consumers continue to demand more from their retail destinations and developers are responding with mixed-use properties and lifestyle centers that create a sense of community.

Often developers of lifestyle centers run into strong opposition from other mall owners and operators, who fear that a decline in foot traffic at their properties will lead to a decline in sales. The average sales per square foot for lifestyle centers is $400, while regional malls average about $330 per square foot. The city of Glendale, California, is in the midst of a battle between lifestyle mall developer Rick Caruso and Glendale Galleria owner, General Growth Properties. Round one went to Caruso with voters narrowly affirming city approval for the new lifestyle center.

Retail indicators look favorable for growth to continue in the industry. There were fewer bankruptcies among retailers in 2004, a 25 percent decline from the previous year. Consumer confidence has continued to gain strength since bottoming out in early 2003 and will be the catalyst along with job growth for increased sales. Retail rents are anticipated to increase through 2005 by a rate that just outpaces the consumer price index, or in the range of 3.5 to 4.5 percent annually. Meanwhile, vacancy should drift down to 5 percent or less as demand for retail space, helped along by new crops of retail categories and concepts, stays steady. European retailers are also helping prop up demand for space as they look to expand into U.S. malls and street-level shopping districts.

A big legal win for Wal-Mart in late 2004 will make it easier for the retailer to expand in Southern California. Governor Arnold Schwarzenegger vetoed a Democrat-sponsored bill that would have required local communities to commission economic impact studies on all super-center-type stores larger than 130,000 square feet, at least 10 percent of which is dedicated to grocery, before approving them. Wal-Mart plans to build 40 Supercenters in the state by 2009.

The retail investment market may see a bit of “normalizing” in 2005 with sale activity remaining high but not at the frenzied pace of the past couple of years. Investment prices seem to have topped out and cap rates have seen a leveling. Southern California cap rates through 2004 stayed below the national average and should continue the trend due to the tremendous amount of excess demand in the market.

— Bert Abel is a senior vice president at Grubb & Ellis’ north Los Angeles office.

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