Demand increasing in some of the weaker submarkets.

FOR several years, a strengthening economy has raised the ceiling of the Los Angeles County real estate market. Now the floor has started to rise as well.

Office vacancies in the first quarter were 11.2 percent, compared to 11 percent in the prior quarter and 14 percent a year ago, according to data from Grubb & Ellis Co. Industrial space vacancies were at 2.1 percent compared to 2 percent for fourth-quarter 2005.

But a closer look at the numbers shows that demand is increasing, especially in submarkets that normally lag in an economic recovery and form the floor for the local real estate market.

Consider the significant tightening in the East San Gabriel Valley, where vacancies dropped to 5 percent from 7.8 percent in the last 12 months. Or Glendale, where vacancy rates went down a tick to 14.7 percent from 14.8 percent. Or downtown Los Angeles. Or the South Bay.

"The market is doing well; the economy is improving; people are starting to hire. And if we weren't before, we're now in full employment mode--(lease) rates are increasing slowly and vacancy countywide is falling," said Joseph Faulkner, executive vice-president at brokerage Charles Dunn Co.

And if it weren't true before, it is true now: the rising office market that has lifted the Westside to soaring heights finally reached all corners of Los Angeles County.

Asking rates countywide for Class A space in the first quarter registered at $2.63 per square foot, up from $2.45 in early 2005. The cost for Class B space also increased to $2.10 from $1.96, while industrial space reached 59 cents, up from 53 cents.

A contributing factor: Despite a rising office market, still superior residential returns means that developers simply are not building enough additional office space to satisfy demand, perking up once moribund markets.

"No new construction means it's harder to find space," Faulkner said. "You have a number of markets with the potential for building new office space, but in this climate (developers) really can't justify it. Residential returns have been out of sight compared to office returns."

Tax factor

Indeed, in response to the returns, developers are not only constructing few office buildings but they have converted existing office space into condos or apartments, causing further tightening for business tenants. Sub-markets affected by the conversion trend run from the San Fernando Valley in the north, through downtown to the South Bay.

"Older B and C space has been converted to residential. That takes a lot of space off the market, and it takes the lower-end rentals off the books," Faulkner said. "It affects mostly smaller tenants, who have a harder time finding space."

Of course, that's great news for landlords, who have their pick of prospective tenants when office space becomes available.

A survey of leasing agents by Bank of America found that on a scale of 1 to 5, with 5 indicating a better market and 3 neutral, Los Angeles scored a healthy 3.83. "New York and Los Angeles are the two strongest currently relative to six months ago, and therefore may continue to outperform," the report stated.

The bank's breakdown indicates that leasing agents expect West Los Angeles to have the highest demand for the next six months, followed by the Tri-Cities, San Fernando Valley, and downtown. However, even last-place South Bay h ad a positive rating of nearly 3.5 on the 1-5 scale.

The survey also found that Los Angeles tenants ranked taxes as their top concern in property management. But Faulkner believes the worry stems not from property taxes but from the gross receipts tax levied by the City of Los Angeles. It runs about $1.25 for every $1,000 in gross receipts for the business, compared to an employee "head tax" levied by some neighboring cities in Los Angeles County.

The tax differential, he said, may explain why the commercial areas around Los Angeles International Airport within the city have a higher vacancy rate (33.3 percent) compared to next-door El Segundo (15.1 percent). The same logic holds in parts of the San Fernando Valley and San Gabriel Valley.

Still, for most tenants, Faulkner thinks parking rates are the top priority as surfacing parking grows scarce.

"There's no end in sight as to what they can charge, and they have captive audiences in many of these buildings," he said.

Meanwhile, for weary tenants there appears no end in sight to higher lease rates, while landlords should expect increasing returns.

The bank's analysis found that "demand for L.A. office space is expected to continue and increase rent by about 4.8 percent annually through 2010." Almost 60 percent of respondents predicted the Westside would see rent increases of 5 percent or more this year.

Faulkner concurred, noting all signs are for a strengthening local economy and a pickup in hiring. He said tenants in the county can avoid leasing by looking at ways to increase their efficiency in space utilization.

But already many tenants are operating at efficiencies near the maximum. So, with rental rates set to increase, he advises clients, if they must, to "lock in long-term rates now or you'll pay through the nose later."