CALIFORNIA CRE TRENDS COVERAGE
Investors, lenders see golden opportunities in California’s commercial real estate market
Investors have enthusiastically returned to California’s commercial real estate market, with lenders right behind them. That message came through loud and clear during the California Commercial Real Estate Trends conference, hosted by France Media’s InterFace Conference Group on Tuesday, Sept. 23, at the Omni Hotel in Downtown Los Angeles.
During his keynote address before more than 400 attendees, Christopher Thornberg, founding partner of Beacon Economics, said California is one of the fastest-growing economies in the country due to a confluence of factors.
“The [economic] fundamentals are good,” Thornberg said. “Employment and income are growing. Wealth is at a new high. Consumer credit is starting to expand. Savings are steady. Foreclosures are down. Homeownership is stable. Mortgage lenders are loosening. Interest rates are low. There are no signs of inflation.”
California’s unemployment rate stood at 7.4 percent in June, down from 9 percent just a year earlier, according to the state’s Economic Development Department. California’s mortgage default rate has also fallen dramatically. It hit an eight-year low at the end of last year, with only 18,120 Notices of Default recorded by lenders, according to DataQuick. This was down 10.8 percent from the third quarter of 2013, and down 52.6 percent from the last quarter of 2012. Meanwhile, the state’s residents still enjoy a healthy median household income of $60,883, compared to the national average of $51,914, according to RealtyTrac.
Flexible, Nimble Lenders Emerge
Aggressive bidding by investors for well-stabilized properties has certainly limited the potential for bargains in California, but it has also caused lenders to loosen their purse strings following the Great Recession, concluded a panel of industry experts during the “Emerging Capital Market Trends” breakout session.
“There is a lot of capital chasing deals,” said panelist Alexa Lauren Mizrahi, a loan originator at Lone Oak Fund. “To stay competitive, you have to be flexible. In the past two to three years we’ve been bringing in junior lenders and secondary financing for borrowers to obtain funds if they need it. We’re lending 50 percent, they’re coming in with 25 percent cash and we’re bringing in a secondary lender who can do the remaining 25 percent. We only do first trust deeds, but we’ll help source a second trust deed. We’ll do it free of charge.”
Fellow panelist Dan Borland, chairman, CEO and president of Opus Bank, noted his company has also changed its strategy to ensure it’s ready to act if a client has a deal he or she needs to jump on.
“Now we do tech, value-add, healthcare real estate,” he said. “We want to be right there with a client so it can take advantage of any opportunity. Today you have to be very nimble, and your expertise has to broaden. You have to be able to provide capital to non-stable assets as well.”
The idea of being flexible and nimble to remain competitive not only extends to lenders, but to investors as well. With so much capital chasing deals, many experts believe they have to take a creative approach and see the potential for opportunity down the road.
“Institutional investors are happy with 3, 4 and 5 percent cap rates,” said Jeff Hudson, the panel’s moderator and a principal at George Elkins Mortgage Banking. “Investors nowadays are trying to create value, as opposed to trying to buy core value.”
Rick Putnam, managing director of Colliers’ Western region capital market group, agreed.
“There is a lot of capital focused on, and demand for, value-add deals,” he said. “The real focus in today’s value-add space is on a low price per pound, good land positioning, good per-key positioning. Yields have come up over the past three years. They’re now in the mid- to high-teens when you’re talking value-add returns.”
Lenders Feel Borrowers’ Pain
The eagerness lending panelists expressed when it came to assisting borrowers in today’s market may seem surprising to some, considering the recent downturn and the harsh lessons many – on both sides of the fence – had to suffer through just a few years ago. Participants expressed, however, that they were empathetic to many affected by the Great Recession. They realized many honest people were the victims of a market with poor fundamentals.
“We all know what happened in 2008,” Borland said. “Good people had bad things happen to them. This is about peeling back the layers of that onion and figuring out what occurred. You have to ask, ‘What in the world did the guy do?’ If a client did everything he could to save his asset and retain cash and did everything honorable but a bad thing happened, we’ll study what happened. You have to study, listen, learn. Anything involving criminal activity, felonies or fraud we won’t deal with.”
While the borrowers behind the projects are obviously very important, Paul Rahimian, a private lender at Parkview Financial, pointed out that many times the decision often comes down to the project or property in question.
“The majority of borrowers have some issue,” he said. “[Maybe] they had a failure in 2008 and banks don’t want to touch them. As long as the asset has equity and we like the project, we’ll do the deal.”
That’s not to say lenders have forgotten all about 2008. Though they acknowledge and appreciate the excitement that has returned to the market, they are mindful that conditions will turn around again at some point. And they want to be ready for it.
“The concern is where we’re at in this cycle now,” Rahimian said. “We don’t want to be so bullish that we get to the 2007 mark and don’t know it until it’s too late.”
Competition Turns Fierce in the State’s Top Markets
Panelists believed there are many positive signs on the horizon for most of the product types across California: rents are rising, many markets now favor landlords, and demand has gotten so fierce that prices have reached record levels.
Caution usually follows such optimism and enthusiasm, however. Foreign money is snatching up the most favorably priced deals, leading many to worry about a negative shift in market fundamentals.
“There is lots of capital chasing deals,” Mizrahi said. “A major concern is whether values are being inflated because foreign investors from China and Russia are buying properties that, for them, are very cheap when you factor in the pricing of the dollar. They’re not concerned about cap rates, and that is a concern.”
The Great Land Grab
Foreign investors, e-commerce companies and major tech companies are some of the biggest players in California’s market today, according to many panelists. Vacant land, property along the coast and any value-add opportunities ripe for conversion are attracting the strongest investor demand.
Once again, this is good news for some asset classes, such as multifamily, retail and office, but their gains have been at the expense of much needed industrial space.
“This is the great land grab where everyone is trying to get land positions,” said Barbara Emmons, vice chairman of CBRE Los Angeles and a “Commercial Real Estate Investment Trends” panelist. “We’re seeing record prices. Current deals are above peak land values. If a site becomes available, people are really looking at whether it can have multifamily or retail potential. We have a big supply issue. We don’t have enough supply. It’s trading at a 4 to 4.5 percent cap rate. I never thought I’d say that two to three years ago. California is a market where people don’t want to part with their real estate.”
Industrial space and other Class B and Class C buildings that can be converted into creative office space is the hottest product on Los Angeles’ Westside, particularly in Silicon Beach.
“We are seeing behemoths of the tech industry wanting to be a part of Silicon Beach,” said Eric Olofson, executive vice chairman and managing broker of Cushman & Wakefield of California and a participant in the “State of California Real Estate Market” panel. “Any market on the Westside that touches the tech and media industries is doing quite well right now. In downtown Santa Monica, we’re seeing high-end space trade for $70 per square foot.”
Like the foreign investors, major tech companies are happy to spend whatever is necessary for the best spaces and the best locations, paying little mind to price tags, cap rates or the cost of build-outs, according to panel members.
“For the Westside, $70 per square foot is the highest number I’ve ever heard in my career,” said Bob Sonnenblick, principal of Sonnenblick Development and moderator of the “State of California Real Estate Market” panel.
Record-breaking rents and sales prices don’t just abound in Silicon Beach, however. The same trends are evident in the office space around Fashion Island in Newport Beach, in the life sciences corridors in San Diego and in San Francisco’s South of Market (SOMA) district.
“This market is a case of the haves and have-nots,” said David Marino, executive vice president of Hughes Marino and an “Office Trends” panelist. “Landlords with vision and capital are winning right now. Tech companies will pay whatever it costs for cool space. Rent is about 4 percent of their cost structure. If you look at tech companies and what they’ll spend on software, rent can be as little as 2 percent.”
This is good news for landlords and any investor who can nab an underutilized space with potential, especially if that space contains bricks, high ceilings and circular ducts. However, this newfound popularity also reminds many of a bust that occurred not too long ago.
“On the surface, this market may smell a little bit like the late ’90s,” Marino said. “But companies like the eToys of the world had business plans and hundreds of employees, but no revenue or customers. Today’s landlord is looking at these tenants and it’s a different kind of tenant than 15 years ago. They don’t have or need as much financing. They can do what they did with 220 employees with 20 employees. And they can do it for $2 million, rather than $20 million. We’re not seeing that many companies come in where landlords are regularly requiring guarantees.”
More Space, Less Absorption
Technological advances and the Internet have deeply impacted the retail and office markets. Many retailers require less space, while creative office tenants want the coolest spaces, but for fewer employees and with less space relegated to those employees.
“A bow truss ceiling can still get from $4 per square foot to $8 per square foot more if you’re an industrial conversion in Santa Monica,” said Tony Solomon, regional manager of Marcus & Millichap-Los Angeles and an “Office Trends” panelist. “These types of conversions are attractive to Millennials, and the rents have gotten to the level where it makes sense for those who can afford to do it. But the workplace is evolving and space use is going down. Pressure on these spaces is going to increase. The number of employees going into these spaces is going to compress, creating less absorption.”
Employers flush with cash who can spend the money on prime locations have one priority in mind: keeping employees happy. That’s particularly the case in markets where competition for talent is fierce.
“At the end of the day, rent is a small part of the equation for these firms,” said Olofson. “The real war is attracting the talent and creative types. Location is a part of that because you have spillover when the area also offers residential and nightlife components. People live where they work. They’re not using their cars as much.”
Downtown Los Angeles, Pasadena, Newport Beach and Santa Monica have benefited the most from this trend, though there are still plenty of investors, residents and employers who haven’t been able to take advantage due to many factors.
“This is an extraordinary recovery,” said Kim Snyder, president of Prologis’ Western region and a “Commercial Real Estate Investment Trends” panelist. “This is a build cycle. It doesn’t feel like a buy cycle anymore. It was three years ago, but there is massive compression on cap rates. The barriers to entry are meaningful and they keep getting more difficult. There is tremendous demand at the end of the day, and a massive inflow of capital that continues to drive cap rates down. The trend is going to keep building, and it just gets tougher and tougher and a little more expensive.”