California's reversal of fortune

“While retail sales are dropping, retail real estate appears to be holding steady, for the simple reason that new stores are being built to meet the needs of the growing population.”

“The office, R&D and industrial real estate markets are especially hard hit, with San Francisco's office vacancies zooming from 2% in June to 10% a year later.”

California is definitely moving up in the world. According to the California Department of Commerce, the state recently overtook France to become the fifth largest economy in the world. Even regions within California have achieved international stature. On its own, the Los Angeles metropolitan area ranks No. 10 among world economies, while the San Francisco Bay Area ranks No. 16.

At the same time, California in 2001 is not nearly so well off as California in 2000, due largely to a drop-off in the various high-tech sectors and the well-publicized energy crisis. A recent survey by out-placement firm Challenger, Gray & Christmas reveals that California leads all other states in the number of job cuts, with 106,834 cuts from January through June.

Of course, as the most populous state, with nearly 35 million residents, California could be expected to rank at the top of almost every category involving numbers of people. Nonetheless, economists consider the rising number of layoffs definite cause for concern.

Though the population stabilized during the early 1990s, it has since picked up steam again, growing 1.8% last year, according to the California Department of Finance. A similar gain was projected for this year, though the unexpectedly large number of job cuts may in fact slow growth by discouraging in-migration from other states and encouraging some Californians to move away.

The population increase is probably the state's biggest attraction as far as retailers are concerned. “The growth out here in major metropolitan areas is a catalyst for rapid change, unlike the more stable environments of the Northeast. It's not just more numbers but changing demographics creating new opportunities,” says Keith Browning, vice president of leasing/Western states for Cleveland-based Developers Diversified Realty Corp. (DDR).

At this point, it is very difficult to measure the effects of the economic downturn on the state's retail market. The most recent compilation of taxable sales by the California Franchise Tax Board dates from mid-year 2000, a time when analysts were still euphoric over the supposed economic miracle wrought by the so-called Internet revolution.

They had ample reason for euphoria. Taxable transactions in California for second quarter 2000 exceeded $110 billion, a full 13% higher than the figure for the same period in 1999. By comparison, 1999's second-quarter taxable transactions were only 5% above those for the preceding year, which were less than 7% higher than a year earlier. Most analysts anticipate a sales decline for 2001 but only because last year's results were so spectacular.

While retail sales are dropping, retail real estate appears to be holding steady, for the simple reason that new stores are being built to meet the needs of the growing population. Though some stores are of course closing, the number of closures appears not to be that significant, for while declining sales may reduce individual store revenues, the declines primarily make the stores less profitable, not unprofitable.

Furthermore, many areas of California remain significantly understored. Matt Krupp, a broker with Orion Partners Ltd. in San Rafael, Calif., calls Marin County immediately north of San Francisco probably the most understored market in the country. Other brokers put most Bay Area submarkets in the shortfall category, and the same is true for many submarkets from Los Angeles south.

The reasons for the shortfall include the inability of builders to keep pace with rapid population growth, the double whammy of high land costs and limited site availability and local growth restrictions that constrain development. Many developers consider the latter the most significant of the three.

“Entitlements continue to be a fundamental obstacle,” says Patrick Donahue, executive vice president, asset management for Donahue-Schriber, a Costa Mesa, Calif., retail REIT with 9 million sq. ft. of space in Southern California and 3.4 million sq. ft. in Northern California. “They seem to get stricter every day no matter which city you're working in.”

As evidence of this, it took Cincinnati-based Madison-Marquette five years to reach the construction phase of Bay Street, a mixed-use project in Emeryville at the foot of the Oakland-San Francisco Bay Bridge. Delaying factors included heavily contaminated soils, the discovery of a Native American burial ground on the site and opposition from various anti-growth groups. The city actually spent 10 years on the project.

Bay Street exemplifies another significant trend sweeping California, along with the rest of the nation: the return to traditional urban patterns. When the project opens in fall 2002, it will have 380,000 sq. ft. of retail combined with 270,000 sq. ft. of residences and a 200,000 sq. ft. hotel, all squeezed together on a relatively compact site.

Browning, whose company has its own mixed residential and retail project under way in downtown Long Beach, says cities throughout California are coming back to life, or in some cases coming to life for the first time. He points to San Francisco and San Diego as the progenitors of the movement, noting that land values have risen dramatically in the heart of both cities. He anticipates a similar rise in Long Beach.

DDR's project, CityPlace, replaces a failed suburban-style enclosed mall with 475,000 sq. ft. of retail space, structured parking for 2,600 vehicles and residential units. Unlike most other urban village projects, however, CityPlace will feature big-box and promotional retailers such as Nordstrom Rack and Ross Dress for Less, as well as the state's first downtown Wal-Mart store and one of only a few in the nation. Another innovative aspect of the project is the inclusion of a “community strip center” anchored by Albertsons and Sav-on.

Browning says the project demonstrates that downtown locations do not require glitz and glamour to succeed. As more people move into center city areas, the demand for grocers, drug stores and other more prosaic retailers will also grow. Furthermore, he adds, discount and promotional retailers are looking for ways to reach these underserved markets. “The only quantum leap for them [at CityPlace] would be structured parking,” he says. “Otherwise the mix is very familiar.”

At the same time, Browning emphasizes, glitz and glamour do have their place, as evidenced by another DDR project in Long Beach, the Pike at Rainbow Harbor. It will have 450,000 sq. ft. of entertainment-oriented retail and restaurant space along with a 14-screen Crowne Cinema. Both projects are scheduled for completion by late 2002.

Another factor greatly influencing retailer decisions in California, says Jeff Kellogg, a retailing specialist in the Long Beach office of Newmark of California, is the growing competition among cities for sales tax revenues, which have replaced property taxes as the most important source of local government funding. “Retail dollars are what run cities now,” he explains, “and the competition for retailers is the small-scale version of trying to attract a major league sports franchise.”

Northern California

More than any other region, the San Francisco Bay Area is suffering from the high-tech industry's reversal of fortune. The office, R&D and industrial real estate markets are especially hard hit, with San Francisco office vacancies zooming from 2% in June 2000 to 10% a year later and other submarkets suffering only slightly less damage, according to several brokerages. Companies such as Intel Corp., Hewlett-Packard Corp., Cisco Systems and Sun Microsystems have laid off thousands of workers throughout the region and more layoffs are announced weekly, if not daily.

None of this appears to have deterred retailer interest, however. Vicki Johnson, a partner in Johnson Hoke Retail Leasing & Development who works the Union Square and Embarcadero Center markets in San Francisco, says retailers have become more cautious about opening new stores, with the number of retailers looking at each available space down from a year ago. Nonetheless, there are still enough to make the market highly competitive.

One sign of the market's strength is the caliber of tenants seeking space around Union Square. Johnson's firm recently completed deals for Yves Saint-Laurent and Boucheron, both of which will be opening their first San Francisco stores. Prada is also coming to the city, along with Prada-owned Fendi, Church & Co. and Helmut Lang, while Hérmès is expanding from 3,000 to 12,000 sq. ft.

The influx of fashion retailers has transformed Grant Avenue from a second-tier address to premier status in just a couple years. Seth Nodelman, a broker with Cushman & Wakefield, says annual rents on the street have climbed to $300 to $350 per sq. ft., numbers that used to be reserved for properties directly facing Union Square.

Also moving up in status are Market Street and the Yerba Buena Gardens area. New York-based Millennium Partners and San Francisco-based WDG Ventures are wrapping up construction of the Millennium Tower on Market below Fourth Street, which combines million-dollar-plus condominiums with a Four Seasons Hotel and a 100,000 sq. ft. of retail. Nodelman, who is leasing the project, reports St. John's Knits became the first tenant to sign, taking 10,000 sq. ft. The rent, he points out, is comparable to that paid by many Grant Avenue tenants, an incredible feat for a Market Street address.

A half block west on Market, the California division of Cleveland's Forest City Enterprises has most of the approvals needed to launch the redevelopment of the historic Emporium building into a 1.5 million sq. ft. complex with retail, dining, entertainment and hotel components. Perhaps the most significant aspect of the project will be placing the entrance to the city's first Blooming-dales on Mission rather than Market. The presence of the 275,000 sq. ft. department store is expected to transform what had been a tertiary location at best into prime territory.

The urban village trend has clearly taken hold in Northern California, with large mixed-use projects in Oakland, San Jose and Sacramento as well as Emeryville and smaller versions in at least a dozen other cities. Rockville, Md.-based Federal Realty Investment Trust has a development in construction in San Jose that Federal senior vice president and CIO Ron Kaplan claims will be the epitome of such projects. Santana Row, which is rising on the site of a former open-air shopping center, will have 680,000 sq. ft. of retail and restaurants, a 20-screen theater, a 200-room Hotel Valencia and 1,200 rental apartments, lofts and townhomes.

What makes it significant, he says, is that it is rising in one of the most suburb- and car-oriented areas in the nation. “The planning of Santana Row was the culmination of our early recognition of the Main Street trend. What we're doing is creating a community not just a project,” he says.

As to retail in general, local market reports from CB Richard Ellis reveal almost no community with greater than 7% retail vacancy throughout the San Francisco Bay Area and few elsewhere in Northern California areas surveyed by the brokerage. Most major submarkets registered at under 5%, though small pockets with higher vacancies do exist.

Development is so tightly constrained throughout the Bay Area that overbuilding is rarely more than a temporary problem, but according to Marcus & Millichap Real Estate Investment Brokerage Co., Sacramento may face a glut of space in the coming year, with 2.5 million sq. ft. slated to come on line.

Marcus & Millichap reports rents rose at least 7% in Northern California markets last year, with San Francisco leading the way at 11.5%. It forecasts an average 3% rise for 2001. During the past three years, total increases have taken pushed monthly rents into the $2.25 to $2.50 per sq. ft. range even in secondary markets such as Petaluma and Santa Rosa, with $3 to $4 per sq. ft. common in many communities, including some residential districts of San Francisco.

Southern California

Perhaps the most noteworthy trend in the southern half of the state is the quickening revival of central cities. “Retailers are always going to look for where the new market is, and that's where the re-emerging markets come into play,” explains Jeff Kellogg, a retail specialist with Newmark of California.

Los Angelenos look forward to the fall opening of Hollywood & Highland, a 645,000-sq.-ft. retail and entertainment project by TrizecHahn Co. designed to bring the sparkle back to a still-bedraggled but improving Hollywood. The San Diego-based developer also has a major project in development in downtown Pasadena. Paseo Colorado will feature 565,000 sq. ft. of retail and entertainment tenants combined with mid-rise residential. Major renewal projects are also coming to Westwood Village, Mid Wilshire and West Hollywood.

Completion of Staples Center, an indoor sports and entertainment arena, has given a great boost to downtown L.A., though so far the effect is more psychological than material. According to Marcus & Millichap, downtown vacancies are running in the 10% to 12% range. However, a large entertainment-oriented development is scheduled to rise adjacent to Staples and redevelopment schemes for Little Tokyo, Olvera Street and Union Station promise to make the city core more attractive to tourists and locals alike.

Much of the change downtown is occurring below radar. A recent article in The Los Angeles Times notes that six commercial projects nearing completion in the Fashion District will add 200 stores to the area by mid 2002. The article says the vacancy level is less than 5% and monthly rents average about $3.50 per sq. ft. Some projects, it reports, are getting $5 to $10 per sq. ft. per month, equivalent to what is being charged for space off Rodeo Drive in Beverly Hills.

Los Angeles saw 5.23 million sq. ft. of retail construction starts the past year and is scheduled for at least 5 million sq. ft. this year as well, according to Marcus & Millichap. The brokerage pegs vacancies at just over 5% but says new completions are likely to drive the rate up 2 to 3 points. Los Angeles has a leg up over other cities because it provides its own energy, which has spared it from rising electricity prices.

Orange County continues to register single-digit vacancies and positive absorption, according to CB Richard Ellis, though current numbers don't match last year's. The brokerage pegs average monthly rent at $1.72 per sq. ft., more than 10% above last year's rate. With the pace of construction slowing — 1.3 million sq. ft. for first quarter 2001 compared to 2.3 million sq. ft. for first quarter 2000 — the vacancy level should hold. Rent continued to rise about 2% per quarter through the first two quarters of 2001, but CB expects a leveling off for the remainder of the year.

In San Diego, the population climbed to 3 million last year, and developers added some 2.5 million sq. ft. of space, according to Marcus & Millichap. This year's total should approach 3 million sq. ft., but vacancies remain under 6% and the average monthly rent is approaching the $2.75 per sq. ft. level for top-tier locations, though the overall average for new space is closer to $2.25 per sq. ft.

The Inland Empire is the state's fastest growing region. Riverside County grew 3.3% last year, according to the state Finance Department, placing it second to Placer County for growth. San Bernardino County had a slightly slower pace. Marcus & Millichap calculated 2.5 million sq. ft. of new retail construction in 2000, with 3 million sq. ft. slated for 2001. Despite this, vacancies are down a few tenths of a point from last year, though still fairly high at about 10%. The brokerage predicts a 3% rise in the average rent this year to $12.60 per sq. ft. annually.

John McCloud is a San Francisco-based writer.