s sales and rental rates for office buildings in the country’s gateway cities such as New York and San Francisco reach near-peak levels, real estate investors are increasingly viewing Los Angeles as the office market with the most upside in the next few years.
The regional investment market is showing substantive signs of recovery – particularly in Santa Monica and downtown Los Angeles – and has reached numbers not seen since the height of the market in the last decade.
As a result, a recent feeding frenzy that has seen Class A office buildings trade hands is expected to continue for the next couple of years as the regional economy continues to improve.
In the latest example, Menlo Park private equity investor GI Partners bought downtown’s One Wilshire office tower for a record $438 million. In the process, it paid a 52 percent premium over the price seller Hines paid for the property in 2007 and set a record for the downtown market in both total sale price and, at $660, price per square foot.
Year-over-year sales of Class A office buildings more than doubled in the first six months of this year, reaching more than $2 billion, according to data from CoStar Group Inc.
“Our (prices) look relatively attractive compared to San Francisco or New York’s, and our economy is only just starting to pick up momentum,” said Michael Zeitsman, managing director and regional head of the southwestern capital markets group at Jones Lang LaSalle Inc.’s downtown L.A. office. “Investors see potential for vacancy to come down and rental rates to starting rising. We might not catch up with San Francisco, but we have a long runway in terms of potential for rents to increase.”
Buyers drawn to the market run the gamut, from owner-users to real estate investment trusts and out-of-town investment companies. Their interests are likewise diverse: Through the first half of the year, they have snatched up everything from downtown’s iconic U.S. Bank Tower – the tallest building on the West Coast – to a four-building Class A creative office complex in the beachside Playa Vista neighborhood.
The increased interest in the buildings has pushed prices up through the first six months of the year to an average of $327 a square foot, a 25 percent increase over the same period a year ago.
Booming sales
For the first half of this year, 37 transactions, with an aggregate value of $2.15 billion were closed, according to CoStar.
In the same period last year, only 15 transactions, with a total value of $697 million, were booked.
The first six months marked the first time since the height of the building-buying frenzy last decade that sales numbers have been so strong.
About $4.9 billion worth of office buildings traded hands in 2006 – roughly $2.45 billion over a half-year – roughly the same size of market the first six months of this year. The peak year for transactions was 2007, when $6 billion in deals were done.
Michael Soto, research manager at the downtown office of real estate brokerage Transwestern, said buyers are looking not only at trophy buildings but also at lesser buildings in prime locations that have potential to see increased value.
“You are seeing buildings all over the region being acquired,” Soto said. “It runs the gamut of the investment spectrum of core stuff and value-add stuff.”
Among the properties acquired this year, New York hedge fund Angelo Gordon & Co. bought two of downtown Long Beach’s most notable office towers: 200 and 300 Oceangate. It acquired the properties as well as an Ohio building for $159 million, or $255 a square foot, from Molina Healthcare Inc., which occupies a majority of space in the properties.
In Westwood, an affiliate of Zurich Insurance bought a nearly fully occupied 94,000-square-foot Class A office building at 10780 Santa Monica Blvd. for $27 million, or $286 a square foot, in April from Angelo Gordon.
Lincoln Property Co., a Dallas developer and real estate investor, has been among the most active in the market recently. The firm, which owns about 12 million square feet across Southern California, about half of which is in the L.A. area, has closed on at least four deals here in the last six months – and is looking for more.
David Binswanger, executive vice president of Lincoln in Southern California, said the company, like many that have purchased office buildings here this year, sees opportunity in buying properties that cater to growth industries such as tech and entertainment, and particularly buildings that require a little upgrading, allowing the company to add value.
Among its purchases this year, Lincoln bought the Desmond Building, a former Willys-Overland Co.’s car dealership and assembly plant, at 11th and Hope streets from Evoq Properties Inc. for $16.3 million. It is planning to spend an additional $16 million to renovate the nearly 100-year-old building into a creative office complex. The vacant five-story, 78,500-square-foot building sits in the heart of popular and gentrifying South Park, just two blocks east of the Staples Center and L.A. Live.
Strong fundamentals
During the recession, tenants – at least those that stayed in business – typically renewed leases for short terms and often gave back space.
But building owners report that tenants today are more interested in signing longer-term leases and taking additional space – at least in the core markets of downtown, Hollywood and throughout the Westside.
That core-market strength has helped offset weakness in some other areas. As a result, the Los Angeles County office vacancy rate was a still-high 17.5 percent in the second quarter, or about where it has been in recent years.
The strengthening in the core markets can be seen in large leases, such as the 300,000-square-foot lease in Playa Vista being negotiated by video-game maker Riot Games Inc.
Rental rates, one of the best ways to measure the strength of an office market, have been getting stronger – rising by 4 cents over the last year to $2.92 a square foot in the second quarter. In prime locations such as Santa Monica and Hollywood, rates are moving more quickly.
For example, Santa Monica posted a 22 cent year-over-year increase in rates to $4.61 in the second quarter; 63 cents since second quarter 2010. In Hollywood, asking rents rose by 40 cents year-over-year, to $3.32 a square foot.
That’s giving investors confidence, as they expect rising rents to pull more companies from the sidelines to sign leases.
The confidence can be seen in lower capitalization rates, which are used to estimate a buyer’s return on investment by calculating the property’s annual income divided by its value.
Higher cap rates mean a greater return on investment. However, cap rates are kind of like bond rates: The higher they go, the more risk they carry. Rising cap rates can imply that building values are sagging as well.
Investors report that they are now getting typical cap rates of about 5.5 percent for high-quality office buildings in Los Angeles, rates not seen since 2007 and a dramatic improvement from the 7.5 percent rate seen at the bottom of the downturn.
Zeitsman said with improving fundamentals and values in the office market, he doesn’t expect cap rates to begin to climb anytime soon.
“The expectation is people are going to benefit from rising returns as we start to see rental growth in the market,” he said. “It’s always impossible to predict but (cap rates) don’t seem to be going up anytime soon. It’s great for the market.”
There is the sense that while the market is trending in the right direction, there is still room for upside.
“You don’t want to invest in markets after they’ve recovered: That’s too late,” Binswanger said. “San Francisco is in its seventh inning of the recovery while L.A. is in its second or third, so it has more legs to go up and is a good relative value to other markets that have recovered.”
One of the players that has moved aggressively in that regard is L.A. developer and investor Ratkovich Co., which closed on Macy’s Plaza, a 1.5 million-square-foot shopping center with adjacent hotel and office building in downtown, for $241 million in May.
The property at 700 S. Flower St., formerly owned by Jamison Services Inc., hadn’t been maintained or upgraded since shortly after it was built in the 1970s. Ratkovich made an off-market bid for the property and now is planning a $160 million renovation to the property to make it more attractive to tenants.
The company, which already owns some of L.A.’s well-known properties like the Variety Building at 5900 Wilshire Blvd. and the Hercules Campus in Playa Vista, a former Howard Hughes aerospace facility, wouldn’t have been as aggressive in its move to acquire the property if it weren’t for the improving economy and location.
“For a while, it was a case of pay attention to what you have and make sure you survive rather than spread your wings too broadly,” said Wayne Ratkovich, chief executive of Ratkovich. “But we have gone through that down period and are a little more attentive (to expanding our portfolio) now.”
Soaring prices
It’s telling, however, that Ratkovich acquired Macy’s Plaza through an off-market deal after scouring downtown for a promising property.
Little has come on the market in recent years that hasn’t been distressed or poor quality as building owners waited out depressed valuations. Many of the high-quality buildings that have been sold were being marketed by owners who needed to exit the properties quickly.
The high-profile sale in June of downtown’s U.S. Bank Tower is a good example.
The 72-story building, the tallest west of the Mississippi River, is one of the best-known on the L.A. skyline, but its soon-to-be defunct owner, downtown real estate investor MPG Office Trust Inc., was pressured to sell under the weight of mountains of debt and possible default. Singapore investor Overseas Union Enterprise Ltd. purchased it and an adjacent parking garage for $367 million.
Though 40 percent vacant – among the highest downtown – the building’s location, its Pei Cobb Freed & Partners design and its towering presence make it one of the city’s most prized buildings. OUE is betting it can bring occupancy and rental rates up substantially, in the end owning not only a trophy property, but one that generates strong income as well.
While the June sale was at the time the highest total price paid for a downtown office building this year, it was still a bargain compared with deals struck globally, according to Kevin Shannon, managing director of CBRE Group Inc.’s El Segundo office, who represented the buyer in the purchase.
“The biggest attraction of U.S. Bank Tower was the price-per-square-foot advantage, not only compared to New York and San Francisco but Singapore and Hong Kong,” Shannon said. “They are looking at opportunities globally and made the determination that this is a great opportunity. Where can you get that kind of Class A trophy for that price per square foot? That doesn’t exist elsewhere.”
How long that advantage lasts is a question.
The combination of limited inventory and deep demand has been bidding up prices – through the first half of the year investment sales averaged $327 a square foot, a 25 percent spike from the average of $261 a square foot in the same period last year.
“We have what I would call a demand-supply imbalance in terms of investors looking to acquire high-quality buildings in L.A.,” Zeitsman said. “Investors are paying a scarcity premium for assets that do come available for sale.”
For instance, Lincoln sold its Playa Vista Plaza, an 89,000-square-foot office building, to Ocean West Capital Partners LLC for $27 million, or $302 a square foot. That’s a 60 percent boost from the $189 a square foot ($16.9 million) paid for the property in 2006.
But the highest price-per-square-foot on the Westside this year was seen in the sale of Campus at Playa Vista, a 340,000-square-foot, four-building, Class A office campus. An affiliate of Houston real estate investment trust Hines acquired the three-year-old complex for $218 million – or a steep $643 a square foot – from Tishman Speyer Properties Inc.
It helps that the campus properties boast the large, open floor plans and floor-to-ceiling windows popular among today’s office tenants, and are in a desirable near-beachside location already popular with tech firms like YouTube LLC and Microsoft Inc., has ample housing nearby and is poised to see a new shopping center completed next year.
As prices continue to rise, however, more and more would-be sellers are getting the confidence to put their properties on the market. Binswanger said Lincoln is already combing through its L.A. portfolio to see what else it can sell.
That is expected to continue to fuel the office sales market here, though it might slow the pace of sale price escalation.
Increased financing
Those numbers are starting to warm the capital markets again.
Brian Halpern, executive vice president of CBRE’s debt and equity finance division in Century City, said financing is coming from traditional sources such as banks or institutional investors such as pension or life insurance funds. Even commercial mortgage-backed securities, similar to the residential mortgage-backed securities that fueled the debt crisis, are making a comeback after two years on ice.
“CMBS is a big positive,” Halpern said. “That’s the one lender profile we lost in the crash, and they’ve come back pretty strong over the last two years.”
He said buyers today can finance up to 75 percent of a building’s cost.
Interest rates have been low – around 2 percent for floating rates and 3 percent to 4 percent for fixed rates, he said. But recent news that federal stimulus policies that have been bolstering the economy might be pulled back next year has sent rates up.
In some cases, they’ve risen nearly a full percentage point.
It’s too soon to tell if this will impact the buying market. Some speculate it could have a cooling effect, but won’t fundamentally slow the velocity of sales here.
“Buyers anticipate rates would move up; it was a matter of when not if,” Halpern said. “The pace of the run-up was just faster than we thought, but capital has adjusted to it quickly. Look at the 10-year Treasury at around 2.5 percent: If you would have woken up from a decade’s sleep in the last eight months, you would be doing cartwheels.”
Even if financing is affordable, investing here doesn’t come without risk, according to Jed Reagan, analyst at Green Street Advisors.
Los Angeles has yet to prove that it will match the growth of San Francisco and Seattle, with its booming tech scene and companies such as Amazon Inc. gobbling up hundreds of thousands of square feet. But the fact that Los Angeles is home to a more diversified business base might have its own benefits.
“Tech has a number of pretty big swings over the past 15 to 20 years, so you see that reflected in the real estate market in the Bay Area, which has been a very volatile market to invest in,” Reagan said. “L.A. has been not quite as volatile … and is more diversified. The greater breadth of L.A. adds some benefit but the trade-off is the economy has been slower to recover here.”
