The real estate market of Los Angeles and southern California are as sprawling and diverse as the region’s geography. From the coastal cities to the valleys to the deserts, the region encompasses three counties—Los Angeles, Orange, and San Diego—and is home to nearly 17 million people, with 9.8 million of them in Los Angeles, the second-most-populous city in the country. There are 40 multifamily submarkets, with 11 of those in Los Angeles alone, according to the University of Southern California (USC) Lusk Center’s Casden Real Estate Economics Forecast; CB Richard Ellis (CBRE) analyzes nine office submarkets in Los Angeles County.
While the region benefits from an enviable number of natural and market assets that extend well beyond the much-praised climate, southern California’s economy was hit hard by the national recession, and real estate across all property sectors was no exception. Now, as the U.S. economy has sustained positive, if slight, growth in gross domestic product and employment, the region’s real estate market is edging back.
Recent conversations with a number of the region’s leading bankers, brokers, and investors reveal an outlook that can be summarized as “apartments, apartments, apartments, and low cap rates create cautious optimism.” However, the real story of the southern California market is far more nuanced, and positive indicators and activity can be found in nearly every sector.
Some of the local recovery, much like the decline, is due to national trends. “This year we have seen a dramatic change in the debt market,” notes Wayne Brandt, managing director and the western regional head of the real estate capital markets group at Wells Fargo Bank, based in Los Angeles. “With loan demand being driven by low interest [rates] and a resurgence in portfolio lending by the insurance companies and large commercial banks, there has been a steady flow of refinancing and the funding for the acquisition of high-quality properties,” he says. He cautions that the recovery is not as strong in southern California as it is on the East Coast because the fundamentals are still weak. “While the downside is gone, there is still little upside,” he adds.
At Union Bank, Michael Stedman, senior executive vice president and head of real estate industries, is more upbeat, citing increased demand from the bank’s customer base. With Union Bank’s 100-year presence in the southern California market and long-term client relationships with a number of the area’s leading developers, Stedman benefits from what he calls “a macro-level view” of the market. “The general improvement in the underlying economy is spurring activity,” he says. “New loan origination this year is two to three times that of 2010, with good opportunities in apartment investment and development, especially in the key coastal markets where we are starting to see job growth.”
Jill Janka, Bank of America’s commercial real estate west division executive, also notes an increase in activity across all sectors. “Year-to-date 2011, we have closed on more lending business that in 2010 and 2009 combined,” she says. Southern California is a bright spot, and a significant portion of the bank’s business is in that market. “The outlook is sunny for core assets in supply-constrained locations, but most of the market is still partly cloudy waiting for job creation to spur absorption,” Janka quips.
| CB Richard Ellis’s 7700 Irvine Center Drive, a nine-story office tower in Orange County, California |
While many of his competitors stayed on the sidelines during the past few years, Wayne Brander, U.S. Bank’s California region manager for commercial real estate, reports that the bank remained an active lender during the difficult period 2008 to 2010. “Because were we willing and able to support our commercial real estate clients during the downturn, we continued to lend and, in fact, grew our business,” Brander reports. “Because we stayed committed to our clients, we were able to help many of them not just refinance, but also to take advantage of new opportunities that were a result of the market upset. Now we are starting to see the positive outcome on those decisions.”
Among the projects that U.S. Bank helped finance is the Avenue in Hollywood (see feature box, page 106.) In 2009, when the Resmark Companies saw the opportunity to acquire an unfinished 180-unit condominium property in a growing emerging residential neighborhood, U.S. Bank saw an opportunity to support a client. Because the previous developers were facing bankruptcy, Resmark was able to acquire the construction loan at a 50 percent discount, with financing from U.S. Bank, and to reposition the property as high-end rental housing. The project is slated to open late this year—at rental rates 10 percent higher than they were just two years ago when Resmark took its pro forma to the bank.
Similarly, Oaktree Capital, an investment management firm focused on alternative markets, has been paying attention to real estate–related opportunities in southern California. “We worked with a public company borrower, purchasing the first mortgage at a significant discount on a brand-new office property with only a 38 percent occupancy rate,” says John Brady, Oaktree managing director and head of global real estate. “Simultaneously, we accepted a deed in lieu of foreclosure while the borrower also paid down a guarantee at a meaningful discount. We created a performance-based incentive structure, and with our capital and an aggressive marketing campaign, we were able to lease the property up to 93 percent occupancy in less than nine months, which enabled us to recapitalize the property with new debt, albeit at a more conservative level, but two years ahead of schedule.”
Brady’s enthusiasm for real estate derives from two sources: the fact that commercial real estate was generally not overbuilt or oversupplied in the last cycle, and the long-term viability of the southern California market. “In spite of California’s current fiscal challenges, we’re particularly bullish on the southern California real estate markets, given the region’s culture of creativity and entrepreneurship, in addition to its positioning as the major gateway to Asia,” he observes.
Hessam Nadji, managing director of real estate and advisory services at Marcus & Millichap, the country’s largest investment services firm, shares Brady’s positive perspective. “We are optimistic about real estate in the region for two reasons,” he says. “First, southern California has a diversified economy: global trade, biotech, and entertainment are growth sectors with a lot of vitality. Second, the region is supply constrained.”
| 2600 Michelson, Irvine, California. |
Nadji notes considerable change in the markets that resulted from the recession. “While the region had been experiencing cohesive growth, the recovery is splintered by market,” he says. “The Inland Empire was hard hit, followed by Orange County, which suffered from the collapse of the subprime lenders, many of whom were headquartered there. Those markets will be slower to recover as opposed to San Diego, which has a more diversified economy, and Los Angeles, which is similarly diverse, though not as robust right now.”
At CBRE, Lewis Horne, executive managing director of the Greater Los Angles and Orange County regions, sees the market from multiple points of view as the head of one of the integrated real estate services company’s most active markets. “As of the fourth quarter 2010, our markets started to show improvement, establishing a foundation for recovery,” he says. “Liquidity appears to have returned as the economic turmoil abroad sends investors to quality, core real estate assets.”
While the office leasing market remains flat, Horne is encouraged by recent office sales activity. “In July and early August, we closed on four significant investment office properties: 2600 Michelson, 3 MacArthur Place, and 7700 Irvine Center Drive, a nine-story office tower in the Irvine Spectrum—all landmark, Class A office buildings in Orange County—and Walnut Plaza, at 1700 East Walnut Avenue in El Segundo,” he says. “There’s a sense that the leasing market has bottomed out in Orange County, and there is strong investor interest in anticipation of increased rents.”
Although the Los Angeles office market has not has yet begun to rebound, with a vacancy rate of 18 percent at the end of the second quarter, Horne, like many others, believes that the transformation of downtown L.A. over the past decade bodes well for the long-term health of downtown and the entire city. Elements of that transformation include the high-density, infill loft conversions and new high-rise residential construction, redevelopment of the Staples Center and the arrival of L.A. Live, as well as the addition of world-class cultural assets like the Walt Disney Concert Hall.
Keeping a close eye on the numbers in Los Angeles markets is Arty Maharajh, senior research analyst of Transwestern. His second-quarter 2011 report puts Los Angeles’s overall Class A office building vacancy rate at 18.3 percent, with 417,083 square feet (38,748 sq m) of absorption for the quarter, bringing the total for the year to 503,773 square feet (46,802 sq m). The average second-quarter asking rental rate was $35.56 per square foot ($383 per sq m).
Downtown Los Angeles—arguably the region’s most significant submarket—is doing significantly better at a vacancy rate of 15.8 percent, but it suffered negative absorption of 58,883 square feet (5,470 sq m) in the second quarter.
“Aside from the negative absorption for the quarter, downtown is gaining traction,” says Maharajh. “This is largely due to a business environment that keeps improving—including accessibility to public transportation and valuable amenities such as restaurants, entertainment, and housing choices.”
He notes that a slew of tenants from a variety of industries—including architecture firm Gensler, law firm Holland & Knight, and Zurich Insurance—recently defected to downtown from other markets in southern California. “And with more projects slated, including the significant redevelopment of the Wilshire Grand hotel site, a CityTarget store, and proposed NFL stadium, downtown is not expected to wane anytime soon.”
Downtown’s second-quarter negative absorption was due to a relatively large move-out of 106,000 square feet (9,850 sq m) by Howrey LLP, a global law firm that suffered financial problems in 2010 and dissolved in the first quarter of this year, says Maharajh. That left downtown’s net absorption at 46,080 square feet (4,281 sq m) at midyear, with an asking rental rate of $33.73 per square foot ($363 per sq m).
By comparison, Hollywood’s vacancy rate was 17.9 percent, with negative absorption of 2,120 square feet (197 sq m) and average rents of $35.45 per square foot ($381 per sq m), while Orange County has an 18.7 percent vacancy rate and average asking rental rates of $25.89 per square foot ($279 per sq m), Maharajh says.
| Rittenhouse Square |
Southern California’s recovery is lagging behind that of Seattle and the San Francisco Bay area, say Tyler Rose, executive vice president and chief financial officer, and Eli Khouri, executive vice president and chief investment officer, both at Kilroy Realty, an integrated real estate firm with a focus on West Coast markets. “Compared to the tech-sector cities, Los Angeles and the region are weaker, more like the U.S. as a whole,” says Rose. “Yet, we saw positive absorption in all markets in the last quarter and even a little rent growth in San Diego.”
“There are hot spots across the region tied to healthy industries—health care and biotech, technology, and entertainment,” adds Khouri. “The most active areas are attractive coastal communities—northern San Diego County, West L.A., some Orange County cities. We recently completed leases for MTV and Universal Music in Santa Monica and are hearing about new build-to-suit activity in northern San Diego County.”
“People who have options—key executives and innovative workforces in leading companies—can and do choose locations that offer a good quality of life,” Rose adds. Both Rose and Khouri make the link between the presence of top educational institutions—including USC and the University of California locations at San Diego, Irvine, and Los Angeles—and the location choices of highly creative and innovative workforces.
Universities are not the only regional assets helping generate real estate activity. “Industrial real estate has come roaring back,” says Richard Green, director and chair of the USC Lusk Center for Real Estate. “Near the Port of Los Angeles there is virtually no space; the reported vacancy of four and a half percent is really a configuration problem. It’s the busiest container port in the United States, and the demand it creates for warehouse and distribution space is being experienced as far away as the Temecula and San Bernardino.”
Activity at the port and the uptick in demand for warehouse space is also an indicator of an increase in consumer spending, albeit modest, which has helped stabilize the retail sector. “We are seeing improvement in retail infill at the high end, but in the B and C class properties, the mom-and-pop shops are gone,” says Horne.
All the industry leaders interviewed note that the apartment sector is the top choice for investors, and for obvious reasons. “A growing pool of investors are circling the county [Los Angeles] while interest rates remain low, driving price points higher and direct cap rates lower,” Marcus & Millichap reports in its third-quarter 2011 Market Update. As buyer demand outstrips supply, cap rates have fallen to the low to mid-5 percent range, the firm notes.
Yet, the demand for housing extends to other specialized product types as well. Stedman cites the Union Bank community development finance group’s activity in affordable housing as an important component of the firm’s business, while the Lusk Center’s Multifamily Report notes that a significant number of the new units delivered in 2010 were affordable or workforce housing.
“Student housing demand is spurring private development as budget cuts at colleges and universities have hurt the institutions’ ability to provide adequate housing near campuses,” says Brander. U.S. Bank is currently providing financing for 495 units of student housing—2,000 beds—located between the Staples Center and the USC campus to meet the demand for new, safer dorms with lots of amenities.
Though all reports suggest that Los Angeles and the region are still several years away from a full recovery, cautious optimism in the market exists, sparked by a change in attitude as well as increased activity. “Early on, clients were just dealing with the real estate,” says Janka. “Now our discussions are about the enterprise. It’s more strategic: they are looking two to three years out and repositioning their businesses.”
