California Office Market
Orange County
Orange County’s office sector continued to build momentum in the third quarter, despite lingering effects from the recession.
The market was buoyed by competitive asking lease rates combined with steady job growth. The vacancy rate for Orange County office space dipped to 14.2% in the third quarter, down from 15.7% the previous quarter and 16% a year ago.
Meanwhile, asking lease rates held steady at about $2.23 and $1.81 per square foot for class A and class B space, respectively.
Net absorption for the third quarter totaled 637,150 square feet, up sharply from the 97,161 square feet recorded last year. The class A market accounted for the lion’s share of activity, posting 566,723 square feet of positive absorption for the quarter. Class B space had positive absorption for the first time this year with 92,634 square feet.
Year-to-date net absorption topped 1 million square feet for the first time since the middle of 2000. The flex office market also saw positive absorption of 74,277 square feet for the third quarter and 204,564 square feet for the year.
Leasing activity for the quarter totaled 1.7 million square feet, down from the second quarter’s 2.2 million square feet, but up from the first quarter’s 1.6 million square feet. Sublease transactions and lease renewals accounted for about 15% of the total for the third quarter.
Vacancy rates were lowest in West County at 11.4% closely followed by Central County at 11.7%. North County recorded vacancy of 13.5%, South County weighed in at 14.1% and the John Wayne Airport area posted 16.1% vacancy.
The airport area accounted for nearly half of the county’s absorption for the quarter with 283,333 square feet, while Central County recorded 136,917 square feet, South County absorbed 128,538 square feet, North County posted 82,795 square feet and West County had 5,567 square feet.
Central County has accounted for about 50% of the county’s total net absorption this year.
Although asking rental rates are holding, concessions still appear to be increasing slightly. Effective rental rates have dropped 5.7% in the past year while asking rates have dropped only 2%.
Construction totaled 149,339 square feet in the third quarter, a fraction of the 1 million square feet under way a year ago. The majority of planned office development continues to be in small buildings, most of which fall below the size threshold,20,000 square feet,for inclusion in the Grubb & Ellis office report. These small building projects comprise about 1 million square feet of inventory this year. This includes more than 130 office buildings that are either recently completed, under construction or planned for completion by mid-2004.
The South Orange County market continues to be the hot area for small building sales, recording more than 65 sales this year (statistics include industrial buildings with office build out). The average asking sale price is $215 per square foot with premier space reaching the $260-per-square-foot range.
The major challenge facing the small-buildings-for-sale market is the potential for oversupply and interest rate trends. Whether development will keep pace with demand will be based on what happens to interest rates.
Tenant retention will continue to be one of the biggest challenges facing landlords. Tenants still have an opportunity to lock in low rental rates. We expect this tenant cycle to continue for another six months.
Forecast
Job growth, a key indicator of demand for office space, has been relatively slow this year. Orange County’s unemployment rate decreased to 3.8% in August.
The professional and business services sector recorded the largest annual gain of 3,600 jobs, which should equate to an increase in activity and stabilization in the office market.
Demand for small buildings for sale is expected to continue as Small Business Administration financing and interest rates remain favorable for business owners. Additionally, the overall institutional investment market will remain strong, too.
Lack of class A office space for sale in Orange County points to class B buildings and office condominiums as the next alternative for capital inflow.
Asking lease rates will continue to hold through the remainder of the year, though effective rates could drop another 2% to 3% as landlords attempt to generate activity.
Vacancies are expected to decline slightly through the end of the year as construction activity continues to slow.
Los Angeles
The Los Angeles County office market posted 568,566 square feet of absorption in the third quarter, sending yearly gains to almost 1.7 million square feet and defying the putative slowness it has been accused of all year.
Burbank and the Westside were responsible for many of the gains, as Electronic Arts, a video games maker, leased the entire 250,000-square-foot, two-building Water’s Edge project at Playa Vista in August, while Warner Bros. Music took all 455,000 square feet of Studio Plaza in Burbank.
Even so, with most tenants in retrenchment phases, average lease sizes continued to wilt, and lease periods, at 53.5 months, stayed shorter than normal.
Landlords, meanwhile, began looking for creative ways to compete, offering simpler leases, better customer service and flexible tenant-improvement packages for multi-market tenants, since the lowering of rents has already bitten deeply into cash-flows and no longer offers a palatable way to win business.
Thanks in part to a flood of capital in search of buildings, sales prices continued to climb. Yet a close look at the price increases reveals that high prices are mostly a rational response to easy financing, not any sort of “irrational exuberance.”
Whether buyers are rational or not, however, now is an excellent time to sell, much as Japanese owners with divestment needs have done.
Market Assessment
Although employment stability has kept demand for space steady, the typical size of newly leased spaces has nevertheless continued to wilt, especially in the South Bay.
Compared to a peak of 14,200 square feet in 2000, tenants now take down, on average, just 9,700 square feet. And if the 7,000- to 8,000-square-foot average of the pre-boom years is any indication, sizes could shrink more.
Average lease terms, too, have stayed short, as many tenants have preferred waiting out economic uncertainty by staying flexible as opposed to locking into long-term obligations, even at fortuitous rents. Large tenants, though, have leveraged their excellent long-term prospects, signing long-term leases while also getting attractive rents from landlords eager to fill vacancies.
That the leasing market has rattled off a series of huge deals this year is hardly surprising, for the wide-open holes of contiguous space in many buildings have put big tenants in a position to play the role of financial plug,and extract value from landlords in the process.
More than half of the county’s available class A space is part of contiguous tracts of 20,000 square feet or more, while almost 24% of available class A space is part of contiguous tracts of more than 100,000 square feet.
As rents fall, some landlords are seeking for new ways to compete. When they convince a tenant to lengthen its obligation on a space, lower rents can reduce the risk of a building and thereby boost its value. Thus, many landlords,especially those with an eye toward selling,have been dropping rents to secure renewals since last year.
Yet the cards left in this strategy appear to be dwindling: effective rents have dropped steadily for the past three years, and one wonders how much more they might fall.
As capital has continued to pour into the Los Angeles office market, sales reached almost $2.8 billion by early October, just $300 million shy of where they were at the same time last year.
The most active buyer has been Maguire Properties, a newly formed real estate investment trust with a 28-year history as a private investor in Los Angeles.
Challenges
So, on whose door does opportunity knock amid all this? Clearly, sellers’.
Holding a product with an essentially static supply, and facing weak competing investments, they are in a position to extract much of the value presented by easy financing.
For the past decade, Japanese owners have been divesting themselves of American office buildings, trying to rein in assets and strategies that got too far-flung during Japan’s boom of the 1980s.
But after beginning with a hop and a skip early in the decade, the divestment began to jump in 1999 and since then has continued to bound, with sales of Japanese-owned assets totaling, in the past four years, close to $1.7 billion.
This divestment will most likely continue, and perhaps accelerate, given the spike in prices.
Forecast
Through the fourth quarter we expect to see more of what we’ve seen this quarter: most tenants retrenching into smaller, shorter leases; large tenants continuing to throw their weight into economical, long-term deals; and, despite landlords’ searching for more non-pecuniary ways to compete, flat to slightly falling rents.
In the sales market, the prognosis is for interest rates to stay low (although the slight increase in 10-year Treasury yields during October suggests they will not go much lower).
So we expect prices to stay robust but not rise and, with them, sales volume to continue at near record pace.
Inland Empire
Still buoyed by affordable housing, competitive office rental rates in relation to neighboring markets and added jobs, the Inland Empire’s office market continued to thrive in the third quarter.
Construction activity rose to 547,000 square feet, versus 358,000 square feet a year ago, extending to the market’s southwestern region to chase current homebuilding.
Another trend emerged: mixed-use centers.
Prompted by urban sprawl, office, small industrial, commercial and hospitality projects are being consolidated.
Corona Pointe, a masterplanned project with retail, restaurants, a Marriott hotel and 200,000 square feet of office space, is the poster-child of this trend. Strong interest resulted in four of Corona Pointe’s buildings entering escrow, while preleasing activity was steady in Riverside.
Taking note of ongoing tenant demand, local investors entered the fray and targeted class A space for acquisition. A very tight 7% class A vacancy rate, low interest rates, rising rents and healthy leasing activity fueled investor confidence, as evidenced by the sale of four buildings to three local investors.
Rising interest rates could dampen investor enthusiasm and shift housing affordability downward. If this should occur, the office sector could see a temporary lag.
Forecast
Moving into early 2004, the office sector will continue on a steady growth path. Some 24,200 new jobs have been created in the past year in Riverside and San Bernardino counties; however, the region’s unemployment rate was 6.5% in July, up from a revised 6.2% in June.
Combined with a continuing housing boom, this growth presents a stark contrast to neighboring markets with still-high vacancy rates, limited absorption and lower, if not negative, job growth. Though the Inland Empire still maintains its key pillars,affordable housing, competitive office rental rates as compared to neighboring regions and added jobs,the region is not immune to statewide economic conditions.
These include workers’ compensation costs and an imposing state budget deficit.
Healthy sale and leasing activity will continue into 2004 as users and investors seek class A space and projects. To meet this demand, construction projects will continue to break ground, primarily in the mature markets of Ontario, Rancho Cucamonga and Riverside, as well as the rapidly growing Corona region.
Construction activity also will increase in the emerging housing markets of southwest Inland Empire, such as Temecula,home of well-educated, white collar San Diego residents migrating inland.
