Economy May Hobble Growth Downtown

Two of Southern California’s largest and strongest real estate developers, the Koll Co. and Davidson Communities Inc., nearly two weeks ago were forced to scrub a $111-million high-rise condominium project in downtown San Diego because they were unable to obtain financing.

As a result, questions are being raised about whether the demise of the joint venture’s Huntington project signals a change in the fortunes of downtown San Diego, where growth has boomed for several years.

A top Koll official says that, although the long-term future for downtown high-rise construction remains bright, the short-term outlook is murky. That’s because lenders are pulling back and requiring substantially more up-front equity in a project--in essence, a large down payment--and, in the case of office buildings, significantly more preleased tenants before they will make loans, he said.

Others are more optimistic, cautioning not to make too much of the failure by Koll and its partner, Davidson, by drawing broad generalizations about what is happening downtown. The Huntington condominium proposal, they say, would have been a tough sell even before the slowdown in the national economy.

But one thing seems to be clear, according to several people involved in downtown’s resurgence: Downtown development is now under a new set of rules and pressures dictated by a number of related financial factors.

The result is a new economic conservatism that is making real estate loans much tougher to come by, a trend expected to last at least for the next year or so and which could lead to the delay or abandonment of some projects, big and small.

To some, that isn’t entirely bad, as the financial marketplace puts on the brakes and becomes more driven by consumer demands and less speculation.

“We’re definitely in a different kind of market,” said Paul G. Desrochers, a top official of Centre City Development Corp., the agency in charge of downtown’s redevelopment. “It’s going to be cautious, conservative growth done in smaller chunks than what we’ve seen the last couple of years.”

Desrochers was in Chicago attending an Urban Land Institute conference when the Koll announcement was made Nov. 2. The ULI is considered the country’s leading urban land use association and is composed of developers, government and private land planners, academicians and financiers.

“That’s all we heard all week, that lenders now want a tremendous amount of equity (as a down payment) and preleasing. Many of the traditional lenders are out of the market for now,” Desrochers said. “This is absolutely a national trend.”

The new financial factors at play include the general downturn in the national economy, new capital requirements imposed on the savings-and-loan industry, concern about the federal budget deficit, the slowdown in San Diego’s and Southern California’s housing market, renewed conservatism on the part of Far Eastern lenders and financial partners, market jitters over the Middle East crisis and predictions in the business press of a bust in Southern California’s commercial and residential real estate markets.

It all adds up to making it tough to get a loan.

William R. (Biff) Porter, Koll vice president, knows all about that. He says that, despite what others may think, the Huntington project was financeable. But it was delayed, in part by the City Council as it weighed the merits of another proposal in an open development competition. By the time the Huntington was approved by the council and a negotiation agreement was made final last January, the financial markets had begun to shift.

All along, Porter said, the Koll and Davidson companies had been negotiating agreements requiring 20% equity to qualify for a loan to build the 36-story edifice. But the dose of bad economic news hitting the country raised the equity requirement to 30%, a jump of more than $10 million, which Koll said it was not able to raise.

Porter said that, as a standard business practice, Koll doesn’t put up its own money as equity, instead raising it from other sources. In this case, the company had negotiated almost exclusively with Far Eastern companies.

After first being favorable to the Huntington, the Far Eastern firms balked, in part because of fluctuations in the Japanese stock market, escalating real estate prices in Japan and higher costs imposed on them to borrow money, Porter said.

An added ingredient, Porter said, were articles in national business magazines, such as Barron’s and Fortune, that predicted a bust in Southern California’s housing boom, particularly in the high-end market above $600,000, which was the Huntington’s niche.

“The new message is that development (both residential and commercial) has to be tenant-driven,” Porter said, adding that Koll spent about $300,000 on the Huntington, not counting the company’s staff time. “A lot of this is a reaction to a lot of stuff that was built (nationally) that didn’t need to be built.”

In the meantime, Porter said, he expects things in the downtown development business to maybe “get a little bloody before it gets better,” as companies adjust to the new conditions.

A bit more optimistic is Patrick Kruer, a member of the Centre City Development Corp. board of directors, a developer and a veteran real estate financier. Kruer has been a board member of Federal Home Loan Bank Board of San Francisco, a former member of the Federal Savings and Loan Advisory Council in Washington and vice chairman of the board of the California Housing Finance Agency. He is a current board member of the Center of Real Estate and Urban Economics at University of California, Berkeley.

Kruer, who had opposed the Huntington, said the project didn’t have the right location or views to command high-end condominium prices, and thus it was harder to obtain financing. “I hate to be right on something like this,” he said.

Banks, Kruer said, are under great pressure. He says the stock of many major banks is depressed and trading at 50% to 60% of its value, making it hard for banks to raise money and grow. “They are being much more selective” than in the past, and “their requirements are much tougher,” he said.

Because of the new climate, he said, financing will become the “real linchpin” of the CCDC’s decisions on selecting development projects.

“More than ever, we’re going to have to make sure the equity is in place to make a project economically feasible,” Kruer said. “Highly leveraged projects will have difficulty getting construction financing.” Although things are tight, they aren’t impossible, he said.

Kruer believes that the specter of economic bust in California is not based on fact. While the state is not recession-proof, and the new economic caution is warranted, California and downtown San Diego are not anywhere near development paralysis, he says.

Kruer bases that belief on several factors: continued high demand for housing, with hundreds of thousands more people coming into the state each year than are leaving; statewide employment growth close to twice the national average; the appeal of downtown San Diego to foreign investors because land prices are a bargain compared to Los Angeles or San Francisco, and the reality that downtown is no longer “the pioneering situation” it was 10 years ago.

Both Kruer and Porter, for example, agree that downtown remains the place to be now and in the long run, although some developers may have to adjust the size of their buildings or wait until demand dictates better conditions.

Porter says Koll expects to build another high-rise office building next to its building on Broadway sometime in 1993-94, when it expects renewed demand after the current crop of new office buildings are nearly full.

But, in recognition of the market, Porter says, his company expects it will have to prelease 45% to 50% of the building before it can get financing. In contrast, Koll’s first office high-rise needed to be about 25% preleased to nail down a loan.

In the meantime, Porter said, the company will stay downtown and concentrate on smaller projects, such as mid-rise developments confined to portions of blocks, which he said will be easier to finance at project costs substantially less than $100 million.

The CCDC’s Desrochers and Kruer believe downtown will continue to be a magnet for construction of reasonably priced rental units, noting that the luxury condominium market may be over-saturated with One Harbor Drive, the twin-tower high-rise under construction.

That project, for example, had to have half its units sold before it was able to obtain financing, according to Desrochers.

“Downtown,” said Porter, “still offers good opportunities. There’s no doubt it will continue to expand and grow.”