The Boom Is Still a Baby
Stan Ross has long been one of the best-known and most respected authorities on Southern California real estate. As vice chairman and managing partner of E&Y; Kenneth Leventhal, the real estate arm of Ernst & Young, Los Angeles-based Ross is an accountant who has developed a reputation as a top-level consultant.
He is considered a trend spotter who combines decades of experience in the business and expertise in the financial facets of real estate to identify where markets are headed and the forces driving them. For example, Ross issued a report recently on the impact he expects the current wave of immigration to have on real estate.
Ross, who will be a featured speaker at the Los Angeles Times-sponsored Real Estate Outlook conference July 16 at the Century Plaza hotel in Century City, is a popular lecturer at real estate symposiums. He spoke with The Times last week, offering his assessment of the region’s real estate scene.
Q: Real estate values are rising very quickly in some Southern California markets, sometimes creating bidding wars for choice commercial properties. Are prices heading for the same unrealistic heights they reached before the early-1990s crash?
A: I don’t think so. I think it’s a lot different this time around. The buyers and the investors are not doing this on high levels of debt as they did before. These are either REITs (real estate investment trusts) or real estate funds that have been in the business for a while and are long-term players.
The REITs are huge companies buying at low debt levels and with the capability to continue holding properties for a long time. Their cash flow is almost four times their debt-service requirements. They have very strong balance sheets. When they buy, they’re buying with a long-term perspective and they have an organization that makes it work. Also, we don’t have the level of speculative building we had before. In terms of the supply-demand equation, I don’t think we’re anywhere close to moving into an overbuilding situation.
Q: Yet we still have substantial chunks of space that are empty or command relatively low rents in some markets--downtown Los Angeles, for example.
A: Actually, our downtown over the last year or so has recovered faster than we all thought it would. L.A. has been “found” again by investors from outside of Los Angeles. There has been a lot of activity by capital markets and investors like Sam Zell [head of the Equity Office Properties Trust, a major REIT] coming into the market because they foresee strong returns in the future. We all thought that we were going to be impacted by the Asian flu with a big sell-off of Asian-owned properties, but if you look around the downtown area, you’ll see that it didn’t happen.
Q: Why didn’t the Asian financial crisis affect Southern California real estate markets negatively?
A: Our initial greatest fear was that there was going to be this giant sell-off of real estate owned by the Asians--that they were going to bail out of the L.A. market and that it might drive prices down. But that did not occur.
When they do decide to sell, we have buyers ready to replace them--the REITs and the funds, who are willing to pay market prices. What is happening is more like the opposite. The Japanese are holding on to their properties here and selling off a lot of the real estate in their own country. In the meantime, investors here are buying properties in Japan.
It’s an interesting twist of fate. Asian capital is not the factor it once was, but it has quickly been replaced by capital from our own domestic players.
Q: Economists say that another recession is always inevitable; they just don’t know when it will arrive. Will the next downturn affect real estate as severely as the last one did?
A: Real estate is impacted by the economic cycles just as any other industry is. If the economy declines, or if interest rates go up, housing will be affected. And if we don’t have population growth and new job formation, then commercial real estate is affected.
What’s good about what has happened in Los Angeles and the rest of California is that we’ve recycled a substantial number of our jobs and we have much more diversity than we had in the past. Some of these industries are not as cyclical as the defense and aerospace industries that impacted us so much in the last cycle. As we move into the 21st century, I think the cycles will be shorter and they won’t be as severe.
Q: How does immigration translate into a force in the real estate markets?
A: The new Americans created by this immigration wave present unprecedented opportunities for the real estate industry to create homes, schools, retail shops, offices, manufacturing and distribution facilities for the new population. We really see immigration as the next big cycle driver.
Q: What other new forces are driving this cycle?
A: One of the big factors, obviously, is REITs. We are going to continue to see a consolidation of the REIT industry, which means the surviving companies are going to be very large, highly sophisticated, highly capitalized operating companies. They have disciplined management, they know what they’re buying, and they have access to cheap capital, so they will continue to grow. But another factor that is going to have a tremendous impact is the new wave of immigration.
Q: Does that mean the end of small, private investors and the entrepreneurial developers who have flourished in Southern California?
A: No, but it does mean the smaller companies are going to have to restructure and maybe joint-venture--align themselves with other investors or sell out and work with some of the bigger companies.
The entrepreneurs will always be welcome, and they will find that the REITs represent an opportunity for them. They will be able to enter into development projects and other deals with these big companies. They will have someone who is a buyer for their developments. They’re just going to have to link up and operate in different ways.
Q: Does that mean you consider REITs good, bad or indifferent for the real estate industry?
A: I like the transformation of the real estate industry from private to public and the liquidity and access to capital that it brings. It’s a whole different ballgame. We did not have liquidity in real estate before we had REITs and the securitization in the industry.
Q: What advice would you offer to a beginning investor in commercial real estate?
A: It depends on what you want to do as an investor. If you’re just going to be passive, then rather than being a limited investor in a small deal where you don’t have liquidity, you’re probably better off picking a REIT and betting on their management and investing in it. That gives you the option of liquidating and exiting the investment at any time.
I’m not sure why you’d want to be a limited partner, unless you had an opportunity for some abnormally high returns on your investment. But beware of the deal that sounds like it’s too good to be true. If you want to be an active investor, then you have to team up with someone who’s got a track record.
Q: It sounds as though you’re bullish on the market.
A: I’m very bullish on the market, and even more bullish on L.A. The reason is that L.A. has been found again; it has all the right macro and micro trends and the growth is here in population and new job formation. That’s a combination that drives real estate.
Q: If real estate is cyclical, how far along in the cycle are we this time?
A: If you compared it to a nine-inning baseball game, we’re just entering the first inning.
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Real Estate Trends
Burbank/Glendale/Pasadena Office Net Absorption
(in millions of square feet)
1996
QII: 0.15
QIII: -0.09
QIV: 0.15
1997
QI: 0.04
QII: -0.10
QIII: 0.12
QIV: 0.22
1998
QI: 0.03
Eight-quarter average: 0.07 million square feet
*
Burbank/Glendale/Pasadena Office Vacancy Rates
1st-quarter 1998, with sublet: 8.1%
Without sublet: 6.6%
*
Note: Net absorption reflects the gain in rented space. Vacancy rate is the total vacant square footage divided by total rentable square footage in all existing buildings. Sublet space is space rented by primary tenants that is vacant and available for sublease.
Source: CoStar
