Limited Demand Seen for Commercial Space
California’s cooling economy will dampen demand for office and industrial space during 2002, say commercial real estate forecasters, who are much more guarded in their outlook for the coming year than they were as 2001 began.
Investors, developers and commercial real estate brokers expect demand for commercial space to remain flat or decline slowly for at least the first half of the year, with recovery coming slowly and gradually--if it comes at all--in the second half.
Layoffs in the first part of the new year will further reduce the need for office space, industry observers say, while slowing retail sales will weaken demand for the warehouses that store consumer goods. This view contrasts sharply from the prospects just two years ago, when an accelerating economy was boosting demand for commercial space.
But the outlook for commercial properties in Southern California is not all gloomy. Forecasters say the size and underlying strength of the region’s economy, continued immigration of people and businesses, and the completion of the Alameda Corridor rail transportation project in Los Angeles County bode well for eventual recovery in the commercial property markets.
For the time being, however, diminished demand means that conditions favor office and industrial tenants more than at any time since the mid-1990s. This is prompting many businesses to renegotiate leases far ahead of their expiration dates in hopes of locking in favorable rates--which many landlords will do in return for a tenant’s commitment to stay.
Two of the country’s largest commercial real estate brokerages, Grubb & Ellis and CB Richard Ellis, peg the vacancy rate at slightly more than 15% for the approximately 170 million square feet of office space in L.A. County and about 11% for the 60 million square feet in Orange County.
Office vacancy rates above 10% are considered a sign of oversupply, but vacancy rates alone aren’t the problem. Substantial amounts of the empty offices in both counties consist of sublease space offered at reduced rents by shrinking or stagnant companies that no longer need all the space they leased.
“When companies start hiring again, they’re just going to reoccupy space that’s on the market for sublease, so we won’t see a big impact on demand right away,” said Stephen L. Bay, an executive managing director at Insignia/ESG.
Sublease space is less of a factor in the industrial market, “but there is still a substantial amount of it that we have to burn through before we will see growth in demand,” said Timur Tecimer, president of Gardena-based Overton Moore Properties, a developer and manager of industrial projects.
Demand for office space will be flatter and more stable throughout Southern California in 2002, observers say, in contrast to the super-heated demand of 2000 and the decline of 2001.
But they say supply and demand are not nearly as out of balance as they were in the recession of the early 1990s, when rents plummeted and plunged many landlords into foreclosure.
“For a recession, we are probably as close to equilibrium as you can get,” said John Long, founder of El Segundo-based Highridge Partners, which develops, invests in and finances commercial properties.
Generalizing about the Southern California office market is difficult, said Bay of Insignia/ESG, who added that conditions can vary considerably from one geographic market to another.
Century City remains a strong market where rents have fallen little, if at all. Demand remains stable in downtown Los Angeles but is weak in South Orange County, West Los Angeles and the Conejo Valley, markets that prospered during the dot-com boom.
“If the tech markets turn around, West L.A. and Santa Monica will pick up again,” Bay said, “but until then, we see what happened in 2001 continuing into 2002.”
The South Bay will get a boost because of money being spent on defense, Bay and Long said, citing Northrop Grumman Corp.’s expected expansion by at least 200,000 square feet to accommodate its portion of the Lockheed Martin Corp. contract to build the Joint Strike Fighter aircraft.
Overall, most of the activity in the office market in 2002 will be renewal negotiations by businesses whose leases are expiring, Bay said, instead of expansions by companies needing more space.
In the industrial markets, sublease space is just one factor that will curtail demand for commercial buildings in 2002, said Tecimer of Overton Moore. Others include continued layoffs, a possible flattening of consumer spending and a continued decline in capital spending by corporations.
But Tecimer also cited factors working in favor of an eventual recovery, including low interest rates, the diverse local economy, the scheduled completion of the Alameda Corridor this year and low energy prices.
On a long-term basis, he added, demand for industrial facilities will outstrip the supply of space that can be developed on the limited amount of land available for building in central and south Los Angeles County.
In the near term, however, “The first six months of 2002 are going to be rocky” for landlords who want to lease large industrial buildings, Tecimer said.
“Throughout the region,” says the Grubb & Ellis forecast, “big industrial product will be a challenge to lease.”
Approximately 20 to 25 buildings of 100,000 square feet or larger are available for lease in the South Bay, Tecimer said, twice as many as a year ago.
But demand for large industrial buildings to buy--rather than lease--remains strong among pension funds and other institutional investors, and Tecimer said small industrial buildings also are popular.
“With interest rates so low, entrepreneurs want to buy buildings in the 20,000- to 60,000-square-foot range,” he said. “The demand is considerably deeper there than it is on the leasing side.”
Lower interest rates also have created an opportunity for investors to profit on the purchase of office buildings by borrowing cheaply, said Long of Highridge Partners, which recently bought a 400,000-square-foot office building in Dublin, Calif.
Such purchases differ markedly from the deals Highridge sought in the last downturn, when the company bought office property at a steep discount and amassed a portfolio of neighborhood shopping centers which it later sold at a substantial profit.
This downturn is much milder than the last one, Long said, so investors “are just not going to see the extraordinary bargains” of the early 1990s.
But when the next recovery begins, Long added, real estate markets won’t have to stage nearly as much of a comeback as they did after the recession of the early 1990s.
