It’s going to be a long, slow road to recovery for the Golden State.
After riding at the forefront of the real estate boom in both the residential and commercial sectors in the mid 2000s, California, with its abundance of land and huge construction industry, seems to be having a particularly difficult time returning to some semblance of normalcy. Individual cities in Florida and Arizona might have been hit harder by the falloff in housing prices, but California cities and towns make up 10 of the 25 worst housing markets in the country, according to Housing Predictor, a market research firm.
In addition, California’s unemployment rate continues to climb. In June, it reached 11.6 percent, 210 basis points higher than the national average of 9.5 percent. In fact, California’s employment situation isn’t likely to show a noticeable improvement until the third quarter of 2010, according to research by Jones Lang LaSalle Retail, an Atlanta-based third party management services provider. By contrast, neighboring Oregon might begin to recover as early as the fourth quarter of this year.
California’s prognosis for the short-term future remains grim. In its 2009 “Mid-Year Economic Forecast,” Jones Lang LaSalle and its research partner August Partners ranked various parts of the U.S. based on indicators including wages, employment, housing price changes, gross metropolitan product and foreclosure rates. A low score correlated to a good economic performance. The Pacific region, including California, received a score of 577, the second highest in the country.
Ahead of ICSC’s Western Division conference, set to take place in San Diego next week, we assembled a panel of local real estate executives to talk about what all of those indicators mean for the state’s retail real estate market. Participants included Eric Hohmann, a San Francisco-based managing director and head of the West Coast region for investment, development and management firm Madison Marquette, Scott Burns, senior vice president with Los Angeles-based brokerage firm Wilson Commercial Real Estate; J. Scott Fawcett, president of Newport Beach, Calif.-based Marinita Development Co.; and Bill Huelsman, a San Diego-based senior vice president with Jones Lang LaSalle Retail.
Retail Traffic: Like Florida and Arizona, California was particularly hard hit by the housing crisis. Do you currently see any signs of recovery in that sector?
Burns: I think that we’ve seen some stability in certain markets, like Los Angeles. Right now, we are seeing improvement day by day. It’s going to be a while before we see true stability because unemployment needs to bottom out before housing really recovers.
Huelsman: There’s been a significant uptick in homes closing, but I think it has been the result of foreclosures and people taking advantage of low prices. I think the housing situation is going to continue to deteriorate for a while. There are tremendous opportunities to buy a single-family home in California and that’s encouraging for those of us who have kids because now we know they’ll be able to buy a home here. But the disappointing side is the job market. Our unemployment rate is several percentage points higher than the rest of the country.
Fawcett: If you asked me two days ago, I would have said no. But according to the Los Angeles Times, sales of existing homes have picked up and prices have increased somewhat. People feel prices are about as low as they are going to get and if they are going to buy a house, this is probably the right time. And builders out here are starting to shop for lots that were taken back by the banks. We are not out of the woods by any means, but [we might be] close to the bottom.
RT: California also became the epicenter for new retail construction in 2006 and 2007. Have you seen a lot of those projects get postponed, or scrapped off the drawing board altogether?
Hohmann: I think there’s probably been an untold number of projects stalled at the entitlement stage, due to market conditions and particularly, financing concerns. That includes some things that Madison Marquette was working on. Fortunately for us, we didn’t come out of the ground with [anything] in the past 18 months, so we are in good shape in that respect. But I think in California we are probably feeling the effects of the dislocation to a greater extent than the rest of the country because we had such a run-up in housing prices and growth in the residential sector that many projects were chasing rooftop construction. We had it very good on the run-up and now we are paying a little bit more than everyone else on the run-down.
Fawcett: If you take the time period starting at the end of 2007 through 2008, those projects couldn’t get financing, so they couldn’t get built. The projects that were started in 2006 and early 2007 and got financing and did get built, frankly, they are struggling. Where they had the majors committed, they went ahead and honored those commitments. Where the problem lies is with the mom and pop spaces. The developers are having an awful time trying to lease the mom and pops and that’s generally where the money’s at. We are talking to tenants who have initially contacted us eight to 12 months ago and they say “We still haven’t quite made up our minds yet.” It’s taking much, much longer to lease space.
Burns: Southern California, where I spend the majority of my time, was a hot spot for retail development and excess development, no question about it--especially in the Inland Empire and parts of Orange County. There have been projects that have stalled and been scrapped, but almost as many have been built and that has had an impact on vacancy rates and rent compression. We are now in a position where we have more retail space than demand will support—we are seeing 8 percent to 10 percent vacancy rates in the markets where we work.
RT: Can we discuss the vacancy situation in more depth? How much of a change have you seen from the peak of the market?
Fawcett: It depends which area you are talking about. In San Diego, for example, because of the difficulty of getting entitlements there, the vacancy rate is only 5 percent. In Orange County, it’s probably 8 percent. And if you go out into the Inland Empire, it’s probably 10 percent. The eastern part of the Inland Empire has been very hard hit.
Hohmann: Vacancy is certainly up, particularly in the newer projects. Recently developed projects are having challenges on a number of levels. One is weak demand from the national tenants. And two, many projects are suffering financing challenges so they can’t get additional capital for tenant improvements.
Huelsman: The vacancy rates have started to accelerate rapidly, though the centers that are closer to central business districts have not experienced as much of a vacancy increase as we expected. Overall, we have seen an increase above 10 percent and we’ve seen a significant increase in tenants asking for rent relief.
RT: How much of an impact has there been on asking rents?
Burns: Due to the overbuilding, we’ve seen quite a bit of rent compression. I’d say in some markets it’s up to 30 percent or 40 percent, in others it’s 10 percent. But it’s also due to [lower] demand. We have fewer active retailers out there looking for multiple stores. And due to the change in the market, we are seeing retailers request rent relief and quite a bit of lease restructuring.
Fawcett: I would say asking rents are down anywhere from 10 percent to as high as 20 percent, depending on the area. And the tenants, even if you give them space that’s ready to move into, they are asking for additional TI money. And then they might say “In addition to that, we want three months of free rent.” And if you say to yourself “I can’t do that,” you then look six months back and say “I was so stupid. It would have been better to put somebody in that space rather than having a vacancy.” I met with a lender the other day and his attitude is that the worst possible thing you can have is a vacant shopping center. Do whatever you have to get tenants in there. It has virtually no value if it’s sitting there vacant.
Hohmann: We have a perspective on the market that’s very broad because we have properties ranging from malls all the way to grocery- and drug-anchored community centers. If you look at lifestyle projects, what we are seeing is that net effective rents have gone down significantly because of higher TI allowances and tenants’ demands for only percentage rent during the initial period. Those deals are much less attractive than they were a year or two ago, but if you want a strong national retailer, that’s what you’ve got to do. At some centers, we are doing those deals because we are being strategic, we won’t do it for every tenant. At more value-oriented centers, rents are perhaps lower than the owner’s pro forma, but a number of those tenants had been previously locked out of the market and now is their time to take advantage of this dislocation. Those tenants are paying the full rent if they can afford it.
RT: Brokers in some of the other markets have reported seeing a bit of a renewed interest in expansion on the part of retailers. Has that been the case in California?
Huelsman: Those retailers that maintained a healthy balance sheet are in a position to acquire very well located real estate at bargain basement prices right now. So restaurants are absolutely showing interest. We are seeing a significant demand from sit-down restaurants, like the Olive Garden and Red Lobster. And I think a lot of displaced workers are out there buying franchises. They are buying a Subway’s or a Domino’s Pizza and that is definitely driving demand. From an apparel standpoint, Forever 21, American Eagle, Quicksilver, anything that’s teen-related is showing significant increases in sales. We think the reason is that the mom is not spending on herself, but she’s spending on her kids.
Burns: I think the increase in demand right now is marginal. There are quite a few tenants I’ve come across who are exploring opportunities for possible future growth. Those I wouldn’t say are meaningful, but they give us hope for growth. And we are working with three or four retailers right now that are new to the market and want to take advantage of lower rents and some of the prime real estate that’s available. One is a wholesaler/distributor and is looking into retail stores and that’s encouraging to us.
Fawcett: There is another interesting phenomenon. I’ve got centers where some franchise operators have told me “We would love to be there. Our real estate committee has looked at your properties, we need representation in your area, but we don’t have any franchisees.” They just don’t have that stable of potential franchisees anymore and they don’t want to open up a corporate store.
RT: What kind of a mood do you expect to see at this year’s ICSC conference?
Hohmann: I am expecting this convention will be productive in moving deals along. I know those deals aren’t going to be as good as those we made last year, but there will be deals.
Huelsman: Looking across how many retailers are going to be coming to this conference, I am mostly seeing the gas stations, the fast food guys, the retailers that are still active and can make business in the local shopping center.
Burns: I think people will be focused. They’ve accepted this new economy and for the most part, people that are spending the money to go will be there to find deals and make deals happen.
Fawcett: I think the mood is going to be much better than it was last year. Last year, we were discovering we were in a kind of tailspin. People are going to feel better because they see a light at the end of the tunnel.