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Navigating Through Tough Times

January 1, 2002

Article by Brad Berton While economic growth in the region has certainly not come to a halt altogether, the global recession and the war on terrorism are constraining user-side demand for all product categories, at least in comparison to a couple years back. Some sectors are obviously affected more than others, as the market grappies with factors ranging from dwindling hotel room demand to still-unmet multifamily needs. So with the Southland's supply-side relatively subdued currently-at least compared to the 1980s-real estate professionals seem pretty comfortable ranking recovery prospects for the various income property groups this year. The consensus * Apatolentt owners will continue to see more demand than they can accommodate, with recession-related exceptions mostly * Office landlords will continue to face a more competitive environment than the one they were thriving in 18 months ago, with ongoing "tech-- wreck" strains tempered in part by renewed defense growth. * Industrial properties in the higher-rent districts won't see the strong absorption levels of recent years, though some markets will remain undersupplied even as the economy struggles to turn around. * Retail projects will likely feel the pinch as development continues amid a dwindling, revenuechallenged tenant base, yet demand might improve later in the year under the quick recovery scenario. * Hotel owners-well, they've got an entirely different set of post-Sept. 11 issues to address. Indeed, the region's multifamily sector looks most promising almost by default, suggests Raphael Bostic, director of the Casden Real Estate Forecast, which is affiliated with USC's Lusk Center for Real Estate. "The apartment sector holds the most potential, in part because the other sectors face serious challenges that will inhibit growth," Bostic says. But while the fundamentals of supply and demand don't exactly set the table for a grand New Year's celebration, they still imply select opportunities for tenants and investors that act insightfully and quickly. Certain well-heeled developers might even look to economically augment their portfolios while SoCal's chips are down a bit, say some real estate experts. Especially where viable infill-type sites are concerned, "developers who can finance themselves will be able to take advantage of the softer market and ultimately book higher returns over the life of the project," says Brian Malliet, vice president of acquisitions and development at Voit Development Co. in Newport Beach. Still, even according to the more optimistic forecasts, the bulk of the region's key economic sectors are facing another tough six months or more. But again, the constraints on demand portend a wide array of near-term implications for SoCal's vast real estate submarkets. Savvy dealmakers wondering which categories will lead-or hinder-the near-term action might want to consider recent reports from the Los Angeles Economic Development Corp., Chapman College and Credit Suisse First Boston. They concluded that in addition to the region's already teetering tourism and technology sectors, durable goods manufacturing, retail, entertainment, construction and the public sector are in for at least a couple stressful quarters. However, better news is forecast for other sectors driving the regional economy, such as health care, consumer staples, communications services and, due in part to the Sept. 11 tragedies, security and defense. These sectors seem set to pick up at least some of the slack for the struggling categories, veteran observers suggest. "Defense and security might make up for some of the lull we've seen in the entertainment and telcom sectors," predicts Jeremy Fletcher, Brentwood-based chief executive of Beacon Capital Partners' Western region. As Fletcher notes, many Hollywood producers had built up inventories in anticipation of mid-2001 industry strikes that never materialized, and hence aren't in heavy production mode today. But it's only a matter of time before the inventories dwindle and the industry gears back up, likely absorbing vacant commercial space in and around Burbank and other entertainment-heavy districts, he says. And the post-9/11 emphasis on security and defense may well become something of a boon for markets such as LAs South Bay, that have traditionally catered to that business sector, adds David Blenko, president and CEO of El Segundo-based Haverford Capital. Of note, at press time, Northrop Grumman Corp. appeared to be on the verge of committing to as much as 275,000 sf of space in El Segundo. Northrop's impending transaction illustrates the nearterm opportunities inherent in a temporarily stalled marketplace. Not only can such expansion-minded property users jump through a window of bargains, investors might likewise look to exploit the indecisiveness seen lately in the real estate capital markets. As veteran CSFB Realty brokers Jeffrey Strnad and Gary Weiss stress, many credit tenants with Southland leases expiring over the next year or so should be well positioned to negotiate attractive renewal or relocation deals. But that leverage could well dissipate as the economy recovers during 2002's second half, they advise. On the investment side, two huge acquisition opportunities should soon offer quite revealing "comps," signifying just how the capital markets view the corresponding Southland office markets. At press time, prospective buyer teams were battling over stakes in developer Rob Maguire's Downtown LA-weighted holdings as well as one of the Southland's premier suburban office collections, the Warner Center Properties portfolio. As Beacon's Fletcher and others are quick to note, the cream of the US real estate investment community have expressed interest in these quality assets, Nevertheless, prudent bidders are also calculating in considerable risk factors such as Downtown's long, but subsiding struggle with product oversupply and the 315,000 sf HealthNet is vacating at one of the Warner Center high-rises. "Buyers will have a tough task pricing those risks and the corresponding liabilities" Fletcher elaborates. As those high-visibility portfolios should demonstrate, property pricing is destined to reflect the fact that rents within most of SoCal's markets seem to have reached a plateau, says Kevin Assef, senior vice president and regional manager at Marcus & Millichap's Ontario office. "Prices will remain flat in 2002," Assef adds. He says capitalization rates should average 8.5% for apartment properties and 9.5% to 10.5% for retail and office properties, as ample capital supplies keep the finance marketplace quite competitive. Assef is anticipating that Southern California investment sales volume will pick up perhaps 5% to 10% in the coming year, as buyers expecting a quick economic recovery capitalize on historically low interest rates. Interestingly, Voit's Malliet notes that the challenging economy and the Fed's continued reduction of interest rates are combining to stabilize property pricing. "Lower interest rates are pulling cap rates down and the economy is pulling cap rates up, causing an overall equalizing effect." Low capital costs notwithstanding, the experts expect a much tougher battle for would-be builders seeking development financing, with the noteworthy exception of non-luxury apartment projects. Most area developers seem to share financiers' sentiments when it comes to speculative projects. As Transwestern Commercial Services' Downtown LA-based regional president Paul Lentz puts it, "our strategy is basically not to break ground until we get large lead tenants." Still, some real estate pros are also anticipating a burgeoning evolution toward mixed-use development, particularly in appropriate high-density locations. "We will see more mixed-use projects in the upcoming year, as developers and financiers come to accept this method of spreading risk over multiple product types," predicts Scott Cairns, vice president of business development at Smith Consulting Architects in San Diego. Indeed, the residential-over-retail configuration now seems to pencil out, especially along key urban transit lines, adds veteran retail broker Dick Carter at Centers Business Management in Encino. "The economics are finally making sense," he continues, adding that office space is also appropriate in some cases. In the wake of the terrorist attacks, however, developers are still having a tough time factoring in the higher insurance costs, cautions Stan Ross, the USC Lusk Center's Chairman. "Financing for new development will be impacted as lenders wait to see when terrorism coverage will be available from insurers," Ross laments. And what's available is certain to be more expensive. Scott Bedingfield, vice president with commercial property and casualty insurance brokerage Cavignac & Associates in San Diego, is anticipating premium rate increases of 10% to 30% for accounts that have been profitable, and even more for those with higher loss ratios or large exposures to natural catastrophes. Deductibles are also increasing, even as coverage is being cut back, he adds. Multifamily Rules So, as 2001 turns to 2002, here's a quick roundup of what the experts are projecting for each of Southern California's primary commercial real estate categories. In the office sector, "supply will definitely outweigh demand for the majority of 2002," says Steve Kolsky, principal at Newmark & Co. in Westwood. Tenants will typically stay put rather than invest time and capital into relocations, he continues, adding that LA's executive-rich Westside and comparably affordable Downtown should fare relatively well in the year ahead. Moving south, Orange County office landlords and developers face similar supply-demand challenges, especially in the highly competitive South County area. There's several million feet vacant now in South County in the wake of the recent development boom, stresses Beacon's Fletcher. "That makes me nervous," he adds. Voit's Malliet agrees, but adds that demand remains resilient for the single-story product that is for sale to users. Further south in San Diego County, the office market looks to be generally depressed, at least for 2002's early quarters, warns Yehudi Gaffen, principal of the locally based construction management firm Gafcon. The Downtown highrise district should hold its own without much new product on the way, but certain suburban submarkets such as Sorrento Mesa will see an oversupply, he elaborates. Likewise within SoCal's vast industrial property arena, "everyone seems to be expecting the first quarter to be slow and maybe the second as well," says veteran broker Barbara Emmons at CB Richard Ellis in Glendale. Still, markets are generally in good shape, with vacancies remaining at relatively low levels in the wake of huge absorption rates seen in recent years, she adds. Emmons is anticipating that the huge Inland Empire distribution hub will set the pace going forward, as the supply of functional space there continues to grow and thrift-minded users look to the cheaper space offered inland compared to the coastal markets. But USC's Bostic cautions that nearly half of the new jobless claims of late are from the manufacturing sector. This does not bode well for industrial real estate in the future, Bostic warns. Still, strong near-in markets such as the San Fernando Valley will typically see demand for industrial space outpace supply, adds Timothy Regan, vice president of development and acquisitions at Voit Development in Woodland Hills. In Orange County, property pricing has been off slightly since the terrorist attacks, but markets remain mostly balanced between tenant demand and product supply, says Louis Tomaselli at Voit Commercial Brokerage in Anaheim. He does note one exception: a slight oversupply of large distribution centers in North County now that some users are endeavoring to sublease sizable spaces. Sublease efforts and continued spec development have also boosted overall industrial availabilities in San Diego, reports Grubb & Ellis' local research staffers. The big brokerage firm anticipates that industrial developers will limit activities to build-to-suit projects near-term while also pursuing potential redevelopment ventures in the stronger built-out submarkets. Despite substantial expansion plans by the likes of the Kohl's department store chain, pundits have particular concerns about SoCal's retail real estate prospects. The LA area is of special concern, as substantial development activity continues even as the retailing environment weakens. Rents will typically remain flat, while vacancies will increase a bit, from perhaps 5% to 6%, projects investment brokerage firm Marcus & Millichap. Retail leasing has likewise dipped sharply in Orange County since mid-2001, as spending has fallen off and some tenants have retrenched, according to Grubb & Ellis. But that should offer remaining tenants a nice window of opportunity to upgrade locations and reposition their stores. On a somewhat brighter note, occupancy within San Diego's retail property sector actually remains near record levels and new retailers continue moving into the marketplace even as others retreat, Grubb & Ellis reports. The company's retail specialists are anticipating greater emphasis on renovation and redevelopment amid a relative absence of major new construction projects. Predictably, the multifamily sector continues to be the region's brightest spot. While rent growth has cooled somewhat in recent months, "it continues to meet or exceed inflation in most Southern California submarkets," says Marcus & Millichap's Encino-based president Harvey Green. And as he and others point out, most of the weakness has occurred in the high-end category since virtually all new units are concentrated in this segment, particularly in San Diego and Orange County. Marcus & Millichap's Assef expects a strong 2002 performance even in the Inland Empire, where cheaper singlefamily housing has been the historic attraction. The reason: The region will see SoCal's strongest ongoing employment gains amid relatively sparse apartment development. John Przybyla, who manages Marcus & Millichap's Newport Beach office, projects average Orange County rent increases of another 3% in 2002. The typical gap between Orange County rents and mortgage payments remains quite wide, suggesting plenty of tenant demand, he adds. San Diego's apartment market likewise remains strong. However, there is some concern about oversupply given the abundance of new projects on the way in the popular Downtown district, cautions Robert Noble, CEO and design principal of locally based Tucker Sadler Noble Castro Architects. And on the other end of the spectrum sits SoCal's hospitality real estate category, which has been hammered by the stinging decline in travel post-Sept. 11. As Bostic laments, "the hotel sector will suffer for some time from the combined effects of the recession, which has dampened business travel substantially, and Sept. 11, which severely hurt personal travel." But the supply of and demand for commercial real estate in Southern California shouldn't get as out of balance as it did a decade ago, predicts John Dobrott, senior vice president at Gale & Wentworth California in Irvine. "The demand/supply intersection is sliding down the chart, but it won't be as sharp or prolonged as it was in the early-1990s."