Commercial Real Estate: Strategies and Updates
The Commercial Real Estate panel is produced by the L.A. Times Brand Publishing team in conjunction with Banc of California, Loeb & Loeb LLP, Nixon Peabody LLP and Torrey Pines Bank.
The historic impact of COVID-19 on the commercial real estate industry has forced numerous new paradigms to emerge. Commercial real estate companies have needed to digitize operations, change workplace protocols, or shutter physical facilities due to lockdowns. Preparing for reopening created a whole shift of focus in itself - all while ensuring the safety of employees and occupiers and considering the finances of tenants and end users. As we move further into Q2, many questions still linger. What changes and trends will be long-term? What legal and financial issues remain? What new role is technology playing? What awaits the commercial real estate industry next year? Here, four uniquely knowledgeable experts share their insights about what’s next for the resilient Los Angeles commercial real estate sector.
Q: How has the COVID-19 pandemic affected the commercial real estate climate?
Justin X. Thompson, Office Managing Partner, Los Angeles, Nixon Peabody LLP: In commercial real estate, the pandemic has created clear-cut winners and losers. Office, retail and restaurant sectors have lost. The pandemic accelerated preexisting trends, including remote work, online shopping, and food delivery, resulting in exceptionally low office occupancy, shuttered brick and mortar retail and emptied restaurants. Even when the pandemic ends, these impacted segments are unlikely to rebound to pre-pandemic levels. Conversely, life sciences, data centers, housing and industrial have won. For life sciences, data centers, and housing, the strong pre-pandemic demand has increased. Demand for industrial has exploded as the need for cold storage, fulfillment centers, and freight forwarding has surged. Industrial uses may be the best hope for re-use of vacated retail spaces.
Paul Rohrer, Deputy Chair, Real Estate, Loeb & Loeb LLP: From our perspective, the greatest effect on commercial real estate has been to create a climate of uncertainty. The pandemic was neither underwritten nor prepared for by the market. From force majeure clauses without reference to “pandemic” to underwriting of acquisitions and financings, the commercial real estate market had not internalized the possibility of a pandemic and its effects. The pandemic punctured many certainties, including those held by market participants. No one knew the pandemic was coming and no one knows what will come next – which is going to continue to make large-scale, longterm investments in fixed assets seem riskier than they once were, and it’s still too early to determine the long-term consequences on the market. Like Dashiell Hammett’s character who is nearly killed by a random falling I-beam, the market has now adjusted itself to beams falling, and when no more fall, will adjust itself to beams not falling.
Q: Do any traditional property strategies require a rethink because of the pandemic?
Hamid Hussain, President, Real Estate and Commercial Banking, Banc of California: Nearly all owners have had to rethink how to operate their property in order to accommodate users, be it tenants, customers or employees. High-rise office properties, for example, in traditional downtown cores will see changes as employers rethink the need to centralize or co-locate in smaller pods in dispersed hub locations. Meanwhile, office owners continue to make changes to afford a safer experience for tenants with “touch-free” systems for doors and elevators, upgrades and improvements to HVAC systems, limitations to elevator capacity, directional flow patterns in buildings, etc. Our expectation is there will be more spacing between employee workstations and greater flexibility to work remotely.
Greg Peterson, Senior Vice President, Commercial Banking, Torrey Pines Bank: The pandemic made it clear that having an actual relationship with your banker is a critical business strategy. Accessing PPP loans in the first round was easier for companies that already had relationships with their bankers; going forward, this remains important. It’s particularly key in redevelopments or complex deals to work with a bank that understands the commercial real estate industry and has the resources and interest in financing these kinds of deals that otherwise might have difficulty getting done. A proactive business bank like Torrey Pines Bank takes the time to learn a company’s unique goals so we can customize lending structures and solutions that best suit their individual needs - all while moving quickly and being highly responsive. It takes a great deal of experience to help companies succeed in Southern California’s ever-evolving economy.
Rohrer: The value that market participants place on the adaptability of a real estate project may increase post-pandemic. Although site acquisition, development and construction of major projects often take many years, the equity and financing behind a project often transition shortly after the project is completed. Therefore, the development and construction-period economic stakeholders desire to achieve the highest possible rents for the lowest possible costs, at the time of initial lease up. What this often results in are projects tailored to a particular use that is expected to be on-trend at the time of initial lease up – which may be one to three years from the date of construction. That way, money is not squandered on things that might not enhance initial occupancy and rental rates, and none of the project’s features detract from its initial use. However, because a project’s expected economic life is likely 50 to 100 years, its ability to adapt to economic, environmental and market changes increase a project’s value over its lifespan. Because adaptability has not been used as a major underwriting factor by those acquiring and financing constructed projects, it is neither properly rewarded nor incorporated in the design of most projects.
Q: Have values in downtown Los Angeles maintained throughout the last year?
Peterson: The downtown L.A. market has softened a bit, particularly on the multifamily side. Part of the reason people live downtown is because of the shops and restaurants it has to offer. But with stores and dining establishments shuttered during the pandemic, residents have had little reason to remain downtown. “People live downtown not because it’s close to work, but because it’s close to museums, restaurants and bars,” Beacon Economics founder Christopher Thornberg said during the Torrey Pines Bank 2021 Economic Forum webcast in early March. The completion of several new apartment projects also is contributing to softening in the multifamily sector, which is expected to start recovering by Q3 and looks fairly good in 2022. Regarding the downtown L.A. office market, thanks largely to long-term leases, values have remained relatively stable throughout the last year.
“Going forward, I do think that revisiting the way local governments approach entitlements for projects will be important to allow for projects to be more adaptable.”
– Paul Rohrer
Hussain: Values have declined in downtown Los Angeles as a direct result of COVID-19 for several property types, including hotels, office and multifamily (condos and apartments). It’s no surprise that the hospitality industry has been hit the hardest because most of the downtown hotels rely on business and convention stays, which mostly evaporated after the 1st quarter of 2020. There doesn’t appear to be much sign of this improving through the 3rd quarter of 2021. Higher confidence through increased vaccinations and possible “herd immunity” will reverse the trend, but it will be gradual. Office values are declining, but transaction volume remains light due to lack of market certainty. Multifamily growth in the downtown area was jobs and amenities driven, but the sheer supply of new construction in recent years, coupled with remote working options, has had negative impact on occupancies, rents and, therefore, property values.
Q: What are the key opportunities and risks for developers in 2021?
Thompson: For 2021, opportunities will abound in the life sciences, data center, housing and industrial segments. The demand for properties in these segments will cause two key risks to materialize. The first is overpayment, which results from simple supply and demand principles. The second is the likelihood that some developers will acquire properties that cannot feasibly be developed at the cost or in the manner contemplated. In Los Angeles, this second risk will frequently be attributable to land use approvals (conditional use permits, zoning changes, etc.) and environmental clearance, both of which can be costly and time-consuming.
Hussain: Liquid, well-capitalized, experienced developers always find opportunities during times of upheaval, and this time period is no different. Fortunes are made, and lost, from unexpected turns in the economy. This will certainly be the case with COVID-19. No one I’ve spoken to about the pandemic expected it to last this long nor saw the depth of change in the way we interact or conduct business. The risk today is still not knowing how long this pandemic will last and what the “new normal” will be.
Peterson: Before COVID-19, the commercial real estate market was strong, so the risks in multifamily are not necessarily related to the pandemic. Multifamily developers were active in 2019 and the early part of 2020, so as those projects are completed, there may be more available supply than demand in the near term. However, because of overall continued housing shortages in Southern California, this should be relatively short-lived. Companies with strong balance sheets in the technology and entertainment sectors will continue to drive demand in the Los Angeles market, creating ample opportunities for developers to build creative office projects with strong amenities. For example, Netflix recently agreed to lease 170,000 square feet of office space in Burbank as it continues to increase its presence in the L.A. market. There definitely is opportunity to develop appealing office space with attractive amenities.
“This past year, the commercial real estate industry was forced to take a hard look at its systemic disparities.”
– Justin X. Thompson
Q: What do you consider to be the most meaningful positive trend in commercial real estate lately?
Rohrer: Industrial property has stayed strong throughout the pandemic and should be expected to strengthen even further with the pandemic’s end. Most obviously, transportation and order fulfillment needs continue to grow. While the pandemic reordered consumption, any net reductions should be temporary, as those among us who have lost their jobs gain post-pandemic employment. Further, the pandemic turbo-charged the transition of brick-and-mortar enterprise to e-commerce, which opens up new opportunities for certain asset classes. For example, while regional malls may not see a robust recovery, the space they occupy may recover in a different form. We have already seen market participants think of creative ways to repurpose these and other asset classes to support an increasing demand for industrial property. Moreover, the last few years of trade disputes and disruptions, COVID-era shortages, environmental and labor concerns, desire for unique and authentic local goods, and acknowledgement of strategic and political needs for domestic manufacturing have led to an increasing need for manufacturing space. A weakening dollar may enhance such trends. Furthermore, industrial property is useful for modern low-rise officing. For several years, low-rise creative office space was outpacing traditional high-rise office usage – and that trend may be accelerated by the pandemic.
Thompson: The widespread adoption of environmental, social and corporate governance (ESG) integration is an incredibly positive and meaningful development. In the commercial real estate context, ESG impacts areas such as resource depletion, waste, pollution, working conditions, health and safety, employee relations, executive pay and diversity. This past year, the commercial real estate industry was forced to take a hard look at its systemic disparities. This reflection has hastened the industry movement to implement and track ESG initiatives. While this is just the first step in addressing underlying issues, it paves the way for us to identify and implement long overdue actions to rectify systemic inequalities.
Peterson: It’s been a pleasant surprise that COVID-19 has not had as big of an impact on commercial real estate in Los Angeles and elsewhere as many of us expected. Of course, certain segments, including retail and hospitality, have taken a big hit because of stay-at-home orders and the public’s reluctance to travel, but online shopping has increased demand for industrial space, and people are starting to return to offices.
Q: Are there any real estate sectors that run the risk of becoming obsolete in the current climate?
Hussain: Not obsolete but transformed, yes. Online shopping has accelerated through the pandemic, and that has meant significant challenges across the brick-and-mortar retail landscape. Regional malls have been hit the hardest and will likely need to rethink their value proposition to customers while being creative and more efficient with land use. The malls that are on enormous land parcels with large surface parking have opportunities for smart redevelopment. This will of course need to be supported by cities and could potentially address the shortage of housing in many parts of Southern California.
Q: What parts of L.A. County do you see as “hot spots” for commercial development in the coming months and years?
Peterson: Tech and entertainment companies like Hulu, Snap Inc. and Google are continuing to gravitate toward Westside communities such as Santa Monica because they’re trying to attract young professionals who want to be in hip beach communities with easy access to great restaurants and shopping. There’s a reason they call it Silicon Beach. Interestingly, market data illustrates the strength of the L.A. Westside submarket, where the total office inventory of 56.1 million square feet had a vacancy rate of just 13.1%, compared with a vacancy rate of 18.3% in the city’s central business district (CBD) and 16.3% overall (JLL). Similarly, many entertainment companies also have a strong presence in the Valley, particularly in Studio City, Burbank and Glendale, so we expect commercial real estate development serving this area to be robust in the coming months.
Thompson: Infill properties located near major metropolitan centers, abandoned retail (big box, shopping centers, retail outlets), and environmentally challenged properties are all primed for development and redevelopment in the coming months and years. In addition, suburban areas will thrive while urban areas will decline as workers push to reclaim their commute time and continue to work from home. This will lead to a veritable explosion of attendant commercial real estate development in some of the more remote areas of Los Angeles County, where land is more affordable and local government is more accommodating.
“It’s been a pleasant surprise that COVID has not had as big of an impact on commercial real estate in Los Angeles and elsewhere as many of us expected.”
– Greg Peterson
Hussain: With the completion of SoFi Stadium in Inglewood, plans for another arena for the L.A. Clippers, the Crenshaw/LAX transit stations, the Olympics slated for 2028 and supportive city governments, we could see emerging hot spots in close proximity to these new venues and near transit stations. Inglewood is largely bounded by the 405 to the west and the 105 to the south, which provides easy access to the area. This will become more evident in the next couple of years as people start attending events at SoFi Stadium and other venues again. Another area that has finally seen its day is the transformation of several of the large aerospace facilities in El Segundo into redeveloped and repurposed commercial developments. We expect this to continue for the next few years.
Q: What new trends are coming to our local industry?
Rohrer: Earlier, I mentioned industrial property as a positive trend nationally – and I would double down on that locally. On top of all of the reasons I have given for national growth, locally we have expanding entertainment, tech and R&D sectors, which appear to grow, overlap and meld under our sunny skies. The past few years have brought heavy demand for studio space and offices to support the increased production and delivery systems, as well as the burgeoning tech and R&D sector. From video games to video streaming services, tech and entertainment have melded and grown here in Los Angeles, and that growth may be expected to continue.
Q: How have federal and local government actions impacted the marketplace?
Thompson: Rent moratoria and stimulus payments have provided much needed support and protection to individuals and businesses that have felt the brunt of the adverse effects of the pandemic. At the same time, the impact of these measures may have prolonged the inevitable - forestalling landlords and lenders from actions that would quickly allow real estate assets to be redirected to other uses. A good argument can be made that government actions should focus more on facilitating and incentivizing efficient changes in the use of commercial real estate. This could take many forms, including more flexibility in processing changes in entitlement and land use requirements and increased use of tax incentives for redevelopment of vacant or shuttered sites.
“Tenants won’t want to make any long-term commitments to their space needs until there is better visibility on the health and economic fronts. Landlords should be prepared to accommodate more short-term extensions.”
– Hamid Hussain
Rohrer: Obviously, federal, state and local governments have acted to freeze and preserve the status quo during the pandemic. From eviction moratoriums, bankruptcy stays, leasing and acquiring vacant hotel and motel space for housing, to infusing massive amounts of cash into the economy, governmental bodies have acted to mitigate the effects of the pandemic. While that has been good, it has created sets of winners and losers and put a hold on change. Consequently, the results of the pandemic’s reordering of jobs and commerce may not become clear for some time, and unintended, and as yet unknown, consequences should be expected. Cities want to regulate use, not just the size and impact of buildings. This slows change. Further, cities’ reliance on sales tax has encouraged them to monetize planning decisions. Going forward, I do think that revisiting the way local governments approach entitlements for projects will be important to allow for projects to be more adaptable, and therefore make the market better able to respond to shifts in economic and behavioral trends. For example, if a project can be simultaneously entitled for use as office, residential, industrial, retail or restaurant space, or some different combination of these, it would allow for that project to respond more quickly to market needs, as opposed to remaining underutilized or vacant.
Q: Do real estate investment trusts (REITs) make as much sense today as they did five years ago?
Hussain: There is still a need for REITs in the marketplace today given that the core or essence of most REITs is to deliver steady dividend income and long-term capital appreciation. In order to do this, the REIT is reviewing micro and macro trends in the marketplace and will deploy funds in order to achieve its basic levels of returns and estimated capital appreciation. This allows the average or unsophisticated investor the ability to leverage industry knowledge and diversify personal risk. This is key when diversifying a stock portfolio, in that, at the end of the day, there is physical collateral to back the investments being made into and by the REIT.
Q: What do tenants need to be thinking about as they seek new spaces in 2021?
Peterson: With many companies taking a wait-and see approach to their office needs, it’s a good time for tenants searching for new space to take advantage of great deals. Subleasing space from businesses that have determined they don’t need quite so much is an attractive option for many tenants, but they must know what they want and be able to decide quickly if a particular space is right for them. One of the big things to keep in mind is that employees may be hesitant about a return to the office, so making sure your new space can accommodate plenty of distance between people is critical. Does the building have touch-free technologies such as voice-activated elevators, motion sensors for faucets, soap, and paper towel dispensers and contactless doors? These are all things that can help your staff feel more comfortable being in the office.
Hussain: There are still too many unknowns about when business will return to normal and just what the “new normal” will look like. Tenants won’t want to make any long-term commitments to their space needs until there is better visibility on the health and economic fronts. Landlords should be prepared to accommodate more short-term extensions over the next few years.
Q: What’s next for the commercial real estate industry heading into this new decade?
Peterson: Digital technology is not a substitute for human connection, so companies will continue to want office space. People still need places to collaborate and connect with each other, and as businesses strive to rebuild the bonds between employees, offices are likely to become even more important. They may, however, look different. Businesses likely will want more breakout rooms and gathering spots to help employees reconnect with one another. To maintain social distancing, some companies also may schedule employees to work remotely some days while others come into the office. As the retail shakeout continues, many well-located malls likely will repurpose department stores as other types of commercial space, including office and warehouse. Retailers want to be close to their customers, so they’re looking for desirable locations for last-mile distribution, and open space in some retail properties could be a great fit.