Current ‘Spec’ Building Wave Shows Restraint

A little more than two years after developers resumed the risky business of building speculative office towers in Southern California, statistics suggest that construction is proceeding slowly enough to avoid creating the kind of disastrous glut of space that was a legacy of the last real estate boom.

Ever since the current construction cycle began, real estate observers have been wondering if the industry--never known for its restraint--would overbuild office space again and drag down the local economy. Research by brokerage firms Cushman & Wakefield and Grubb & Ellis suggests that new construction and demand for new space are fairly balanced, at least for the time being.

Tenants have filled nearly 39% of the 1.7 million square feet of speculative office space that has been built in Los Angeles County since construction resumed in 1997, according to Cushman & Wakefield. In Orange County, tenants have leased 53% of the approximately 950,000 square feet of speculative buildings that have been completed.

At those rates, industry experts say, developers should be able to fill their buildings within a year to 18 months of opening their doors, the period that most allow for in their financial planning.

On the other hand, demand for office space can fluctuate dramatically from year to year, so estimating how long new space will take to fill involves a certain amount of guesswork.

For example, demand for office space in Los Angeles County grew by 3.6 million square feet in 1998 after growing by 2.2 million square feet in 1997, according to Cushman & Wakefield. But the growth rate in demand for office space in L.A. County has slowed this year to about 350,000 square feet for the first half of the year, or an annual rate of 700,000 million square feet, according to the brokerage.

A speculative or “spec” office building is one that starts construction with few or no tenants signed up, in contrast with “build-to-suit” projects that developers start with tenants already standing by.

Speculative office construction ground to a halt in Southern California in the middle of this decade. The early 1990s recession, in combination with overzealous building during the late 1980s and early 1990s, had produced a surplus of offices in both Los Angeles and Orange counties. The competition depressed rents throughout the region, driving many owners into bankruptcy and forcing lenders to write off millions of dollars worth of bad debt.

By 1997, however, developers believed it was time to build again because the region’s growing economy had filled much of the empty space and even produced shortages in some business neighborhoods. But developers haven’t raced to break ground at the same pace they did before.

“There are more constraints right now,” said Cliff Goldstein, a partner at Los Angeles-based J.H. Snyder Co., which is building the 600,000-square-foot second phase of the Water Garden office project at Olympic Boulevard and Cloverfield Avenue in Santa Monica.

“It takes a lot more equity to build a project today, which should prevent people from leveraging too much,” Goldstein said. In the last building cycle, he pointed out, developers could often borrow 100% of the value of a project, risking none of their own money. Flush lenders were eager to share in what seemed like can’t-miss opportunities at the time.

“Lenders today are more prudent,” said Alan Pyenson, a vice president at Transpacific Development Co., which completed one of this cycle’s first speculative office buildings, a 50,000-square-foot project at Cerritos Towne Center, in November 1998.

Pyenson said Transpacific hopes to break ground on an eight-story, 165,000-square-foot speculative building at Cerritos Towne Center later this year, but that lenders probably won’t fund construction until there are tenants for about a third of the space.

The market seems to be taking a breather as memories of the real estate bust linger.

“There was more talk of speculative building a year ago,” Pyenson said, suggesting that the steady but not spectacular pace of leasing has made lenders and developers cautious about supporting new projects.

One of the buildings leasing fastest in the current construction cycle is not yet completed. Koll Center Irvine North, a 170,000-square-foot office tower at Main Street and MacArthur Boulevard in Irvine, is 60% rented and has leases in negotiation that might take it to 90% filled within the next 30 days, said Nader Shah, a partner at Newport Beach-based Koll Development Co. The building is scheduled to open Oct. 1.

“I wish I could tell you why we’ve done so well with our leasing,” Shah said, “but I don’t think we’re doing anything differently than others who have buildings to market.”

Koll plans to build an identical property later this year at a site across the street from its current project, but Shah said that will probably be the company’s last traditional office tower in the area for some time to come.

“There seems to be a corporate philosophy shift toward campus-style space,” Shah said. “We’re not looking for more high-rise opportunities, but we’ll be looking to build two- to five-story buildings.”

Demand for low-rise space, often referred to as “flex-tech” buildings, is fast outstripping demand for office tower space, according to Royce Sharf, a broker with Julien J. Studley Inc. in Orange County. Research reports don’t generally break out separate statistics on high-rise and low-rise space, but Sharf and others say low-rise is clearly the hotter market in Orange County.

“There’s still activity in the accounting and law firms that use a lot of traditional space, but the shift in the Orange County tenant base is clear,” Sharf said. “The high-tech and biotech firms want the flex-tech space.”

Many developers are considering both high-rise and low-rise projects, said Tim Strader, manager of real estate development in Irvine for Phoenix-based Opus West Corp., which is building a 12-story, 267,000-square-foot speculative office building called Opus Center Irvine at Main Street and MacArthur Boulevard. The building is due to be completed in September.

Opus has no signed leases for the project but expects to complete a deal for 69,000 square feet “any day now,” Strader said. He estimates Opus will sign leases for an additional 30,000 square feet within 60 days.

The varying rates at which the completed buildings are filling underscore the unpredictable nature of speculative development.

“In a perfect world, the building would be 100% leased on the day of completion, but nobody really expects to do that,” said Jack Mahoney, president of Summit Commercial Real Estate, which recently opened Continental Plaza II, a 240,000-square-foot speculative building in El Segundo.

The new building is about 25% leased, according to Mahoney, who said Summit has leases in negotiation that could bring the project to approximately 70% leased within the next two months and fully leased within six months.

Speculative development is centered for the most part in such markets as El Segundo, Santa Monica and others where the office vacancy rate hovers around 10%. Although there is no exact rule to determine when the time is right to build, developers and brokers say the decision is usually driven by a combination of a relatively low vacancy rate--in the 10% range--and a perceived demand for more space in the area.

Thus, new buildings are going up in stronger markets while weaker markets still suffer from a surplus of space.

Downtown Los Angeles, for example, still has about 8 million square feet of empty office space out of an inventory of 32 million square feet, according to a recent report by Cushman Realty Corp. The downtown market represents about 15% of L.A. County’s 157 million square feet of office space but accounts for nearly 40% of the 21 million square feet of space that’s empty in the county. Some brokers say the downtown figures are skewed, however, because much of the empty space there is in old, obsolete office buildings that are difficult to rent.

The largest single speculative office building to be completed in the current construction cycle, according to industry reports, is the 529,000-square-foot, 24-story Glendale Plaza in Glendale.

The building is about 30% leased, with about 60,000 square feet of leases in negotiation that could bring the building to more than 40% leased within the next month or two, according to Doug Marlow, a CB Richard Ellis broker who is marketing Glendale Plaza. Others in the industry say the leasing pace looks a bit slow at the building, which hasn’t attracted the host of entertainment-related firms that many real estate observers expected. But Marlow said the project, which opened in March, is on track to be fully leased within the 18 months allowed by developer PacTen’s financial plan.

Goldstein, the Snyder Co. partner, said developers must be conservative in their leasing estimates.

“Real estate development is a risky business,” Goldstein said. “You’re always speculating, to some extent, that we won’t be in a major recession two or three years down the road. The rewards are there if you’re right, but the downside is [substantial] if you’re wrong.”

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Getting Their Fill

Speculative office buildings developed during the latest real estate cycle are being rented at a healthy pace in Southern California. Figures show average occupancy rates of new buildings as of June 30:

Los Angeles County: 38.7%

Orange County: 53.0%

Both Counties: 43.8%

Source: Cushman & Wakefield