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Tough times for California's commercial real estate market

by Greg Lucas, published

The signs can be seen almost everywhere. Downtown Sacramento. San Diego. Either side of Lincoln Boulevard between Marina del Rey and Santa Monica. Along the Wilshire Boulevard corridor, from downtown Los Angeles to the coast. Walnut Creek. Pleasanton. Riverside. Fresno. Eureka. Santa Rosa. Napa. Even Olive Mills Road, one of the main drags of tony Montecito near Santa Barbara. Each are phrased a little different: “Space for Lease.” “Retail/Office Space Available.” “For Sale." The state of the Golden State’s commercial real estate market is anything but golden.

Through June, vacancy rates in the Fresno area averaged 15.6 percent. Concord in Contra Costa County has 845,000 of its 3.7 million available retail and office square footage empty – a vacancy rate of nearly 23 percent. Downtown Los Angeles has a 15.7 percent vacancy rate. In Riverside, the vacancy rate is 26.4 percent. Sacramento is closing in on 20 percent. Nationally, the vacancy rate averages 12 percent, according to Grubb & Ellis’ 2010 forecast of the commercial real estate market. In 2009, there were almost no building permits issued for office or industrial projects in San Diego, Orange County and Los Angeles. The same for San Francisco and the Silicon Valley.

The midyear look at construction by the American Institute of Architects predicts spending on non-residential construction nationwide will fall more than 20 percent this year with hotel construction down 43 percent and office construction down 29 percent. Depending on the analyst or forecast, improvement isn’t expected until, at best, 2011 or 2012.

     “As the recovery from this deep recession takes hold, investors in commercial real estate are increasingly of the view that 2012 is going to represent an improvement,” wrote Jerry Nickelsburg, senior economist for the University of California at Los Angeles Anderson Forecast, in January 2010’s California Commercial Real Estate Survey. “To be sure, the commercial real estate market has not turned but optimism about the future, a precursor to a turn in the market, certainly has.”

Put another way: The “good” news is the commercial real estate market has likely hit bottom.

“At some point you’ll have to see improvement because the numbers are so low you can’t go lower,” said Dennis Meyers, principal economist for the state Department of Finance. “We’d like to say there’s great upward potential. But without job growth you’re not going to see offices fill up.”

California’s commercial real estate market is whipsawed by an economic Catch-22. When recession-ravaged businesses closed their doors, vacancy rates shot up. Most businesses that survived shed employees, lowering demand for space. In other attempts to reduce their bottom-line, many employers sought cheaper space or a better deal from landlords, driving down rental rates. In upscale Westwood and Santa Monica, for example, rents have declined by 30 percent since 2008, according to a Grubb & Ellis second quarter 2010 report on the Los Angeles commercial real estate market.

But while commercial real estate’s hammering is a by-product of the recession, its comeback is necessary in order for the state to come back. While home building employs more people -- and its collapse was felt more immediately and profoundly -- empty office and warehouse space is a major hamper to the state’s economic recovery. In the midyear economic forecast of California State University at Fullerton’s Mihaylo College of Business and Economics, commercial real estate is cited as one of the three key forces dragging the recovery.  “It is necessary for (commercial real estate) to turn around for a continued recovery,” wrote Anil Puri and Mira Farka, the forecast’s authors.  But they conclude the picture for commercial real estate is “likely to get worse before it improves.” Like the recession as a whole, the areas hardest hit in the commercial real estate market are the Central Valley and Inland Empire.  Almost one fourth of the 28 million square feet of commercial space in the Ontario, Riverside and San Bernardino area is empty.  “General demand remains spotty at best,” Grubb & Ellis’ second quarter 2010 report notes dryly. In Fresno, no new construction occurred between April and June of this year. Space reductions and office closures have pushed up vacancy rates by throwing more sublease space on the market.

Commercial real estate prices have fallen 40 percent from 2007.  “There should be little change in the next quarter as the market treads water in what is hoped to be the final stages of the recession,” Grubb & Ellis says.  While hitting bottom isn’t exactly “good” news, it does offer “great upward potential,” as Meyers calls it.  He and other forecasters see some positive signs, although mainly in coastal areas – particularly Southern CaliforniaA key improvement is that the ports of Los Angeles and Long Beach are busier. Grubb & Ellis notes that, through June, activity at the ports has increased for four straight months. In part, the boost comes from other countries gradually recovering from the recession and stateside retailers replenishing their inventory.  “If port-related activities heat up enough that will heat up the demand for office and storage space,” Meyers said.  That’s been the case for the port-dependent South Bay area of Los Angles County.  Sales and leasing activity there of warehouse and other industrial space rose 95 percent year-over-year, according to Grubb & Ellis.

Not all segments of the economy are contracting, though. Some are growing – and looking for office and retail space. Growth sectors include for-profit educators, lawyers, health care and, in some areas, the state and federal government.  In Sacramento, for example, one of the largest leasing transactions of 2009 was for 227,000 square feet of downtown office space for the U.S. Army Corps of Engineers.  The state of California’s “Department of General Services continues to solicit office space for expanding state agencies in virtually every submarket” of the Sacramento area, Grubb & Ellis writes in its 2010 forecast for Northern California and the Central Valley.

But despite the modest positive signs in both the state and national economy, recovery for commercial real estate -- demand for office space and new construction -- traditionally lags behind the general recovery by six or more months because, as Meyers says, more jobs need to be added before more space is needed.  Meaning that hitting bottom isn’t the same as recovering.

“We’re forecasting that vacancies will be declining and rents will be appreciating across all property types by the middle of next year,” Brett White, CEO of CB Richard Ellis told the Los Angeles Times in a September 13 interview.

     “Recovery will be incremental because job growth is so anemic. Companies are doing anything they can to increase production without hiring more people. Most companies just got done letting go hundreds, if not thousands, of employees. That’s a painful, gut-wrenching process.”

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