Editor s Note: Recently National Real Estate Investor convened a group of Southern California real estate executives at the Peninsula Hotel in Beverly Hills to discuss the state of the Southern California market. Nearly all agreed it has hit bottom, but from there the submarkets are as varied as the ocean breezes.
Q: The widely held perception is that the Los Angeles market is down, it's depressed, the patient is critical but is showing signs of life. Is that an accurate perception?
George Kallas: Our No. 1 region in the United States is the Los Angeles region. We're experiencing a great deal of success here in Los Angeles in total, which encompasses brokerage, investments, all aspects of our business with the exception of our mortgage banking group. Some of our people have so much work they can't keep up. It's sort of like the old days.
Q: So the perception is false?
Kallas: I'm on the opportunistic side of the business, so we are able to capitalize on it.
Steve Roth: George, your activity as a brokerage firm is somewhat related to the health of the real estate market. In my case, it's almost inversely related. So it does say something about the recovery here. But if you go beyond your company's success, what is your opinion about the health of this market? How far have we recovered from the ,80s?
Kallas: My experience is that in October, November and December of last year is when the turnaround came in Los Angeles. We started seeing job growth and that's your biggest indicator, and we started seeing positive population growth numbers. You even see things like in early 1995 and the latter part of 1994, you see more moving vans coming back than going out, you see more license plates, etc. So there are all kinds of indicators.
You can't look at Los Angeles like you can other cities, because you've got a series of submarkets. One of the tightest real estate markets we have right now would be up in the Tri-Cities area in Burbank, Pasadena and Glendale.
We're in a position right now where there's some spec building going up there. If you go to South Bay and you're in industrial, the activity is so fast and furious that people can't keep up with the activity and most of it is affected by trade and also re-engineering from the defense industry. If you're going to buy, the place I'd buy today in office buildings is in South Bay. The market's still bad, it's getting ready to turn around, a lot of ten ants are looking in that area, as are a lot of tenants looking in West L.A.
Q: Has the employment growth been internally driven or are some firms actually moving into the L.A. area7
Kallas: We see some firms moving in. Netscape is one indication of a company that's looking at moving into this area and the reasons they are moving are the old-time real estate reasons -- amenities, location, airport, etc.
Harvey Green: What is driving the reasons we're doing so well has been what has collapsed the marketplace. We're doing well because we're disposing of a lot of REO or pool-buyer assets that are being bought in the marketplace. Or by tenants that are downsizing, firms that are outsourcing. All the reasons that are because of a bad economy, are the reasons why we as brokerage firms have been doing really well.
Is it the bottom of the marketplace or are we doing brokerage activities in disposition because of the bad marketplace7 That's an important point to look at. Because of the activities that I'm involved in, until recently, most of it has been the depressed market that has driven the activity.
There's been a demographic shift in the marketplace because of the earthquake, because of riots, because of a number of actions that have occurred in Southern California in general. People who own apartment buildings in the San Fernando Valley or people who were involved in the South Bay aerospace industry, which a lot of Southern California was built on, are all of a sudden scrambling for a different tenant base, moving different types of businesses around and we're amazed at the number of businesses that did move, and the number of hightech businesses that moved into South Bay that would previously be occupied by secondary support businesses.
We track Southern California in terms of L. A. County as 52 submarkets. As George said you have the Media District which is tight as a drum. And then you have areas where you can go into part of Orange County or San Diego County or in South Bay where you can look through a building and there is no occupancy whatsoever in the office market.
My personal opinion is that we're not at the bottom of the market, but we're close enough to the bottom of the market that prudent acquisition is mindful, and it's a time to buy in Southern California.
Kallas: It's really interesting being in L.A. Most of our economists will tell you to buy office buildings downtown. That's their pick.
Q: Why?
Kallas: Because they see office employment growth and they see a great deal of it over the next 10 years. They don't see the impact of hoteling and downsizing. They see continued growth of office employment. Because the whole economy is shifting and changing to a service economy, and they've been pretty right on in their projections. Last year their pick was suburban office buildings which they say you're too late on today.
Russ Bernard: I don't doubt that downtown won't be a great purchase, but over what period of time? I think you have to have a risk tolerance to purchase property downtown.
Kallas: I would say in downtown L.A. you probably do. It just depends on what you're looking for, the kind of quality you're looking for that makes a big difference.
Q: Is there still a good inventory of non-performing assets?
Green: The only product type I think that would be the exception to that is industrial in most of Southern California, except in maybe Palmdale.
Kallas: You're going to have to look hard and fast to find it. Whenever we run into one we jump on it as fast as we can because we know that there won't be very many.
Green: How much of the pool-buying activity is still out there? It seems that the JE Roberts are still holding onto pretty large portfolios of real estate which are not really performing well and the market hasn't come back and crashed through the level at which disposition of the asset gets the return to the money partners.
Roth: Let me make a couple of points. First of all, as to supply, there is still a tremendous supply of underperforming assets held by financial institutions. If you look throughout the 1980s, the life insurance companies were lending. As much as 30% of their ongoing lending activity was done in California and a big portion of that was in Southern California. That stuff is still out there. Some of it's been rolled, some of it's coming due, but there's still a huge supply.
Now maybe due to the fact that the pressure is off these major financial institutions to do much about their problems because they've reduced their problems elsewhere, they've brought their ratios more in line, their stock prices are doing better, nobody seems to be on that whole bandwagon anymore or jumping on them for underperforming assets. So maybe because of a lack of pressure you're going to have this quiet rolling of these problem assets and you really won't see them in the market. That's one scenario.
The other scenario is they aggressively tackle them. The supply is there, the question is whether it's going to come on the market or not. Of course you've got the whole foreign bank situation which we all know were very heavy lenders and buyers in this market. That hasn't hit yet. So at issue is when that's going to hit.
I guess I'm a little less optimistic than some of the other people here today on this market. No question it's bottomed, no question it's off the bottom, but let's just talk facts. Prices are still down 30% to 40% from their late-,80s levels. Does that mean it's a healthy market? They're still down 30% to 40%. Take other markets like the Pacific Northwest where they're 110% of their late-,80s levels.
Where's it going? I don't see the evidence of job growth and I don't see the positive fundamental factors. I see some tightening in certain markets. We've obviously had a major cap rate drop primarily driven due to the excess capital coming in more than anything. But I haven't seen a whole lot of real rental growth. That's a general statement, because West L.A.'s different from downtown and all the other markets. But this is still a market that we need to have a high risk profile to participate in on average.
Green: Part of that, though, is that in the mid,80s how much was future value acquisition where you bought a building that had no cash-on-cash yields. You were hoping for future appreciation. And then today, what is the downside risk of a building where you're getting a legitimate 20% cash-on-cash return on real operating expenses in place on given rents, giving no allocation to vacancy? Are you really taking a big risk with that?
I'm of the opinion that the downside risks versus the return are such that appreciation is a giveaway. If appreciation of the market comes into play, you're going to be an acquisition genius and you're going to make a ton of money In the meantime, you're making a 22% to 25% cash-on-cash yield.
There is a lot of capital in the market. I think there also are a lot of people who were "California" investors who went to Texas and Denver and are now looking back at Southern California.
Kallas: The exception to that is Ontario where they've jumped 30% to 35%.
Green: Or the Media District or a couple of others. But overall Southern California rents have not moved.
Q: So why would someone want to invest here who is not prepared to wait for the turnaround?
Green: Because you're getting such great cash-on-cash returns on actual rents. There are some interesting yields out there.
Kallas: You talk about L.A. downtown and then you compare it. To this day, Denver downtown rents still haven't come up. But if you go out into any other part of Denver, the rents are up, activity's up in almost every product line.
You have a million square feet of office tenants running around the West Side right now. They want from 100,000 sq. ft; to 400,000 sq. ft. And we're not talking about the Tri-Cities area.
Industrial tenants cannot rent space almost anywhere. We've completed two or three recent build-to-suit transactions, of 400,000 sq. ft. to 600,000 sq. ft. Those kind of deals usually take six months to close and they closed in 90 days because people want to lock up the sites.
If you look at the retail industry, we have the same problems in Southern California that they have all over the United States. We're over built, although we're filling up. The only things that aren't filling up today are the mom and pops. The malls have to take on a different character. We recently completed two entertainment malls and that's the new thing. It's keeping up with what your clients want.
Bernard: George, are the large office and industrial tenants coming from Los Angeles or elsewhere?
Kallas: We're seeing both. We have some biotech firms that are looking. As you probably know, we have the largest number of engineers in the world.
Bernard: All out of work.
Kallas: We're looking at a company out of Atlanta for warehouse space. We're looking at a company out of Northern California that's looking to move out of Silicon Valley. They want to be closer to the entertainment industry. The entertainment industry and trade are driving Southern California right now.
Q: Starwood is one of the biggest hotel RElTs in the country. How much product do you own here?
Jeff Lapin: None. We own one small hotel in the valley. I got out of Los Angeles in 1987, and I was very lucky or very smart. The market collapsed. I don't see a lot of people moving in, just moving around. It's tough to do business here.
But since mid-summer we are aggressively looking in Southern California. I think we've hit bottom. There is a whole bunch of upside and no downside. We're long-term players. It will come back. My timeframe is five to seven years, so I'm a little more out there than most of the people in this room.
Q: How are occupancies doing?
Lapin: Occupancy rates and room rates have dropped 25% to 40%, and the fact that they've come back 10% from last year is all wonderful, but that's not so wonderful compared to investment alternatives in the rest of the country. In the last two years we've been aggressively acquiring in a lot of different places other than here. But now there are several properties for sale and I feel comfortable that it's not going to get any worse.
Q: Re-branding and new-branding is happening at a frenzied pace in the rest of the country. Is the same thing happening here?
Lapin: There has been some re-positioning in Los Angeles, but not like you,d find in the other large metropolitan areas. The Marriott in Century Gity is going to become a Park Hyatt. The Westin downtown probably will not be a Westin. We own 42% of Westin. But there hasn't been the wave of "sophistication" in Los Angeles as in other places because everybody's been scared to invest. When you see the money start coming in, you'll see some re-positionings and some reflags of properties.
One of the problems downtown is the city and county of Los Angeles. I see a huge, modern convention facility that was built downtown in the middle of a war zone. I've met with the city several times on a hotel site there. But the political climate is a minefield down there. It's another reason people are not attracted to L.A.
Roth: Jeff made a good point. The investors we deal with are national investors, and they have alternatives. They have alternatives not just in real estate. Like Russ, firm for example does not need to be in real estate. It can be in corporate situations, and they certainly don't have to invest in Los Angeles. Are you going to really make any money here because of the negative factors that are going to continue to impede growth? That's what it all comes down to.
Q: You've said that the traditional lenders are back in the real estate lending business, and a lot of people thought they,d never come back. Did they learn their lesson?
Roth: There's no question that we've almost come full cycle in the lending business with the banks and insurance companies back in with both feet on a national basis across the board. We've removed the S&Ls as a lending source, but we've replaced the S&Ls with the Wall Street conduits. So there's no question that there's money and debt capital out there. That is evidenced in part by the competition that's been given to conduits. Securitization was roughly $20 billion in 1994, and it looks like in 1995 it's going to be closer to $15 billion to $16 billion with very little change in interest rates year to year. Which tells me the competition is from the direct lenders. So they're back.
Q: Do you see that trend continuing?
Roth: No. We may have reached this healthy balance between securitization and direct lenders.
Q: And RElTs are still an influence.
Lapin: The activity has been unbelievable. IPOs have slowed down in most sectors. My sector is still lagging, but there's still a lot of capital out there, still a lot of lines of credit that haven't been utilized.
Q: Russ, Steve just said you have alternative investments out there other than real estate, and you've created a $500 million fund. Why?
Bernard: It's really the overall philosophy of Oaktree and prior to that TCW, which is opportunistic investments and taking advantage of inefficient markets. We still see a tremendous amount of real estate distressed in Sourthern California and across the rest of the country. Now you can say that transactions have increased but the value of property has slowed down across the board. There ar a lot of institutions that have no liquidated assets. Portfolio sales have probably dried up, but the one-offs and single-asset transactions are still tremendous.
We see a lot opportunities in purchasing. How well that does, ask me in five years. It's difficult to make projections. We try to underwrite an asset based on where it sits in the market today, how is it doing today. Let's not make assumptions about the growth rate, and let's not assume that it returns to its original price. You can look at an asset and say, "Buying it at $0.50 on the dollar or half of what it cost to build it, gee it still must be a great deal." And the answer to that is, "Not always."
Roundtable Participants
Russ Bernard Principal Oaktree Capital Management
George Kallas Sr. Executive Vice President CB Commercial
Harvey Green Sr. VP, Managing Director Marcus & Millichap
Jeff Lapin President & COO Starwood Lodging Trust
Steve Roth President Secured Capital Corp.