The office market hasn’t looked this good in years.
Recent reports from brokerages such as CB Richard Ellis Group Inc., Grubb & Ellis Co. and Voit Commercial Brokerage LP peg Orange County’s overall vacancy at below 10%.
They cite a combination of strong leasing activity, or absorption, coupled with limited development of new offices.
The market shift has not been lost on developers. A few medium sized projects, such as Olen Properties’ five-story building in Brea, already have broken ground. The list is growing of larger projects planned for late this year or next year, including high-rises.
The most ambitious project is Michael Harrah’s proposed 37-story office tower in Santa Ana. The Irvine Company plans twin high-rises at the Spectrum, according to the city, and big leases by mortgage companies appear to be spurring other projects in Irvine.
Los Angeles-based Maguire Properties Inc. plans a 20-story tower at Park Place in Irvine, with a big chunk going to subprime lender New Century Financial Corp.
Yet developers face higher costs today than perhaps ever before in OC. The greatest spike has been in land costs, which have shot up in recent years as more key commercial sites are bought by housing developers. Prices for steel and concrete also spiked last year by as much as 60% in some cases.
Higher costs appear to have contributed to delays in development of some projects,with unusually wet weather this season also a factor.
Meanwhile, skeptics have pointed to moderate job growth, a potentially over-heated housing market, and a pending mortgage industry correction as signs the office market recovery may hit a snag.
With all that in mind, the Business Journal put the following questions to executives with some of OC’s largest developers, owners and brokers of office space:
Is office development poised for a rebound in OC?
If yes, then when and what type of buildings in which cities (such as low-rise versus high-rise)?
Will higher costs of materials and land curb new office development?
Does a future economic soft patch threaten to derail the office market recovery?
Following is an edited version of their responses.
FRANK CAMPBELL
Vice president,leasing
Equity Office Properties Trust
Irvine
There is much to be optimistic about OC’s office market. Asking rents are up, tenant improvements are down and parking charges are on the rise.
This has raised overall rents by as much as 10% to 15% since mid-2004. There are limited large blocks of space available in the market above the 50,000-square-foot range.
The first quarter was the 10th consecutive quarter of positive absorption in OC. That is an impressive streak, one of the best in the country.
The OC office market was a strong performer in 2004, as evidenced by 2.1 million square feet of absorption. The market saw 1 million square feet of absorption in the first quarter of 2005.
OC counted just 30,000 square feet of new office space in the first quarter, the seventh quarter in a row where completed construction fell below the 100,000-square-foot level. Office completions are expected to remain muted in 2005, though the development pipeline could quickly fill in the next couple of years.
As a result of the current market conditions, OC is likely to see some new construction sooner rather than later. Office rents quickly are trending toward levels that support new construction.
Many of the most desirable development sites have opted to pursue residential entitlements because of the value associated with land for housing. However, several premium office sites still remain in the airport area submarket, the most likely area to experience new office construction first.
Additionally, there are other sites in South County around the Irvine Spectrum where development activity could occur. The larger space requirements that we’re hearing about are for completion in either 2006 or 2007.
Due to the higher cost of materials and land, the new developments are expected to result in tenants paying a premium versus today’s rental rate economics.
The county’s economy should continue to expand, with annual job growth expected to be about 3% above the national average.
But the county isn’t without challenges. Although the OC residential market is booming, big changes in interest rates could negatively impact some of the more than 54,000 jobs in the mortgage lending industry and related sectors.
OC’s diverse economy and multiple sources of growth likely will be sufficient to support the economy in the long term. Expanding global links,manifested in local companies managing import flows (autos and apparel, for example) and investing abroad (semiconductors and electronics, for instance),are more than likely to keep OC a leader in globalization.
Defense spending, expected to grow at a 4% to 6% rate in the coming years, also should support local aerospace, electronics, and supply and logistics companies.
KEVIN MCKENZIE
President
Parker Properties LLC
Aliso Viejo
There already is significant evidence of a strong rebound for office development in OC.
With office employment growth in OC shining, the area has demonstrated consistent strength. Pru-
dential Real Estate Investors in its first quarter outlook stresses how much job growth has been a driver to the property markets.
Last year, net absorption in the office sector was 3.1 million square feet. This year, the pace continued with 1 million square feet absorbed in the first quarter. The second quarter appears to be on pace to maintain that trend.
Investment sales also are growing. The recent announcement of AEW’s acquisition of 100 Bayview in Newport Beach for $375 per square foot gives a great boost to developers looking at construction costs in excess of $300 per square foot.
As with all cycles, development won’t occur until the supply/demand fundamentals support doing so.
Depending on who you talk to, there is 5 million to 7 million square feet planned or under construction and set to be completed during the next three years.
That represents about 6.5% of the existing base of 92 million square feet. If OC continues a 3 million-square-foot absorption trend, the vacancy rate with all of the planned construction would be less than 6% in three years.
Office space in the planning stages covers the spectrum from low-rise to high-rise. In markets where land values have been driven up (in part due to the trend to convert commercial land to residential), developers have had to pursue higher density. That trend hasn’t affected all markets and developers.
Meanwhile, higher construction costs have a direct effect upon development activity. Higher costs translate directly to the need for developers to make up the difference in rent.
With the tightening of the office markets, rents are poised to see some dramatic increases in the next few years. Another key element to new office development is the availability and cost of capital. Notwithstanding the continued increases in short-term interest rates, investors continue to hold, and in some cases even lower, their return expectations for development.
The anticipated rental increases tied to continued strong investor demand will fuel the anticipated development in OC.
A future soft patch will have an adverse effect on the office market recovery. With OC’s diverse economic base and high quality of life, it should weather a soft patch well.
ROBERT FLAXMAN
Chief executive, president
Crown Realty & Development Corp.
Crown Realty’s analysis indicates OC finally is showing the right signs for new office development.
The regional economy has kept the local office market active since 2001, with restraint from the development community paying off in a healthy, if not robust, leasing environment today.
For the new developments planned, the key has been rising rents and local tenant demand meeting the increasing costs of construction and absorption of available space.
Countywide, brokerage reports have shown vacancy rates continuing to drop, falling near or below 10% in key submarkets, including the John Wayne Airport/Irvine central business district and Central County (Orange and Santa Ana).
Since construction of new office space has been limited in the past four years, developers are gearing up now to put projects in motion in anticipation of the future demand.
CB Richard Ellis reported in its first-quarter analysis that OC should see 3.5% job growth per year during the next two years. This growth will continue to chip away at current vacancies.
The strength of the regional economy is related to its diversity,not just the mortgage lending industry, which of course has shown an appetite for large blocks of space.
Legal and professional service firms, real estate development companies, technology companies and a host of others also have shown an appetite for class A office space.
The positive economic climate has made it difficult to find large blocks of contiguous space for growing office users.
The available space becomes even more constrained when parking becomes an issue in today’s efficiency focused work environment, where a 4-to-1,000 parking ratio is a minimum requirement for most large tenants.
This demand places an even greater strain on current available space, making new development an attractive choice for larger tenants where parking meets or exceeds that need.
DAVID ALLISON
Chief operating officer
Voit Development Co.
Newport Beach
Office development is poised for a rebound in OC.
Vacancy rates have fallen significantly because of strong absorption and are in a range that historically signals new development. And rents have risen and are expected to continue to rise faster than inflation in the near term based on the tight supply and expected job growth.
The number of planned projects is increasing as we speak. High-rise construction is more likely in urbanized hubs where land is relatively expensive, denser uses are permitted and rents are generally higher.
The higher costs of construction and land act as a headwind that will slow the pace of new development.
These higher costs are offset to a degree by an abundance of cheap capital in the real estate market that is aggressively pursuing projects to finance. Overall, I foresee more office development than we’ve seen in the recent past, but not a situation where overbuilding will occur as it did in the late 1980s.
The big question on everyone’s mind has to do with long-term interest rates and what level they will be at in the future. Everyone expects them to rise, the question is how much and how quickly?
Recently, Federal Reserve Chairman Alan Greenspan indicated he thinks long-term rates could remain low for some time to come, even as the Fed raises short-term rates. I hope he is right since that would be good news for real estate developers and investors.
In my judgment, the economy appears to be growing at a solid pace, with good corporate profitability, low inflation and job growth.
THOMAS A. MURPHY
Vice president/leasing director
Jones Lang LaSalle Americas Inc.
Irvine
While residential development, especially vertical housing, has been the highest and best use recently because it commands a better return on investment, additional office development also is planned.
When vacancy rates move under 10% and rental rates surge to levels that can justify costs of construction, office developers’ thoughts turn to new construction.
In fact, for some time now developers and landowners have garnered entitlements, engaged architects, met with city planning and zoning officials and in some cases purchased land sites specifically to take advantage of the upcoming market opportunities and beat the competition “out of the ground” in the next wave of office development.
Threats to development take many forms, but those that affect depth in the tenant market are especially lethal.
The frenzied development at the turn of the century of low-rise, large floor plate office space with free parking designed to accommodate technology companies, combined with the tech bust in 2001, increased vacancies to more than 20% in most areas of the county.
This glut finally has been absorbed primarily due to the explosion of the mortgage industry in OC.
While the reliance on this industry to continue to occupy space poses its own inherent risk, it is only one of several that could negatively impact occupancy. These include the costs of doing business in the state, lack of affordable housing, traffic and others.
Yet there are just as many reasons for continuing optimism: long-term real estate appreciation, job growth, weather and quality of life, access to blossoming markets in Asia and others.
But at least as important is the drive by institutional America to invest more of their investment dollars in real estate assets. This trend sprang from the turbulence of the stock market and gained momentum when the institutional investment community began to classify real estate as “investment grade” rather than the “junk bond” status it held before.
Institutional investments in real estate today make up 12% to 15% of the investment dollar, an increase from 4% to 5% in the mid 1990s.
This mandate to invest in real estate combined with the drop in interest rates is largely responsible for the dramatic rise in the prices of class A properties in the past two years. These prices do not represent practiced real estate principles or historic cap rates.
Yet this need to invest in real estate has met the pent up demand to develop and will result in the next round of new office projects in OC. Already there are a minimum of 10 class A office projects poised for development in the John Wayne Airport area.
Office development, however, will not likely reach the same proportions as in the mid-1980s and 1990s. Availability and the cost of land will make it difficult to realize the returns necessary, even with rental rates of $3 per square foot per month on the horizon.
BARRY A. KATZ
Managing director, asset services
Office brokerage
CB Richard Ellis Group Inc.
In the 1980s, OC averaged 3 million to 4 million square feet of office development a year.
Since then, there has been a slowdown in office development activity with only a few new projects completed by Opus and Koll, for example, between 1999 and 2001.
But several factors indicate that office development is ready to make a phased comeback in OC.
The initial development phase could consist of up to 2.5 million square feet of space ready in 2007 and beyond.
Net absorption has increased during the past four quarters, causing vacancy rates to decrease. This has continued to push rents up each quarter, which should justify new construction in 12 to 18 months.
During this period, office demand likely will continue at a healthy rate because of a strong local economy. Excitement within residential high-rise will continue to push land prices past feasible office land prices. Examples include residential projects such as Lennar’s Central Park and Bosa’s Park Place high-rise condos. Consequently, absorption, vacancies and rents should continue to favor existing owners.
While several factors suggest office growth is imminent, the increased cost of materials and land prices could impact office development.
The increase in construction costs has boosted necessary coupon rates from the high $2 level to about $3.25. Some developers are hesitant to start new projects because current rental rates aren’t at the necessary levels. Additionally, most developers require an anchor tenant with a significant commitment to begin a project.
In the short term, land prices also will continue to restrict development of office space. Office land values are about $40 per square foot, while apartment and condo values are $70 per square foot and $100 per square foot, respectively.
Given these costs, developers have little incentive to build low-rise office space, as the returns are nonexistent. However, rents are continuing to increase due to the lack of construction combined with continuing positive absorption.
Hitting the Key Mark
Once office rents reach $3.25 to $3.50 per square foot, eight to 15-story office buildings become profitable ventures.
The Irvine Company’s twin high-rises at the Spectrum support this notion, though they also have a somewhat unique opportunity to develop low-rise office on sites in which they already own the land. This includes both the Irvine Technology Center and the Spectrum, where they do not have the same cost concerns impacting low-rise office.
High-rise office development will occur in the John Wayne Airport and Irvine Spectrum submarkets. These are the only locations with prime, undeveloped parcels in which the decision to build office can be justified when compared to building apartments or condos.
When completed, there will be some shift among tenants as they absorb the new space and landlords seek to backfill any resulting vacancies. This will generate opportunities for tenants with different size needs for new and existing office space.
An economic softening always could hinder the office market recovery. A mild event, such as incremental mortgage rate increases, is unlikely to have a big impact.
A more significant economic event, in which the net result is the loss of jobs, could delay the office market recovery.
