The Orange County office market closed the third quarter on steady footing.
Vacancy was 12.8% (including office flex space). Vacancy for pure office buildings was slightly lower at 12%.
This is a marked improvement versus last quarter’s 13.5% for all office space and 12.9% for pure office space. Improvements in vacancy can be attributed to a general lack of office construction as well as an improved economic outlook by companies seeking office space.
Overall asking rents were up this quarter by 5 cents with class A space posting an average of $2.26 per square foot per month. Class B rents remained flat at an average of $1.79 per square foot per month.
Office tenants prefer class A space, which still is underpriced and offers more competitive tenant improvement packages.
Countywide net absorption was positive at a strong 734,024 square feet. Improved market conditions aside, positive absorption is a result of deals that were signed in the second quarter with occupancy reflected in this quarter’s absorption.
Class A space had another great performance with 201,624 square feet absorbed in the third quarter. Class B properties absorbed a solid 526,292 square feet and class C space had an anemic but steady performance at 6,108 square feet.
Flex space, which is relatively weaker than pure office space, improved with 190,608 square feet of absorption.
Widening Rebound
All data suggest one thing: Orange County is going through a period of noticeable improvement. This improvement is slowly making its way to all types of office space, producing a more stable office market. And as the supply of small office buildings for sale diminishes, companies will be herded into the leasing market.
Challenges
Cautious office leasing activity is the major challenge facing the market. Moderately improved confidence in the health of the economy is generating some office job growth, but the market needs stronger levels of job creation to gain firmer ground.
Improving business confidence is another precursor to better performance in the office market. There is some pent-up demand among companies performing in cramped quarters. After the election, some of these companies may feel confident enough to expand, boosting leasing activity.
Forecast
Landlords will finally begin to see the pendulum swing in their favor by mid-2005.
Office vacancy rates should continue to drop at a steady pace due to limited construction and increased demand. As a consequence, office lease rates will continue to improve moderately.
With construction costs skyrocketing, asking rents must rise 15% to 20% for new buildings to become feasible. No significant construction is anticipated for the coming year.
Demand for buying office space will continue, as interest rates have not changed drastically enough to affect buyers’ appetite for acquisitions.
The leasing market has picked up steam, continuing its modest gains from the second quarter.
Broker incentives and tenant concessions are still in the market but on a much smaller scale than in early 2004. The Los Angeles metro area posted strong third quarter absorption of 1.6 million square feet, nearly doubling the year-to-date absorption.
The West Los Angeles market led the way with nearly 686,000 square feet of absorption, more than doubling its year-to-date total. The downtown submarket posted its first quarter of positive absorption this year with slightly less than 40,000 square feet.
Vacancy dipped in all submarkets except North Los Angeles, the tightest market in the region, where vacancy remained flat at 10%, and the South Bay, where vacancy was unchanged at 19.3%.
Overall vacancy for Los Angeles County dropped 7 basis points from 15.7% in the second quarter. Rental rates remained flat for the second quarter in a row with negligible changes in class A and B office space.
Office investment continued its scorching pace in the third quarter. Due to constrained construction, in part from poor property fundamentals and city commercial zoning regulations favoring residential, prices for investment properties continue to soar.
Sellers are placing properties on the market at high “wish-list” prices and waiting for the bidding wars to ensue.
The strong national economic picture has waned in the second half of the year. Although the unemployment rate remained at 5.4% through the end of the third quarter, job growth turned bleak with just 96,000 jobs added in September.
Despite anemic job growth, the Federal Reserve sent the message that the economy remains strong by raising the key overnight lending rate to 1.75%, the third quarter-point rate hike this year.
Revised gross domestic product data also suggest that the economy is growing at a faster pace than previously thought.
But long-term bonds so far have not followed the Fed’s lead, and commercial real estate investment has continued in high gear, fueled by capital that has shown no sign of receding.
Investment Remains Robust
Despite the interest rate hikes, office investment remains robust. Property appreciation is driving the market value as leasing fundamentals stay weak.
During the third quarter, Tishman Speyer Properties bought a 370,000-square-foot class A building in West Los Angeles at 6300 Wilshire Blvd. for $202 per square foot. The same property traded in the second quarter at $165 a foot with the same fundamentals.
More capital from pension funds is getting reallocated to real estate investment which puts pressure on the smaller private real estate investment firms, which are forced to bid against investors with deep pockets. TIAA-CREF, one of the nation’s largest pensions, joined with Equity Office Properties Trust to buy the Colorado Center in Santa Monica from Tishman Speyer for $445 million, topping more than 15 bids.
Forecast
Leasing activity will remain on a path of recovery as long as the U.S. economy adds jobs and GDP grows at a healthy pace.
In the near term, there may not be any increase in rents. But if the Los Angeles metro region can sustain recent absorption levels, and vacancy slips down to the 10% to 11% range, rent increases could be triggered.
Some of the stronger submarkets like Wilshire Center, Tri-Cities and North Los Angeles may start to see increases in rent, albeit minor ones, by the end of the year.
As interest rates rise, investors will focus more on underlying leasing fundamentals, putting pressure on lower-performing properties. Rising interest rates eventually could erode property values, adjusting cap rates higher.
But long-term interest rates have remained surprisingly low and may not rise enough to have much impact on property values for at least the next 12 months.
Overall vacancy decreased by 10 basis points while asking rental rates rose and construction activity tripled versus a year earlier.
Absorption this year is half of last year’s, with a shortage of available space constraining absorption momentum. Nearly half of the construction completed this year has been absorbed, with another 1.3 million square feet is slated for completion in the fourth quarter.
Orange County companies, attracted by the Inland Empire’s housing boom and marginally lower rental rates, continued to trek inland. Anaheim-based Fremont Investment and Loan signed a lease for 40,000 square feet in a five-story office building set to deliver by January.
Meanwhile, local investor interest continued for class A space with the acquisition of Corona Corporate Centre and Chino Hills Professional Plaza. Both buildings were nearly fully occupied when bought.
As cities such as Ontario and Corona are propelled by mass development, and their civic identities begin to evolve, developers are beginning to concentrate their attention on the emerging High Desert market.
Forecast
Orange County companies supporting the residential base will continue to migrate to the Inland Empire office market, though at what pace?
Average rental rates in Orange County were $2.27 and $1.79 for class A and B space, respectively, at the end of the third quarter.
Inland Empire average asking rates were $1.85 and $1.51 for class A and B space, respectively. As migrating companies access the region’s growing labor force of skilled white collar professionals and office
vacancies continue to decline, rental rates will see an increase of 3% to 5% in the near term.
Corona,a proven hotspot for Orange County companies,is expected to see class A asking rates rise to $2.25.
With healthy preleasing trends for space under construction, the overall vacancy rate will stay relatively flat as net absorption posts modest gains. In the next six months, growth will be modest if supply does not outpace demand.
In the longer term, the region’s expanding labor base of technicians, professionals and executives will attract a second wave of office users.
