Orange County is seeing its heaviest level of commercial development in more than a decade.
The county’s largest developers have close to 18 million square feet of office, industrial, retail and other development under construction across the county, according to Business Journal figures.
Major office towers are nearing completion. The market for smaller, for-sale office and industrial buildings continues to thrive, and huge mixed-use projects in Anaheim, Irvine and Tustin are moving forward.
The value of the area’s commercial development outpaced housing construction for the first time in recent memory last year, providing
the OC economy a big boost in light of the slumping housing market.
This year’s heavy dose of commercial construction and slow home sales means that trend will continue at least into 2008.
Beyond that, the signs for the local market are a bit cloudier.
The well-documented troubles in the subprime mortgage market, heavily rooted in OC, have put a damper on the area’s office market, and boosted its previously rock-bottom office vacancy rates by a few points in the past year.
Nearly 4 million square feet of office space here could be put back on the market,topflight office space totals roughly 100 million square feet in OC,by the local mortgage companies once all is said and done, according to market watchers.
Another worrying trend: The slower-than-expected leasing environment for new offices here.
Less than a quarter of the space at the five towers going up in Irvine is accounted for. No one is saying developers here have overbuilt, but the slow pace of leasing is likely to make other developers pause before moving ahead with any additional projects in the near future.
In Santa Ana, what will be the county’s biggest office tower is feeling the same effects of the recent slowdown.
One Broadway Plaza, the 37-story tower long-planned by Michael Harrah’s Caribou Industries Inc., was initially slated to break ground by March.
Santa Ana officials require Harrah to lease half of the 600,000-square-foot building before starting construction. That pre-leasing was hoped to be done earlier this year.
Now, Harrah said he hopes to have leasing in place by October or November, although no deals have been struck yet.
Once One Broadway gets the go-ahead to start, it will take about two years to complete the project, Harrah said.
So far, the slowdown of the area’s housing market hasn’t spilled over into the commercial sector. The two sectors are likely to become more intertwined going forward, with mixed-use projects such as Tustin Legacy, Anaheim’s Platinum Triangle, and the Great Park in Irvine all moving ahead.
The million-dollar question facing the area’s commercial real estate market: Is Orange County’s commercial sector due for a slowdown in the next few years?
The Business Journal’s Mark Mueller asked executives with some of OC’s largest developers, owners, investors and brokers of office, retail and industrial space for their opinions on the state of the commercial market, with an emphasis on how long the area’s construction boom can last.
Following are edited responses.
Steven Case
Senior vice president, leasing,
office properties
The Irvine Company
Newport Beach
We remain bullish about Orange County,and, in particular, Irvine.
Everybody has certainly read about the troubles in the subprime mortgage sector. It’s a big story, no question. But there’s another, perhaps even bigger, story brewing that warrants headlines: record leasing activity.
At the Irvine Co. alone, we have leased about 1.7 million square feet since January in OC,and that’s not including Broadcom Corp.’s new 700,000-square-foot campus at University Research Park in Irvine.
The companies that are growing, moving and renewing leases in our buildings are as impressive as they are diverse. They include industry leaders in the fields of engineering, financial services and technology. This diversity keeps Orange County’s economy strong and growing even when a particular industry like subprime falters.
One of our most noteworthy recent leases involves Fluor Corp. The company will expand its Orange County operations by more than 100,000 square feet when it moves its gas and chemical division to Irvine Spectrum.
Soon, we will deliver our first new high-rise office buildings in 15 years. The first, 18100 Von Karman, is just minutes to John Wayne Airport. The other two,20 and 40 Pacifica ,are located in the heart of Irvine Spectrum.
The companies that fill 20 and 40 Pacifica will operate across the street from Nordstrom, Target, Javier’s and a resort-like apartment community,the ideal place for workers to live, shop and play.
Our county,and Irvine,have every necessary ingredient for success: outstanding buildings operated by industry leaders; a desirable mix of housing options; an array of entertainment and recreation, including open space; a Mediterranean climate and world-class K-12 schools and universities.
Roland Chavez
Senior Vice President
O’Donnell/Atkins
Irvine
As land experts predominantly dealing with development and redevelopment, we have seen a fairly substantial swing in the market for multiuse development properties.
Whereas the markets of yesterday typically saw for-sale residential groups acquiring the majority of properties, they are now on the sidelines, as they clean up their balance sheets and churn through existing inventory.
With groups being very selective, multifamily for-rent and traditional office and industrial developers are able to financially compete for sites that they could not have 18 months ago.
Given their extended period of inactivity, we are seeing a tight marketplace for available commercial properties. This is further facilitated by the continued strong employment in Orange County and the diverse job base which has continued to escalate market rents for all product types in this marketplace.
While we do see a scenario where this newfound building boom could lead to a short term over-saturation of new projects, we do not see this as likely given the projected rebound of the residential market in 2008/2009. Another important factor in the development boom will be the 12-month expectations for construction costs, most importantly the multiproduct trades.
Should the for-sale residential developers renew their previous pipelines, we would expect that a lack of qualified contractors would create a short-term spike in costs that may shelve some projects until costs subside.
Bill Halford
Chief executive, president
Bixby Land Co.
Currently, Orange County’s overall office market is at 6.9% vacancy and the airport area submarket continues to be the market segment of choice by most tenants.
By the end of 2007, new developments totaling 1.3 million square feet will be added to the airport high-rise segment. This level of new construction, combined with modest pre-leasing that has occurred to date, is projected to push vacancy as high as 14% by late 2007.
Owners of the newly developed high-rises are all well-capitalized, patient and likely to hold rents in the $3.50 full service gross range even in light of a temporary swollen vacancy rate.
During the next two years, new high-rise development is not likely. However, when net absorption brings vacancy into the 8% to 10% range, new development will resurface.
The airport area’s low-rise market is presently at 5% vacancy and continues to see strong demand,many tenants prefer the convenience of surface parking and rental rates that remain below the high-rise alternatives.
Select development opportunities do exist for infill low-rise in the airport area, as well. Tenants unwilling to pay high-rise premiums (about $3.70 per square foot including parking charges) will continue to seek low-rise alternatives.
Doug Holte
West regional partner,
director of OC, San Diego operations
Hines Interests LP
Hines entered Orange County as a long-term investor because of the region’s strong fundamentals for commercial real estate. The region counts historically strong job growth, a diversified professional industry base, a dwindling supply of vacant land for new development that creates barriers to entry and a progressive business culture with a demand for quality projects.
These market dynamics remain a force that has contributed to our accumulation of a portfolio of properties with a five-to-seven year development horizon. We expect to be an active investor and developer well into the next decade.
2211 Michelson is an example of the type of project you can expect from Hines to meet current corporate real estate demands. It’s a state-of-the-art, architecturally distinctive development that makes use of new green technologies and sustainable design.
Additionally, the office tower is one of the final developments within the several original masterplanned office campuses in the county. As these last vacant parcels disappear, Orange County is fast becoming an infill development market, creating supply constraints necessary for a healthy commercial real estate market.
Each of our current developments in Orange County, planned or in entitlement phases, involves the adaptive reuse of an existing infill property,either through creative redevelopment of existing structures at 2323 Main St. in Irvine, the complete redevelopment of a full city block in Irvine at Jamboree Road and Michelson Drive as a 700,000-square-foot office campus, or the future development of a mixed use retail, housing and commercial environment at Angel Stadium.
Paul Marshall
President, Southern California
Opus West Corp.
Irvine
The recent increase in commercial projects completed has been in response to countywide job growth, overall market stability and a lack of new construction in the preceding time period. Orange County has been fortunate to have a strong, desirable market from a local perspective, and it’s prospered along with the economy nationally.
We don’t see a significant economic shift that would greatly affect development in the immediate future, say two-to-three years and most likely beyond.
I would expect some relatively minor fluctuations in both supply and demand during that time period as the local and national economy respond to housing, financial markets and elections.
A localized constant on new projects is that developable properties have clearly tightened as the market has densified and become more urban. This will somewhat restrict the opportunities going forward.
The new model going forward will be harder to underwrite as developers have to consider re-use of existing or more expensive cost alternatives.
Commercial development is highly localized. It’s difficult to make broad statements in a market as large as Orange County, but in general, we should see continued development in a form that is perhaps more mixed-use orientated, both horizontally and vertically. This again is a natural response to a dense marketplace and the demand that exists for quality office space with adjacent services.
As we look forward, we see a diverse base, healthy demand, relatively stable economic future, and subject to an unforeseeable event, moderate market fluctuations and steady growth.
Kevin R. McKenzie
President
Parker Properties LLC
Aliso Viejo
Although demand has waned from record setting levels, vacancy remains at low levels. The current wave of construction, in the absence of any further net absorption, will bring vacancy over 10%.
Will the construction activity increase? Not likely,until office demand re-asserts itself.
That will happen, however, as the strength and diversity of the Orange County economic engine will prevail despite current concerns over the housing and mortgage industry.
There continues to be pressure on rent. Tenants have had to deal with the sticker shock of significant rent escalations due to limited supply of quality product. Further pressure on rents will come from the high sales prices of existing class A space.
Already high construction costs and annual forecasted increases of at least 6% annually will also affect the delivery of additional office product to the market. Office rents will not only have to hold firm, but follow construction cost increases if additional office space is to be constructed.
In the near term, there will be a lot of push and pull. Concerns over the impact of the shake-up in the subprime mortgage business and rising interest rates will factor into all current lease negotiations. The demise of New Century Financial Corp. will result in more space on the market in addition to the uncommitted product under construction.
It remains to be seen what effect the housing and subprime slowdown will have on the Orange County office market, but the primary near-term effects,slower absorption and higher vacancy,will force landlords to exercise discipline. Tenants will have some better economic choices, especially in sublease space.
For new, high-quality class A office product, tenants should not expect to find the strong institutional sponsorship willing to make significant concessions.
Within the large regional office market of Southern California,Los Angeles, Orange County and San Diego,there is little available office space relative to the overall market base. This strength could result in migration of tenants to Orange County. While this has not happened before, the current tight conditions may cause tenants to think differently than they have in the past.
Peter Moersch
First vice president,
CB Richard Ellis Group Inc.
Anaheim
Retail tenants and developers are scrambling to find opportunities in the market. Expectations are that the retail segment of development has life for many more years.
Orange County has enjoyed a growth in real estate values during the past few years that is unprecedented in history. Property owners have been developing and redeveloping their commercial sites to adapt and benefit from this growth. Most have profited handsomely.
Since about midway through this period, there have been experts and owners that have predicted the downturn on the horizon. Until recently there have been few signs in any of real estate’s sectors that have shown signs of a slowdown much less a crash.
This situation changed recently as well-publicized slowdowns in new home construction have combined with a far less publicized thinning in the pool of capable investment buyers and a higher threshold of compliance in capital markets.
The more-cautious market is still paying high prices for quality assets but will struggle to find opportunities that have not been examined in detail during the past several quarters.
This could be interpreted as a sign that the market is turning but there are still several drivers for the area that will fuel new retail development for the area.
The primary driver is the relative lack of vacant land available for new projects. New and existing tenants continue to seek ways to expand into the market to benefit from the quality demographic base of the county.
As a result of these two opposing forces, the existing base of commercial buildings needs to be revitalized into more modern developments with higher density designs. Outdated designs have given way to redevelopment of district wide areas.
Developers are learning that a balance of jobs, services and shopping are required to make a project successful. The initial run to high density housing has cooled with a realization that most properties must fit a “mixed use” profile to be successful. As the population increases a second driving force, traffic, will drive the need for redesigned commercial districts.
New retail development will take place for years as the obsolete formats are replaced by new formats.
John O’Brien
President,
Guthrie Development Co.
Costa Mesa
Despite signs of a subtle market correction, the Orange County industrial market is poised to remain strong for the foreseeable future.
Activity will remain strong in “A” locations, which are sound areas in the heart of the industrial community where people are willing to pay a premium for the site.
The majority of these locations are in North County cities such as Anaheim, Orange and Brea.
While the industrial market has historically followed the housing market, we have not seen this pattern yet. However, should growth slow, it should maintain a healthy pace instead of the rapid growth we are currently experiencing.
Small, for-sale industrial space in the 3,000 to 6,000-square-foot range will continue to lead the market, primarily because of the many entrepreneurs in Orange County, but also due to the lack of land.
We are also seeing a strong demand for midsize properties in the 25,000 to 50,000-square-foot range, primarily due to a scarcity of available space. The constraint to most development is the inability to secure a parcel of land large enough to accommodate midsize and large projects.
To circumvent the land issue, there is a strong redevelopment opportunity with the many older buildings or underutilized parcels.
The industrial market in Orange County should continue to flourish due to the region’s vibrant and diverse economy. Virtually any location across the market represents a strong development opportunity if there is available land redevelopment opportunity.
Kurt Strasmann
Managing director, Orange County,
Grubb & Ellis Co.
Newport Beach
There are five new high-rise office projects going up across the county, consisting of almost 2.5 million square feet of space.
Those buildings are anticipated to experience a sluggish lease up during the next six months. They should lease up well in the following six to 12 months, but the initial slow start could give pause to other developers considering similar projects.
Leasing activity for new and existing office properties will likely remain slow during the next two to three quarters, primary due to the “sticker shock” of lease rate appreciation, tenant improvement cost and parking costs.
Tenants will likely postpone their real estate decisions as long as possible, until there is a clear understanding of the future outcome of absorption of sublease space and new developments in the market.
Many tenants with immediate lease expirations are opting for short term renewals as means to keep their options open, hoping for future lease rate reductions.
Positive job growth figures for 2007 and 2008 enforce a positive outlook for continued absorption in the office sector. Tenants may discover that landlords will not be lowering lease rates and will have to compete with an increase in demand for office space.
In the industrial sector, the local outlook remains extremely bullish, even though development will continue to lag.
The industrial base in Orange County will continue to shrink due to redevelopment opportunities to a higher and better use project. This reinforces the overall strong fundamentals for ownership.
Sale activity will remain exceptionally strong in the investment sector for quality product. Lesser quality will be more difficult to deal with as financing has changed,that means no more 10-year interest only loans.
Vacancy rates in the industrial sector will remain at historic lows during the next year, hovering in the 3% to 4% range.
Annual lease rate appreciation will continue in the 4% to 6% range. Leasing activity will be strong in the under 20,000-square-foot range, but softer in the 50,000-square-foot and over range.
Louis Tomaselli
Senior vice president,
Voit Commercial Brokerage LP
Orange
Commercial development in Orange County is as strong as it’s been in 20 years and should remain strong in the foreseeable future.
Vacancy rates are at historical lows and occupancy rates are at historical highs. An increase in job growth, which has been slow for the beginning of 2007, would continue to drive occupancy rates higher.
Even with the high costs of purchasing commercial buildings, small entrepreneurial companies are motivated to buy and own their own facilities (typically in the 3,000 to 6,000-square-foot range), as it represents an opportunity for them to make a strong long-term investment in their business.
There is also speculation that the industrial market will follow the housing market as it continues to slow. However, severe overpricing of homes is one of the main reasons we are experiencing a drastic slowdown.
Although commercial development and construction costs are at an all-time high due to the lack of developable land in Orange County, the industrial market is not overpriced based upon living costs in Orange County, and it continues to demonstrate strong market fundamentals.
A majority of new industrial development in Orange County is in North County, which is less office intensive, but more service oriented. South County tends to offer more office space for small technology and R & D; type companies.
CoStar Group reports that 342 industrial buildings were sold during 2006, while the outlook for 2007 is estimated to improve more than 10% to 375, further validating the strength of Orange County’s economy and the high demand for industrial product.
