The Orange County office market was considered one of the strongest in the U.S. a year ago.
It’s only gotten better since.
Local brokerages such as CB Richard Ellis Group Inc., Grubb & Ellis Co. and Voit Commercial Brokerage LP report that OC’s overall vacancy is approaching 6%.
Average rents have risen close to 12% during the past year, and now stand at about $2.30 per square foot (average rent and vacancy statistics vary by brokerages’ tracking methods).
In addition to strong leasing activity, brokers have cited the limited development of new offices as a key reason behind the strong surge in rents. That’s about to change. A number of large projects now are moving forward.
Among the big, mainly speculative office developments in the works:
The Irvine Company is building its 20-40 Pacifica project in the Irvine Spectrum. The two-tower project will total about 625,000 square feet.
The Irvine Co. also is building a 10-story, 231,178-square-foot office building at Irvine Center Towers near John Wayne Airport. It has plans for another 150,000-square-foot building at Jamboree Center along the San Diego (I-405) Freeway.
Houston-based Hines Interests LP is building a 261,400-square-foot building at 2211 Michelson Drive.
Maguire Properties Inc. of Los Angeles is building a 530,000-square-foot tower at its Park Place office complex in Irvine.
Opus West Corp. said in April it plans to build a 313,000-square-foot building at its Opus Center Irvine complex on Main Street.
Parker Properties LLC has started on the latest phase of its Summit office campus in Aliso Viejo. The developer is adding 260,000 square feet of speculative office space. Also on tap is a 242,000-square-foot office tower set for the Summit for Pacific Life Insurance Co.
There still are some big issues facing the developers, despite the rosy local forecast.
Construction costs continue to rise, OC’s big base of mortgage tenants are showing weakness and signs of a cool-down in the local housing market has some on edge.
Industrial Market
Industrial developers targeting small business owners have found a profitable niche in OC during the past several years.
While large-tenant projects have disappeared from the scene for the most part because of the high cost of land, smaller building projects have thrived.
Of the roughly 1.4 million square feet of industrial space now under construction in OC, most is geared toward small users, with buildings running in the 20,000-square-foot range and under.
Companies specializing in these types of projects, which typically sell in the $300 per-square-foot range, made up a good chunk of the Business Journal’s list of largest commercial developers (see list, page 37.)
But the lack of new, rentable industrial space on the market has withered, and is one main reason industrial vacancy rates have dropped to about 4% countywide.
The Business Journal asked executives with some of OC’s largest developers, owners, investors and brokers of office and industrial space for their opinions on the markets.
Is there enough office and small-user industrial development in the works to handle tenant demand in OC? If not, how much more is needed?
Will recent downturns in the mortgage industry give developers pause before starting a new office project?
How are rising construction costs being managed by the industry? How much will rents have to increase to justify new construction?
Have rising interest rates made it harder to sell smaller, for-sale projects to small industrial owners? How much higher can rates go before prospective owners are scared off?
Will OC ever see larger industrial developments aimed at the large user, or will the sector continue to be dominated by the smaller, for-sale projects?
Are industrial and office projects still getting pushed aside by more profitable residential developments?
The following is an edited version of their responses, which are organized by executive, with office contributions at the beginning and industrial later.
JAMES V. CAMP
Senior vice president of development/
acquisitions
Voit Development Co.
Newport Beach
With several new projects coming, OC is anticipated to soon have enough office space in development to handle demand.
Most of the new space coming online will accommodate small office tenants and users in search of larger space requirements including full floors.
OC has a shortage of big blocks of office space ranging from 30,000 square feet and larger. Companies looking to occupy an entire floor have been finding space harder to come by and the new projects in the pipeline will provide relief to this problem.
Nonetheless, there is a significant amount of second-generation space coming back online from mortgage companies, which are currently in the midst of a downturn.
Despite these downturns, developers have not slowed development, since most office projects take many years to plan and complete. Only if the mortgage industry experienced major consolidations would developers be impacted by the recent downturns in this one industry.
Rising construction costs also have been a recent concern by office developers in OC. Developers have to incorporate these rising costs into their analyses, adding a 1% cost escalation factor per month to offset these growing costs.
There is no cost moderation in sight and cost increases are expected to continue due to the rising cost of oil, steel and concrete. Developers will have to look for creative avenues to justify these costs, and rents will have to grow in excess of construction, land and soft costs increases in order to keep developers’ proformas intact.
Since the residential market is slowing, developers of office projects are not being pushed aside by the high-rise residential projects in OC as they were in the past few years. The residential developers that once paid double or more for land are not moving forward with many of these residential projects, allowing new office developments to continue to move forward.
With solid and sustained positive job growth in OC, the office market continues to thrive. The job growth is creating enough demand to fill the new office developments coming online and will continue to positively impact the office market as long as economic growth continues.
FRANK CAMPBELL
Vice president,
leasing
Equity Office
Properties Trust
Irvine
Equity Office has seen the average asking full service gross lease rate in Orange County climb 11.7% compared to a year ago. This is the ninth consecutive quarter of rent growth.
OC’s economy is one of the most vibrant in the nation, and together with rising rental rates, Equity Office feels these strong office fundamentals justify new construction.
Consider the supply data: More than 260,000 square feet of new office space was delivered in the first quarter of the year, and an additional 1.7 million square feet is forecasted for the remainder of the year.
Will this alter what appears to be a well-balanced supply and demand equation? We don’t think so. The overall OC economy should continue to show moderate gains this year.
While we are seeing a slowdown among the construction and finance sectors, and while home sales and appreciation will continue to slow during 2006 as interest rates rise, an actual decline in employment has yet to be predicted by even the most bearish economists.
Although Equity Office expects a slowdown in the mortgage and financial services industries, this impact on the overall economy will be relatively modest, and more than offset by OC’s considerable population growth, and the healthy and diverse economy.
Construction costs are on the rise, but this trend will not stop many of the development projects from moving forward. These costs are justified given the current health and strong projections for the OC economy.
OC posts the third lowest vacancy rates among Equity Office’s strategic markets and is considered by many to be one of the strongest economies in the U.S.
It’s interesting to note that 37% and 31% of OC residents reported high housing costs and traffic congestion, respectively, as the most important problems facing the county.
The location of commercial developments and its proximity to employee pools have never been more important than today. As traffic becomes more of an issue, employers will use new office locations as leverage to attract and retain valuable employees.
STEVEN CASE
Senior vice president, leasing
Office Properties
The Irvine Company
OC’s economy continues to show signs of strength with companies from different sectors growing and expanding at a steady pace.
The county’s office market is the tightest in the nation, and vacancy rates have achieved historic lows. Low unemployment and solid job growth projections make us particularly bullish about the next five years.
Is there enough new development under way? At the Irvine Co., we are working hard to address the demand. We have begun construction on three new high rises,our first new towers in 15 years.
We’re not just focusing on high-rises. Next spring, we will complete a nearly 700,000-square-foot office campus for Broadcom Corp. at University Research Park.
We also are building office campuses at Discovery Business Center and Irvine Technology Center.
What about questions about the impact of a downturn in the mortgage industry? In OC, we are positioned well to withstand economic downturns in a particular industry because of our diversified economy.
The county’s landlords continue to experience strong demand from a variety of professional service firms, including financial planners, insurance companies, institutional banks, law firms and others.
ROBERT FLAXMAN
Chief executive, president
Crown Realty & Development Inc.
If projections are to be believed and our nation’s economic trajectory continues its general upward climb, future job growth across multiple industry sectors will continue to fuel demand for office space in the county well into the last half of this decade.
If this premise holds true, then office development now on the books or in motion will just meet the anticipated demand for office space in the foreseeable future, most likely at significantly higher rents that will meet the associated rising costs of construction that has everyone questioning the move today.
Yes, construction costs have risen, but if rents continue to rise due to limited space and continued demand, returns will be justified.
That being said, the biggest concern for OC in the near term is just how much space the mortgage finance industry will be giving back in the coming months.
Market reports are indicating that nearly 900,000 square feet is coming back on the market from many of the county’s leading mortgage companies, as either direct givebacks or for sublease.
It could cause a stall in rent growth for the immediate future as the market absorbs the additional space, although all indicators point to pent up demand that should begin to backfill the higher-quality space in the interim of new developments delivering.
OC is slowly becoming an infill market. You can attribute this to the dwindling supply of commercially viable development sites in most of the county’s major submarkets, and the challenges of acquiring land and entitling for new development or redevelopment.
A key fundamental underpinning the move forward with new development is the conversion of many former commercial sites to high-density residential uses.
Competitive barriers to new office development are going up because of the demand for housing, and the promising returns of a for-sale product. This will bode well for future office buildings.
BARRY M. GAIL
Senior director
Cushman & Wakefield Inc.
Irvine
The unraveling of the mortgage industry juggernaut in OC is in full swing.
While Ameriquest’s recent announcement to put 600,000 square feet of sublease space on the market was a dramatic punctuation mark, the “rightsizing” within the industry has been ongoing for close to a year.
Big names like E-Trade (60,000 square feet), Town & Country Credit (40,000 square feet), Novastar (35,000 square feet), Acoustic Home Loans (80,000 square feet), Impac Mortgage (130,000 square feet), Countrywide (46,000 square feet) and Option One Mortgage (34,000 square feet) have either returned, remarketed or are subleasing space.
The interest rate escalation has been the prime mover behind the setback, but market saturation along with slowing housing sales due to historically high prices have been contributing factors.
Is it still a good idea to develop more office space?
Developers planning office space are savvy, experienced and market-wise companies. Occupancy levels are excellent, ranging from the low to mid-90% levels.
Job growth countywide is good. Unemployment levels for OC are among the country’s lowest, settling in at less than 4%. Rental rates continue to and have been rising steadily during the past several years.
The last prominent high rise,2040 Main St. in Irvine,was delivered four years ago. Historically, new development brings excitement and expands absorption. To cap it off, if you are in a high risk industry with a pedigree to build, where better to wager than OC?
The negatives or reasons to pause are less obvious. The bane of development always has been time to market. From conception to delivery is a challenge that causes sleepless nights and prevents all but the well-heeled from entering the fray.
While modern construction technology has shortened the delivery gap for the typical high rise product in this market from 18 months to 15 months, much can happen in today’s mercurial environment.
The key questions that have yet to be answered include: How will the market respond to new product rates? The precious cost of land and materials will push rental rates to new heights. Developers will require rents of $3.50 per square foot rents and higher to satisfy investors.
This is new ground for OC office tenants.
How will the mortgage industry reversal of fortune affect absorption? Conventional wisdom suggests the 20% reduction in space used by the mortgage industry will not swing the balance from landlord to tenant.
Could be, but what if 30% or more space is returned to the market by real estate companies?
High-rise office space users connected to the real estate industry include residential developers, title, escrow, law, accounting, commercial brokerage, consulting and financial services companies, among others.
The answers to these questions will be revealed very soon and the excitement generated by the new development reinforces the premise: There is no finer place to live and work than OC.
WILLIAM
HALFORD
Chief executive,
president
Bixby Land Co.
Newport Beach
On the office market: OC office vacancy is now at 6% with 3.7 million square feet under construction.
Although net absorption is declining due to the lack of available inventory, new space is 18 months to two years away when vacancy rates will likely be at 4% or less. So the new office development is in balance with projected demand.
The recent downturns in the mortgage industry will have a moderate impact on vacancy,1% to 1.5%,and most of the subleased space has less than three years.
There is really nothing that can be done to manage escalating construction costs. A 20% rent spike should be attainable for new development being delivered in the next 18 months to two years.
On the industrial market: Most small-user industrial development has been small buildings “for sale.”
As interest rates increase, the demand for this space will moderate. However, industrial vacancy is only at 6%, so the lack of leasable alternatives could fuel this “for sale” demand further than one might think.
Industrial projects still are getting pushed aside by more profitable residential and office development. This will remain a trend as the densification of Southern California continues and land values escalate.
OC never will be a distribution center like the Inland Empire. The combination of high land value, lack of affordable housing and a decreasing labor source will continue pushing OC toward smaller industrial buildings as opposed to large distribution buildings.
DOUGLAS HOLTE
West regional
partner,
director of OC, San Diego operations
Hines Interests LP
OC continues to be a prime market due its growing population, depth of business infrastructure and economic diversity.
All of this contributes to vacancy rates hitting historic lows and the new large-scale developments in the pipeline in OC.
Hines has geared our efforts toward the quickly maturing Michelson corridor in OC’s John Wayne Airport submarket to meet the obvious demand for high quality, innovative office environments.
More than 260,000 square feet of new office space was delivered in OC the first quarter of the year, and an additional 1.7 million square feet is forecasted for the remainder of the year.
If the Irvine central business district can maintain occupancy above 90%, while still providing ample room for tenant expansion and growth, then this is a healthy market from a developer’s perspective.
Therefore, we feel it is safe to say that current demand will sustain current supply and in fact encourage future development projects in major OC metro areas.
Studies show that the mortgage industry represents about 8% of the OC office market. We expect their reduced employment to add back 2% inventory to the market. This is not especially troubling given the very low office market vacancy coupled with dramatic job growth among many other industries in OC.
With building material costs on the rise across the nation, it is understandable that developers are concerned about the cost-benefit ratio of building new developments.
Prices of all materials and labor have increased significantly as the global economy has grown during the past four years, though we are finally seeing some evidence of price stability.
Hines benefits from having an entire team dedicated to negotiating and purchasing building materials for our current portfolio of ground-up developments across the globe.
Orange County is seeing a demand for high-rise, high-density residential developments, and due to this demand it is difficult for office developers to compete with residential developers and the pricing they are willing to invest for land to develop for sale housing. We expect some cooling off of multi-family residential land sales, and also expect more sites to be reconsidered for true mixed-use with residential, office, retail and perhaps hotel.
BARRY A. KATZ
Managing director, Office Specialty Group
CB Richard Ellis
Group Inc.
During the past 12 months, vacancy levels have dropped to historical lows, leading to a tight office market and an upward pressure on rents.
In the first quarter of this year, net absorption has remained healthy, yet experienced a slowdown. This slowdown is mainly due to minimal inventory rather than lack of demand.
However, there is more than 3.6 million square feet under construction that is set to be delivered to the market by the end of the year or in early 2007.
The question is how much more space will existing mortgage companies give back to the market?
While many of these companies are experiencing a decline in activity due to increases in interest rates, others are shifting their business model in order to stay in business and pick up market share from weaker competitors.
These mortgage givebacks coupled with new construction will diminish the shortage of inventory and could even lead to an abundance of space by late 2007.
The construction of apartments and high-rise condos can now be seen in areas that were zoned for strictly commercial uses. A couple examples are the A-Town development that Lennar is building near Anaheim Stadium and projects by Bosa, Lennar and Opus along the Jamboree Corridor in Irvine.
Increased construction costs play a significant role in the necessary higher asking rents of new space.
There is a major difference between existing office space asking rates and rates for new buildings.
PAUL MARSHALL
President, Southern California
Opus West Corp.
Irvine
The OC market consists of several distinct submarkets that have very specific dynamics both on supply and demand.
Generally, since the late 1980s, the development pipeline has been very controlled and responsive to market demand. The reality is that development is a fairly lengthy process, which naturally creates a gap in the response to market vacancies.
The three-year absorption average has been very healthy, resulting in a low vacancy that should continue to drop through 2006 until new space is finished. Assuming current demand stays static, space being developed now will provide a fairly equal supply to demand relationship in 2007 and 2008.
Otherwise, look for 2006 to tighten further and subsequent years to hold steady.
The anticipated mortgage company space giveback should have less than 1% impact to the overall vacancy. That’s noteworthy but not critical.
There isn’t a catch-all answer to handling rising construction costs. In some cases pre-stocking of material provides some relief. We have mitigated much of the recent exposure by committing to cost prior to committing to rents or sale prices.
We believe costs will continue to increase at percentages that haven’t necessarily been the norm, but are more manageable in relation to expected rent increases.
Clearly in the airport area and isolated other OC markets, residential building has displaced traditional office project opportunities.
As the demand diminishes, there will be a shift back to more traditional development.
KEVIN R.
MCKENZIE
President
Parker Properties LLC
Aliso Viejo
Depending on the source, the OC office market is either the No. 1 or No. 2 market nationally.
A year ago, there were strong, clear signs of improvement in the market, but the current strength exceeded most expectations. The office market has enjoyed a spectacular run having absorbed more than 10.5 million square feet during the past three years
Vacancy is now down to 6%,a historic low. With 5.6 million square feet vacant, it’s a little more than the almost 4.7 million square feet absorbed in 2005.
That’s good for landlords and developers and not so good for tenants,especially those who aren’t thinking ahead. During the past year, asking rents have increased more than 11% with a 37% decline in vacancy.
There’s relief in sight for tenants with about 3 million square feet under development.
It will not likely take any pressure off of continued rent increases, but tenants will at least have options.
After such a phenomenal run, which is likely to continue, it’s important to keep a keen eye on a couple of threats: construction costs and demand.
From a developer’s perspective, construction costs continue to be a significant threat. With overall construction cost inflation forecast at about 1% per month, developers have added a new contingency to their budgets: cost inflation.
Concrete, steel, glass, plastic, asphalt and labor seem to top the list of rotating causes. The good news for office developers is that rents have been keeping pace with these increases and capital continues to be eager for development.
On the demand side, it’s no surprise that the mortgage industry has taken a pause. It’s worth watching, but the diversity of the overall economic engine in OC will continue to support strong demand.
RYAN SMITH
Senior vice president
Buchanan Street Partners
Newport Beach
Some near-term challenges are imminent, but the overall fundamentals of the OC office market remain solid.
With slightly less than 3 million square feet of development either under way or planned for delivery within the next two to three years, the OC office market is poised to remain tight for the foreseeable future. This limited new supply, combined with the continual increases in construction costs, will force rents to climb at greater than double-digit percent increases for the next few years.
The one setback that is starting to arise in the OC office market is the downsizing of the mortgage industry. While the overall exposure is difficult to assess, most experts believe that the mortgage and related industries comprise somewhere between 5% and 10% of the overall market.
Job growth forecasts for OC correlate with annual projected positive absorption of about 3 million square feet. Even with recent layoff announcements by Ameriquest and others, the demand will continue to outpace supply.
However, developers will continue to be challenged by the escalating costs of construction. The saving grace has been the rise of rental rates, which is expected to continue.
Total construction costs for a mid-rise office building in OC today are between $350 and $375 per square foot, assuming you can find the land.
This ultimately means that new buildings will have to achieve rents around $3.50 per square foot per month, full service gross.
Rents in the market for class A office space already have reached well into the $3-plus range. The best news for developers is that there is plenty of capital available to invest in the OC office market.
The residential market in OC has been booming lately as well. There are more than 14,000 units in the pipeline and the recent success of The Marquee Park Place and The Plaza Irvine will continue to attract developers and capital to the market.
But the condo market has cooled off across the country and the rapid rise in office rates have started to create competition for sites. While residential land still commands a premium, the gap will narrow over the next few years.
TERRY W. THOMPSON
WCB Properties
Based on the low unemployment rate in OC, job growth projections, supply constraints and barriers to entry, demand is greater than supply, which is causing a tremendous upward pressure on rents and spurring development activity.
Over the longer term, there is a finite availability of remaining land zoned for office space and the fact that a number of sites have been rezoned to residential condo conversion sites has further limited the remaining development sites for office space.
With the OC area continuing to be a desirable place to live and work, with a highly skilled labor pool, over the long term there likely won’t be enough developable office sites to accommodate demand.
That, I believe, is one reason why the more progressive cities of OC are exploring redevelopment areas that not only include residential and retail, but are incorporating office sites into their redevelopment zones in order to continue to attract business and increase their employment base.
In the meantime, with a very low vacancy rate and the projects being developed still nine months to 12 months away from being completed, I wouldn’t want to be an office tenant with a lease that expires during the next 12 months to 18 months.
In general, I think the industry continues to underestimate the increasing construction costs. In addition to the rising materials cost, the cost of labor has continued to increase due to the demand for contractors in the market.
Even with rental rates on the rise, based on the imputed land cost and value coupled with the increasing construction cost, it is difficult to make deals pencil out.
In this market, we really are in uncharted waters on how much rental rates can be pushed. Given the supply and demand dynamics I believe that they can be pushed quite a bit, but we have not been in a position as much as this before where you really need to be looking forward to where rents can be rather than looking in the rearview mirror at recent comps as to where they have been.
In addition, with this being a landlord market, more of those increased construction costs can be passed along to the tenants, which helps limit a landlord’s increased construction cost exposure.
There are signs that the dynamics are changing between office and housing projects. There are definite signs that high-rise condo buildings have been overbuilt and that there is a forthcoming over-supply of this space relative to the demand.
Again, based on economic supply and demand dynamics it appears that too many sites have been converted from office to high-rise residential.
The sites already converted, completed and under construction have been successful investments for those developers. But time will tell on the other ones that are still in the planning or conceptual stages.
We know of an office site that was in negotiations to convert to a residential high-rise condo site that is now reconsidering based on concerns on the depth of that market and the shortage of supply of available office space.
BRANDON
BIRTCHER
Birtcher Development & Investments
Demand from owners of small industrial companies appears to still be outpacing the availability of industrial buildings for sale in OC.
Hundreds of small business owners will continue to control the rising cost of occupancy by becoming an owner of their facility as interest rates remain low and the forecast for the regional economy for the next 24 months appears to be strong.
Demand seems to be particularly strong for buildings in the 10,000 to 50,000-square-foot size range.
Although the prime interest rate has increased by more than 400 basis points from its 40-year low just a few years ago, most real estate loans taken by industrial building owners have been tied to the 10-year Treasury bond, which has remained relatively flat.
As a result, ownership remains very attractive to most business owners. Today’s 10-year Treasury bond still is near a 20-year low, providing a very affordable option to rising rental rates.
Not until the 10-year Treasury bond approaches the 8% mark, will we start to see any significant slowing in the demand for ownership of small industrial buildings.
Demand will remain high due to a scarcity in available space caused primarily from a lack of available zoned land and the length of time it takes to entitle new projects.
The price at which industrial users will be willing to buy their building continues to rise, resulting from a dramatic increase in construction costs during the past 24 months.
The increase in construction costs pushes rents even higher for new industrial for-lease space. For this reason the analysis of ownership versus leasing will tend to favor ownership during the next 24 months.
The ability to consolidate smaller industrial sites in order to redevelop newer industrial space for sale is becoming much more difficult as a result of residential and office demand for the same properties.
Although this is a natural tendency in a maturing market, it presents an interesting urban planning challenge for city officials who are attempting to strike a balance between job creation and sales tax revenue generation versus higher density residential and office projects.
One of the questions planners need to address is whether or not this higher-density residential belongs in older residential neighborhoods in need of redevelopment, rather than red
