Top-Tier Office Market Shows Restraint This Time Around
Sale prices for the most desirable office buildings in Los Angeles and Orange counties have yet to reach the peaks they hit a decade ago despite an extended market recovery and growing demand, a survey has found.
The figures suggest that the commercial property market is not in danger of overheating the way it did during the last real estate cycle that ended badly in the early 1990s, when the overpriced market collapsed and helped drag Southern California into recession. Chastened investors and developers are apparently showing more restraint this time around, allowing property values to rise at a healthier pace.
The study by Cushman & Wakefield Inc. shows that the amount paid per square foot for top-tier buildings last year was less than in 1989 for six Southern California markets: Century City, Brentwood, downtown Los Angeles, El Segundo, the San Fernando Valley and the John Wayne Airport area in Orange County.
Buildings are generally selling for $50 to $100 per square foot less today than they did in 1989, the top of the last real estate cycle. El Segundo is an exception, with current values at $200 per square foot compared with 1989’s $210.
What the numbers suggest, said broker Richard Plummer of Cushman & Wakefield, is that values of office buildings should rise steadily in coming years, assuming the economy remains stable and rents continue to climb.
“Many of today’s aggressive investors believe there is still significant upside to building values due to increasing rents,” Plummer said.
Rents are a bellwether for what will ultimately happen to sale prices, broker Bill Boyd of Grubb & Ellis said. Building values are influenced predominantly by rental rates, which, in turn, are influenced by market demand.
Buyers, particularly from Japan, bid up prices in Southern California--especially on so-called trophy properties--in 1989, Boyd said. The survey’s figures “show how out of control prices got.”
“Today’s prices are much more sober,” Boyd said. The high prices paid in the previous cycle meant that investors sometimes settled for annual returns of as little as 3% on their investments, compared with 8% and above today.
A big difference now, Boyd said, is that investors are buying properties based on the returns that buildings are actually producing--the cash flow from rents--rather than on overly optimistic assumptions about future rental income.
Among those who see significant potential for building values to rise is John Long, managing partner of El Segundo-based Highridge Partners, a real estate investment and development company that is building on speculation a $50-million, 237,000-square-foot office project at 300 Continental Blvd. The new building will be adjacent to Highridge’s headquarters building, which it sold to real estate investment trust Arden Realty Inc. in 1998.
Values of buildings in El Segundo could rise to $300 per square foot over the next five to 10 years, Long estimates, though the values might be academic because none of the current building owners there is likely to want to sell.
“Most of the owners in this market are long-term holders,” Long said. “Our plans for our new building are to hold it, not sell it.”
At about $200 per square foot, the cost of the new Highridge building is unusually low, Long said, because the company bought the land some time ago. The cost would probably run closer to $250 per square foot if the land had been purchased today, he said. When the building opens in about a month, Highridge expects to have about 50% of the space leased at rents of about $30 per square foot a year.
Values have risen in El Segundo because of a robust recovery in the office market following the aerospace downturn, Long said. “El Segundo has gone through a pretty dramatic transition from being extremely dependent on aerospace 10 or 12 years ago to being a very diversified, technology-based economy today.”
The recovery has filled office space and enabled landlords to raise rents--in turn raising the value of buildings. Long said El Segundo has another advantage: It didn’t suffer like other markets from the rampant overbuilding on speculation.
“Whenever you see a situation where the cost to build an office building is $250 a square foot and the sales price goes to $400 a square foot, you can be pretty sure that $400-a-foot sale is, over the long term, out of sync,” Long said. A rule of thumb is that sale prices should probably run no higher than 20% above the cost of constructing a new building of the same type, he said. The 1989 peak prices were out of line because they bore little relationship to construction costs or properties’ cash flows.
Prices in the 1980s were pushed to overheated levels by buyers who sometimes ignored buildings’ incomes in favor of the prospect of being able to sell them for more than they paid, said Barry Beitler, president of Beitler Commercial Realty Services and one of the region’s most active brokers in office sales in recent years. Buyers are more cautious today, he believes, because the collapse of the early 1990s is still fresh in their minds.
“While those bad memories are fading and, in some cases, have disappeared, the idea that Los Angeles and the economy could experience hard times is one reason that the peaks in prices of 1989 have yet to be duplicated,” he said. “There have been different categories of buyers setting today’s pace, for the most part not including the investment dollars of foreign countries that we saw in the late ‘80s.”
Those who do buy office properties today can probably expect reliable returns, said real estate consultant Douglas McEachern of Deloitte & Touche. However, those returns are likely to be considerably more modest than the big gains some buyers made by snapping up distressed properties in the early 1990s. He said today’s buyers are more likely to be long-term holders.
“The pension funds and some of the investment funds that are in the market today work on a much longer horizon than some of the Wall Street funds that are looking to hold a property two to five years and sell it,” McEachern said. “There aren’t a lot of other individuals or organizations buying now.”
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Playing Catch-Up
Prices for top-tier Los Angeles-area office buildings have yet to rebound to peaks set in 1989. Price per square foot paid for prime office properties:
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Price per square foot Submarket 1989 1998 Century City $450 $356 Brentwood 420 314 Downtown L.A. 350 200 John Wayne Airport 280 230 San Fernando Valley 300 210 El Segundo 210 200
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Source: Cushman & Wakefield
