CEQA Actually Helps Push Office Pricing

LOS ANGELES—Supply constrain caused by CEQA and strong capital demand is pushing office prices up, according to Greg Ames, a managing director at Trammell Crow. Ames sat down with us for an exclusive interview to discuss the Los Angeles office market, where he explained opportunities for risk-adjusted returns are limited in this market and prices are continuing to rise. We didn't stop with pricing. In this office-market interview, we discuss development, the industries driving the market and where companies are migrating.

GlobeSt.com: Which industries are driving the L.A. office market, and why?
Greg Ames: LA is an exciting place to be, with great fundamentals and strong job growth right now. The truth is though you cannot narrow it down to any one or two or even three driving industry sectors. We have tech, entertainment, media, manufacturing, finance, healthcare and government. All sorts of industries making big impacts driving expanding occupancies and increased rent as vacancy decreases, and every one of them has their own story across a wide array of submarkets. Clearly we are benefitting from a positive macroeconomic environment, California always lags two years behind national recoveries, but when I compare our local financial underwriting with other deals we develop nationally, it is striking how unique we are in the diversity of our economy and the breadth of opportunity. Clearly, there are regional economies that really are tied to only one or two industries, and when those industries are running well, everyone prospers—but in the down years, the regional economies struggle. LA on the other hand is more like a good stock portfolio with lots of diversity in both people and economic drivers. That means we all need to keep our eyes on lots of different metrics that measure our economic power and drive our investment decisions.

GlobeSt.com: Like multifamily, most of the new office development underway is mixed-use complexes with retail and onsite amenities. Is this the new standard for office?
Ames: I dare say it is. The simplest answer is: because our lifestyles have changed. Our expectation as a society, toward the trifecta of a diverse work-live-play lifestyle, represents a big cultural shift with very few boundaries. What developers aim to supply from a product perspective is to simply reflect that diversity. On the corporate side, decision makers are seeing that the more pleasant the work environment is, the more time people will spend there and the higher the productivity. Better space, with better amenities, and fewer reasons to leave equates to higher yields and production. We saw the mixed-use trend initially in multifamily, partly because it was earlier in the development cycle and leads the trend curve, but also because multifamily tends to target a very specific demographic, allowing them to price very precise bets on amenities. The success of these highly amenitized projects, done well, is easy to notice. The office built environment follows this dynamic, and its users are demanding better space, with more amenities both adjacent and built-in as mixed-use. So, yes, there will be a steady trend toward convergences and mixes of use.

GlobeSt.com: Some markets, like the South Bay, are seeing low vacancy rates and increasing rents, while other markets, like Downtown, have large blocks of vacant space. Why are we seeing this dichotomy in the market?
Ames: Let's think about it. South Bay is roughly 32 million square feet, with around 18 percent vacancy and call for $2.40 per square foot rents. Downtown L.A., by comparison, is almost the exact same size—32 million square feet, with slightly less vacancy, 17%, and higher rents at $3.00 per square foot. The numbers would suggest that Downtown LA is actually in marginally better shape than South Bay. So what gives? The difference is that Downtown LA is a class-A high-rise market, with more expensive buildings, and all of that vacancy is consolidated into a small geographical area. The 17% of vacancy is located in architecturally significant buildings with vertically stacked competing space with similar space competing head-to-head with each other. While South Bay has much more class-B product—more creative office, more adaptive reuse—spread out across a wider geographic range, which pound-for-pound is driving a higher return than a lot of the Class A space. At the end of the day though, it's about where people and companies want to locate to attract the highest and best talent.

GlobeSt.com: Office property values are climbing. Where are values today, and where are they headed?
Ames: Finding the opportunity for strong, risk-adjusted returns remains a challenge for most institutional capital sources. There are not many great options. As long as capital is looking for a home, real estate will provide it. This applies even more so for foreign capital which not only looks for the stability of dollar-based investments, but also prices the value of real estate as an inflation hedge. The combined dynamic simply makes U.S. real estate an even greater magnet for foreign capital. We saw this with the Chinese monetary policy tinkering last month, and it rattled the market but it did not lessen demand for U.S. real estate. If anything, it made it even more urgent. This only adds to the capital demand pool. Further, we are looking at an almost historic spread between cap rates and interest rates. Even when interest rates do go up, there seems to be little direct impact on cap rates. As long as there continues to be demand on the capital side of the equation and supply remains systemically constrained (thank you, CEQA!), pricing will continue to rise. As Nigel so aptly put it, “these [speakers] go to eleven.” Indeed, they will.

GlobeSt.com: Playa Vista, Santa Monica, El Segundo, Century City and Hollywood all have very active office markets for different reasons. What are the next big submarkets in Los Angeles for office?
Ames: Those are certainly the biggies, market-wise, but they all highlight different elements of the same migration trend; that is, companies are migrating toward people. Get closer to the talent base and where they want to live. If you cannot perfect that, then at least get closer to the transit that delivers the talent base home to the mothership. Proximity to workforce is as much an issue for intellectual property companies as it is for manufacturers. So, where the people go to live and play, companies will follow. I believe this bodes well for Downtown LA. The vacancy is higher, relative to other markets, which means there are still large blocks of space in the market and some nice chunks of space for the right user. Unlike other markets, the Downtown LA population is growing tremendously and in turn, more companies will migrate in or proximate to downtown to leverage the increasing labor market. But again, this is an incredibly diverse market with independent drivers in every neighborhood. The challenge to creating successful office products is spotting the momentary arbitrage before someone else does!