In August 2003, Stonebridge Holdings of Los Angeles spent $30 million for a coveted 12-acre site in Olympic Boulevard in West Los Angeles, with the intent of building a medical office project and a small hospital. Less than a year later, in July 2004, Stonebridge decided to sell half the site to a multifamily developer for an undisclosed sum, which brokerage sources peg at $18 million, or $3 million more than what the owner had paid. That's not bad for an 11-month investment.

In the first half of 2004, the Southern California commercial real estate markets have warmed up from tepid to overheated. All classes of real estate, including industrial and hospitality, are attracting money and squeezing cap rates, despite the essentially flat performance of the assets themselves.

Burning Off Excess Office Space

At the moment, office owners in Los Angeles and Orange counties are sitting in a proverbial sweet spot. The market is strong enough to attract high prices, but not quite robust enough to justify new construction. (In Orange County, rental rates average $2.26 per sq. ft. monthly, but new construction would require rents of at least $2.80.)

In general, cap rates are tightening. A year ago, they averaged 9% to 10%; now they range from 7% to 8%. Case in point: A joint venture between Equity Office and TIAA-CREF recently agreed to pay $443.6 million for the 1.7 million sq. ft. Colorado Center (formerly the MGM Plaza), despite the center's loss of its anchor tenant, MGM, and an occupancy rate of only 82%. That's $80 million more than seller Tishman Speyer had paid for the complex in 2000.

Meanwhile, Los Angeles-based REIT Maguire Properties spent $260 million in April to buy the first phase of the 5 million sq. ft. Park Place mixed-use development in Orange County. It spent another $214 million in July to buy the second phase, which consists mostly of 2 million sq. ft. of office, residential and retail space to be built over the next 20 years.

After a decade with very little new construction, the Los Angeles office market is noticeably tighter, with the vacancy rate at 16.1% in the second quarter of 2004, down from 18.3% in the second quarter of 2003, reports Cushman & Wakefield.

Excess sublease space is burning off, even in downtown Los Angeles, the county's largest market that has been plagued by an overhang of sublease space for years. For example, 25 floors formerly subleased by Atlantic Richfield Oil Corp. (ARCO) in three different buildings has been leased — a significant turnaround.

“By itself, that lowers the overall downtown vacancy by two [percentage] points,” says Kinden Mitchell, a Cushman & Wakefield broker who negotiated the lease of 13 of those floors in the ARCO Plaza twin towers on behalf of landlord Thomas Properties.

The Orange County office market also is showing modest improvement with Class-A space leasing for $27.12 per sq. ft. With only 89,000 sq. ft. completed, the vacancy rate had shrunk from 17.3% in the second quarter of 2003 to 15.5% in the second quarter of 2004.

“We are on track for 2.4 million sq. ft. of absorption in 2004, twice that of 2003,” predicts Chris Deason, senior vice president of the Orange County office of Voit Commercial Brokerage.

Hotels Stage a Comeback

The resurgence of tourism has nearly lifted hotels out of the undervalued category, with occupancy slowly climbing back to 2000 levels. Little new construction occurred in Los Angeles and Orange counties during the first half of the year. The exception is mid-level products, such as the 127-room Days Inn & Suites in Anaheim and a 156-room Courtyard by Marriott in Foothill Ranch, both in Orange County.

As for major projects, “the planning cycle in Southern California is so long and predevelopment is so expensive that there is a high barrier to entry,” says Bruce Baltin, senior vice president in the L.A. office of PKF Consulting.

One of the few big hotels planned is a 1,200-room convention center/hotel in downtown Los Angeles, to be built by Staples owner Anschutz Entertainment Group of Denver. The complex is part of a project comprising several city blocks of retail and theatrical attractions surrounding Staples Center.

Hotels in Los Angeles County posted a healthy occupancy rate of 74.4% in the second quarter of 2004, up from 66.9% a year earlier, according to PKF Consulting. Revenue per available room (RevPAR) averaged $90.50 in May, compared with $78.87 in May 2003. In Orange County, occupancy rates in the second quarter registered 70.4%, up from 64.5% in the second quarter of 2003. RevPAR averaged $80.93 vs. $71.88 a year earlier.

Appetite for Retail Remains Strong

National retailers are clamoring to enter the affluent Los Angeles market “but can't find anything,” says Ken Shishido, a retail broker with Lee & Associates. In Orange County, retail development was down 25% at the end of June from the same period in 2003, while prices were up 14%.

One exception to the retail slowdown was the May opening of the $130 million The Pike at Rainbow Harbor in Long Beach by Beachwood, Ohio-based Developers Diversified Realty. But major projects like the Pike are not the norm. Neighborhood centers and transit-oriented developments are the product of the future, says broker Reza Etedali, president of Reza Investment Group of Orange County.

“There is a baby-boom population that wants to live closer to work, and also be closer to shopping,” he says.

Meanwhile, investors are hungry for traditional retail products such as neighborhood centers — when such deals are available. Neighborhood centers in Orange County have recently sold for $150 per sq. ft., while regional malls command between $130 and $150 per sq. ft., according to Etedali.

Multifamily: An End to the Fever?

L.A., like much of the rest of the country, has been building new multifamily projects at a fever pitch over the past few years. The area's continuous population boom — and inadequate housing production — are driving the trend, and the resulting inflation in housing prices ($430,000 for a median-priced home in L.A. and more than $500,000 in Orange County) has consigned many would-be homeowners to the rental market.

Now, however, the growing cost of steel and timber may be undercutting an already expensive development type.

“We may be getting out of multifamily and getting more heavily into condominiums,” says Cliff Goldstein, partner of J.H. Snyder Co. The firm recently completed the 335-unit Oak Creek development in Agoura Hills and just started the 700-unit NoHo Commons mixed-use development in North Hollywood.

Meanwhile, apartment rents continue to climb. In the combined Los Angeles-Orange County metropolitan statistical area (MSA), the apartment rents in the second quarter averaged $1,336 per month, a 3.7% increase above the previous year, according to RealFacts, a real estate research firm in Novato, Calif.

Occupancy totaled 98.4%, virtually unchanged from June 2003. Construction also is moving apace, with 6,878 units projected for completion by year's end, compared with 3,455 units in 2003 and 3,000 units in 2002, according to the same source. The apartment vacancy rate was a tight 4%.

Industrial: Running Out of Room?

The Los Angeles industrial market is lean, with a 4.5% vacancy rate at mid-year, unchanged from a year ago, according to data provider CoStar Group Inc. But developers seem to be running out of room — only 3.5 million sq. ft. of new space has entered a market of more than 1 billion sq. ft. Industrial rents were $7.16 per sq. ft. at the end of June, vs. $6.23 per sq. ft. during same period in 2003.

Orange County appears most popular with small owner-occupants, according to John McDermott, a national director for brokerage Sperry Van Ness. Out of $500 million in industrial sales in the first half of the year, “nearly all were for small buildings, with only seven deals larger than $10 million,” he says. The average sale price was $80.34 per sq. ft., according to CoStar.

As in the case of office space, it is still cheaper to buy existing industrial buildings than to create new ones. For industrial owners, as with owners of other types of types of real estate in Southern California, the high cost of construction is good news, and there is little to worry about — that is, until the next round of construction starts.

Morris Newman is a Los Angeles-based writer.

LOS ANGELES - BY THE NUMBERS

COMBINED POPULATION OF METRO AREAS: 13.24 million

UNEMPLOYMENT RATE:
6.3% LOS ANGELES
3.4% ORANGE COUNTY

LARGEST PRIVATE EMPLOYERS:

  1. Kaiser Permanente, 27,635 employees

  2. Boeing Co., 23,468 employees

  3. Walt Disney Co., 21,000 employees



Source: Los Angeles Almanac;
Orange County Business Journal

METRO AREA STATS

Office (Los Angeles):
16.1% vacancy, 2Q 2004
18.3% vacancy, 2Q 2003
Rent per sq. ft.: $27.60, 2Q 2004

Orange County:
15.5% vacancy, 2Q 2004
17.3% vacancy, 2Q 2003
Rent per sq. ft.: $27.12, 2Q 2004
Source: Cushman & Wakefield

Multifamily (Los Angeles):
3.4% vacancy, 2Q 2004
3.5% vacancy, 2Q 2003
Rent per unit: $1,184, 2Q 2004

Orange County:
4.4% vacancy, 2Q 2004
4% vacancy, 2Q 2003
Rent per unit: $1,269, 2Q 2004
Source: Marcus & Millichap

Retail (Greater Los Angeles, including Orange County):
4% vacancy, 2Q 2004
4-6% vacancy, 2Q 2003
Rent per sq. ft.: $45-$48, 2Q 2004
Source: NAI Commercial Real Estate Services

Industrial (Los Angeles):
4.5% vacancy, 2Q 2004
3.9% vacancy, 2Q 2003
Rent per sq. ft.: $7.16, 2Q 2004

Orange County:
7% vacancy, 2Q 2004
6.5% vacancy, 2Q 2003
Rent per sq. ft.: $8.36, 2Q 2004
Source: CoStar Group Inc.

Hotel (Los Angeles):
74.4% occupancy, 2Q 2004
66.9% occupancy, 2Q 2003

Orange County:
70.4% occupancy, 2Q 2004
64.5% occupancy, 2Q 2003
Source: PKF Consulting

MAJOR PROJECTS UNDER CONSTRUCTION:
NoHo Commons, a transit-oriented mixed-use project in North Hollywood

Cost: $200 million

Developer: J.H. Snyder

Completion: Mid-2005

Staples Center Phase 1, includes a 1,200-room convention hotel, theater and 40,000 sq. ft. plaza in downtown L.A.

Cost: $1 billion

Developer: Arena Entertainment Group

Completion: 2008-2015

Grand Avenue, a 3.2 million sq. ft. mixed-use project on four publicly owned parcels near the Walt Disney Concert Hall in downtown L.A.

Cost: $1.2 billion

Developer: The Related Cos.

Completion: To be determined

Investor: L.A., Orange Counties are ‘Solid, but Oversold’

Los Angeles is known for its warm climate, but one local real estate investor has another way to describe it: overheated. Zaya Younan, who three years ago founded Woodland Hills, Calif.-based commercial real estate investment firm Younan Properties, fears that office and hotel prices have risen outrageously in the Los Angeles and Orange County markets, thanks to exuberant buyers.

“You're buying Class-A office properties here [in Los Angeles] for about $220 per sq. ft., while the maximum rental rates you can collect are $24 per sq. ft.” An investor can buy a comparable building in Dallas or Phoenix for about $80 per sq. ft. and can collect $15 per sq. ft. rental rates.

To be sure, Younan still believes that Southern California has a strong economy. In fact, he's bet on it himself. Younan paid $28 million in January for the 172,000 sq. ft. Sepulveda Center in West Los Angeles. The seller was Equity Office Properties Trust.

Younan now owns 25 buildings with a total of 3.2 million sq. ft. in the western U.S. But he is concerned about what he calls the “significant compression of cap rates,” adding “we haven't seen anything like this in 10 years.”

He doesn't believe that the mediocre performance of Southern California's properties in any way justifies sharply lower cap rates. The problem, he says, is that buildings with 90% occupancy in Los Angeles are selling at a 7% capitalization rate.

While he has limited expectations for L.A., Younan doesn't lose sleep worrying about interest rates. As he says, “We feel strongly that the economy is going to expand, and yields will exceed any negative impact from rising rates.”
Morris Newman