Investment bank Lazard Freres & Co. had been negotiating to buy property

In what may be the most high-profile real estate deal to unravel amid the uncertainty caused by insolvent dot-com tenants, the $260 million sale of J.H. Snyder Co.’s Water Garden II in Santa Monica has fallen through, real estate sources said.

“The buyer backed away,” said Howard Sadowsky, vice chairman of Julien J. Studley Inc., who thinks Snyder will go with another buyer within three months.

Developer Jerry Snyder has admitted shopping the building around but said last week that he was never under any contract to sell the 600,000-square-foot complex in L.A.’s hottest leasing market.

However, real estate sources said the real estate arm of New York-based investment bank Lazard Freres & Co. had been in the process of buying Water Garden II. Officials with Lazard Freres Real Estate Advisors declined to comment.

Few local real estate observers were surprised by the news, in light of the amount of sublease space that has poured onto the Westside market in recent weeks and the increasing concerns about a widening economic slowdown.

Water Garden II, though fully leased back in October, now has more than 20 percent of its space on the market.

“The marketplace has definitely shown signs of weakness in the past 60 days,” said Ian Strano, senior vice president at First Property Realty Corp. “It’s happening every day. A lot of deals are falling out of escrow right now.”

High rents had pushed the Water Garden II’s estimated sale value to $430 per-square-foot, or $260 million. But the calculations used to reach those numbers, based on rental income, may not reflect the reality of the market.

Previous demand for space by dot-coms has pushed leases at some A-list sites into the stratosphere. But now that the demand has softened, other Westside complexes like MGM Plaza and Water Garden I have seen growing amounts of sublease space go on the market.

“Some of those tenants are not strong, and a letter of credit doesn’t help you when you’re in a sinking market,” Strano said. “(Landlords) got very high rents in a frenzied market, but that doesn’t mean those rents will continue to escalate over time.”

Water Garden II leased up at an astounding rate over the past year, as the incredibly tight Santa Monica market shot past Westwood to become the office submarket with the lowest vacancy rate.

Although Snyder’s leasing team shied away from dot-coms after the tech wreck last April, a number of tech tenants already had been signed. As a result, actual occupancy in Water Garden II dropped significantly in recent months as companies such as Sapient Corp. have scaled back operations.

Still, the building has a number of strong tenants, including Sutro & Co., Foothill Group, a Wells Fargo & Co. subsidiary, Sony Music Entertainment Inc., Regus Business Centre, Getty Images Inc., and amenities such as Caf & #233; Bizou.

The amount of space becoming available throughout the Santa Monica submarket is growing. At Water Garden I, MarchFirst (with 30,000-square-feet already sub-subleased to eHobbies) has put an additional 24,000 square feet on the market, while much of the 151,000-square-foot space occupied by troubled eToys at Kilroy Realty’s Corp.’s Westside Media Center is expected to come on the market soon.

Still, the market is extremely tight, said Steve Solomon of Colliers Seeley International, the broker on a number of projects in El Segundo, a market that has benefited from the lack of space in Santa Monica.

“There is not enough supply (on the Westside) to handle the demand for the next 12 months,” Solomon said. “Two years from now that could be different. When we get to 10 percent (vacancy rate), that’s when people will start to react differently.”

Craig Silvers, an analyst with Sutro & Co. who follows L.A. public real estate companies, said he expects that it will take most of 2001 before the sublease space opened up by dot-coms is filled. But there is little new office space coming online in the next six months, and Silvers said brokers he has talked with in recent weeks are setting up a number of tours for January for emptied dot-com space.

“You had the dot-coms grabbing as much space as they could, and the more established companies didn’t want to play that game,” Silvers said. “Now that the dot-coms are out of the market, the established companies are taking their time and carefully evaluating, which means the frenzy’s over.”

It’s unclear how the situation will impact Snyder, who has faced difficulties at two retail projects that have lost theater anchors a retail development in Rancho Mirage in the Coachella Valley and his 250,000-square-foot retail project in Westchester, the Howard Hughes Promenade.

“One would assume Snyder is going to use the money (from a possible sale of Water Garden II) for his other developments,” Silvers said.

Snyder built Water Garden II in partnership with TransAction Cos. and Colony Capital. He was also the lead developer on Water Garden I, which was later sold to owner J.P. Morgan.