The Ronald Reagan Building in downtown Los Angeles has long housed crucial state offices, such as an appeals court, the highway patrol and the regional office of the governor. But now the building is part of the largest pending office transaction in the country, and it is also one of the most controversial.

At the heart of the plan is the proposed sale to commercial investors of 24 state-owned office buildings, including the Reagan building. The deal represents a wrenching decision on the part of the state to sell off iconic buildings in Los Angeles and other cities. The state needs cash to help resolve its budget shortfall of $21 billion. Los Angeles-based broker CB Richard Ellis (CBRE) is marketing the properties, which offer 7.3 million sq. ft. of space.

Offered separately or as a portfolio of 11 assets, the properties drew more than 300 written bids from investors worldwide. The offers were vetted in a process that took months, as the field was narrowed to just a few well-heeled prospective buyers.

Some of the offers exceeded $2 billion, says Eric Lamoureux, a spokesman for California's Department of General Services. “We've narrowed it down to a final offer, and we're doing our financial analysis.”

But at the eleventh hour, critics are pressuring the state to reconsider the sale, as objections mount to disposing of the assets while the government tenants remain in place and the state pays to lease their offices for a minimum of 20 years. Independent financial reports have challenged the sale strategy as ultimately more costly to the state than keeping the buildings.

Lamoureux acknowledges the dilemma that officials face. “We find ourselves in a very unfortunate situation in California in that we are experiencing a severe budget crisis, and the need to generate revenue is critical right now. We expect more than $600 million that we can put back into the state budget, and as a result that would allow us to not have to cut other critical programs or increase taxes to make up the difference,” he says.

State finance experts are combing through the figures, however, to determine whether the sale would ultimately be in the best interest of the state. No timetable has been set for completion of the deal, which would also privatize the Junipero Serra Building. The latter structure houses offices of the state health department, the department of corporations and other agencies.

The sale, of course, would invigorate the Los Angeles office market, which has shown improvement year to date in both transactions and fundamentals, but the market is nowhere near as dynamic as it was in 2007.

What investors want

“What capital wants right now as you emerge from the recession is safety. Investment committees want cash flow,” says Kevin Shannon, vice chairman at CBRE. “These are 20-year leases from the state of California, so the income stream is a core income stream.”

The $2 billion price tag didn't faze the investors, adds Shannon. “The vast majority of buyers were completely comfortable that they're going to get a steady stream of cash flow over 20 years.”

The state portfolio, however, is by no means the only intriguing transaction drawing investors' attention. Broker Jones Lang LaSalle negotiated the $208 million sale of Union Bank Plaza, a 40-story tower in downtown Los Angeles to investor KBS Realty Advisors. “They're buying it for their REIT, KBS REIT II, and have filed a form with the Securities and Exchange Commission,” says Michael Zietsman, managing director of capital markets at Jones Lang LaSalle. The transaction was scheduled to close in mid-September.

The Union Bank property, which has 645,000 sq. ft. of space, attracted as many as 15 bids, says Zietsman. “Investors seem to be willing to say that we've stabilized, that we've hit the bottom of the rental cycle.” Little growth is projected through the end of 2011 in the Los Angeles office market, he adds.

Orange County dilemma

Brokers agree that investors generally are looking for well-leased, Class-A properties. But when it comes to location, some submarkets command higher prices than others. Downtown and West Los Angeles, for instance, can ask and get higher lease and sales prices than a number of other submarkets.

Many sections of Los Angeles County are getting higher rent than in neighboring Orange County, which was hit hard by the subprime crisis and is still recovering. Many commercial properties in Orange County have been sold at distress prices, or at least deep discounts, over the past two years.

In Orange County, $623 million in office deals have closed or are under contract, says Shannon of CBRE. However, $414 million of the deals involve properties sold at distress or deeply discounted prices, as part of the extended fallout of the subprime mortgage crisis.

“Many of the buildings in Orange County have fairly high vacancy rates,” says JLL's Zietsman. “Orange County had a lot of subprime mortgage lenders and subprime mortgage brokers, and a big percentage of the economy was driven by the subprime lending market and by the mortgage market. They suffered a lot; a lot of companies went bankrupt.”

Whole floors and at times whole buildings in Orange County emptied out as mortgage lenders turned out their lights, followed by builders and other tenants associated with residential home buying. Eventually, the trend hurt commercial real estate as the problems widened. More than two years after the recession started, office properties in the region are still being sold at a faster pace in Orange County than in healthier sections of metro Los Angeles, such as Westwood, Santa Monica or Beverly Hills.

One notable Orange County transaction is the sale of Pacific Arts Plaza. “That asset is being bought by a group called American Assets, the investment arm of a very wealthy private individual,” says Zietsman. He estimates the price at roughly $260 per sq. ft.

The property needs work, he says. “It's an asset that's got some vacancy, a lot of deferred maintenance that would be regarded as a real sort of value-add investment.” He estimates the property's vacancy rate at about 25%.

Wanted: Jobs

Lingering effects of the subprime crisis are not the only factors hindering a more robust commercial real estate recovery in Los Angeles. The high jobless rate has also taken a toll. According to the California Employment Development Department, the seasonally adjusted unemployment rate in Los Angeles County rose to 12.4% in July from 12.2% in June. A year earlier, unemployment registered 11.9%.

The largest monthly reduction in jobs in the county occurred in the government sector, which lost 29,300 jobs between June and July. More than 21,000 of the lost positions were in local education, including teachers. Until employment growth resumes, it's unlikely that office rental rates will climb, says Zietsman.

The last couple of years have been slow, but there has been an uptick in real estate activity, says Shaun Stiles, director of office properties for Colliers International in Los Angeles. “On the leasing side, activity did pick up after the first of the year. The first and second quarters we did see more activity in the market. Tenants were out looking for space, and touring and actively negotiating for space.”

The activity hasn't yet translated into substantial net absorption, but it's a good indicator that tenants are showing renewed interest, he says.

“We've started to see tenants lock in longer-term deals, which usually is a good indicator. A couple of years ago we were seeing a lot of one, two, and three-year deals. Now we're starting to see five, 10 and even some 15-year deals,” notes Stiles.

His largest deal so far this year was a 70,000 sq. ft., five-year lease renewal on the west side of Los Angeles. The tenant was a biotech firm that closed the lease transaction in July. “A lot of the deals for 2010 have been renewal deals,” observes Stiles.

“You haven't had a lot of relocations.” Of the tenants that relocate, most are involved in a flight to quality, moving up to a higher building class while rates are still low.

Los Angeles-based Ivory Investment Management LP recently signed a 66-month lease renewal valued at more than $2.3 million for 11,357 sq. ft. in a 24-story tower on Wilshire Boulevard on Los Angeles' west side, according to LA Realty Partners principal Hunt Barnett.

Stiles of Colliers International does not anticipate that substantial rate increases for office space will occur anytime soon. “But at the same time, I don't think we're going to see any substantial decline. If we're not at the bottom we're close,” he says.

Landlords are still providing concessions, in many cases more so than in 2008 or 2009, he says. “We are seeing rent abatement, free rent, and parking concessions.”

The exception is downtown where rates remain steady, he says. “But downtown is largely controlled by just a few large landlords that hold their rates a little bit more than some other submarkets.

If the state of California's property sale takes effect as planned, another powerful landlord could settle in among the few that now maintain their healthy rents.

But investors may have to find sources other than the government for their next mega-deals involving 100% leased, Class-A properties. The state has no intention of putting another batch of office buildings on the market, says Lamoureux of the Department of General Services.“There are no immediate plans at this point.”

Denise Kalette is managing editor.

LOS ANGELES: BY THE NUMBERS

METRO POPULATION
9.8 million

Source: U.S. Census Bureau

UNEMPLOYMENT RATE:
12.4%

Source: California Employment Development

METRO AREA VITAL SIGNS

Office:

14.3% vacancy 2Q 2010

12.4% vacancy 2Q 2009

$26.02 effective rent 2Q 2010

$27.88 effective rent 2Q 2009

Source: Reis

Multifamily:

5.5% vacancy 2Q 2010

5.4% vacancy 2Q 2009

$1,340 effective rent 2Q 2010

$1,365 effective rent 2Q 2009

Source: Reis