Arco Center put on auction block by pension group.

Arco Center, one of the premier office towers in downtown Los Angeles, has been quietly put up for sale by its majority owner, the Ohio Public Employees' Retirement System (OPERS), for an asking price estimated at between $120 million and $140 million, sources told the Business Journal last week.

Title records show a title insurance order was opened Jan. 23 for that 32-story, 660,000-square-foot tower, indicating a sale may already be in the works.

Escrow on that order had not closed as of press time, so details could not be ascertained from title records. Also, principals involved in the deal refused to comment last week.

"I have discussed this (Business Journal inquiries) with ownership, and they do not want me to comment," said Martin Morgenstern, director of Cushman Realty Corp., the brokerage firm hired by OPERS to find a buyer for its red-granite Arco Center tower.

John Cushman, president of Cushman Realty, is assisting Morgenstern in that effort.

OPERS' outside adviser Wells Fargo Real Estate Group, also refused to comment last week.

Arco Center is about 80-90 percent owned by OPERS. The remaining portion is owned by SC Enterprises, a holding company of Shurl Curci.

Curci, the original developer of Arco Center, told the Business Journal last week that he was aware OPERS is looking to sell the building. But he said he did not know any details about the deal.

"What they (OPERS) are doing is within the framework of our agreement," he said. "My views about whether they should be in the market right now or not are academic."

Curci implied he would prefer not to sell Arco Center right now. But OPERS, as the majority owner, is in the driver's seat.

"Office buildings are out of vogue with U.S. pension funds right now," Curci said. "As Americans, we always tend to go with what's in style.

"But people who make their own decisions are usually right and people who go with what's in style for the moment are usually wrong," he continued. "That's why people who start out life with nothing end up wealthy, and people who start out rich end up with nothing."

Several industry sources agreed that OPERS' decision to unload Arco Center couldn't have come at a worse time. Commercial property values in downtown L.A. are depressed due to the economic recession and a huge oversupply of new office space in that market.

Also, lease rates are low, which is good for tenants but terrible for property owners and their lenders.

The number of buyers considering major office purchases has dwindled to precious few in recent years, as financing for such purchases has virtually dried up.

In short, it's a buyers' market in downtown L.A., and only the most desperate property owners are even considering selling right now.

Meanwhile, the fact that no major office sales have taken place in downtown L.A. for almost two years is likely to make the sale of Arco Center the subject of great interest among other commercial property owners in downtown L.A.

"It's very hard for anyone to get a sense of what cap rates are on Class A office buildings anymore," one downtown broker explained, "because there hasn't been a good comparative sale in years."

A "cap rate" is the multiplier used by buyers and sellers to calculate a property's selling price, based on its annual net cash flow.

It roughly equates to the buyer's anticipated internal rate of return. But inflation or appreciation can cause the actual rate of return to be greater than the cap rate, and deflation or depreciation can cause the opposite.

For example, Arco Center currently has an annual net cash flow of $9.5 million, sources told the Business Journal last week. With that cash flow, a cap rate of about 7.9 percent would be needed to fetch a selling price of $120 million ($9.5 million divided by 0.079 equals $120 million.)

For any given net cash flow, the cap rate and selling price move inversely. In other words, the higher the cap rate, the lower the selling price, and vice versa.

So buyers are typically encouraged by high cap rates, and sellers are motivated by low cap rates.

The most recent major office sale in downtown Los Angeles was transacted at a cap rate of about 7.25 percent, sources said. That mid-1990 sale involved two Japanese companies buying the Home Savings Tower at 660 S. Figueroa St.

But economic conditions for downtown real estate have deteriorated significantly since then, sources confirmed, meaning cap rates are much higher.

Some sources estimated cap rates on major downtown highrises could now be as high as 10 percent, or higher. At a 10 percent cap rate, Arco Center would only bring a selling price of $95 million, assuming its current net cash flow.

OPERS apparently hopes to increase the attractiveness of Arco Center to potential buyers by promising certain "guarantees."

Cushman Realty recently mailed out information packets on Arco Center to a select number of brokers, only one of whom works in the Los Angeles area, Cushman Realty's Morgenstern revealed last week.

That information packet discloses that OPERS will guarantee any buyer of Arco Center an occupancy rate of at least 95 percent, and an annual net cash flow of at least $12.6 million.

Arco Center is currently 87-percent leased, with a net annual cash flow of $9.5 million.

Hence, OPERS is effectively offering to pay any buyer about $3 million a year, or more, if the building's cash flow deteriorates.

The length of this "guarantee" is crucial to determining the attractiveness of this offer to any potential buyers, sources explained.

If the term of the guarantee is only one year, it would amount to nothing more than a $3 million adjustment to the eventual purchase price. If the term of the guarantee is 10 years, or longer, however, it would effectively remove a buyer's downside risk, as well as add at least $30 million to the purchase price.

A 10-year guarantee could be very attractive to a pension fund, sources said, because such entities are always looking for guaranteed returns.

A 10-year guarantee might also be attractive to OPERS, as the seller, because it would increase the selling price by $30 million. OPERS, under the guarantee, would repay that $30 million in increments of $3 million a year for 10 years. That deal would be attractive to OPERS because the present value of money is greater than its future value.

"Anybody with enough money to buy a building this size is too sophisticated to be fooled by some illusion of a 'guarantee' for one year," said one source familiar with the deal. "The buyer is going to 'cap' this guarantee in the same way he 'caps' a building."

Meanwhile, the major tenants at Arco Center apparently had not been notified as of last week about the building being up for sale.

Those tenants include: Arco Petroleum Products Group (266,000 square feet), the law firm of Morris, Polich & Purdy (40,100 square feet), Courdert Brothers law firm (39,500 square feet), and Wilson Elser et al (32,000 square feet).

Another law firm was reported to be negotiating for 10,000 square feet of space at Arco Center last week. But that deal had not been inked by press time.

Although Arco Center's occupancy rate of 87 percent is considered respectable by downtown standards, that occupancy took several years to achieve.