August 30, 2019
By Dennis Kaiser
A standing-room crowd of nearly 500 commercial real estate leaders gathered last week at The Resort at Pelican Hill in Newport Coast for the annual Connect Orange County conference. The afternoon featured a keynote address by KBS Realty Advisors Chuck Schreiber (watch the video here), as well as three deep-dive panel discussions.
Orange County’s CRE industry leaders discussed the key facets impacting the region. That included a robust conversation about co-working, opportunity zones, technology, hot property types, and key political issues facing the sector.
CBRE’s Jeff Moore, who moderated the panel, kicked-off the conversation noting he’s seen more changes occur in the last seven to 10 years compared to the previous three decades he’s been in the commercial real estate industry. One of the biggest changes is the arrival of co-working and flexible space operators.
NKF’s Jay Nugent agreed that co-working is one of the biggest trends in Orange County, mainly because it has gone from “non-existent” to the second largest occupier in the market. Nugent says tech companies have been leading the market over the past 10 months, though he notes there’s a dichotomy between professional services companies and tech tenants that is affecting the market.
Stream Realty Partners’ Brett Kluewer says Orange County has been characterized by a “sea of commodity office,” and that’s starting to change. He sees a “flight to differentiated space” emerging.
The trend toward co-working is “cool” thanks to WeWork, noted The Bascom Group’s Jerome A. Fink. He points out it could be a viable business if they “do a great master lease, keep expenses low,” and deliver a nice-looking space for minimal dollars. “WeWork changed the game” and established a “new paradigm” in the market, he notes.
Buchanan Street Partners’ Timothy J. Ballard says the “continued densification across property types,” is squeezing more people fitting in “less and less space.” He pointed out part of that is for cost reasons, though it is also as a result of “lineal workers,” which is changing how space will look and landlords must adjust to that.
Colliers International’s Cody Cannon noted that a typical co-working space deal averages 2,000 square feet and is occupied by six to eight employees globally. Yet, Orange County is unique in that it has a highly educated demographic of high-income households with larger amounts of capital to invest, and that creates a great environment for incubation space. He says tenants can scale up in a co-working facility and have the flexibility to downsize if the market slows down. Though he wonders if co-working is a short-term trend or if it will become a longer-term consideration.
Nugent suggested the market may be at a saturation point for co-working. Though Orange County was “behind the curve on co-working,” he notes, the market currently has about one to 1.5 million square feet of co-working space representing about 1.5% of the market. He sees the co-working operators focused on building the enterprise business, where they lease large chunks of space to larger companies like Microsoft or Pepsi. Nugent notes, if they are successful with that business, it pits co-working operators against traditional leasing models and would be disruptive.
Panelists noted that co-working environments are popular now, but some of the limitations such as finding quiet spaces to do focused work or providing an environment to grow a brand and company culture over time may challenge the long-term viability of the concept. Fink noted, his experience in co-working spaces reveals they are “cool and fun,” but it can be a bit challenging to work when people are playing ping pong nearby or there’s an event like a singles night. He believes once the cool factor wears off, companies will seek a more “mature” work environment. Fink envisions a time when a more “toned-down version” of the wild and crazy co-working environments of today will emerge.
Fink noted that the new lease regulations that now require companies to capitalize lease obligations as a liability rather than an expense may negatively impact co-working operations. And the co-working model has not yet been “stress tested” points out Nugent, which would be the case a downturn.
Ballard pointed out co-working spaces may have solved an accounting problem and been good for companies, since most tenants are not in the business of real estate. Yet in the long run, continued expansion by co-working firms like WeWork is not likely going to help landlords from tenant perspective.
There are some interesting scenarios that could play out in a downturn for co-working operators, which are single purpose entities and provide corporate guarantees for leases. Nugent says, if the market turns, co-working operators may elect to close 10 locations in a market, consolidate or come to the landlord and seek to renegotiate their lease.
Fink believes that in about a year WeWork will arrive at the “too big to fail” crossroads. He noted it is “cool” to have a co-working operator in a building, but if they take up more than a couple of floors and the cap rate goes up, there could be significant negative consequences should a downturn arrive in the market.
Whether as a result of the advent of co-working space’s shorter-term commitments or in anticipation of a market slowdown, panelists are seeing shorter term deals in Orange County. Ballard notes tenants are seeking early outs in leases, and Fink notes co-working may lead to traditional landlords to go to shorter terms, too.
Another topic the panel touched on was opportunity zones. Fink believes opportunity zones are real opportunities and Bascom is pursuing them. His fear is that if too much development ensues for tax reasons only without true market demand, there could be pockets of overbuilding.
Ballard noted the interest in opportunity zones was high for the first nine months after the program was announced, typically by those seeking tax breaks. He expects there will be mistakes made due to those tax deals if they didn’t pencil out otherwise, and the deals will fall apart when people figure that out.
Cannon agreed the popularity of opportunity zones has emerged as a trend on a global and national scope. In Orange County it has been a “game changer” especially for markets that received the designation, such as Anaheim, Santa Ana, Buena Park and parts of Costa Mesa. It has impacted multiple property types and he’s seen deals trade for 20% to 40% higher because of demand. But he cautions, the “cake must be there” too, as there must be sound fundamentals to the deal.
The panel touched on the impact of technology in real estate. While Ballard noted CRE was one of the last sectors to embrace technology, mainly because its leaders didn’t grow up with computers, that is changing. He thinks over the next decade a “dramatic change” is coming as a generation of leaders take over who are more adept and accustomed to technology their whole lives. The industry will be disrupted as people start making decisions based on what they hear and discover online, rather than needing to physically tour sites or properties.
Cannon agreed, noting technology is arriving faster today than it has in the history of CRE. That will help make brokers more efficient and bring new data points that can be quickly analyzed into savvy real estate decisions. Technology is also opening up new avenues globally, Cannon says. Technology creates larger pools of investors not considered before and in volatile economic times, traditional investors may now more readily look at real estate as an alternative investment.
One way that technology is playing a role in today’s CRE industry is it eliminates geography as a barrier. Ballard said a senior living asset typically may receive 90% of its tenants from those who drive by the property. By comparison, a non-age restricted property is less dependent on drive-by traffic and a property may only see 10% of its prospective tenants via drive-by.
Shifting gears to property types, Fink noted the challenge on the multifamily side is low expected internal rate of return over a 3-5-year period. As a value-add buyer, Bascom has seen expected yield on deals drifting down now to the low teens for levered IRRs. He says they are fortunate if they can achieve a low double digit return. Though he pointed out Orange County’s multifamily sector is healthier than it has ever been, despite new construction being expensive.
Development is concentrated in nodes and the impact to the average B or C class renter would be minimal, says Fink. He notes, California cap rates have always been in high four range or mid four range but have dropped.
Ballard pointed out developers are not building enough of multifamily, primarily because of the cost structure that has increased dramatically over the past five years. He says about the only type of product that pencils is high-end projects. He indicated there’s a full pipeline of capital available, including more institutional money with “no end in sight” for multifamily product. He expects cap rates to drop because of the influx of cash buyers.
On the office front, Nugent says the market is experiencing strong demand, and strong absorption has helped stabilize assets the past 24 months, especially in the Airport and Spectrum submarkets of Orange County.
Stream Realty Partners’ Kluewer sees a bit of stagnation in the office sector with no new construction on the horizon, except for landlords like Irvine Co. He notes the new product hasn’t leased up at the pace landlords would have liked. Another interesting factor to consider is the rising tenant improvement allowances that have gone from $30-per-square-foot to upwards of $100-per-square-foot, notes Ballard.
Shifting over to the industrial sector, Cannon says 80% of that product is Build-to-Suit, with e-commerce having a significant impact on the market. He says demand continues to be high and isn’t expected to abate anytime soon. That’s because SoCal is located on an international freeway between the ports and global trade channels. That will continue to fuel e-commerce growth and may change how retail looks, though consumers are still buying.
Among the issues panelists said the real estate sector should be paying attention to today are the split roll tax, rent control and dual agency legislation. Fink said rent control is a challenge in California and states with strong rent growth, because it introduces uncertainty. Kluewer agrees it is a “slippery slope” for the state, and it may eventually pull companies out to states such as Texas, Arizona or Nevada.
Ballard noted there may be some companies that don’t need to be in California, and the higher costs and legislation will push them out. Companies that need to be in the state, like Google, will remain, he predicts.
Cannon advised getting educated on the issues and their details, because they will have profound impacts on CRE should they be passed. Some will affect the business of real estate, while others will affect occupiers since costs will likely be passed through to them.
Luster still remains on the Golden State though. Cannon pointed out the historic low interest rates and available capital combine nicely with job growth, low unemployment and diversification to foster transaction volume and activity in Orange County.
Yet, Fink said Bascom has slowed down their acquisitions volume this year, mainly as a result of high competition from new investors for multifamily deals. He notes there has never more competition. Ballard says they are not buying much either. Though their lending activity has picked up, in some cases to refi construction loans to help a developer see a project through to completion when construction timelines took longer, and costs rose higher than budgeted.
The Orange County real estate sector is keeping an eye on the coming election year, to determine how it may impact the economy in general. Panelists noted in the last election, people took their foot of the pedal and it took longer to sign deals. Though they agree, the region is in a significantly better position today than when a mortgage crisis loomed over the market in 2009. The economy is more diverse, and the Orange County market fundamentals are solid, they say, which would act as a hedge against an economic downturn.
For comments, questions or concerns, please contact Dennis Kaiser