OFFICE IN REBOUND
Stronger Economy, Dearth of Construction Should Help Office Market Improve, Experts Say
By MATHEW PADILLA
Orange County’s office market has shown some healthy signs in the past several quarters, with companies leasing and buying more office space than they returned to the market.
And a recent slew of positive national economic data has added to the belief that the office market here will be swept up along with the rest of the country.
But uncertainty remains about the timing of the recovery and the impact of higher interest rates on the robust for-sale market, as well as on mortgage companies, which have been big takers of office space in recent years.
The Business Journal posed a question about the relationship between job growth and the local office market to a panel of industry leaders, including developers, economists and commercial brokers.
In May, U.S. employers added 248,000 jobs, marking the third straight month of strong gains in employment. Many economists believe that job growth eventually leads to greater demand for office space, but are not certain when. The three-part question: What impact do you believe the strengthening economy will have on OC’s office market? When should we expect to see vacancies fall and rents rise? And what types of companies do you expect to see leasing space this year and next?
Mostly, the respondents are optimistic. They see vacancies continuing their downward trend and see rental growth coming.
But several experts say that many factors have to be weighed, and at least one person points out that companies first will grow into their excess capacity before leasing up more space. In any case, the county’s average vacancy rate remains above 10%, which makes now a critical time for the market.
Following is an edited version of the responses.
ESMAEL ADIBI
Director, A. Gary Anderson Center for Economic Research
Chapman University
Demand for office space is driven by changes in payroll employment in the financial activities and services sectors of the local economy. Our forecast shows about 18,000 additional jobs will be created annually in these two sectors in 2004 and 2005.
With a limited supply of new office space, we expect a gradual decline in the vacancy rate and moderate upward pressure on lease rates throughout the remainder of this year, and well into 2005.
While we see a very limited upward demand for space from the financial services sector, we anticipate the demand for office space to be concentrated primarily in the professional, business, education and healthcare services sectors of the OC economy.
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JAMES CAMP
Senior vice president,
development and acquisitions
Voit Development Co.
Office vacancy already has been declining for the past six months. The strong national job growth numbers point to continued growth for OC, which is well positioned to capture a large share of the new jobs.
OC is not dependent on one, or a select few industries. In fact, we anticipate job growth in the county in everything from back-office banking and insurance to high-tech companies, which are slowly rebounding here.
As far as rents go, with the significant reduction in vacancy (from 14.2% in the first quarter of 2003 to 12.2% in the first quarter of 2004), we see rents going up in the very near future.
With 1.5 million square feet of positive absorption in the past six months, The Irvine Company already is indicating that it will be raising rents at its two-story office buildings.
One of the biggest changes in the market is that big blocks of office space of more than 35,000 square feet are being swallowed up quickly.
Large tenants in the market are taking up a majority of the remaining large space, including a number of 2004 examples: Indy Mac’s recent lease of 123,000 square feet; Hawthorne Savings’,now Commercial Capital Bancorp’s,35,000 square feet, Westcliff Labs’ 62,000 square feet and Del Mar Analytic’s 45,000 square feet.
Tenants seeking more than 35,000 square feet are going to have trouble finding space. And while there’s a lot more available at the 20,000-square-foot level, this segment of the market is experiencing positive absorption as well.
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BERT DEZZUTTI
Senior vice president, Los Angeles region
Equity Office Properties Trust
Overall, our outlook is positive. After absorbing more than 2 million square feet last year, the OC market slowed, but remained positive, with 155,000 square feet of net absorption in the first quarter.
The first quarter marked the sixth consecutive quarter of positive absorption, something that hasn’t happened since 1998, which is a good sign that the positive momentum will continue.
OC remains one of the most attractive areas to live in and that should continue to drive entrepreneurial business growth.
Anecdotally, we’re also seeing an increase in the number of companies trying to lock in longer term deals now, which typically means that we’ve hit the bottom of the cycle and we are on the rise as companies realize the tide is shifting and their window of opportunity is narrowing.
Companies recognize that now is the time to secure leases in the finest quality buildings by capitalizing on today’s favorable market conditions. While it’s a good sign that companies are beginning to lease more confidently, ultimately, we need additional and sustained job growth to see the need for office space to really rise.
The good news is that we feel that we’re starting to benefit from the early stages of an office recovery, and that small businesses are helping lead the recovery.
When should we expect to see vacancies fall and rents rise?
After leading the country in 2003 with a 330 basis point decline in vacancy, OC continued the trend with a drop in vacancy of another 20 basis points in the first quarter to 13.9%.
The first quarter was the sixth quarter in a row in which the vacancy rate has dropped. The 13.9% vacancy rate is the lowest this market has seen since the first quarter of 2001.
If the economic pundits are accurate and the office market continues to improve, vacancy rates should continue falling through next year.
Before we see rental rate growth, we’ll need to see tenant improvements and concessions come down. We hope OC will continue to improve with positive absorption in 2004 and the following years.
What types of companies do we expect to see leasing space this year and next?
We are experiencing high levels of leasing demand from small businesses, which we believe are leading the economic recovery. As more jobs are generated, we anticipate small business deals to continue to drive the majority of leasing activity throughout the remainder of 2004.
There are a lot of 5,000- to 10,000-square-foot tenants in the market along with a few coveted large corporate customers. There seems to be a number of small law firms growing, while a few big ones are shrinking.
We’ve also noticed that the majority of positive absorption is in class A space, indicating a “flight to quality.”
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ROBERT FLAXMAN
President
Crown Realty & Development
OC continues to be one of the nation’s healthiest office markets, and we expect it to remain so.
Crown always has felt comfortable investing here. Lack of vacant land for new development, a high quality of life and a healthy, if not robust, economy have made it one of the nation’s most attractive places to own and develop commercial real estate.
Part of our faith in the market is evidenced by the contracting vacancy rates and positive absorption countywide in the past four quarters. OC managed to avoid the worst of the recession, thanks to our diverse economy. The growth of financial services companies and the mortgage lending industries buoyed the regional office market in recent years.
More importantly, the development community in OC showed restraint in building new office space.
Since 2002, new starts have been kept at a minimum. This has allowed the market to absorb much of the office vacancy in the county, so now we are beginning to see signs of stabilization and absorption in the key submarkets. We see this as a very positive motivator to initiate new development projects now to meet future demand.
Demand for new office space typically lags shortly behind general economic and job growth.
With consecutive quarters of national and local job growth as a benchmark, we finally are seeing the right conditions to move forward with plans for projects expected to deliver in late 2005 or early 2006.
By that time, we expect job growth and the general economy to coincide with demand for new space.
Due to the above factors, Crown Realty is moving forward with plans for a 185,000-square-foot class A building at the Xerox Center in Santa Ana.
The Central Orange County submarket has the tightest vacancy rate in Orange County and few options for tenants seeking large blocks of contiguous space. The project currently is in the design phase with Nadel Architects. We expect to deliver the building by first quarter 2006.
We continue to receive inquiries for large, contiguous blocks of class A office space.
Many of these inquiries are coming from the traditional OC industry sectors including professional services, mortgage lenders, insurance and financial companies. Added to the mix are companies in the medical industries, a group poised for growth in the next couple of years.
As evidence of the growing demand in the county, we recently signed a one-tenant lease for 105,000 square feet at one of our existing office properties in Brea. We expect to see more leases of this size in the county during the next two years as companies continue to expand here or enter the OC market.
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MARK FRIEND
Senior vice president
CB Richard Ellis Inc.
Many tenants already have an excess capacity of office space, leaving a lot of room for expansion. The strengthening economy will close the gap between leased and available space as companies relocate or expand.
When should we expect to see vacancies fall and rents rise? They already are falling and OC should continue to see vacancy drop and rents rise. There has been a slight increase in rates this year.
What types of companies do we expect to see leasing space this year and next? We definitely can expect to see national companies leasing space in the next year. Most of these companies scaled down and we expect to see them taking up space for operations and sales offices.
There also is ongoing growth of law firms in OC. In the next two years, we expect to see law firms leasing more space.
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WALTER HAHN
Real estate consultant
Ernst & Young LLP
Chapman University says OC’s going to add about 27,000 jobs this year and 30,000 jobs next year. (Hahn is on Chapman’s advisory board.)
Basically, we have strong job growth here and it’s getting better. Yes, a certain percentage of those jobs is going to get housed in office space. Nobody really knows what the percentage is.
A fairly high proportion of the kind of businesses that are growing in OC comprises office users: financial services, business services, information technology services, software, biomedical research and so on.
In other words, OC isn’t a manufacturing county. In the past 15 to 20 years, it’s moved to a services economy and a lot of those service jobs are high-paid professional service jobs: attorneys, accountants, mortgage lenders, consultants, software developers and biotech researchers,a lot of which are done in offices on computers these days. A lot of those workers use offices.
This means, in my view, pretty strong demand for office space. That’s been showing for the past six to nine months; office space absorption has been slowly picking up. Now it seems to be going at a pretty good clip and it should improve.
To me this is the classic recovery part of the real estate cycle.
We had a down period. OC lost a few jobs in 2002. Office vacancy rates went up. In addition to that, the county still has been working off 2 million to 3 million square feet of excess two-story tilt-up office space.
The Irvine Co. started in the late ’90s with University Research Park. It was getting close to class A rents for that less expensive construction. Everyone else jumped in.
By 2003, there was this huge excess of vacant two-story tilt-up office space. The rents were less than in the class A space, so when those buildings got built, they sucked a lot of tenants out of the class A space. That dinged occupancy and rents in those class A buildings.
Then, with the big over-building in two-story tilt-ups, those guys started cutting rents. My estimate is that a lot of that two-story space has been filled up so it’s not that big a part of the market and none has been built in the past two or three years unless it was for an owner-user.
From what I’m hearing, leasing is going pretty good now for class A space. The big competition is gone from the two-story tilt-up. With job growth, that is increasing demand for all kinds of space.
One more thing: Typically what happens in the recovery part of the real estate cycle,when class A rents are relatively low,is that a lot of businesses move out of class B and C spaces to class A space. And I think there may be some of that going on, too.
But things should be pretty good for the office market for the next few years.
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BILL HALFORD
President, office properties
The Irvine Company
We are encouraged by the national job report, and all signs point to an improving local economy.
OC has the lowest unemployment rate, 3.2%, of any large metropolitan area in the U.S.
The national rate is 5.3%.
The county also added 22,000 new jobs last year, third highest in the nation behind Las Vegas and Riverside. And, during the past four quarters, OC absorbed more than 3.3 million square feet of office space,second best in a decade.
What does all this mean for the local office market?
Vacancy rates are declining steadily, concessions are diminishing and rents are beginning to move.
During the past 12 months, OC’s vacancy rate fell faster than any other suburban or metropolitan market in the country, according to CB Richard Ellis Inc. The county currently is about 87% occupied.
The improving economy should lead to heightened demand from the same types of companies that already operate here.
It should be an exciting year.
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MATT MONTGOMERY
Senior manager of real estate
Opus West Corp.
One of the first things in OC that will be affected by the increase in job growth and the strengthening economy is office leasing and rental prices.
There isn’t a substantial amount of office properties available on the market as vacancy is down. For example, Opus West developed and owns 2040 Main St., which is 96% leased and the Irvine Concourse is currently leased at more than 90%.
As availability and vacancy rates decrease, rental prices will increase in OC. Companies also will be looking to expand their office space as job growth continues to climb and the number of employees begins to increase, too. In regards to timing, we feel that we will see this increase in about six months.
In addition, increasing housing demand will affect OC’s office market. There are several existing office buildings and proposed office development land that are being rezoned to accommodate the need for housing.
With growing population and more companies looking at positive growth, OC’s office market will continue to strengthen.
There is a diversity among the companies in OC that makes it difficult to pinpoint certain industries that will be active in the leasing market.
However, the county has become a place where many companies strive to be, thanks to its central location and ability to service both Los Angeles and San Diego counties, a very skilled employment base and the great quality of life.
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RUSS PARKER
Executive vice president,
development and marketing
Parker Properties
There are additional factors beyond job growth that need to be considered when discussing the office sector recovery in OC, including interest rates, capitalization rates, construction costs and investor and lender perceptions of the market area.
So, in addition to positive job growth on a national and local scale, which certainly is a key indicator that we pay close attention to, we also focus on future interest rates and capitalization rates, particularly the spread between the two.
Real estate fundamentals, such as vacancy, job growth and new construction, have never been more aligned with capital markets than they are now, according to Property & Portfolio Research’s May newsletter.
There seems to be a consensus that interest rates will increase moderately by the end of the year. Since inflation is in check, there appears to be little pressure for a dramatic increase in interest rates by the federal government.
The office sector has been perceived to have greater risk factors than current commercial investments, multifamily and warehouse. However, with job growth and decreasing vacancy, office investment should gain more investor enthusiasm, exemplified by lower cap rates and healthier spreads between interest rates.
The OC and Southern California market arguably is the most attractive area for investment in the U.S., and the real estate fundamentals in the county are in better equilibrium than the rest of Southern California.
There are two troubling factors that could affect office development to a certain extent. These are the drastic cost increases of materials such as scrap metal (rebar and studs), concrete, drywall, and steel; and the shortage of affordable housing.
While both of these situations are worrisome, many in the industry feel that the recent construction material cost increases are temporary, and that real estate fundamentals and the desirability of OC as a place to live and work in will overcome the shortage of reasonably priced homes.
In conclusion, we are very bullish on the Orange County and Southern California office markets. At our projects in Valencia and Aliso Viejo, we have experienced rapid absorption and steady rental rate increases since late 2003.
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STEPHEN STAMBAUGH
Chief financial officer and
chief investment officer
Shea Properties
The impact of a stronger economy on OC’s office markets: California must continue the current trend of becoming more competitive with other states for employment expansion. We must avoid increasing the tax burden on all businesses, which discourages new hiring.
Tax increases from ideas like canceling Prop. 13 protection will flow through to businesses of all sizes in this state. The result could be more jobs in Arizona and Texas that could have been created in OC.
Just as job creation lagged the economic recovery, so too will leasing of new office space lag the new job creation. Available sublease space and existing underutilized employer facilities, the so-called shadow space, will absorb a significant portion of the net new jobs.
Types of companies that will lease space: Broad economic expansion increases the demand for all services. New leasing in 2004 and 2005 will come from the traditional base of financial, insurance, real estate and other service companies in the county.
Mortgage companies will be less of a factor than in prior years. We may see some technology companies increasing space commitments now that corporate capital spending is increasing.
Declining vacancies and increasing rents: Countywide vacancy will continue its steady decline, but some areas will recover more quickly. The South County submarket has demonstrated the most consistent space absorption during the past 12 months.
With an existing office base under 20% of the countywide total and its proximity to new residential communities, the South County vacancy rate will decline proportionately faster than the overall market. Vacancy could drop to single-digit percentages by the end of next year.
Significant increases in the costs of steel, concrete and other building materials, coupled with increasing land costs, adversely impact the feasibility of new construction at current rental levels.
This should limit new supply additions so that new leasing does bring the market into balance.
Rental rate increases probably will reflect the overall inflation level in 2004 but likely exceed it in 2005.
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KURT STRASMANN
Managing director, Orange County
Grubb & Ellis Co.
Basically, I think you are starting to see vacancies decrease now, especially among large blocks of space.
There are very few opportunities available in the 75,000-square-foot range and above. In that size range, I think you will see some rental rate appreciation.
I think job growth is estimated to be positive in the range of 20,000 to 25,000. I think all the markets are starting to firm up, with the exception of one,Brea. There will be some significant availability coming online in Brea.
The mortgage companies still are leasing up space. Subprime lenders are doing well, and they continue to lease up space.
Owners will start out by holding off on concessions first. This is a six-month crystal ball.
