When Paseo Colorado in downtown Pasadena opened in the fall of 2001, the project marked a turning point in Southern California's evolution. This was the region's first example of a mixed-use redevelopment project, and its 391 residential units atop 557,000 sq. ft. of specialty shops and restaurants were almost entirely leased before it opened.

The success of Paseo Colorado also signaled a dramatic shift in the region's attitude toward high-density, urban living and the return of residents to city centers. Once the poster child of urban sprawl, Los Angeles has begun to reinvent itself as a mature, vertical metropolis, with the highest population density emanating from downtown along light-rail transit corridors that previously did not exist.

This evolution is a direct response to the city's drastic shortage of affordable housing and a freeway system nearing total gridlock. And the population growth has not stopped. According to the U.S. Census Bureau, 800 people arrive daily in Los Angeles County alone.

“The future is in high-density housing — good-quality mixed-use projects close to public transportation,” says John McDermott, regional manager for Irvine, Calif.-based real estate firm Sperry Van Ness.

A Vertical Metropolis

Pasadena was the first city in Southern California to rezone in order to allow mixed-use development, says Bob Champion, president and CEO of Champion Development. Los Angeles recently passed a zoning ordinance to allow mixed-use projects on major boulevards, and other cities are following suit. “Cities are waking up and realizing there's a housing crunch, and the more progressive ones are changing zoning codes to allow mixed use,” Champion says.

The City of Los Angeles relaxed rules for mixed-use projects in its Central Business District (CBD) a few years ago, allowing the city to focus on becoming a 24/7 market. About 50 residential projects, with more than 6,000 units, are under way or proposed downtown.

Many of these projects involve restoring and repositioning historic office and industrial buildings for housing. For example, MJW Investments' $130 million Santee Court converts 10 early 20th century buildings in the fashion district to loft apartments, ground-floor retail and fashion showroom space. And with the 5-year-old Staples Center — a 20,000-seat sports arena that is home to the NBA's Los Angeles Lakers — in place, as well as the $275 million, 2,295-seat Disney Concert Hall opening this fall, Hollywood's young, hip crowd and professionals who work there are beginning to migrate downtown.

“What is really remarkable about downtown's residential activity is the large amount of affordable and workforce housing being created there,” says Allen Kingston, who heads Century Housing Corp., an affordable housing lender. Many projects, in fact, have affordable or workforce components of 20% or more.

Many Orange County cities are rezoning for higher-density projects to solve a housing shortage. The City of Anaheim, for example, is implementing a Downtown Mixed-Use Overlay Zone to encourage repositioning of retail centers as suburban villages and create more affordable and workforce housing. According to affordable housing developer Mike Costa, president of Simpson Housing LLC, tax credits and bond financing enable developers to build affordable housing with market-rate amenities, making these projects acceptable in mainstream communities.

Land's End

A lack of vacant land is spurring a flurry of infill redevelopment activity in all product types. The biggest chunk of open land near Los Angeles was gobbled up by the Playa Vista project, a 1,000-acre master-planned community near Marina del Rey that will include 3.5 million sq. ft of office and retail space and 3,246 residential units.

Orange County's largest parcels will disappear with the redevelopment of two defunct naval bases, renamed Tustin Legacy and Heritage Fields. Tustin Legacy is a 1,511-acre development that calls for 4,600 residential units and 9.2 million sq. ft. of commercial space on the former Marine Corps Air Station in Tustin.

Soon to be annexed by the City of Irvine, the Heritage Fields project will occupy a 3,775-acre portion of the 4,700-acre former El Toro Marine Corps Air Station, which is currently being auctioned off by Colliers Seeley.

Vacant land in outlying areas of Los Angeles County is disappearing, too, as large employers move north to Valencia, where there is less traffic congestion and housing is less expensive, notes Gary Toeller, vice president of development for Opus West. The developer is building three industrial projects with large floor plates ranging from 20,000 sq. ft. to 38,000 sq. ft. in that market.

The mixed-use revolution also is continuing in Pasadena, where several major projects are on tap. These include the 150,000 sq. ft. The Pasadena Collection and the Central Park Market at Del Mar Station, which includes 347 residential units, 30,000 sq. ft. of retail and 121,000 sq. ft. of office space.

Housing Shortage

Even with so much residential development, planners worry it is too little, too late. The Southern California population is expected to grow by 6 million people over the next decade, and already demand is 100,000 units ahead of supply. The shortage of housing is keeping the overall apartment vacancy under 5%, according to Marcus & Millichap, and rents are climbing by 2% and 3% per quarter.

Rents, averaging $1,217 per month in Los Angeles and $1,177 per month in Orange County, already exceed the federal government's housing affordability guideline, which suggests that housing expenses should not exceed 33% of net pay for a family of four earning the area's median income of $52,100 annually.

With such strong market fundamentals, investor competition for fewer available properties has apartments trading at record high prices and “unbelievably” low cap rates of 5% to 6%, notes McDermott. Buyers are willing to pay high prices due to low interest rates and are “betting that people will rent forever,” he explains, adding that the median price of a single-family home now stands at $350,000, which puts homeownership out of reach for most families.

Industrial's Dominance

About 40% of the nation's international cargo moves through Southern California ports and airports, driving growth in the logistics/distribution industry. As a result, industrial real estate in the region has weathered the recession better than many markets, says Jack Kyser, chief economist for the Los Angeles Economic Development Corp.

“While manufacturing employment declined, other aspects of industrial activity soaked up industrial warehouse space,” Kyser says. Overall industrial vacancy in Los Angeles County has not dipped under 4.7% since the economy tanked two years ago, while nationally it stands at nearly 10%, according to Grubb & Ellis.

However, vacancy is likely to rise above 5% over the next year with the delivery of 4.8 million sq. ft. of industrial space currently under construction, according to Cushman & Wakefield.

The popularity of industrial property with investors is second only to multifamily. Industrial properties are trading at record low cap rates in the 7% to 8% range, says Steve Case, senior managing director for CB Richard Ellis in Orange County. “Small industrial buildings are unbelievably hot right now,” he says, because low interest rates are enticing users to become owners.

Currently, there are 250 industrial and R&D buildings with 10,000 sq. ft. or less under way or planned in Orange County. Leasing in larger buildings of 50,000 sq. ft. or more is in a slump, raising Orange County's average industrial vacancy rate to 9.28% in the second quarter of 2003, reports Voit Cos.

Retail On a Roll

Increased consumer spending is pumping up the economy and has positioned Southern California's retail market as among the strongest in the nation, reports Marcus & Millichap, which reports that retail sales grew by 2.6% in 2002 over 2001.

Showing strong confidence in the retail market, Kohl's has opened 28 stores in Southern California this year and other retailers are expanding. As a result, the retail vacancy rate in Los Angeles County dropped from 5.3% in the second quarter of 2002 to 5.2% in the second quarter of 2003. Rents also grew by 3.1% in 2002 and are expected to rise another 2.5% in 2003.

Neighborhood shopping centers anchored by a grocer or drug store enjoyed the most growth and were the No.1 choice of retail investors. A number of high-profile shopping centers changed hands, with investor interest in this product type evident in sale prices, which rose 11% in 2002 and another 10% so far this year.

According to Richard Walter, president of brokerage Faris Lee Investments, 60% of sale transactions are 1031 exchanges and a lot of that money is going into Passco Real Estate Enterprises Inc.'s tenant-in-common (TIC) model. Walter, who brokered the $148 million sale of the Puente Hills Mall by Krausz Cos. to 32 different buyers participating in a TIC structure syndicated by Passco, notes that competition for properties has pushed prices to record highs and cap rates down to 7% to 8%.

Tom Jahncke, senior vice president and director for Passco, contends that even with the lower cap rates, investors will still realize returns over the 14% to 16% Passco targets in a combination of cash flow and appreciation. However, he admits that “they're looking at longer holds of five to seven years, where previously it was at three to five years.”

Office Hits Bottom

Although the office leasing market has seen better days, it appears that vacancy rates have stabilized. The overall vacancy has hovered around 18% for two consecutive quarters, reports Cushman & Wakefield. Joe Vargas, managing director for Cushman & Wakefield, says there's good demand for Class-A space, with a movement to quality due to lower rents and concessions.

The good news is office construction is down, and most projects under way are at least partially pre-leased, notes McDermott of Sperry Van Ness. “No one has cranes in the ground saying ‘if we build it they will come,’” he explains.

For example, the 60,000 sq. ft. Phase II of Corona Corporate Center under development by Irvine-based Armstrong Butcher Properties LLC is 100% pre-leased to three tenants, and the 256,274 sq. ft. Western Asset Plaza in Pasadena by Maguire Partners is 60% pre-leased to Western Asset Management Co.

In addition, Aliso Viejo, Calif.-based Shea Properties has completed the first of nine buildings in Vantis, a 1.5 million sq. ft., $350 million office campus in South Orange County. The 177,000 sq. ft. building is anchored by Safeco Insurance.

According to Cushman & Wakefield, just 855,526 sq. ft of office space is currently under construction in all of Los Angeles County, and 223,984 sq. ft. is under way in Orange County.

Vargas notes that the brightest spots in Southern California are West Los Angeles and the Tri-Cities area (Burbank, Glendale, Pasadena), where vacancy at the end of the second quarter stood at 14.6% and 15.2% respectively — the lowest in the region. Despite a soft rental market, investors continue to buy office buildings due to low interest rates and an excess of capital.

A number of major office complexes have changed hands, including several trophy properties downtown. Younan Properties CEO Zaya Younan, who plans to buy 3 to 5 million sq. ft. of office space this year, believes that the current weakness in office product presents “an opportunity to buy prime assets at discounted rates.”

Crown Realty & Development, however, has sold a couple of buildings at prices that surprised its president, Robert Flaxman. According to Case of CBRE, office properties are trading at cap rates in the 8s and 9s. “Folks are buying and selling at those high values,” he says. “It doesn't mean that the guy who buys from me today made a mistake. Well-located property will, over time, be okay.”

Room at the Inn

Southern California's hotel market has fared better than most of the nation, but Smith Travel Research reports that the average daily rate (ADR) in Los Angeles dropped by 2.4% between the second quarter of 2002 and the second quarter of 2003, from $109.86 per night to $107.22.

Inventory grew by 991 rooms in 2002 compared with 942 rooms in 2001, according to Atlas Hospitality Group. Orange County added only 1,451 rooms in 2002, down from 3,284 rooms in 2001. However, two upscale beachfront resort hotels opened since the beginning of 2003. The Hyatt Regency Huntington Beach Resort and Montage Resort & Spa in Laguna Beach added a total of 779 rooms to the Orange County inventory.

Nationwide, uncertainty in the marketplace along with declining revenues resulted in the lowest sales volume in a decade, notes Atlas President Alan Reay. Orange County, however, was an exception. The county rang up 30 investment sales in 2002 with a total value of $336.6 million, up 11.1% over the previous year. Orange County also captured recognition as the “most expensive hotel market in the nation” away from San Diego. The average price paid per room was $56,212 compared with San Diego's $53,933 per room.

Since the beginning of this year “ADR and occupancy rates have definitely firmed up,” says Reay, “but there's still some pockets where rates and occupancy have not gotten back to pre-9/11 levels, especially the LAX and John Wayne Airport areas.”

Meanwhile, Reay notes that hotel prices have moved up considerably, due to low interest rates, high investor demand and a dwindling supply of for-sale properties. And prices are likely to continue to escalate, says Reay. “The development pipeline has slowed,” he explains, “basically because it's tough to get a loan for a new hotel.”

Patricia L. Kirk is a Los Angeles-based writer.

Los Angeles-BY THE NUMBERS

POPULATION:

City: 3.6 million

Metro area: 9.5 million

UNEMPLOYMENT RATE: 6.3%

LARGEST EMPLOYERS:

  1. County of Los Angeles
    93,354 employees
  2. Los Angeles Unified School District
    78,085 employees
  3. United States Government
    56,100 employees


METRO AREA STATS

Office:

16.8% vacancy, 2Q 2003

17.9% vacancy, 2Q 2002

Rent per sq. ft.: $24.48 2Q 2003

Source: Cushman & Wakefield

Multifamily:

3.4% vacancy, 2Q 2003

3.4% vacancy, 2Q 2002

Rent per unit: $1,126 2Q 2003

Source: Marcus & Millichap

Retail:

5.2% vacancy, 2Q 2003

5.3% vacancy, 2Q 2002

Rent per sq. ft: $1.89 2Q 2003

Source: Marcus & Millichap

Industrial:

4.7% vacancy, 2Q 2003

4.6% vacancy, 2Q 2002

Rent per sq. ft.: $6.12 2Q 2003

Source: Cushman & Wakefield

Hotel:

68.8% occupancy, 2Q 2003

71.2% occupancy, 2Q 2002

Average Daily Room Rate:

$107.22 2Q 2003

Source: Smith Travel Research

MAJOR PROJECTS UNDER CONSTRUCTION:

Disney Concert Hall, A 293,000 sq. ft., 2,265-seat concert hall

Cost: $275 million

Developer: Walt Disney Co.

Completion: October 2003

Pike at Rainbow Harbor, A 370,000 sq. ft. entertainment complex on an 18-acre waterfront site in downtown Long Beach

Cost: $130 million

Developer: Developers Diversified Realty

Completion: Fall 2003

Sunset & Vine, A 625,000 sq. ft. mixed-use project in Hollywood that includes 2,000 apartments and 87,000 sq. ft. of retail space

Cost: $125 million

Developer: Joint venture between Bond Capital and Canyon-Johnson Urban Fund

Completion: 2004

Caltrans Headquarters, A 600,000 sq. ft. office facility

Cost: $162.5 million

Completion: Mid-2004