Office Space Built on Spec Filling Quickly in Region

Growing businesses in Los Angeles and Orange counties are filling new office buildings pretty much as fast as they are being constructed, suggesting that developers and lenders in this real estate cycle are doing a more prudent job of matching supply with demand than they did in the now-infamous overbuilding debacle of the late 1980s and early 1990s.

Nearly 30% of the speculative office space that was built in L.A. County and almost 40% of that built in Orange County during 1999 was leased by the day it was completed, according to a new study by the local offices of real estate brokerage Cushman & Wakefield. The study shows that much of the speculative space built in the two counties in 1997 and 1998 also was leased by the time it was completed.

A speculative building is one that a developer begins without any tenants committed to leases, in contrast with a build-to-suit project developed for a specific tenant or tenants.

Overbuilding of so-called “spec space” was one of the culprits in the Southern California recession and commercial real estate collapse of the early 1990s, when the glut of space depressed rents throughout the region, driving many owners into bankruptcy and forcing lenders to write off millions of dollars worth of bad debt.

The Cushman & Wakefield statistics for the last three years show a relatively brisk rate of speculative space “pre-leasing”--the signing of leases before construction is complete. Having a substantial amount of the space pre-leased has helped most developers fully lease their buildings well within the year to 18 months they typically allow for filling a building.

Another sign that supply and demand remain fairly well matched in is that the vacancy rate has continued to decline despite the more than 3 million square feet of new office space built in each of the two counties over the last three years.

“If you look at how fast the speculative space is being leased without looking at the vacancy rate, you don’t get the full picture,” said Janice Stanton, national managing director of investment research for Cushman & Wakefield. “Because it could be a situation in which the new space gets leased by tenants who are emptying out the older buildings.”

The countywide office vacancy rate has declined to 14.5% in Los Angeles County and 12.2% in Orange County during the last three years, according to Mike Rago, Los Angeles-based Western region senior research manager for Cushman & Wakefield. Those countywide rates, however, don’t reflect how low the vacancy rates are in some of the tightest office markets, places such as West Los Angeles and Burbank, where rates have long remained below 10%.

According to Stanton, the office leasing picture in Southern California mirrors that of markets throughout the country.

“About a year ago, we were a little concerned that if we kept building at the same rate as we were then, we might run into a problem [of oversupply],” Stanton said. However, she said, the pace of construction has generally slowed.

Current trends suggest the rate of pre-leasing may increase again in Los Angeles County when year-end figures for 2000 are tallied. Of the 2.9 million square feet of spec space under construction in Los Angeles County as of mid-March, nearly 40% has been leased, according to Cushman & Wakefield.

The brokerage’s study shows how quickly speculative buildings are leasing on average, but some projects are leasing much faster.

A number of Kilroy Realty Corp.’s speculative office projects begun in 1999, totaling about 700,000 square feet, have been fully leased either before or soon after construction was completed, according to Hugh Greenup, a Kilroy executive vice president.

For example, EToys has leased all 151,000 square feet of Kilroy’s speculative Westside Media Center on Olympic Boulevard west of Bundy Drive, where construction is scheduled to be finished in September. Other pre-leased Kilroy projects include the Kilroy Airport Center in Long Beach and Calabasas Park Centre in Calabasas.

Greenup said Kilroy has leased space quickly because, in part, the El Segundo-based company is building in “supply-constrained markets where it’s not likely that a lot of new space is going to come on the market.”

Supply and demand also remain well-matched in part because capital sources generally “seem to have been pretty responsible this time around” in providing financing for speculative projects, said David B. Blenko, president of El Segundo-based Haverford Capital Inc.

“My perception is that there is more capital competing for industrial and apartment projects because office poses greater risk,” Blenko said.

Blenko said lenders generally view office projects as riskier because they take longer to build, meaning developers must try to guess how strong the demand will be 18 months to a year from the time they begin construction, versus six to 12 months for construction of industrial buildings. Apartments are considered a safer lending bet because Southern California’s housing shortage virtually assures a continuing demand, he said.

Nonetheless, Blenko said Haverford still finds many office projects appealing, either as a lender or as a joint venture partner with a developer. Haverford provided $15 million in financing to Newport Beach-based Koll Development Co. last year for a $40-million, 176,170-square-foot speculative office project under development at Colorado Boulevard and Lake Avenue in Pasadena. Koll officials said at the time that the development had been delayed for months because of the difficulty in obtaining the final $15 million of financing.

Developers say the demand for office space varies considerably from one business neighborhood to another within Southern California. That means speculative building generally is taking place where vacancy rates are low, but little or no building is going on where vacancy rates remain relatively high. For example, no new office space is being built in downtown Los Angeles, where the vacancy rate remains relatively high--about 20%.

“It’s a question of finding the right market and building the right type of space, too,” said Kevin Read, vice president of acquisitions for Irvine-based Lennar Partners, which is developing two 178,000-square-foot office buildings and a 1,100-space parking facility in the $70-million first phase of its LNR Warner Center project in Woodland Hills. Lennar’s project at the northeast corner of Canoga Avenue and Burbank Boulevard eventually will include eight five-story office buildings, a hotel, a fitness center, several restaurants and a day-care center.

Despite what many refer to as the current building boom, the amount of office space that’s empty today is only about 40% to 50% of the amount that was empty in 1990, both in Southern California and throughout the country, Cushman & Wakefield’s Stanton said.

The more than 2.1 million square feet of new speculative space completed in Los Angeles County last year and more than 2.4 million square feet of new space in Orange County were part of almost 76 million square feet delivered nationwide during 1999, Stanton said.

She said supply and demand will remain well matched if construction remains at or below current levels and the economy remains sound, but there is always the possibility of unforeseen economic developments that could reduce the demand for office space.

Even so, she said, the current pace of construction would not be likely to produce an oversupply anything like the glut of the ‘90s.

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Office Speculation

Healthy “pre-leasing” rates for speculative projects in Los Angeles and Orange counties for the last three years are allaying fears of overbuilding. Space built and space leased by day of completion, in millions of square feet:

*

Note: Vacancy rate includes both directly leased and subleased space.

*Only one building was completed in Orange County in 1997. The project was not pre-leased but since has been fully leased.

Source: Cushman & Wakefield