When Will OC See the Return of Spec Building?
In the go-go real estate market of the 1990s, developers found a piece of land, got it entitled and built on it whether they had tenants lined up or not. But those heady days of development are over in Orange County, at least for this business cycle.
The market is soft and vacancies are up. Lender confidence is down. Way down. Building on speculation is a relic: developers must gain substantial prelease contracts before the banks will hand out money. And in some cases, even a preleased project can’t gain financing.
Business Journal reporter Daniel Williams asked a number of real estate insiders what economic or market factors would lead to a reemergence of building office projects on speculation.
Hank Adler, real estate tax partner, Deloitte & Touche LLP’s Costa Mesa office:
To build spec office, vacancy rates will have to have a dramatic decline. Spec building is a function of vacancy, not economic conditions, though economic conditions drive the vacancy rates.
In other markets around the country, developers wait for the economic boom to kick in. In Orange County, I believe developers will jump in once the vacancy rates drop to a manageable level.
Dougall Agan, principal, Laguna Hills-based Foothill Ranch Co.:
There’s too big of a glut of open space on the market now. That’s the bottom line. Right now we’re seeing tenants rent space at or below replacement costs.
But there’s just too much space out there. We have to get it absorbed before any development can take place.
Jeff Gill, managing principal, Irvine office of MCG Architecture:
I think there needs to be a shift in thinking about how communities are developed in Orange County. We’ve become more urban than our suburban roots. The sprawl is over because land is scarce. Because of that, I think developers need to look more to mixed-use projects: office over parking, residential over retail.
Aliso Viejo is a good example of a community that was developed with mixed-use projects in mind.
Also, because land is scarce, developers will have to be creative with land: tear down an existing building and build there.
Tim Good, senior managing director, the Irvine office of Charles Dunn Co.’s investment properties group:
Many developers have land ready to go; they’re just waiting for market conditions to change.
First, we need a correction with the vacancy rates. We need to bring them to a level that’s less alarming. With low-er vacancy rates, we’ll have higher rental rates. When developers see that, they’ll begin to make their move.
Also, lenders have applied discipline since the early ’90s. And they’re wary of handing out money in the present conditions.
Rob Guthrie, president, Laguna Hills-based Guthrie Development Co.:
You have to go back to Real Estate 101 for the answer: Vacancy rates have to drop to the point that it gives lenders a feeling of confidence. Right now they don’t have that. I have a deal under contract that’s 100% preleased, but the lenders don’t feel comfortable with the current market.
Jack Mahoney, chief executive, El Segundo-based Summit Commercial Properties (developer of Anaheim Gateway):
We’ll need several quarters of a recovering economy plus an increase in job growth. We’re seeing some build-to-suit projects, but that’s a different thing.
But to (build on spec) now would be a sign of madness. I don’t think you’d get the financing anyway. I’d say we’re three to four years off before you see spec projects.
Mike McNerney, senior vice president, Irvine office of Lowe Enterprises:
The main thing is we need to see a significant amount of positive net absorption. For the past 18 months, we’ve had flat to negative net absorption.
Right now, we have such a huge overhead of product and it’s put significant pressure on rents, dropping them as much as 25%.
Royce Sharf, corporate vice president, Irvine office of Julien J. Studley Inc.:
We have to weed through significant supply before anything can be done. Right now, you have a classic case of supply and demand, with supply heavy and demand very light.
In the office environment, you have two developments to look at: class A high rise and concrete tilt-up. Both of those markets are very soft now. And lenders will keep a close eye on the supply-demand balance.
Chuck Hunt, senior managing director, Cushman & Wakefield Inc.
The OC economy has been less than spectacular, and until it improves, speculative development will remain dormant here.
Unlike the last recession, when developers overshot demand by a wide margin, today’s fundamentals are out of whack because tenants overestimated their demand for space.
Surely some product is overbuilt,flex office in South County for example,but to a large degree the excess amount of vacant space is due to tenants overestimating their future space needs, and now they’ve dumped it back on the market.
Once the economy really starts to improve,and not just consumer spending, but business investment and job growth,we will see more demand for office space and start to absorb the excess sublease space.
During the last business cycle, speculative construction projects were non-existent for six years, from 1993 until 1998, and didn’t resume until the direct vacancy rate dropped below 10% in 1997.
During the second quarter, the county’s direct vacancy rate was 15.6% and the overall vacancy rate was 17.6% that’s more than 11 million square feet of available space,and net absorption is still negative.
We may be in for another dry spell.
That being said, there could be some limited opportunity for spec development for one or two well-placed, quality buildings that could succeed if the developer remained grounded in reality about current market conditions.
Stadium Gateway, a 268,000-square-foot class A building in Anaheim, is an excellent case in point.
It’s now 96% leased and, except for New Horizons Worldwide Inc.’s 88,000-square-foot prelease, all of the leasing activity,more than 168,000 square feet,was during the last seven months.
The challenge, of course, is identifying those limited opportunities.
