Southern California Office Market
SPECIAL REPORT: Commercial Real Estate
The Orange County office market had a tough first quarter in tenant activity, absorption levels and rental rates.
Several factors accounted for the troubles: office space oversupply, weak job growth, disappointing corporate earnings and an overall slow economy. These factors made for difficult business conditions for landlords, tenants and brokers.
Asking lease rates for class A office space fell 20% to $2.10 per square foot in the first quarter after hitting a record high of $2.60 per square foot per month last year.
Most of the class A vacant space is in John Wayne Airport area and South County. Average airport area rates decreased by about 15 cents per square foot in the first quarter, while South County rates fell by about 10 cents per square foot. The Central, North, and West County markets had only nominal price changes in asking rates.
The OC office vacancy rate in the first quarter rose 25.3% to 16.8%, compared to the December quarter. Just 38% of the 3 million square feet of completed construction last year is occupied. The John Wayne Airport area had a 27% increase in vacancy,the largest in the county,to 17.1%, compared to the fourth quarter. Central County has the lowest vacancy rate at 7.2%.
The good news: activity is picking up and increased absorption is expected in the second quarter.
Consumer confidence picked up during the first quarter, with the OC consumer confidence index rising 16% to 110.2 vs. the fourth quarter.
Several positive indicators are expected to help the real estate market in this year. The county’s unemployment rate decreased to 3.7% in the first quarter, down from 3.9% at year-end. Job growth is expected to increase by 4% this year. The median family income is projected to rise 6% to $71,200 and retail sales are expected to increase 9% in OC this year.
Forecast
The office market is picking up. Large and small tenants are in the market touring and negotiating. In the last half of 2001 there were only a few tenant deals for landlords to close or seriously negotiate. Now with the increased activity, landlords are in a position to close deals if they’re willing to stretch financially to meet tenant demands.
The challenge is pricing. Although activity is up, there is still a price issue. Landlords will need to be flexible on concessions to help bridge the financial gap in order to close deals.
It will remain a tenant’s market in 2002. Slowly activity is increasing and deal volume will pick up. Expect to see lease rates in the airport and South County markets continue to fall for the next three to six months.
The West, Central and North markets’ asking lease rates will remain flat or slightly decline. Rental growth and positive absorption should rebound at the year-end.
Three months into the new year, the question remains as to when this real estate downturn will reach the bottom. The country officially went into recession last March and by the second quarter conditions had worsened in the Los Angeles County office market.
The technology bubble burst and the amount of vacant space ballooned, resulting in close to a million square feet of negative net absorption, the low point to date for this downturn. The economy took another hit with Sept. 11, which worsened companies’ overcapacity problems.
Space again was dumped on the market, pushing the vacancy rate up a full percentage point. Negative net absorption for the fourth quarter alone was 800,000 square feet while the tally for the year reached negative 3 million square feet.
While this quarter’s results reveal continued negative net absorption, it’s at a lower level than it was following the tech bubble burst and the events of Sept. 11.
This could be the indication that landlords and tenants have been waiting for, to show them that Los Angeles County’s commercial real estate market has indeed hit bottom.
But other factors indicate that the bottom might still be ahead.
Recessions typically last 15 to 18 months and real estate market lags behind general economic recovery, economists say. Another indicator is the rate at which office space is being vacated in Los Angeles County. Vacancies increased 25.7% from the fourth quarter and 8.3% from the previous quarter.
The increasing amount of available sublease space is even more telling.
Sublease space is up 50.1% from the fourth quarter and 29.7% from the previous quarter.
While finding space won’t be difficult for tenants, leasing it will be a challenge for landlords. Subleasing space will be the norm even as the economy picks up. The challenge for landlords will be to have tenants look at their space,first.
What will attract tenants? Rents.
As the bottom of the real estate downturn nears and the rate that space is being put on the market slows considerably, activity levels may still not pick up much. The challenge will be for the economy to provide the growth to drive office occupancy at a healthy level.
There aren’t a lot of known new tenants on the horizon. That’s not to say there won’t be any signature deals. Northrop Grumman Corp. is expected to sign a 300,000-square-foot lease in El Segundo. But where other tenants will come from is a question mark.
Forecast
The defense industry is the focus of optimism in Los Angeles County. The expectation is that the billions of defense dollars destined for Los Angeles County will provide a stimulus for the local economy. But even within the defense industry, there has been consolidation of space.
The challenge will be to attract businesses of all types into the region to drive positive net absorption.
The bottom could be six months away. Along the way, the rate at which available sublease space is put on the market should fall along with average asking rates. As sublease terms expire and the space goes back to owners as direct space, there will be vacancy concerns.
Also, price cuts will help lure tenants away from direct space into sublease space, which will translate into depressed rates for landlords.
In West Los Angeles, the tech crash is now a year old. Price reductions and increased vacancy have become even more evident. Space from bankrupt tech companies has now come back to owners.
Now landlords are faced with lowering rents further to compete with neighboring sublease space, which is increasing in quantity. As a result, rents in West Los Angeles will continue to fall, dragging down the average lease rate for the county.
The Inland Empire office market closed the quarter strong, performing much better than many of the larger and more mature office markets in the Los Angeles region.
This growth market has been ahead of the curve for the past two quarters. The market also turned in a better year-end performance than its neighbors, finishing the year with positive net absorption and only a slight increase in vacancy rates.
This trend continued into the first quarter despite negative regional and national economic trends.
Exceptionally strong local economic trends will help the young Inland Empire market maintain stable absorption and vacancy trends into midyear. Lease rates will continue to hold steady in the near term. Any slowing in speculative project preleasing could cause a slight increase in vacancy rates later in the year.
As the Inland Empire office market continues to mature, look for more redevelopment of existing older downtown areas, along with the addition of some cutting edge mixed-use projects in recently established parts of Rancho Cucamonga and Ontario.
Many California developers have turned a blind eye to mixed-use projects because they don’t fit into standard zoning or development formulas.
But a few developers are beginning to favor these projects thanks to stronger market conditions, somewhat easier entitlements and more favorable financing. The One Town Square project planned in Rancho Cucamonga is one example.
New construction continues to head east into Riverside, Corona and most recently the San Bernardino submarkets. This migration east mirrors a trend that began late in 2000 for speculative industrial projects. The Inland Empire’s office landlords and tenants never had as wide of an economy-based “expectation gap” as did neighboring Orange, Los Angeles and San Diego counties. The gap between what tenants want to pay and what landlords demand is a bit more in balance in the Inland Empire because, in part, of the limited amount of sublease space.
Forecast
In the near term, landlords will continue to be accommodating as they focus on keeping their office properties occupied. However, office tenants in this market cannot expect the scales to be tipped in their favor much beyond the end of the year.
As a result of the dynamic local economy, office activity should hold steady into mid-year. Vacancy rates will remain in the low teens without any major swings. But the pace of new speculative space coming to market in the latter half of the year could cause a temporary increase in vacancy rates. Considering the national economic picture, slow and steady growth will be a major accomplishment for the office sector.
Because of the small size of the Inland Empire office market, a slight downturn could very quickly affect vacancy rates and pricing negatively. Until now, this young market has held its own, but it would be unlikely to maintain the current momentum if the regional or national outlook should darken further.
The national economic picture looks like it’s improving, too, which bodes well for this expanding office market.
