With the stock market vacillating and signs the economy is slowing down, many investors are looking to bricks and mortar as a safe haven. And the Los Angeles area in general and Westside in particular are viewed as among the choicest investment markets in the country.
After all, rents and occupancy rates have been moving up in the L.A. Basin, and relatively little new office, industrial or apartment space is under construction. Meanwhile, L.A.-area rents remain cheaper than in places such as San Francisco and New York City, meaning there may still be plenty of local upside potential.
Countering the strong fundamentals, however, are rising interest rates and some doubts that L.A.’s strong rental growth will continue. There’s also a lack of sure-fire moneymakers on the block at this point in the cycle and some investors are just getting pickier.
All of this makes for an interesting investment climate, both for the entrepreneurs and for the dominant investors at the upper end of the spectrum pension funds and the advisory firms that invest on their behalf.
“There are two contradictory forces working. On the one hand, you have the fact that, as mortgage money rises in cost, it’s harder and harder to make a project feasible,” said Allan Kotin, principal at real estate consulting firm PCR/Kotin. “On the other hand, because of fears about the stock market going south and the perception of L.A. as one of the healthier regional economies, equity people are more interested in L.A. Which way it will balance out? I don’t know.”
New market realities
Pension funds are the latest players to dominate the big pool of real estate investors, which has evolved amid changes in the economic climate and tax laws.
Up until the 1986 tax reform act, syndicates that sold shares in limited partnerships to wealthy individuals drove the real estate investment market. Life insurance companies also played a big role until they were forced by regulators to divest much of their holdings starting in 1991. The 1980s also saw the emergence of cash-flush thrifts, followed by the Japanese, who snapped up trophy properties all around Los Angeles and throughout the country.
Then came the real estate recession of the early 1990s and the rise of real estate investment trusts and Wall Street opportunity funds, which capitalized on the growth opportunities. Richard Ziman’s Arden Realty was especially adept at snapping up prime office buildings at bargain-basement prices.
But as the real estate market emerged from the recession, the bargains started disappearing and REIT shares took a slide. The recent stock uptick notwithstanding, REITs have since been largely sidelined, although Arden, Macerich Co., Spieker Properties and others have been able to make selective purchases. And some REITs, especially Arden, have become active developers.
Pension funds, meanwhile, have stepped up their activities and continue to provide much of the major capital for top-tier deals.
“Pension funds are buying real estate now. They’re the players,” said Gary Carpenter, executive vice president of U.S. operations for Vancouver-based Bentall Corp. “Because other players are out of the market, there’s an opportunity to step in without heavy competition.”
In many cases, pension funds made so much money in the stock market during the late-1990s’ run-up that they have found themselves under-allocated in real estate. They typically tap private investment and advisory firms, such as CB Richard Ellis Investors and Lowe Enterprises Investment Management, to put their money in real estate, following a host of criteria.
“With the huge run-up (in stocks), real estate has been huffing up the hill trying to catch up just in terms of keeping their percentage allocation of the whole fund,” said Bleecker Seaman, executive vice president at Lowe.
In general, pension funds are only interested in the very best buildings on the market.
“For quality stuff, pension funds have found the field left to themselves,” said William Puget of Cushman Realty Corp. “If it doesn’t fit their criteria, they’re not interested. That leaves the balance of the field to people who are more price-conscious.”
Still, pension funds have gradually become more aggressive real estate investors, branching out from core assets to the inner city and more “opportunistic” plays. Opportunistic plays involve buying undervalued assets often outdated buildings with high vacancies and low rents and undertaking major renovations that will draw new tenants at higher rents.
“(Pension funds) are looking for enhanced yields from management-intensive properties,” said Richard Pink, vice chairman of CB Richard Ellis Investors. “They’re willing to do redevelopment and repositioning and take more risk than pension funds traditionally have.”
German investors have also made inroads as the next major foreign investors in U.S. real estate, succeeding the Asian investors who were active in the late 1980s. But the Germans have concentrated mainly on the East Coast, as well as Chicago and San Francisco. Until the German currency stabilizes, real estate observers don’t expect those investors to be major buyers of L.A.-area properties.
On a lower-profile level, private and individual investors continue to invest in real estate, although smaller investors will be hit hardest by the recent rise in interest rates. These buyers run the gamut from working people with a few thousand dollars to invest, to trade buyers looking for a tax advantage, to multimillionaires looking to diversify some stock winnings and entrepreneurs looking for “value-added” deals.
“You have to remember also that most real estate is not institutional quality, either because of age or size or use,” said George Smith, CEO of George Smith Partners. “Most of what gets bought and sold is that 32-unit apartment house, that 40,000-square-foot center, that 15-year-old industrial property. That’s really the guts of the real estate market in terms of where most of the transactional activity and value is.”
But Smith noted that even that market is fully priced relative to risk at present.
“The expectations on the sellers’ side vs. that class of buyers probably has a half to a 1 percent pricing spread,” Smith said.
In the current market, buyers don’t anticipate huge growth in rents and values. Earlier in the cycle, buyers were willing to pay more, and therefore accept a lower initial return, because they were betting that the asset would appreciate substantially over time.
“Generally, investors see the market as fairly boring, at equilibrium. The only way to make money is active management,” Pink said. Active management typically involves increasing a building’s occupancy rate at higher rents.
Dearth of no-brainer deals
Several prominent L.A.-area properties have traded hands recently and others are currently up for sale. While the sellers would like to put their sales proceeds back to work in other properties with upside potential, the opportunities are much slimmer than they were a few years ago, and entitled land for development, while also desirable, is hard to come by.
That difficulty in obtaining entitlements suggests that overbuilding will not pose a big threat, as it did in the 1980s. Even entitlements in outlying areas are tough to come by, as evidenced by the trouble Newhall Land and Farming Co. has been having with getting its massive Newhall Ranch project off the ground.
As a result, entitled land has become a hot commodity.
“Demand for space is as high as ever, so every time we find land for sale, it gets purchased for high prices,” said Jim Kinetz, senior vice president at Lee & Associates. “There’s more money than product.”
A lot of the investment activity of the mid-to-late 1990s was generated by opportunity funds and contrarian investors who snapped up properties, fixed them up, raised occupancies and sold out at healthy profits. But as the market has recovered, such opportunities have dwindled.
“There’s still a huge reservoir of capital available to supply value-added investors with debt and equity financing, but the opportunities have almost vanished,” Puget said. “In part because of the economy, there are far fewer vacant buildings.”
It’s not just that the low fruit has been picked from the tree, but “all the ripe fruit anywhere has been picked from the tree,” Kotin said. A lot of funds are taking equity positions in new developments because the prices of existing properties are too high to achieve their targeted returns, he said.
Some buyers have simply become more picky. Where there would be 10-12 bids on a property in 1997 and 1998, there are now five or six, said David McKenney, senior vice president at CB Richard Ellis.
“What we’re seeing is, there’s a lot of capital available for investment, but it’s become more selective,” McKenney said. “The competition is intense, but there are fewer players.”
In short, opportunities are scarcer, but they exist for those willing to search diligently, said one value-added player.
“I think certainly the easier, more-obvious buildings have been purchased,” said Stephen Muller, president of the Muller Co., which last summer paid $32 million for a Torrance office park it has been fixing up. “The sophisticated, knowledgeable guys can stay busy now.”
Boding well for the L.A. market is that real estate fundamentals remain strong, and there are still enough investors who think there is more room for growth, setting the stage for continued investment sales activity in the coming months.
Among the choice properties for sale are Marvin Davis’ Fox Plaza in Century City and The Tower in Westwood, owned by Tishman Speyer Properties.
“If there’s a good story behind a piece of real estate today in California, it is readily sought after,” said Marc Renard with Cushman & Wakefield.
Charles Bruni, senior vice president of investment banking at Jones Lang LaSalle, agreed.
“If you have good product,” Bruni said, “there’s still a lot of investors.”