The office market is responding favorably to steady economic growth in Orange County.
The most significant economic driver for the office market is job creation. The OC unemployment rate was 3.6% in February, up from 3.5% in January, but below the year ago estimate of 4.1%.
Escalating rents and a low vacancy rate have triggered new office construction. Since 2000, there has been a steady decline in the construction of office buildings countywide. However, the trend of high-rise office development has returned in OC.
There is 3.8 million square feet being developed, with 2.3 million square feet planned and 2.9 million square feet is proposed.
Institutional investors became the major buyer of predominantly suburban assets where they accounted for 27% of sales volume in 2005. Demand from institutional investors remains strong and runs exceedingly deep.
It appears that net capital flow has changed significantly. Institutional buyers either directly or through their investments in private equity funds, have emerged as the dominant capital source of office properties.
The Irvine Company bought Newport Gateway Center and Irvine Center Towers in the John Wayne Airport area for $545 million, while West Coast Business Properties purchased a 15-story office building at 1851 E. First St. in Santa Ana for $77.5 million.
Meanwhile, Tishman Speyer Development purchased the two 10-story buildings at 4000 MacArthur in Newport Beach, which are headquarters for Conexant Systems Inc. and Mindspeed Technologies Inc., for $133 million.
Airport Area
The submarket continues to tighten and closed the quarter with a vacancy rate of 8%, down 270 basis points from a year ago.
The decline in vacancy helped bring average asking rates for class A and class B space in the submarket to $2.89 and $2.27 per square foot, respectively.
That’s an increase of more than 15% from the previous year.
Construction activity has slowed dramatically during the past four years, when more than 500,000 square feet of office space was added to the submarket.
Through the first three months of 2006, developers added 1.3 million square feet to the submarket.
Despite strong activity, the airport area experienced negative net absorption of 184,830 square feet.
This is due in part to the acquisition of Newport Technology Center at 500-540 Superior Ave. in Newport Beach, by Newport Healthcare LLC, an affiliate of Hoag Memorial Hospital Presbyterian. The hospital plans to turn the office complex into a medical facility.
South County
The vacancy rate in South County was 6.1% in the first quarter, compared to 10.3% a year ago. With this low vacancy, average asking rates have been on the rise.
Class A rates closed out the first quarter at $2.87 per square foot while class B finished at $2.21 per square foot. The submarket will benefit from more than 4,000 new homes and 87 acres of office, retail and entertainment space planned at the former El Toro Marine base.
North County
Construction activity in the older cities of North County has been minimal in recent years. The five-story, 131,687-square-foot 6 Pointe Drive class A project in Brea completed construction in January.
The pace will remain slow, with only 80,000 square feet anticipated for 2006.
Vacancy has decreased distinctly. The 5.9% rate posted at the end of the first quarter is down from 8.2% a year ago.
North County is expected to continue its tightening trend with lease rates increasing 10% by the end of year.
The average asking rent is $1.96 per square foot, up 3.1% from $1.90 per square foot in the fourth quarter.
Central County
The submarket continued to account for a substantial amount of OC’s available space with 1.5 million square feet, an increase from 1.1 million square feet in the fourth quarter.
Central County, OC’s second largest submarket, saw a swell in direct vacancy for all classes during the past three months, rising to a first quarter rate of 9.8% from the fourth quarter’s 7.4%.
The rise from the previous quarter was caused by negative net absorption of 192,814 square feet in the period. This primarily was due to the amount of sublease space that has come on the market from mortgage companies.
The direct weighted average asking rental rate for class A space in Central County increased 6 cents to $2.16 per square foot per month, versus a year ago.
Challenges and Opportunities
The office market’s overall health will depend significantly on the national economy’s ability to weather the effects of the Federal Reserve’s continual push of interest rates, specifically in the residential homebuilding and finance areas.
With construction levels at their current pace, OC will need to post significant positive absorption levels to account for the nearly 1.5 million square feet of new office space set to come online during the next 12 months.
Should vacancy rates hit 10% in the second quarter, many landlords will most likely consider offering concessions to keep coupon lease rates up.
The Los Angeles metro region witnessed a significant decrease in vacancy in the first quarter compared to a year ago.
The difference can largely be attributed to tightening markets in both West Los Angeles and in the South Bay. As a whole, L.A. metro finished the quarter with an 11% vacancy rate.
This represents a decline of 300 basis points, fueled by year-over-year basis-point drops of 510 and 430 for West L.A. and the South Bay, respectively.
Absorption for the quarter totaled 750,000 square feet.
All but two of the region’s submarkets contributed to this positive net absorption,the Tri-Cities and the San Gabriel Valley accounted for 114,179 square feet of negative absorption.
The West L.A. and South Bay submarkets experienced dramatic leasing activity, pushing their respective vacancy rates down to 8.4% and 16.1%.
Currently, the tightest submarket remains North Los Angeles, where vacancy held steady at 7.3% and absorption was positive for the 13th consecutive quarter.
L.A. metro’s monthly average asking rents for Class A space climbed to $2.63 per square foot, an increase of 9 cents from the past quarter and 18 cents from a year ago.
North L.A.
North L.A. began the year with solid leasing fundamentals and maintained its standing as the tightest submarket in LA. With a 7.3% vacancy rate, demand for dwindling inventory pushed monthly average rental rates for class A property to $2.33 per square foot, a 14-cent increase versus the same period last year.
New construction totaling 470,000 square feet will bring some relief to tenants upon completion, however it represents only 1.7% of existing inventory for the submarket.
Although not as impressive as in prior quarters, North L.A. still recorded its 13th consecutive quarter of positive net absorption, finishing the first quarter at 41,435 square feet.
Longer lease terms are becoming the norm and reflect tenants’ views that rents will continue to increase.
West L.A.
The West Los Angeles office market began the new year just as it finished 2005, with increasing occupancy and rental rates. The Westside ended the quarter with an 8.4% vacancy rate, a 70-basis-point drop from the fourth quarter.
New, as well as expanding tenants, contributed to 448,000 square feet of positive net absorption. The submarket’s lack of availability allowed landlords to maintain their rent hikes.
West L.A. finished the first quarter with average asking rental rates for class A buildings at $2.99 and class B rates at $2.67 per square foot per month. These rental rates are up 6% and 4%, respectively, from the fourth quarter.
The dwindling supply of larger blocks of space put pressure on tenants contemplating a move into the Westside, further fueling leasing activity.
Santa Monica, with its pristine ocean views and close proximity to major freeways, is arguably the most coveted submarket in West L.A., evidenced by its 80-basis-point drop in vacancy and increase in class A asking rental rates to just under $4 per square foot per month.
Mid-Wilshire
Mid-Wilshire saw a slight decrease in occupancy in the first quarter from the prior period. Despite this 130-basis-point dip, the submarket finished the first quarter with the region’s third lowest vacancy rate, behind North L.A. and West L.A.
The quarter ended with Mid-Wilshire’s class A monthly average asking rate at $1.44 per square foot, up just 1 cent from a year ago. Similarly, class B monthly average asking rates were reported at $1.31 per square foot, just 3 cents higher than a year earlier.
Absorption for the first quarter was a modest 11,406 square feet.
Downtown L.A.
The central business district of Los Angeles experienced a whirlwind of leasing activity during the first quarter. Downtown netted positive absorption of 28,202 square feet and held its vacancy rate steady at 15%, just 10 basis points higher than last quarter.
Class A average asking rates increased 21 cents to $2.83 per square foot, versus a year earlier.
Vacancy is at its lowest point in many years. Tenants are foregoing moves into the surrounding suburban submarkets, opting for the convenience of the city’s mass transit system, proximity to headquarters of several companies and relatively affordable rental rates.
However, as more tenants make their way into the central business district and vacancy continues to decrease, average rental rates are expected to climb.
Burgeoning population growth in recent years is luring financial institutions, escrow companies and attorneys to the area, thus facilitating an office construction boom.
Are developers being overly optimistic about the market’s potential growth? Not yet, according to the first quarter.
Quarterly absorption levels are nearly parallel to the fourth quarter, the vacancy rate persists at a flat 7% and asking rental rates for class A and B space are on the rise.
Early tenant committals for space under construction will continue to drive future absorption levels. However, as project size thresholds evolve, and the number of projects increases, the market is prone to temporary lags in vacancy figures as demand plays a game of cat-and-mouse with supply.
In Redlands, for instance, California Plaza, a 50,000-square-foot building, finished construction 100% available,pushing San Bernardino submarket’s vacancy rate to 11.1%, up from the 9.5% record at year-end 2005.
Although corrections are feasible, they will prove short-lived in a market that remains vastly underserved in office space when compared to bordering Southern California counties.
Investors, aware of revitalization efforts in the San Bernardino and Riverside corridors, will continue to be active, furthering the $89 million invested in high profile acquisitions this quarter alone.
Market Assessment
Closing 2005 with the tightest vacancy rate in the nation, the Inland Empire began 2006 with a consistency exhibited in prior quarters. Namely, vacancy rates remained low, asking rental rates rose, construction activity was up and absorption values were evenly paced.
Of these points, the latter is perhaps the most closely watched in a market with an office inventory of only 20.3 million square feet, as the pacing at which new space finishes construction is crucial to maintain a supply and demand balance.
Thus far there has been a balance: 78% of the 427,875 square feet that completed construction in first quarter was absorbed.
A perpetuating demand for new space brought the market-wide vacancy rate to 7%, down from 8.4% the previous year, while monthly asking rental rates were up 11 cents and 20 cents for class A and B space.
Quarterly absorption was 412,412 square feet.
For the first half of 2006, smaller, free standing buildings available for acquisition will prove to be a hot item.
In Rancho Cucamonga, Palmae Business Center, a four-building development finished construction with all units sold to users. The buildings, which had asking prices ranging from $205 to $215 per square foot, comprised a total of 72,890 square feet.
Small buildings, particularly hot in the airport and west, will attract strong user and investor interest as property values steadily appreciate and asking class A rates are expected to increase as much as 12% in 2006.
Forecast
The rate at which new office space is introduced to the market is an industry concern. And these concerns are not unwarranted.
In Riverside, Market Street Corporate Center, a two-building 127,608-square-foot project that debuted 100% available in September, is now 50% leased.
Murmurs of slow tenant committals have also been heard at Rancho Cucamonga’s mixed-use Victoria Gardens.
As building size thresholds evolve with taller mid-rises breaking ground across the region, expect temporary vacancy rate fluctuations and longer lease-up times in specific submarkets and projects.
Developers, meanwhile, will delay future groundbreakings until early commitments are received.
Investment activity, particularly around the redeveloping San Bernardino and Riverside submarkets, will continue to be active.
In Riverside, Hunter Park Office Plaza, a 115,743-square-foot complex, sold to Government Properties Trust Inc. for $18.2 million. Triple Net Properties paid $33.5 million for the 127,500-square-foot Mission Square. And a private investor purchased a 67,000-square-foot office building.
All three buildings were fully leased to tenants, including Wells Fargo Home Mortgage and Best, Best & Krieger and Varner.
In San Bernardino, Alliance Commercial Partners bought four buildings along Hospitality Lane, totaling 234,000 square feet.
The buyer, in anticipation of the region’s burgeoning office growth, plans to renovate the class B complex to a class A facility, stabilize at 100% occupancy, and sell for a profit.
