Investors’ Willingness to Accept Lower Returns Prompts Churn

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In what may turn out to be a record year for office building sales, investors in 2004 continued to drive up prices on Los Angeles County commercial properties, despite only marginally improving rental conditions.


The returns buyers are willing to accept on commercial real estate investments have grown even smaller in the past year, according to real estate economists at both USC and UCLA.


While final sales are still being tabulated, cumulative transaction values last year will likely top the $4.14 billion set in 2003 a high not seen since the late 1980s, according to trade publication Real Estate Alert.


But vacancy rates and average asking rents which ultimately determine the returns a building can generate have remained relatively unchanged, according to fourth quarter data from Grubb & Ellis Co.


At $2.45 a foot, average L.A. County asking rents are only 2 cents higher than they were a year ago. And despite landlords countywide filling 2.8 million square feet of vacant office space in the fourth quarter, the county’s 14.8 percent vacancy level has fallen only 1.4 percent in the past year.


Richard Ziman, chairman chief executive of the county’s biggest landlord, Arden Realty Inc., said real estate investors have accepted that they will have to pay more for office properties, even though the financials may not have improved much.


“It’s a new market,” he said. “It’s understood we can’t buy buildings at the (rates) we used to. I don’t see that changing for several more years.”



Changed formula


In years past, buyers of commercial buildings would have expected to pay prices that would have resulted in a 9 percent return on the investment, based on a measurement of incoming rents minus costs. Today, that number has shrunk to between 6 percent and 7 percent.


In three recent deals in diverse L.A. County submarkets, investors accepted returns ranging from below 5 percent to less than 7 percent, according to Real Estate Alert. They are Beacon Capital Partners Inc.’s $133.5 million purchase of Figueroa Plaza in downtown Los Angeles; Broadway Real Estate Partners LLC’s $151 million buy of Wilshire Rodeo Plaza in Beverly Hills and American Realty Advisors Inc.’s $34.3 million deal for 200 S. Los Robles in Pasadena.


Stuart Gabriel, director of the USC Lusk Center for Real Estate, said investors are willing to pay high prices because of their confidence in the market’s future and easy access to low-interest financing.


With the economy beginning to post positive job-growth numbers, investors are banking on companies expanding their operations in the near term.

“It’s a bet,” Gabriel said. “It’s a bet the funding environment will continue to be attractive and there will be high demand for these properties in the future.”


Grubb & Ellis is forecasting a tightening of the leasing market in 2005, with demand spiking by mid-year, especially in already-tight markets such as North County, Tri-Cities and Wilshire Center.


“Certainly in markets with the lowest vacancy, those are the ones where things will continue to tighten and where increased demand will have the greatest effect on rents,” said J.C. Casillas, Grubb & Ellis’ L.A. research director.


There is some danger that the prices investors are paying for real estate are too high, Gabriel said. If rents and occupancies don’t improve, the values of the buildings may fall and investors could end up losing money. “It’s fair to say, if nothing else, real estate markets are priced to perfection,” he said. “In other words, the risk is abundant.”



Clouds on horizon


Foremost is the possibility that the U.S. trade and budget deficits will lead to interest rate hikes that would constrict the flow of capital into the real estate market, Gabriel said.


“The trade deficit is not a deficit; it’s an abyss,” he said. “It’s a black hole at an unprecedented 6 percent of GDP and our budget deficit isn’t far behind.”


Should the confidence of foreign lenders become shaken, Gabriel said interest rates could rise dramatically. “There would be an upward adjustment in interest rates that would have a dramatic affect on real estate in different sectors,” he said.


Despite possible interest rate hikes and a fragile economic recovery, Stephen Cauley, a professor of real estate investment at UCLA’s Anderson School, doesn’t see the tempo of the market changing anytime soon.


Los Angeles commercial real estate will continue to attract high prices, he explained, because of the number of large pension funds are looking to buy in the market.


“Pension funds are looking for an alternative investment and real estate is increasingly looking good because the fundamentals are better,” Cauley said. “It’s incredibly costly to build new real estate in California so when the economy picks up they stand to gain.”


Gabriel said that a weakening dollar a byproduct of the twin deficits may cause foreign investors holding the euro or Japanese yen to enter the U.S. real estate market in 2005.


The exchange rate gives Europeans, in particular, an ability to buy up properties at a lower cost than their U.S. competitors. Gabriel said the influx could potentially be on the scale of Japanese investment in L.A. real estate in the early 1990s.


“It’s something we are watching closely with some anticipation that there is going to be an increase, given the fluctuation in exchange rates,” he said.

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