“I am going to become California’s job tsar,” Arnold Schwarzenegger announced in his state-of-the-state address this month.
The Hollywood hard man and newly elected governor has taken on a big challenge: sorting out the world’s fifth-largest economy. It’s been spluttering badly since the technology sector imploded three years ago.
At 6%, unemployment is running higher than the national average. Moreover, in recent years, companies have fled California’s high costs, moving to other states or outsourcing jobs to cheaper overseas locations, including India and China.
There’s also the small matter of a $14bn shortfall in the 2004-2005 state budget. Schwarzenegger is proposing to slash over $4bn in spending, with nearly half the belt-tightening hitting welfare programmes and the state’s health insurance plan for the poor and disabled. Another $1bn will be shifted from money set aside for transport improvements.
There will be no new taxes and Schwarzenegger is asking voters to approve a $15bn bond issue.
“California’s demography is very powerful. It has a big population and prospects of much higher growth relative to other parts of the US. That’s why we want to be here, investing,” says Mark Preston, president of Grosvenor USA.
“The good things about Schwarzenegger are that he’s a free agent and pro-business. Does that mean he will turn California around? I don’t know.”
Preston, like other investors in California’s real estate, has been looking for signs of an upturn “like an eagle”. And now there are a few. “There’s definitely more business being done,” he says. Vacancy rates are edging downwards in many office centres, and rent levels are stabilising after a three-year slide. Even Silicon Valley has seen the first net take-up of space in a long, long time (see box, p47).
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“Everybody’s confident that we’re just now turning the corner,” says CB Richard Ellis’s senior vice-president in Silicon Valley, Mark Schmidt. “Occupancy rates will probably be flat in the first two quarters of 2004, rental rates will probably stay flat, then we’ll see a slight uptick in Q3 and Q4.” |
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He’s perky because, after three years of continuously rising vacancies, the last quarter of 2003 saw a net take-up of 500,000 sq ft of office and R&D space. |
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But there’s still a lot of empty space to soak up in Silicon Valley 50m sq ft of offices/R&D, a 22% vacancy rate. Office rents are at rock bottom, having nosedived from a national high of $72-$84 per sq ft pa at the top of the tech boom to around $12-$14.40, while R&D space is leasing for as little as $9. |
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“When we have a downturn, it’s horrible, but Silicon Valley can recover quickly. We’re coming off a three-year low. I think things will start picking up in 2005 and 2006,” says Schmidt. |
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It all depends on investment and job growth in the technology industries. Silicon Valley’s collapse was the worst in a US metropolis since the Great Depression, with San Jose losing 18.5% of its jobs. |
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But now, Schmidt and some economists are calling the bottom of the market. Local tech companies are beginning to turn a profit. “Our bellwethers are Cisco and Intel,” says Smith. He points to recent take-up by semiconductor companies like Marvell (see investment box, p49) and smaller chip designers. Successful internet operators are also moving: the US auction site eBay expanded by 700,000 sq ft. And there’s been some steady growth from biotech companies. |
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These are the existing techie industries, but everyone is looking for the next big thing that will fire up Silicon Valley. The two new buzzwords are defence and nanotechnology. The US drive for homeland security means the government is throwing money at defence contractors and this means things such as sophisticated scanners and sniffers. Nanotechnology is what makes everything smaller and faster, shrinking mobile phones and speeding up computers. “The government’s putting $6bn-$7bn towards it, so we’re seeing a lot of instant start-up companies working on it,” notes Schmidt. |
“We’re starting to see more activity in the tenant market,” confirms Todd Doney, CB Richard Ellis’s man in Los Angeles. “Some are making commitments of five, 10 or 15 years, which they were hesitant to do before.”
However, it’s too early to talk of a recovery and there’s a north-south split to the office market: San Francisco, the Bay Area and Silicon Valley are in pretty bad shape. Taken together, they have 37.5m sq ft of vacant office space. And that’s not counting the “shadow space”, where tenants are paying rent but are not occupying the space.
“We’re not seeing a lot of demand, though there is some trading up, from class B to class A space,” says Marshall Lees, who heads Slough Estates’ US arm. Slough has a big slug of flexible office/service and light industrial space in the San Francisco Bay area, with some biotechnology space thrown in.
“Rents have come down,” says Lees. “But our portfolio has remained resilient through the traumas. A lot of our leasing was longer-term in the late 1990s, even on our conventional space.
Rents have probably reached bottom, and we’ll see recovery, provided there’s job growth and some demand for space.”
Indeed Schwarzenegger’s new home town, the state capital Sacramento, is a case in point. Cheaper than the Bay Area during the boom, it has attracted administrative/back office operations, with the state government being one of the big occupiers.
“Sacramento’s a more stable market. There hasn’t been a massive increase in vacancies. Rents are not far off the peak, but turnover is down,” says Robert Greacen, property director of UK & European, which has a business park there.
However, Sacramento’s fundamentals have been softening as some new development has come on stream. Average office rents have been stable at $19.80 per sq ft pa, shading down 20 cents or so towards the end of 2003, but they are expected to drop as another 500,000 sq ft comes to the market in the first half of this year.
“The Sacramento market is expected to weaken because of the state budget crisis. But the government moves so slowly that the decline may take a while to be visible,” notes Turner Newton, the chief executive of Capital & Counties USA. He has an office building there, a converted bank across the street from the state senate. “It’s unique there are practically no vacancies,” he says.
Southern California meaning Los Angeles, San Diego and Pasadena is in much better shape. Less dependent on the technology industries, and therefore experiencing less of a building boom in the late 1990s, the southern office centres have about half the vacancy rates of San Francisco and Silicon Valley.
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Location |
Av rent |
Vacancy |
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($ per sq ft pa) |
rate (%) |
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Sacramento |
19.80 |
12.7 |
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SF financial district |
29.70 |
19.9 |
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San Francisco (city) |
26.50 |
18.5 |
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SF peninsula |
27.70 |
24.1 |
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Silicon Valley |
27.10 |
19.0 |
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Los Angeles |
25.00 |
14.0 |
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Downtown LA |
22.60 |
17.0 |
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San Diego |
21.60 |
11.5 |
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Source: CBRE. Data applies to grade A space, at Dec 2003 |
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Americans have been on a credit-fuelled shopping spree. With retail sales growing nationally 5.6% last year, this sector of the property market has been holding up relatively well, especially when compared with the bombed-out office market. Grosvenor’s California portfolio includes two shops in San Francisco and a small unit on glitzy Rodeo Drive in Beverley Hills, and Mark Preston is looking for more of these downtown stores. “Proper downtown retail in the US is few and far between. The yields are not bad, in the low 7% band, so the gap with offices is not that great. But they are hard to come by.” |
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“Retail is hot right now,” agrees Bob Gilley, senior vice-president in CBRE’s investment team. “It’s tough to get hold of it’s performing for owners, there’s no reason to sell.” |
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Capital & Counties’ US arm is in the happy position of having 1.4m sq ft of the stuff in California. Its $260m worth includes the landmark Ghiradelli Square shopping and leisure centre in San Francisco (developed from a 19th-century chocolate and spice factory); the Serramonte Center, an 862,600 sq ft regional mall in the southern Bay Area; and, in southern California, a 112,000 sq ft shopping centre in Davis. |
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US turnover rents means that landlords’ income is tied to retailers’ performance. “Sales have been flat, but California is showing signs of coming out of recession,” says Capco USA’s CEO, Turner Newton. |
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Capco is opportunistic, looking for purchases where it can add value, rejigging leases, repositioning the tenant mix, or rezoning. But as Lees says:”The market is so heated up for retail it’s virtually impossible to buy on a basis we’re comfortable with.” |
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However, last year two big 1.3m sq ft malls did change hands in California. Simon Property Group paid $333m for a 51-year lease on the Stanford Shopping Center in Palo Alto. This mall has swanky shops like Neiman Marcus, and clocked up sales of over $500m in 2002. Also in the Bay Area, the Mills Corporation paid $265.5m for Milpitas’s Great Mall. |
Indeed, Moody’s Investor Services’ latest quarterly report on US commercial real estate markets ranks LA as the second strongest area, with nearby Ventura County, Orange County and San Diego also in the top 12.
UK & European’s Greacen also rates San Diego highly enough to be starting on a 400,000 sq ft office building, the first to be built downtown in more than a decade. Broadway 655 is 50% prelet, to Milberg Weiss Bershad Hynes & Lerach and two other law firms. “I know that market well. It’s very tight, there’s a demand for downtown. Rents are climbing,” he says.
Slough is also heavily involved in San Diego, with 1.4m sq ft of largely biotech space in the city. The developer is finishing off two campus buildings in its Torrey Pines Science Center for drugs company Pfizer.
“We’re looking at acquiring extra land, probably for more conventional development,” says Lees.
Los Angeles is so vast that it is really a collection of smaller submarkets. And some are doing better than others. In the north of the city, Ventura County has the tightest market in southern California, with an 8.8% vacancy rate. And in the most expensive locations Beverly Hills and Santa Monica in west LA rents actually ticked up 24 cents to $32.88 per sq ft towards the end of 2003.
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Given California’s real estate crash, you’d think yields would have moved out and there were some good bargains to be had. |
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Think again. California has the same sort of disconnect between the occupier and investment markets that we have in the UK. The combination of low interest rates and a good yield on real estate, particularly relative to other asset classes, means investors are keen on the sector. “It seems like every institution has a billion dollars to spend and there’s more private capital than we’ve probably ever seen,” says Steve Hermann, senior vice-president in CB Richard Ellis’s California investment team. But there haven’t been many sales over the past two years. Owners have deeper pockets this time around, and low interest rates mean less pressure. That seems to be changing. Prices have been driven up, narrowing the gap between buyers and sellers. “We’re predicting it’s going to be a much more active sales market over the next two years,” says Bob Gilley, who works with Hermann. “There’s a lot of distressed properties and a huge market for properties well leased to long tenants. Now that there’s a bit of a premium paid for well-leased properties, owners are thinking it might be a good time to sell.” However, with so few transactions to date, no one knows where prices are. “Yields are all over the board,” says Hermann. “It’s really tough to ballpark it depends on the tenant.” |
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Take Four Foundry Square, a new 233,000 sq ft office in San Francisco leased for 15 years to Sun Microsystems, but not occupied by them. It was bought by Cottonwood Partners for $117m, a yield of around 10.25%. “Sun is considered investment grade, but it’s had problems. The building sold for $500 per sq ft, which is a pretty strong number. On the flip side we see empty buildings selling for $50-$60 per sq ft,” notes Hermann. |
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UK & European has sniffed around Silicon Valley, thinking it might be able to pick up a bargain. “For a Palo Alto building with substantial vacancy, there were 40 bids. Investors bid ridiculous capital values per sq ft. Everybody knows Silicon Valley will recover, but it’s not good value,” says UK & European’s chief executive, Robert Greacen. |
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For example, last month US REIT Equity Office Property, Silicon Valley’s biggest office landlord, paid $103m $300 per sq ft for Opus West, a 343,000 sq ft building in downtown San Jose. It is 25% vacant. |
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A month earlier, EOP had sold a 194,000 sq ft building, also in San Jose, to the tenant Brocade Communications Systems for a record $550 per sq ft. Brocade figured this was better than paying over $65 per sq ft pa in rent, plus expenses, on the remaining 10 years of its lease. The company estimates that it can save as much as $6m. |
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Other recent corporate purchasers of Silicon Valley offices include the internet auctioneer eBay, which bought the former Novell campus in San Jose for $190 per sq ft, while Marvell Semiconductor paid $73 per sq ft for 900,000 sq ft of the former 3Com’s Santa Clara campus. |
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European investors are also joining the gold rush. “We’re seeing quite a bit of German money teaming up with local equity sources,” says Gilley. German fund Kam Am, for example, bought half of Mills Corporation’s shopping centre in the Bay Area (see Retail box, p48). |
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Two others that have teamed up are Prentiss Properties and the Dutch pension fund ABP. Their joint venture plans to invest up to $510m over the next 18 months in the US, with two of the core markets being northern California and the San Diego/Orange County area. |
Also, after years of decline, downtown LA is being reborn. Projects such as the Frank Gehry-designed Disney Hall, the new home of the LA Philharmonic, have brought glitz to the city core. “We’re seeing a resurgence. In downtown LA, we’re seeing a boom in the residential community, which we’ve never had before,” says Doney.
Arco Towers, two landmark office towers which had become rundown and lost tenants, are part of this renaissance. They were bought last year for $260m by developer Jim Thomas, who plans a $150m refurbishment. Only 60% of the 2.7m sq ft is occupied.
In contrast, Grosvenor has exited downtown LA. Its 48-storey Citigroup Plaza (below), one of the city’s signature skyscrapers (it featured in the 1980s TV series LA Law), was bought by Beacon Capital Partners for over $170m equivalent to $200 per sq ft. The building is 95% occupied.
“We sold in LA because that capital market is so strong. I don’t buy all the renaissance story,” says Preston.
However, the big question for Preston, Thomas and other investors is when an economic pick-up will translate into the jobs that Schwarzenegger wants.
“Sooner or later people will have to commit to investment in space, machinery and labour,” says Lees. “Inevitably California is going to bounce back. It’s been through these real estate crises before.”
