Steady absorption, a lack of new development and job growth expected to improve rents, vacancy in 2004 Michael Gottlieb To get a sense of the optimistic outlook for the Los Angeles office market, look no further than Arco Plaza. A year ago, the 2.6-million-square-foot dual tower office complex in downtown sat half empty after years of declining occupancy and unresponsive management. Then came Thomas Properties Group Chairman and Chief Executive Officer James A. Thomas, who admits to "lusting" after Arco Plaza for the past 10 to 15 years. Thomas, who purchased the complex in 2003 for an estimated $270 million - less than half of its purchase price in the late 1980s - remembered the complex's heyday. "This was the place," he said, "and this was where all the prestigious tenants were." Since Thomas bought the property, occupancy has jumped to 60 percent thanks to City National Bank's decision to take 310,000 square feet of the plaza in a 15-year deal valued at more than $200 million. Meanwhile, Thomas is moving ahead with a three- to five-year plan to complete $125 million in upgrades, leasing and tenant improvements to attract additional tenants. "We want to be 100 percent [occupied], and we will get there," he said. That faith in the eventual success of Arco Plaza is reflective of the optimism that the real estate investors and owners are showing in the Greater Los Angeles office market's march toward recovery, even if the fundamentals remain soft. Though Southern California has been among the strongest regions in the country since the recession, Los Angeles has been slower to recover than surrounding counties. Preliminary fourth quarter 2003 figures by Property & Portfolio Research Inc. show Los Angeles overall office vacancy dropped slightly to 17.4 percent from 17.6 percent in the third quarter. Meanwhile, Orange County saw office vacancy drop by more than a half percent, to 15.5 percent, and Inland Empire vacancy fell 0.4 percent, to 10.5 percent, according to the Boston-based research firm. Still, marketwide vacancies in the most recent downturn fell far short of the 22 percent Los Angeles reached in the recession of the early 1990s. And although marketwide rents continued to slip in 2003 according to Property & Portfolio Research, they fell less than 10 percent from peak levels - far less than San Francisco, which saw rents fall by more than 20 percent. Holding Steady While the 2004 Casden Real Estate Economics Forecast projects soft job growth for Los Angeles County, most of the caution tempering Los Angeles office market optimism is gone. National and regional economic outlooks are expected to continue to improve. The report, released by the University of Southern California's Lusk Center for Real Estate, predicts a 25 percent reduction in countywide office vacancy rates with overall average asking rents moving above $2.50 per square foot per month by the end of 2005. "Although the rate of job growth for both 2004 and 2005 is expected to hover between 1 and 2 percent, the total number of new jobs added will greatly exceed the number added to either the Orange County or Inland Empire labor markets," the forecast states. No new market leader has emerged, however, to take the place of the high-tech industry as a major economic driver. Earlier this month, the Los Angeles office market also got a bit of bad news when the city was dropped from among those competing for the new Virgin airlines U.S. headquarters. Nonetheless, expected strength in financial services, entertainment, high-tech, health services and defense industries should bolster Los Angeles' diversified economy, offsetting losses from manufacturing and the mortgage industry, which is expected to shed 65,000 jobs nationwide this year, according to the Mortgage Bankers Association. The broad-based growth sparked the resurgence of the West Los Angeles submarket, highlighted by Electronic Arts' decision to occupy 250,000 square feet at Water's Edge in Playa Vista. Vacancies have fallen from their cyclical peak of 18.5 percent in midyear 2003 and are expected to reach 15 percent by the end of 2005, according to Property & Portfolio Research. The Westside's expected resurgence will help reverse the South Bay submarket's slide, following the tech industry's collapse as vacancies eased down in the third quarter to 18 percent. The economic growth also will sustain the strength of the San Fernando Valley and Tri-Cities submarkets, where vacancies have fallen from a high of 17 percent in 2002 to 15.2 percent in mid-2003. This growth will benefit downtown's ongoing transformation into a 24/7 market, although downtown is not the center of nationwide buzz it was at the beginning of 2003, as one of the top central business districts in the United States. Another plus for the 186 million-square-foot Los Angeles office market is the limited new office completions, which are expected to decrease this year to 1.8 million square feet from 2.5 million square feet in 2003, according to Marcus & Millichap's 2004 annual office report. The largest build-to-suit project under way is the 700,000-square-foot Caltrans headquarters downtown. Los Angeles remains one of Equity Office Properties' top 10 markets nationally, said Bert Dezzutti, regional senior vice president of the nation's largest office real estate investment trust. "The biggest thing is the new supply is like de minimis. It is not a factor," he said. "We have never come out of a recession where new supply is in check. This time it is purely demand." Yet, for all the good things happening in the Los Angeles office market - concrete job formation, a lack of new inventory and pockets of markets where buildings are reaching 100 percent occupancy - the optimism is somewhat tempered by larger issues facing the region. Larry J. Kosmont, president and chief executive officer of Kosmont Cos., said that although the economy appears to be turning around, tenants are not leveraging up their demand for office space. "You could go through a year of healthy hiring in L.A., but you might not feel any healthy increase in demand," Kosmont said. "In general, I think it will be a sideways year that should look better." Several factors could mitigate the demand for office space. First among them is the nationwide hangover of underutilized space, often called hidden or shadow space, which Kosmont estimates at 10 to 15 percent. "It is really hard to get a sense of how much overhead is in the market," he said. "You are seeing a change of patterns in how people use space." Moreover, political and fiscal uncertainty from Sacramento coupled with the high cost of doing business in California have many businesses looking at how they can reduce their exposure in the state. Many are shifting operations to cheaper states or moving out of the country, with India topping the list. "Businesses are definitely on notice in California," Kosmont said. "But, there is not a business in the world that wants to walk away from the fifth-largest economy in the world [California]. The question is, how efficiently can they be here and still operate in the marketplace?" Investment Outlook Nationally, the West Coast attracted 27 percent of the commercial real estate deal count and led in the number of transactions in all property types except hotels, according to the CCIM Institute and Landauer Investment's third quarter survey. "Throughout the past nine years, the West Coast has ranked in the top three regions each quarter in aggregate activity, and led the nation in investment for most of the late 1990s," said Barry Spizer, 2003 president of the CCIM Institute. Los Angeles played a significant role in this trend in 2003, with a number of notable sales. Real Capital Analytics tracked 72 transactions valued at $5 million or more at an average price of $178 per square foot through the third quarter of 2003, according to Property & Portfolio Research. Harvey Green, president and chief executive officer of Marcus & Millichap, said the aggressive pursuit of real estate investment opportunities might outlast the historic low interest rates and concerns about stocks. "A number of people who left the equity marketplace went into real estate investment for the first time," he said. "I think some light bulbs went off when they realized that, unlike the equity markets, they can control the exit strategy. In a lot of instances, people who thought that real estate is a high risk vehicle have found that it is a lower risk investment." That's not to say that there is no risk, he added. An intensification of global unrest coupled with a 100-plus basis point increase in interest rates, or another large national event on the scale of the Sept. 11 terrorist attacks, could derail Green's outlook for 2004, however. Greg Rickard, senior vice president and district manager for KeyBank, said many die-hard investors stayed out of last year's feeding frenzy, but others jumped in, undaunted by low capitalization rates. Investor appetites may be tempered this year by pricing, interest rates and improving equities markets. "The big attraction to real estate before was soft earnings and the flight of capital looking to generate returns. The same scenario is not repeating," he said. Like most in the real estate industry, Rickard anticipates relatively stable interest rates this year, with the presidential election and the Federal Reserve's preference for inflation over deflation. "While inflation can be damaging to an economy, it is less damaging than deflation," he said. "[The Federal Reserve] is more likely to hold interest rates down a little longer to stimulate growth." That has resulted in an increase in the yield curve as short-term rates hold steady and long-term rates rise, reflecting positive market sentiment. A moderate rise in interest rates could temper the aggressive investment atmosphere, but others are waiting in the wings. REITs more or less stayed out of the buying frenzy, but could step up to the plate this year as they look to expand in core markets such as Los Angeles. Equity Office for example, did not acquire any new real estate in 2003 until Dec. 31. In fact, the REIT, which owns 17 million square feet in Southern California and 7.2 million square feet in Los Angeles, was a net seller; pruning noncore assets while streamlining operations and improving broker and tenant relations. Sales in Los Angeles for the REIT included the 171,365-square-foot Sepulveda Center to Younan Properties for $28 million as part of a series of dispositions comprising more than 1.3 million square feet for $177 million. "What you had was discipline in terms of the REITs not deploying a lot of their precious capital to acquire buildings that might have been overpriced," Dezzutti said. "The discipline is there because it has to be there. Otherwise you are going to reduce your overall earnings. I think there will be more opportunities as interest rates move up because pricing will start to move up. Real estate companies with access to the cheapest capital will have an advantage." Arden Realty Inc. took a similar approach in 2003 with its 18.8-million-square-foot Southern California portfolio, which was 89.9 percent occupied as of the third quarter. "The assets we looked at over the past year have simply been too costly for us," said Robert Peddicord, senior vice president of leasing and property operations. "I am proud that we have focused on our existing portfolio." That may change this year. "What we are looking at is, as the market grows, we look at increasing the quality of our portfolio. We are not much into growth, so much as increasing the synergy of the properties around our existing assets," he said. East Versus West In the past few economic cycles, the pendulum seemed to swing back and forth between downtown Los Angeles to the east and the Westside submarkets. During the high-tech boom, the Westside captured much of the momentum with sky-high rents and low vacancies. And when the bottom fell out of the high-tech market, downtown emerged as one of the top central business districts in the country, thanks to the massive influx of capital for iconic projects and the creation of thousands of new residential units in old commercial buildings. This year's outlook shows the momentum shifting back west, according to Raphael Bostic, director of the Casden forecast. "I think we are going to see a lot of investment in areas that have been traditionally strong," he said. "Downtown won't be as vibrant as it has [been] in the past." But many see the days of the back and forth between the city's major markets as coming to an end as each matures in their own way. "It sure seems like, the last 20 years, every time we took two steps forward, we took a step backward and large tenants moved out of the market," said R. Todd Doney, executive vice president of CB Richard Ellis in downtown Los Angeles. "The market downtown is not the same market it was 20 years ago. The market is made up of a bunch of smaller, midsized firms. I don't see the ability of one or two tenants to relocate in the middle of the night and create a big hole." Doney views the substantial investment in downtown by sophisticated real estate people as a sign of the submarket's bright future, and noted that the top 15 buildings boast a vacancy rate of about 8.7 percent, and larger office owners are pushing rents higher. It may not happen this year, but Doney notes that downtown has had years with 1 million square feet of positive absorption. "We have seen big absorption numbers downtown," he said. "I think people have sort of forgotten about that. It is entirely possible we could have another." Meanwhile, Century City-based Jeff Pion, executive vice president and member of the board of directors for CB Richard Ellis, said the general economic rebound would help bring back West Los Angeles. "The last year has been characterized by lackluster tenant demand," he said. "At the end of '04 we will see rents come back." The Westside's entrepreneurial nature and creative talent pool will help drive the recovery. "Because of our intellectual capital, the growth of West L.A. is relatively secure because companies will always choose to be here," Pion said. "While we had our share of the dot-com correction, our cycle wasn't as deep as other markets because of our diversity." Tenants can still find concessions today, including free rent and increased tenant improvement allowances. But those will start to dissipate as occupancy tightens. And then rents will increase. Exactly when that will occur is hard to say, Pion said. He equates tenant decisions to homeowners trying to find the very lowest interest rate to refinance a home. "You never know when the very bottom is, but you feel pretty good when you are plus or minus 0.5 percent from the bottom."
January 20, 2004