SCOTT PERLEY : Rebuilding the Office Market : Broker Sees County Avoiding Houston, Denver Fate

For a while, it seemed as if it would never stop. Orange County’s businesses created more jobs, which brought more people into the county, which meant even more jobs for the companies that audited the books, did the legal work and sold insurance. And all those lawyers and accountants needed office space. There were plenty of lenders who took a look at all the activity and told a developer: “Sure, we’ll lend you enough to put up another office building.” And the developer did. Pretty soon the Orange County skyline was spiked with glass office towers 10 stories and higher.

Now, however, some people are beginning to wonder whether Southern California can avoid the fate of cities such as Denver and Dallas, cities caught with too much office space when their economies slowed down and left with phalanxes of empty “see-through” office buildings. Bad real estate loans were a major cause of the crash in the savings and loan industry, and overzealous commercial banks have been burned too.

Last week, L. William Seidman, chairman of the Federal Deposit Insurance Corp., said it wasn’t just developers and lenders in Texas, Colorado and Arizona that have recklessly overbuilt. One of the spots with a potential for big trouble, according to Seidman, is Orange County.

There are lots of people, though, who will argue that those Southwestern cities’ economies aren’t nearly as diversified as the Southern California economy. So, the argument goes, Orange County should be able to avoid a fate similar to Houston, which went down the tubes with the decline in the energy industry.

One of those people is Scott Perley, a vice president and manager of the Irvine office of the commercial real estate brokerage Cushman & Wakefield of California Inc. Cushman & Wakefield is a New York-based company and part of the Rockefeller family interests.

Perley, however, has lived in Orange County most of his life. He holds degrees in electrical engineering and business administration from the University of Colorado and a master’s degree in business from Cal State Fullerton.

Brokers tend to be some of the most knowledgeable observers of the real estate market since their livelihood depends on being well-informed. They also tend to be nearly as optimistic as all those lenders and developers. The local office market has some problems, Perley noted in a recent interview with Times staff writer Michael Flagg. But he also argued that the potential for disaster is nowhere near as great as the FDIC painted it last week.

Q. The vacancy rate for office buildings in Orange County, all the surveys agree, is more than 20%. Why so high?

A. One misconception about the real estate business is that it’s a supply-and-demand business. It’s really not. For the most part it’s a capital-driven business. If there’s money available to build, people will build, especially if they can do it with somebody else’s cash. If you don’t build, someone else will. So if you have a lender or a joint venture partner who’s willing to fund a project, more than likely something will be built. Then there are a number of fairly large landholders here--the Koll Co., the Irvine Co.--and they’re going to build, too. Right now you have a situation where the money supply has contracted considerably (because the lenders are backing off), and that’s really the constraint on the marketplace. But if money were available, you’d still see a lot of buildings going up.

Q. This isn’t really unique to Orange County, is it? Office markets seem to be driven by the lenders most everyplace.

A. That’s the way it works. It’s a little easier here, though, because this is a high-demand location and people want to lend here. We have population growth, we have a sound economy and generally full employment; it’s a place people want to come to. When you combine all that, it makes it easier to lend here and easier to justify development.

Q. How does our vacancy rate stack up to comparable markets around the country?

A. It is a little high. We’re still considered a suburban market and I think suburban vacancy rates nationally are probably in the high teens as opposed to our low 20s. And downtown markets are more in the low to mid teens, say 12% to 15%.

Q. Doesn’t that suggest more than a run-of-the-mill problem to you?

A. Vacancy isn’t the only criterion for measuring a market’s strength or weakness. The key factor is leasing activity. We’ve had strong leasing in the last few years and so the vacancy rate hasn’t been terribly critical. It’s taken roughly 2 to 2 1/2 years to lease a new building. Most developers will assume that’s the case and build it into their construction estimates. But you can never be absolutely sure. And it’s when it’s going to take longer to lease the building that it really starts to hurt, the problem being that when you start an office project it’s a long time before you actually have the building. You have to get plans and approvals and then it’s 18 months or so for construction. It could take three years to get it built, and you don’t know what the economy’s going to be like in that third year or how much competition you’ll face from other new buildings.

Q. So leasing activity has been pretty strong?

A. It’s very strong. We’ve seen absorption (the net increase in occupied office space) in the range of 3 million square feet each year in the last few years. The occupied space in office buildings in the county is in the 35-million-square-foot range, so that’s a considerable increase we’re seeing. You’re talking 8 to 10% of the base added each year. It would be unreasonable to assume that’ll continue forever. The numbers just aren’t there. You can’t keep the service sector growing that fast.

Q. So we’ve seen a lot more office construction in the last few years than it’s likely we’ll see in the future?

A. Undoubtedly. We’ve built nearly two-thirds of our office base in the last five years. That’s a lot of space.

Q. How much of this strong demand for space has been generated solely by the extremely low rents landlords are charging in order to get people into their empty buildings? And doesn’t that mean you’ve got lots of people moving into buildings merely for the sake of a better deal and leaving empty space behind in the buildings they just left, a sort of real estate version of musical chairs?

A. Yes, that has generated a lot of leasing activity. But we’ve also seen a big increase in the amount of office space rented too.

Q. Are the low rents a serious problem for landlords? At least one survey shows landlords are still charging 1985 prices for rents.

A. Yes. Rents technically have been flat for five years.

Q. Is that going to continue?

A. I don’t think there’s any great feeling of optimism that it’s going to change in the next few years. They’ve got to get some of the inventory off the market before there will be pressure on rents to increase. And based on what the economists say, there’s obviously some question about how aggressively the economy’s going to expand.

Q. What happens if these anemic rents go on for another couple of years? Aren’t we going to have some developers who’re going to have to unload their buildings?

A. More than likely, yes. Most developers don’t build to sell--their objective is to hold property. If there isn’t as much new development activity for a developer, he has to look elsewhere for revenue, either in cost-cutting or in selling a building.

Q. As you said, we have some enormous landholders here who aren’t under quite as much pressure to produce a lot of revenue from a building right away. But what about the smaller guys? Isn’t this going to mean serious trouble for them?

A. Development attracts people on a highly leveraged basis, who may not have enough capital to withstand the down cycles in the marketplace. Those who are undercapitalized may have to stretch a little too much on the land acquisition, making it that much more difficult to be profitable and, yes, there may be some of those developers who have to fold their tents and find another business.

Q. Isn’t it slightly ominous that some of the non-real estate companies--the insurance companies, manufacturers and others--that formed joint ventures with local developers are now selling their stakes in the buildings they constructed? Is it possible they see something we don’t?

A. I’m not sure ominous is the right word, and I don’t think their view is any clearer. I don’t think there’s any question that the returns today have not materialized to the degree these people thought they would. The more sophisticated publicly held companies that have done joint ventures do exhaustive studies on where to place their capital and maximize their returns. And their perception is that they’ve got equity there that they can see a better use for somewhere else.

Q. Is there a construction slowdown now--as all the surveys seem to indicate--that could mean a better market for landlords?

A. I think so. There are a number of projects that are being delayed that a year ago people were counting on being built. There’s Mola Centre; Trammell Crow has talked for a long time about beginning another office tower but that’s not being built; McDonnell Douglas, I think, originally had planned a new tower sooner than they now do; the Bramalea Bayview site (construction) had been expected to be under way by this time. Those are all something of a reaction to the lack of financing and demand.

Q. I’m told that a much larger percentage of the construction these days in the office market is in smaller buildings going up in the relatively undeveloped southern half of the county. True?

A. There is a heavier amount of construction in South County than there has been in the past, particularly at the Irvine Spectrum (a massive Irvine Co. office and industrial park in Irvine). And most of them are (low-slung) buildings.

Q. Is this overbuilt market we’re in now unique, or have you seen this kind of thing before?

A. Yes, there’ve been times when rents haven’t kept pace with costs. The concern here is the degree of this cycle--in other words, how bad is it? Are you getting a Houston situation, or a Denver? And the consensus is that, while we’re not recession-proof, we’re at least a little recession-resistant. We’re not totally dependent on the oil business or any other single industry. On the other hand, we have a fairly large defense industry and there’s some concern about that and how it’ll affect the service sector.

Q. So you’d disagree with the comment Mr. Seidman of the FDIC made last week that Orange County may be poised on the edge of a catastrophe?

A. Yes, it’s very difficult for me to perceive that there’s some catastrophic problem facing Orange County that’s right around the corner. Sure, we have a high vacancy rate, but in terms of quantifying the amount of space that’s vacant, it’s about 10 million square feet. You look at Houston, and they have numbers like 30 million square feet of empty space and negative absorption; that is, a situation where you might have 36 million square feet of occupied space one year and 30 million the next. But there’s no industry or group of industries that could leave Orange County overnight and have that kind of impact.

Q. What kind of companies are taking office space in the county?

A. On an historic basis, they’ve been firms that are already here. They could be high-tech companies or companies consolidating multiple offices around the county. We have seen an influx of large law firms to the area. Most of the accounting firms are already here, but they’re also expanding. Insurance companies are attracted to basic population growth.

Q. The John Wayne Airport area has become the focus of the county’s new “downtown” in a few short years. There’s by far more office construction there than anywhere else. Why?

A. The airport’s a big attraction. Then there’s the proximity of the freeway. But a lot of it’s entitlements. There’s a lot of land there with entitlements to build. There’s a certain synergy when that happens: Certain types of property attract more of that type.

Q. I find it ironic that the Irvine Co. originally planned that neighborhood as an industrial area. I’m told it wasn’t until the Koll Co. started building offices there in the 1970s that the place really took shape as an office neighborhood.

A. Even when Koll began Koll Center Newport it was still the Irvine Industrial Complex that was adjacent to it. And the industrial complex wasn’t even completed. It was a surprise to the Irvine Co., too.

Q. Speaking of the Irvine Co., they seem to have bagged most of the really huge tenants--the Gibson, Dunn & Crutcher law firm and PacTel Cellular, for instance--in the last few years. Why?

A. They certainly have the ability to be more aggressive in going after these people because they’re not really on an equal footing with the developer who had to come in and buy the land at market rates. Although the deals the company has made have been perceived to be market transactions. But at least they have the flexibility to go a little bit lower to get that tenant if they really want it. Those deals you mentioned were favorable deals to the tenants, all things considered. But I don’t think the company gave away the store.

Q. What about Anaheim, Santa Ana and the central part of the county, where a lot of new buildings are sitting half full?

A. Downtown Anaheim is a lot like downtown Santa Ana in one respect: the freeways missed both of them. And development follows the freeways. The vision Santa Ana had for its downtown Civic Center area has never really materialized as they would have liked it to. It’s a great improvement over what it was 20 years ago, unquestionably. But they would love to have the activity that’s now starting to occur around MainPlace (the big mall north of downtown near the freeways, where several big new office projects have been announced). The same thing’s true of downtown Anaheim. You can’t get there without driving through areas that aren’t quite as attractive as you’d like them to be.

Q. What about the southern half of the county? Are we going to see these glass office towers marching down there in the next 20 years as that part of the county develops?

A. I would doubt it. The Irvine Spectrum will be the southern boundary of the high-rises. There’s going to be a significant population base down there, but I think they’ll be driving to Spectrum.

Q. Let’s talk about what all this mean for the brokers. Coldwell Banker--your old firm--and Grubb & Ellis have by far the largest market share in the county. Then there are your present company and another dozen or so on the second rung. As this construction boom winds down, as you say it will, isn’t it logical to expect a shakeout where some companies will shrink or disappear?

A. We estimate there are 1,200 or so brokers in the county, chasing $100 million in business a year. I don’t see the actual revenues declining because the base will continue to get bigger. But there’s a perception that we don’t really have the business to support the brokers that are here. On average, those figures work out to about $100,000 or so in business per broker. But in reality, of course, it doesn’t work that way. Twenty percent of the brokers probably make good money and the other 80% are in all probability struggling. The rule of thumb is that it takes $50,000 a broker to break even for the brokerage house, what with the cost of rent, marketing materials and the rest. So, to do well for himself and the company, the broker has got to do much better than average. Obviously if there are a lot of brokers doing much better than average, it stands to reason there are an equal number or more who are making less.

Q. Does that mean some brokerages will get smaller or disappear?

A. There will be some firms that decide to close their doors.