Less than a decade ago, downtown Los Angeles was pocked with vacant eyesores — aging office and industrial buildings emptied out in the 1990s during an era of corporate downsizing and relocation. The liveliest nightlife bustled on skid row, and many workers fled to the suburbs at sunset, considering the city's core too dangerous a place in which to linger.

But the inner city's fortunes are changing. The infusion of $17 billion in private investment since 1999 is transforming downtown into a place to live, work and play, and giving Los Angeles the same caché as other top cities. In less than a decade, the number of residential units has expanded from 3,200 to 11,000, and another 8,000 market-rate units are being built.

“Those who weren't believers in downtown are having a tough time defending their position that downtown isn't emerging as a 24/7 place to rival some of the great cities in the United States,” says Marc Renard, capital markets managing director at Cushman & Wakefield in Los Angeles.

Among its impressive new developments, downtown has snared AEG's $2.5 billion sports entertainment hub called L.A. Live. The project's first phase opened in October near the Staples Center and Los Angeles Convention Center on downtown's south end. It houses the Nokia Theater, a 7,100-seat venue that will host award shows. When complete, the 5.6 million sq. ft. L.A. Live development will include a hotel, condos, offices, movie theaters, retail, restaurants and clubs.

At downtown's north end, the Related Cos. is building the Grand Avenue Project, a 3.6 million sq. ft. mixed-use development near Walt Disney Concert Hall. The $2.5 billion project's first phase is scheduled to open by 2011.

The emergence of major new projects was inevitable given downtown's daytime population of more than 400,000, says William A. Witte, president of Related of California. Development would have occurred sooner, he says, if not for the recession of the early 1990s.

The genesis of growth

The upgrading that started in 1999 with the opening of the Staples Center arena — home both to the NBA's Los Angeles Lakers and Los Angeles Clippers — has continued with the conversion of aging industrial and office space into condos and apartments, along with ground-floor retail.

The resulting influx of residents helped bring national retailers and restaurants and lured more companies downtown.

In fact, the central business district is having one of its best years since the boom of the 1980s, reports Cushman & Wakefield. During the third quarter, more law and architectural firms opened offices downtown, where costs were lower, and that trend is expected to continue.

Grubb & Ellis reports that 340,000 sq. ft. of Class-A space was absorbed in the third quarter for a yearly total of 500,000 sq. ft. When counting all classes of space, Colliers International reports that 684,500 sq. ft. of the 773,100 sq. ft. of office space absorbed in 2007 occurred during the third quarter.

Only South Bay, which also benefited from high rents in West Los Angeles, has come close to matching downtown in absorption this year.

Westwood rents were 78% higher than in the third quarter of 2006, Grubb & Ellis reports. Class-A monthly rents downtown climbed to $2.95 per sq. ft. by the end of the third quarter while Class-B rose to $2.28, an increase of five and seven cents over the second quarter, Grubb & Ellis reports. That compares with West Los Angeles rents of $4.30 for Class-A space and $3.40 for Class-B.

Rising rents in West Los Angeles are prompting some companies to keep a few top executives at their exclusive address, while moving the rest of the office to more economical locations, office analysts say.

Some firms choose downtown for its entertainment appeal to clients and employees or its freeways and mass transit, says Chris Maling, a senior investment associate with Marcus & Millichap.

“Downtown is going to be the dominant center for office, retail, entertainment and for living in an urban environment,” says Maling.

Office market tightens

In the central business district, the vacancy rate in the third quarter dropped to 14.1%, which is 1.5 percentage points lower than a year ago, Cushman & Wakefield reports.

Downtown has seen its biggest spike in office rents in 20 years, says Jeff Kreshek, vice president of leasing with CIM Group, which is building a mixed-use development.

“You are seeing rate increases across the board in Class-A and B space, everywhere from 20% to 100% higher than four years ago,” Kreshek says.

The lack of properties exceeding 100,000 sq. ft., growing demand and rising rents may soon add up to downtown LA's first new high-rise office tower since 1992. Maguire Properties, which developed much of the downtown skyline in the 1970s, plans to build a 50-story, 950,000 sq. ft. office tower when 50% of the space has been pre-leased.

“In our view, once you get down to a 12% vacancy rate, there is nowhere else to go,” says Peggy Moretti, a senior vice president with Maguire Properties. “We would never build on speculation. When we bought this, we looked at those entitlements as liquid gold because there is not a lot of land available.”

Retailers ready for influx

Brokerages report that retailers are moving downtown in anticipation of increased residential growth, pushing the vacancy down 180 basis points over the past 12 months to 5.8%. By the end of this year, Marcus & Millichap predicts the retail inventory will grow 2.6%, nearly twice as much as in 2006, with more on the way in 2008.

Retail asking rents for greater downtown Los Angeles rose 6.2% over the past 12 months to $2.78 per sq. ft. monthly. Revenues downtown jumped 8.6%, one of the highest retail increases in the region, Marcus & Millichap reports.

New upscale restaurants from quick-serve to high-end as well as lounges and bars are under construction in downtown. More than 75 historic buildings and office towers have been converted into mixed-use projects with retail.

The biggest jewel, however, came in July when CIM Group opened the first supermarket downtown since the 1950s. The upscale store, Ralph's Fresh Fare, which anchors a loft development, reports $1 million in sales per week, double the expectations. That got the attention of competitors. Suddenly, Albertsons, Gelson's, Vons and Trader Joe's are searching for a piece of the downtown grocery business.

“The supermarket is nothing more than a shining example of how these urban areas can work,” says CIM's Kreshek, who credits other developers' vision. “They started dipping their toe in the market, and it picked up steam and people like us took the area to another level.”

Investment activity slows

Brokerages note that cap-rate compression has led to fewer downtown office properties changing hands, averaging in the mid-5% to low-6% range in the third quarter, down 50 basis points over the past 12 months, according to Marcus & Millichap. Sales velocity declined 15%, the firm says.

Grubb & Ellis points out that investment activity downtown was light in the third quarter with the largest sale the 665,000 sq. ft. One Wilshire Building, which sold for $287 million, more than $437 per sq. ft., a high price. The third-quarter median price for office properties fell 8% to $217 per sq. ft. in a year, Marcus & Millichap reports.

On the retail side, appreciation pushed the median price downtown to $318 per sq. ft. annually for multi-tenant buildings, up 21% from last year, according to Marcus & Millichap. For single-tenant properties, the price rose 5% to $297 per sq. ft.

“There is a tremendous amount of demand for existing property, but the problem is we are finding a lack of buildings on the market,” observes Dan Fasulo, managing director of Real Capital Analytics. Commercial real estate owners anticipate properties continuing to appreciate, says Fasulo.

The lack of deals doesn't mean a lack of interest among investors, says Reza Etedali, chief executive officer of REZA Investment Group, a Los Angeles-based retail investment advisory firm.

Owners aren't rushing to sell because they don't know what to invest in, Etedali says, but the credit crunch could pressure more of them to sell.

“If the investor buys hoping the cap rate will go lower, the chances are they are going to be disappointed. We are going back to the old way of investing — buying and adding value,” Etedali says.

Riding the price escalator

The credit crunch and housing slowdown are being felt downtown, where condos average $650,000. In view of the prices, some developers may wish they had held onto their office properties.

One investor who bought a 23,000 sq. ft. parking lot three years ago for $4.5 million was offered $20 million a year ago and turned down the request, says Melika Jahangiri, an investment advisor with Sperry Van Ness.

Investors who missed the boat downtown are considering areas such as Koreatown west of the central business district, where rents are rising with the influx of downtown jobs, says Jahangiri.

Downtown is poised to capitalize on Southern California's projected population increase of 3 million over the next 20 years, says Hal Bastian, director of economic development for the Los Angeles Downtown Center Business Improvement District.

Investment and development opportunities still exist downtown, especially with the limited supply of housing and continued growth in jobs, says Renard. “I have made this claim for the last five years that downtown Los Angeles is one of the greatest opportunities for real estate investment,” says Renard.

“If you start comparing downtown Los Angeles to New York City or San Francisco, I think the potential for tremendous rental growth is the driving force why someone should invest in downtown.”

In a few years, the spiffed-up central business district, with its new sports, office, residential and retail projects, will be almost unrecognizable from images of the 1990s, when hard times left office vacancy rates hovering at 20% and downtown streets dotted with vacant buildings.

“Ten years ago, nobody thought it was possible, myself included,” observes Kreshek. “I think a group of pioneers identified downtown many years ago and starting working on it before some of us. They had a vision of what it could ultimately be. All the dynamics lined up correctly to make it happen.”
Buck Wargo is a Las Vegas-based writer.

LOS ANGELES - BY THE NUMBERS

METRO POPULATION:

13 million

Source: U.S. Census Bureau

UNEMPLOYMENT RATE: 5.1%

Source: Los Angeles County Economic Development Corp.

LARGEST EMPLOYERS:

  1. Kaiser Permanente
    32,180 employees

  2. METRO AREA VITAL SIGNS

    Office:

    Northrop Grumman
    21,000 employees

  3. Boeing Co.
    15,825 employees

  4. Kroger Co.
    14,000 employees

Source: Los Angeles County Economic Development Corp.

9.0% vacancy, 3Q 2007

Multifamily:

9.9% vacancy, 3Q 2006

$27.60 annual rent @ sq. ft. 3Q 2007

$24.52 annual rent @ sq. ft. 3Q 2006

Source: Marcus & Millichap

3.5% vacancy, 3Q 2007

Retail:

2.9% vacancy, 3Q 2006

$1,365 mo. effective rent, 3Q 2007

$1,296 mo. effective rent, 3Q 2006

Source: Marcus & Millichap

7.1% vacancy, 3Q 2007

Industrial:*

7.2% vacancy, 3Q 2006

$26.93 rent per sq. ft., 3Q 2007

$25.26 rent per sq. ft., 3Q 2006

Source: Marcus & Millichap

3.4% vacancy 3Q 2007

Hotel:

3.7% vacancy, 3Q 2006

$6.38 annual rent per sq. ft., 3Q 2007

$6.07 annual rent per sq. ft., 3Q 2006

Source: Marcus & Millichap
*Includes flex and warehouse

79.3% occupancy, 3Q 2007

MAJOR PROJECTS:

78.9% occupancy, 3Q 2006

$123.18 average daily rate, 3Q 2007

$114.50 average daily rate, 3Q 2006

Source: Smith Travel Research

L.A. LIVE — It includes 5.6 million sq. ft. of mixed-use development near Staples Center and Los Angeles Convention Center. The 7,100-seat Nokia Theatre will host concerts and numerous television award's shows. There will be restaurants, clubs, ESPN studios, bowling alley, movie theater, more than 100,000 sq. ft. of office space and a 54-story Ritz-Carlton and JW Marriott hotel.

Developer: AEG

Completion: 2009

Cost: $2.5 billion

GRAND AVENUE — Mixed-use development of 2.8 to 3.6 million sq. ft. is planned. The project has 2,100 to 2,600 housing units, 400,000 to 600,000 sq. feet of retail and dining, and a Mandarin Oriental Hotel. The hotel was designed by architect Frank Gehry and is located opposite the Walt Disney Concert Hall.

Developer: The Related Cos.

Completion: First phase — 2011

Cost: $2.5 to $3 billion