The L.A.-area commercial real estate market bullied its way forward in the third quarter, shrugging off the effects of dot-com meltdown, soaring rental rates, steep hikes in energy prices and other factors that should have crippled growth.
Behind the surge: Old Economy companies.
“There’s brisk demand from a lot of traditional companies because I think they’re very profitable,” said Clay Hammerstein, senior managing director at Insignia/ESG. “There’s brisk demand from the service industries. All the law firms are growing, the accounting firms, the investment banks are still very bullish and very much in a growth mode. As a result of that, the traditional companies are continuing to grow and absorb space.”
Office tenants moved into 1.37 million more square feet of L.A. County office space than they vacated in the third quarter, according to Grubb & Ellis Co. That’s almost double the net absorption in the second quarter.
That strong leasing action came despite a rise in the average monthly asking rent to $2.31 per square foot, up from $2.28 in the second quarter. And it drove down the countywide office vacancy rate to 12.3 percent, from 12.9 percent in the second quarter, Grubb & Ellis reported.
“I’m surprised the vacancy rate actually declined, because there were a lot of projects that came on during the quarter,” said Craig Silvers, senior analyst in Sutro & Co.’s research department. “Technology firms just haven’t been as active in the overall market, but someone else is picking up the slack. That much of a decline is very strong.”
Some industry observers attributed the market’s strength to low levels of construction and the tremendous resilience of L.A.’s diverse economy in the face of turmoil in the technology sector.
Still, as the recent flurry of mergers and acquisitions among dot-coms start to have an impact, the tech sector can be expected to slow the market, Silvers said. “It’s a pretty decent-sized swing factor,” Silvers said. “The vacancy rate isn’t going to get much worse, but it’s going to level out a little while. You’re not going to see this drop, which, again, is a surprise.”
Many observers are predicting a slowdown, however, due to a more cautious business climate. That caution is emanating from the tech sector, but is quickly spreading to those sectors that do high levels of business with the tech companies. Concerns are further fueled by profit warnings coming from Wall Street.
“Last quarter we saw the early signs of it. We are seeing it definitely continue,” said Matthew Miller, a principal at Cresa Partners and a tenant broker. “It might be that things continue to go up, but slower. It depends on what happens in the next 12 months. A lot of what was driving demand was growth in the technology sector.”
The numbers may not show it yet, but the pace has already slowed, Miller said.
“There has been more new subleases hitting the submarkets, particularly on the Westside, than in the last five months,” Miller said. “Now it’s come back to a much healthier balance.”
Rents can’t continue to climb as steeply as they have, and that’s giving tenants a bit more leverage, Miller said.
“For clients who aren’t in a hurry, they’ve got the luxury of a little more time to negotiate,” Miller said. “But we’re still seeing a lot of clients who are in a hurry, and those transactions are still being done at a hyper-negotiated rate.”
A closer look at the numbers does indeed reveal several pockets of weakness. Ten of the 27 submarkets tracked by Grubb & Ellis posted negative net absorption in the third quarter, meaning tenants vacated more space than they moved into. Among the hardest-hit submarkets were Glendale, which posted negative net absorption of 110,300 square feet; Central Torrance, which lost 106,597 square feet of tenant occupancy; East San Fernando Valley, which saw its tenant base shrink by 104,832 square feet; and Downtown Long Beach, which lost 97,276 square feet of tenancy.
Not surprisingly, the Westside continues to post the strongest performance, with 377,115 square feet of positive net absorption in the third quarter, up from 265,023 square feet in the prior quarter.
But with the average monthly asking rent on the Westside flirting with $3 a foot, tech-related tenants are beginning to migrate into lower-cost areas, such as the South Bay and downtown Los Angeles.
Business leaders downtown in particular have made an active effort to lure in dot-com companies, despite what many property owners see as a relative credit risk. So far, the strategy seems to be working.
Hammerstein points to how downtown rents have gone up despite high vacancy rates, thanks to downtown leases to such companies as Hiwire.com Inc., which moved from Hollywood, and Full Moon Interactive. Meanwhile, companies behind Web sites such as weddingchannel.com are looking for downtown space.
“Historically, those types of companies haven’t been downtown, but because it’s economically favorable and the product is a very institutional, high-end product, they’re looking at that and saying, ‘We can meet our qualitative criteria and save some money,'” Hammerstein said.
Brokers say demand for teleco space in downtown and increasingly in outlying areas remains strong. That’s evidenced by Menlo Equities’ purchase of the 600 Wilshire and 626 Wilshire buildings, which have a combined 500,000 square feet of space across the street from teleco epicenter One Wilshire Boulevard. Menlo Equities plans to convert those buildings to teleco uses.
In the industrial sector, developers are busy, with 12.3 million square feet of space under construction. And despite the steady stream of new space coming on the market, the countywide vacancy rate in the third quarter remained unchanged from the second quarter, at 3.8 percent.
“That’s an extraordinarily tight number, and you’re going to continue to see the numbers very low in industrial,” Silvers said. “L.A. is increasing its presence as a transportation hub.”
Developers are also building new office space, but at a very cautious pace. About 3.7 million square feet of office space is under construction, a very small amount considering the county’s existing inventory of 163 million square feet.
“This is very disciplined development,” said Jim Biondi, senior vice president at Grubb & Ellis. “We’re not seeing the amount of speculative construction that we saw in the mid- to late-’80s. This time around, the capital sources are much more disciplined about funding speculative office projects.”
That “discipline,” however, is causing headaches for some tenants.
“Companies who are large tenants, who need six floors, they’re having a real problem,” Biondi said. “That’s why we’re seeing some of these projects coming online. It’s very difficult to find bulk space, full floors and up.”
The Westside continues to see its fair share of construction activity, with the looming development of Constellation Place expected to open up more than 400,000 square feet. Aside from new projects such as Wateridge Park and Howard Hughes Center, where Arden Realty Inc. is picking up the pace of construction, there’s not much going up right now. J.H. Snyder Co.’s Water Garden II is now almost fully leased.
“If you look at the Westside, there’s not that much being built. But in other markets there could be,” Miller said. “There’s a lot of product in the hopper that’s going to be built, and we’re going to see some markets like the West Valley in a potential oversupply situation next year.”
Indeed, the Conejo Valley is currently the most active L.A.-area submarket, in terms of new office construction, with 906,769 square feet under way, Grubb & Ellis reported.
Some projects expected to soon get going include MaguirePartners’ long-delayed 300,000-square-foot office complex at 611 Brand Blvd. in Glendale and the second phase of Plaza Los Fuentes in downtown Pasadena, a 350,000-square-foot project with a housing component across the street from TrizecHahn Development Corp.’s Paseo Colorado.
But other developers are expected to hold off.
“People who are not sure, who are on the bench, they may think twice right now,” Miller said.
When it comes to new construction, the South Bay is likely to move to the forefront in the coming months, where little construction has gone up so far. In Redondo Beach, American Standard Development Co.’s Tech Center is nearing completion. The four-story, 220,000-square-foot building has wiring and load capacity oriented to meet the needs of tech companies looking to move south.
Set to break ground in the next month or two is Continental Development Co.’s The Atrium at Continental Park in El Segundo. That project is designed to have two 138,000-square-foot office buildings; a 130,000-square-foot building on Grand Avenue in El Segundo built by Opus West Corp.; and a 170,000-square-foot building at OMA Properties’ Crosspointe at the 105 and 405 freeways.
Developers are clearly emboldened by the strong leasing action going on in the El Segundo/Manhattan Beach office submarket, which posted positive net absorption of 329,146 square feet in the third quarter. That was stronger than any other submarket in Los Angeles County.
