Orange County is facing a lot more questions about the health of its real estate market than it was a year or two ago.
Overall, the county’s still seen as being a good investment for long-term investors, but it’s no longer listed among the country’s top regions for developers and investors, at least not in the near-term.
The weakened housing market has put several big housing projects across the county in limbo and has led to speculation about the financial health of many of the county’s homebuilders and developers.
Sizable land sales appear likely as some housing developers look to offload some of their assets. Commercial investments made at the peak of the market are now being re-evaluated amid a tough credit market.
Office vacancy rates have nearly doubled over the past year to about 16%, thanks largely to the implosion of the subprime mortgage market and the slowing local economy. The addition of new class A offices towers and mid-rise buildings to the market,totaling more than 2 million square feet,is coming at a time when rental rates are softening and sublease space is prevalent.
Developers of smaller, for-sale industrial and office condos,a staple of OC’s commercial development market the past five years,are expected to have a tougher time finding buyers because of general economic fears and credit issues.
Retail buildings are coming on line when consumer spending is showing signs of slowing.
And outside OC, the Inland Empire,where many developers flocked for less expensive land,is facing some of the most severe economic pressures seen in the country, let alone California.
All in all, the pressures facing OC’s real estate market are likely to cause plenty of suspense for the remainder of 2008 and 2009.
The Business Journal’s Mark Mueller asked executives with some of OC’s largest developers, owners, investors and brokers of commercial space and land for their opinions on the state of the market and what to expect in the next year.
Over the following pages are their edited responses.
What to Expect in OC’s Office Market
With OC’s economy in flux, the Business Journal asked a leasing executive from the county’s largest landlord, The Irvine Company, and tenant brokerage Cresa Partners whether they are seeing signs that leasing activity is poised to rebound over the next six months? They also commented on what they are hearing from tenants about their space needs and if there are there any local industries or business sectors that could help fill the space left by the mortgage industry.
Steven Case
Senior vice president of leasing and office properties
The Irvine Company
Newport Beach
The Irvine Company takes a long-term view and focuses on owning and operating best-of-class buildings in premier locations. Our strategy has served us well,both in thriving and challenging economic times.
Despite the challenges facing the local economy, we have seen positive leasing recently in selected industries. Our University Research Park and Newport Center projects are nearly full. And under tough conditions, we have signed several significant leases at our new buildings. In Irvine, our new 20 Pacifica building is 33% leased, and our new building at 18100 Von Karman Ave. is about 24% full.
In terms of industries that show promise, we’re seeing solid activity in the online and video gaming industry. We’ve also had some of Orange County’s best known companies expand recently in our portfolio.
Blizzard Entertainment is a good example of both. The gaming giant has more than doubled its size in Irvine. And we recently signed four other gaming
companies. We’ve also seen recent expansions involving Broadcom, Cisco and Fluor. Two years ago, Fluor wasn’t in Irvine. In May, it added a fifth building in Irvine Spectrum, and now leases 278,000 square feet. Broadcom and Cisco also added buildings, bringing Broadcom’s total to 749,000 square feet and Cisco’s to 186,000 square feet.
There have been other recent developments that make us especially optimistic. Irvine was just named America’s Safest City for the fourth consecutive year. The governor declared nearly 50,000 acres of wild lands on the historic Irvine Ranch, a California Natural Landmark, adding to the region’s growing reputation for environmental conservation and outdoor recreation. Several Irvine schools were named among the best in the state, and the city’s four high schools were listed among the county’s 10 best.
These factors make a compelling argument for existing companies and those who are considering relocating.
Jeff Manley
Managing principal
Cresa Partners
Newport Beach
Will we see greater leasing activity over the next six months? Our business is driven by the prospect of job growth and then the actual growth in jobs. Depending on which economists and which statistics you rely on, we are poised for flat to slightly negative job growth over the next nine to 12 months. If that holds up, then we will have modest to low leasing activity in the area.
There will be some modest activity because companies have leases that expire and they are forced to do something as their lease expiration approaches. Some will move to quality (the newer high rises), some will stay in place and renew, some will do short-term extensions to see if the market swings more toward the tenant.
My sense is that the vacancy rates, which drive lease rates, will remain at their current levels for the next nine to 12 months and will lower slightly as the job market slowly improves.
Even though vacancy rates are higher than we have seen for a while, lease rates will remain relatively stable because the major landlords (The Irvine Company, Hines, Opus and Maguire) that have recently completed high-rise office buildings are patient and will remain patient.
What are the tenants’ space needs? Tenants are becoming increasingly conscious of space efficiencies and the square feet per employee are being driven down, requiring companies to take less space. In addition, the sustainability issue (LEED metrics) is becoming much more mainstream and companies will have to demonstrate to younger, environmentally conscious prospective employees what they are doing to protect the environment and how their work space reflects that ethic.
Once the mortgage industry rebounds, it too will help drive space absorption,not to the extent that it did a few years ago, but if OC was popular three or four years ago for the mortgage industry, it will be again in the future.
What to Expect in Land Valuations
OC’s land values are holding up better than other areas of Southern California, but there are still signs of trouble facing many area developers who bought land at the peak of the market. We asked an executive from one of the county’s top land brokerages, O’Donnell/Atkins, to discuss what we’re likely to see over the next year.
Tom Reimers
Executive vice president
O’Donnell/Atkins
Irvine
Over the next six months, we predict land values will experience continued downward pressure resulting from increasing foreclosures on development projects by lenders. By the latter half of 2009, we are expecting land prices to stabilize and settle into a more predictable trading range where they should sit until re-sale and new home inventories are burned through and home values begin to show some signs of appreciation. Regardless of what happens in the broader economy, OC’s tight supply of developable land and concentration of higher-paying jobs will keep home and land prices high relative to surrounding counties.
However, the real wild card in all of this is time: How long will the broad economic weakness persist? How long can lenders hold out for 70%-plus recoveries on their upside-down loans? How long until Federal regulators require disposition of assets at whatever price the market will bear?
As lenders come to grips with the inherent complexity of the underlying development projects, more lenders will aggressively move to get these assets off their books in one way or another.
On a transactional basis, this means we’ll continue to see the upward trend in land deals that we’ve experienced since the beginning of the second quarter. This should continue on a measured basis through the next 12 months. If, at any point, there becomes widespread Federal intervention with the lending institutions, the small stream could become a torrent.
However, there appear to be several intervening processes that could moderate that torrent, including the length of time associated with the foreclosure process, bankruptcy filings and corporate acquisitions.
What to Expect in Leasing, Sales
The slow pace of sales and leasing seen in the latter half of 2007 appears to have carried over into 2008. We asked three managing directors of OC’s top brokerage firms if they’re seeing signs that either sales or leasing activity is poised to rebound over the next six months. Also asked: what’s likely to be the best (or worst) performing sector in the short term in OC?
Jeff Moore
Senior managing director of Orange County
CB Richard Ellis Group Inc.
Newport Beach
According to an economist with Torto Wheaton Research who recently spoke at CB Richard Ellis’ Southern California retail symposium, from a macro perspective the current economic state will begin to improve as the erosion in the housing market slows toward the end of 2008 and into 2009.
From a more micro-Orange County perspective, deal volume in both sales and leasing in all sectors continues to be off, but the positive news is that deals are still getting done.
There is still debate about how quickly the debt markets will come back, as lending is only getting tighter for leveraged buyers and developers. In addition, as buyers, sellers and lenders alike are proceeding more cautiously through the due diligence process, deals are taking much longer to close. Also affecting the sales market is a lingering disconnect between buyer and seller expectations when it comes to pricing. As one client put it, “there is still a lot of reality check in the works.” As this gap inevitably begins to close, the market will become much more opportunistic and deal volume will increase.
On the leasing side, our sales professionals are starting to experience an increase in activity in the industrial sector, which, while slower than last year, has been the most consistent sector throughout 2008 thus far.
In the retail sector, while some national brands have announced store closings or a slowdown in expansion, particularly in the home furnishings sector, other national chains continue to be active in the market, albeit more cautious in their approaches to deal making. In addition, growing retailers are more focused on infill and mature markets than on tertiary markets that have been more significantly tied to homebuilding. Overall, well-located retail in OC continues to be strong due to mature population densities and an affluent base.
Finally, in the office sector OC continues to feel the effects of the subprime mortgage fallout. While the past three consecutive quarters have posted negative absorption in the sector, there isn’t a significant amount of mortgage space left and with much of the county’s once 4 million square feet of new construction now complete, the construction pipeline for 2008 is now just 671,000 square feet. These two facts bode well for the beginning stages of a rebound, particularly as we look to growth industries like technology, healthcare and government to begin to generate positive absorption in the county once again.
Martin Pupil
Senior managing director,
OC, Inland Empire
Colliers International
Irvine
While the OC commercial real estate market may not be poised to rebound in the next six months, its solid fundamentals position the region for an eventual strong recovery.
The overbuilt office market coupled with no job growth has caused a large vacancy factor for the class A office segment, which is the sector struggling most during the current real estate downturn. Absorption will inherently remain low.
However, OC’s strong aerospace and technology base will serve as the main driver toward future positive absorption and the market will eventually self-correct.
Leasing activity has been minimal with tenants focusing on renewing for shorter time periods in order to consider future options. However, expectations between tenants and landlords are aligning, which will boost confidence and activity in the leasing market.
OC is still recovering from the capital markets crisis, which has resulted in a gap between buyers and sellers within the investment arena as well. The weak dollar will attract foreign capital sources to flow into the market, stirring up activity for investment properties,a sure sign of a recovery in OC.
Industrial real estate is still experiencing low vacancy rates and high demand and will remain stable and healthy in the coming months. There is minimal construction of new industrial product taking place. The only new industrial projects slated to come on line in the next six months are in the smaller owner/user condo category.
Kurt Strasmann
Regional managing director of OC, Inland Empire
Grubb & Ellis Co.
Newport Beach
The office market is reaching the bottom and now will start climbing out through the end of this year and well into 2009. We will be back on high ground by 2010.
The key area to watch is job growth. This year, 15,000 jobs are expected to be lost (a lot of this has already happened). Our forecast for 2009 is that approximately 15,000 jobs will be gained, which will provide the momentum for the office market to come back.
Tenants and buyers continue to try to time the market for rock-bottom pricing. Tenant activity continues to be all lateral moves and strictly based on economics. There is no net absorption. We will see moderately lower prices through the end of this year.
Landlords with heavy vacancy will be extremely aggressive to secure tenants. Landlords whose rent roll is solid with little vacancy will hold firm on pricing. It is very much a building-by-building situation.
The good news is that there are a handful of large transactions (50,000 square feet and larger) in the works this year and the 3,000- to 8,000-square-foot leases are steady. But the market is still looking at two years of negative absorption.
Any new office development is a long way out. There is still strong investment demand for offices, but at significantly discounted prices. Underwriters are extremely conservative, and with good reason. Forecast for the remainder of 2007: Direct vacancy will increase from 15% to 17% to 19%, effective lease rates will moderately come down (5%) and deal activity will remain at the current levels.
In the industrial market there is very low vacancy (4.4%), but very little tenant and buyer demand. Although fundamentals remain strong, there is no depth to the market. Prices will remain stable due to low vacancy and no significant construction. Developers continue to have an extremely difficult time in making any sense of land prices. Again, this will limit construction over the next 12 months.
There is no end in sight regarding the lack of liquidity in the investment market. Stabilized core assets will remain in demand. Value-add projects with vacancy will continue to be highly difficult to sell without big price discounts or seller financing.
Best performing to worst performing sectors in order: industrial, apartments, office and finally retail.
What to Expect in Real Estate Investment
How is OC holding up as a target market for major investors? We asked the head of Bixby Land Co., one of the county’s most active buyers of office and industrial buildings last year, how much real estate investment activity OC is likely to see over the next year, what sectors of the commercial real estate market will hold up best over that time, and how attractive the local market is compared to rest of Southern California.
Bill Halford
Chief executive, president
Bixby Land Co.
Irvine
Investment activity throughout the U.S., for the balance of 2008, will most likely remain dormant. To date, 2008’s investment volume has been only 20% to 30% of what it was during the same period in 2007. Due to the current delivering of real estate and the difference between asking price and selling price between buyers and sellers, the market it is not likely to reactivate until 2009.
Industrial property values within OC should hold steady as vacancy remains below 7% and very little construction activity is anticipated within the next year. Office values in OC overall enjoy less certainty, although that cannot be generalized countywide.
Central Orange County, which has a vacancy approaching 15% and lackluster new demand from tenants, will be slow to recover causing a negative effect on values. Newport Center submarket and the properties located in Newport Beach will continue to benefit from high tenant demand and vacancy below 8%. The Airport Area submarket is a tale of two cities. The new developments that are seeking premium rents will continue to see sluggish demand as many tenants remain hesitant to commit to long-term leases during uncertain economic times. Existing buildings with stabilized occupancy will continue to benefit from steady cash flow.
What to Expect in the Inland Empire
Are OC-area developers still bullish on the Inland Empire? We asked two local development firms with big plans for the Inland Empire,Birtcher Development and Investments and Opus West Corp. ,what sectors and markets are holding up best, and how will the next year play out inland.
Paul Marshall
Division president of Southern California
Opus West Corp.
Irvine
Opus West is very active in developing office, retail, industrial and apartment real estate in the Inland Empire and feels that the market has both short- and long-term opportunities. The primary driver of those opportunities is population growth, which results in an increase in jobs and services. Since the Inland Empire is a clear benefactor of population growth for many reasons, we are bullish on the long-term development viability of our products.
Having said that, there are different drivers and influences for each product type that make a global analysis less telling and force a micro view of each sector. The industrial market historically has been very active and is heavily influenced by the nation’s busiest ports,the ports of Los Angeles and Long Beach,as well as the need to service a heavily populated Western U.S.
We expect the industrial market to slow somewhat as it mirrors the current economic slowdown. However, the historical base and demand combined with pressure from the ports and decreasing inventory of land should be positive drivers.
The office market is fairly fluid and will experience some challenges over the next year as the 2007/2008 pipeline is absorbed.
Our retail product is performing very well and we would expect that to continue. A drop off would not be caused by a lack of demand as the market has matured and needs the service. However, the retailers who have slowed expansion and new store openings for various reasons could possibly contribute to a slowdown.
The apartment sector should fare well, but it is important to keep a cautious eye on the shadow that could be created by the single-family home supply.
Shannon Hondl
Senior vice president of acquisitions and development
Birtcher Development and Investments
Irvine
In the western part of the Inland Empire there is a slowdown in the market due to political uncertainty, lower gross domestic product, lower port volume out of Long Beach and higher oil prices. Additionally, the subprime fallout has negatively impacted the market. The market is in a holding pattern as deals are not being made. In the long run,12 to 18 months,we will see improvement in the Inland Empire West market.
In the Inland Empire East, the industrial market is being hampered much more by overbuilding. It will likely take at least two years to correct. The biggest concern in this market is the amount of buildings being planned in this region, which is creating lots of competition and keeping rents flat or pushing them lower.
Overall, in the long run, the Inland Empire’s industrial market will continue to be one of the better industrial markets in the country, following closely behind Long Beach/L.A., New Jersey and Chicago.
What to Expect in the For-Sale Condo Market
The for-sale industrial and office condominium market has been one of the strongest sectors of the local commercial real estate market so far this decade. We asked one of the sector’s top developers, John O’Brien of Guthrie Development Co., and one of its leading brokers, Voit Commercial Brokerage’s Louis Tomaselli, what to expect over the next year. Are certain areas in the county holding up better than others? Are potential buyers still looking to buy rather than lease?
John O’Brien
President
Guthrie Development Co.
Costa Mesa
The for-sale industrial and office condominium market will remain slow for the rest of 2008. The market will begin to pick up in the beginning of 2009 when consumer confidence returns.
With the lack of assurance in the market and the mixed messages that real estate is recovering one day and crashing the next, many business owners are leasing or renewing previous leases throughout the county. Potential buyers will ride out the market and wait to see what happens in the economy and election, as well as with their businesses over the next six months before making their moves.
The traditional central markets in OC are holding up better than the fringe markets. Central, established industrial markets like Anaheim have been better equipped for the slowdown in commercial real estate, and those without large supplies of product on the market are still profitable. One example is Guthrie’s industrial project in Paramount, which is the only small for-sale condominium industrial project in town. Those types of markets have more activity and will continue to have activity through this downturn.
With money still available to some potential buyers, OC may begin to see any influx of sales once the market settles and the uncertainty about the upcoming election subsides. With a lack of new product coupled with historically low vacancy rates, OC may see a surge in demand and a major shortage of available new space. Projects take a while to entitle and build so once people start looking for space to buy again, there will probably be a shortage of new space.
Louis Tomaselli
Senior vice president,
Voit Commercial Brokerage LP
Orange
Continued slowing demand for industrial buildings countered by a halt in new development should result in a flattening of the market over the next year. The slowing will be more severe for the office condo market. Minor reductions (5% to 7%) in the pricing of industrial buildings are expected to meet the slowing demand. In 2006 and 2007, older second-generation buildings were priced comparably to new buildings in the for-sale market. As the flattening market drives the price of new buildings down, second-generation industrial buildings will likely experience a 10% to 15% decrease in pricing in order to solicit interest from buyers who prefer to buy new buildings.
Slowing of the office condo market is speculated to be more severe initially due to a smaller pool of potential buyers coupled with aggressive lease rates, including new concessions of free rent and tenant improvement allowances, which will encourage potential office condo buyers to remain tenants.
As a result of this trend, North Orange County industrial is the strongest sector, representing 42% of the market by volume. South Orange County is not faring as well because it is composed of a greater number of office buildings.
The market experienced the height of building sale velocity in 2006 and 2007. It is predicted that 2008 through 2009 will only have 50% of the volume that was recorded in 2006 and 2007. Most of the new product should be fully absorbed in the next 12 to 18 months due to limited construction.
Long-term ownership has always outweighed leasing throughout every economic slowdown the market has experienced. Buyers are still buyers and will typically trade up in building size and expand when prices are more advantageous. The driving force for buyers is the availability of capital.
