Experts question whether recovery is within sight.

Glut of foreclosed property keeps market in doldrums

The $64,000 question for the Los Angeles County real estate industry continues to be: "Have we hit bottom yet?" The answer, unfortunately, continues to be: "Probably not."

The main reason, industry sources say, is that banks still have huge portfolios of foreclosed properties here, as does the federal government's Federal Deposit Insurance Corp. and Resolution Trust Corp.

Those bulging portfolios have to be unloaded some time soon. And today's buyers aren't paying anywhere near 100 cents on the dollar.

"The market is saturated by a large overhang of distressed product owned by bank REO (real estate owned) departments, the FDIC and the RTC," noted Grubb & Ellis Co. in its 1992 forecast for the Los Angeles Basin. "This product will be sold and auctioned at fire-sale prices that will drag down the value of other product."

Bruce Ballenger, former Coopers & Lybrand accounting firm partner in charge of distressed property consulting, said the RTC has not had any fire sales yet. But investors' knowledge about the number of distressed properties facing disposal has been enough to depress market values.

"It's like when good weather brings an extraordinary amount of wheat to market," explained Ballenger, who now runs his own consulting firm, Ballenger Associates, in West Los Angeles. "Everybody knows only so much wheat can be consumed each year. So the price of wheat goes down based on that knowledge, even though the wheat hasn't been sold yet."

Only the big boys are likely to participate in the REO/RTC/FDIC sell-off, however, because the properties are being bundled into such sizable portfolios.

"Clearly, the action today is with the RTC and other portfolio sales," said Jack Rodman, managing partner of the L.A. office of accounting firm Kenneth Leventhal & Co. "The big-money boys -- the Sam Zells, Jeffrey Gaults, the JMBs, the Basses of this world -- are all focusing on that," he said.

While the few buyers with available cash may be having a heyday, owners and lenders are being hit hard. No industry sector or geographic region of L.A. has escaped unscathed. But clearly some are faring better than others.

The hardest-hit industry sectors are the hotel and office markets.

Hotel occupancy rates have dropped only slightly in the past year, but room rates have dropped significantly, Rodman said.

"Room rates in L.A. have dropped 4 to 7 percent, which is steep considering they (hotel analysts) expected a 5-to-7-percent increase," he said.

The hotel slump has prompted Korean and Taiwanese investors, notorious bottom-fishers, to start actively shopping for bargains.

"We're now seeing hotels bought from banks or the RTC for about 40 percent of their replacement cost," Rodman said. "The buyers are earning 10 to 11 percent on that investment, with lots of upside potential."

In the local office market, corporate tenants are continuing to consolidate due to recessionary pressure and a spate of mergers.

Meanwhile, the blue-sky pro formas put out by office developers in the late 1980s are now coming back to haunt them. Office property values have fallen some 30 percent from their 1989 peak, reported Rodman.

As a result, lenders are increasingly requiring developers to come up with more equity, or risk losing their buildings to foreclosure or bankruptcy.

One prime example is Two California Plaza in downtown Los Angeles. That new 52-story skyscraper was effectively taken off the market a few weeks ago when its main construction lender, Citicorp Real Estate Inc., asked its developer, Metropolitan Structures Inc., to come up with $50 million or so in additional equity.

That decision removed 1 million square feet of new office space from the glutted downtown market, at least temporarily. Similar moves by owners and lenders at other downtown towers, like the one at 550 S. Hope St., could help firm the downtown submarket sooner than anticipated, some downtown brokers contend.

Once new buildings downtown achieve 50 percent occupancy, owners and lenders appear willing to consider taking the rest of their buildings' space off the market for a year or so. By that time, the thinking goes, the market should have firmed somewhat and rents will have stabilized.

The office vacancy rate in downtown L.A. was 21.4 percent as of Dec. 31, almost double the 12.8-percent vacancy rate downtown a year ago.

Downtown vacancy is expected to worsen a bit further this year, as another 1.78 million square feet of new office space hits that submarket.

Leasing activity was actually quite brisk in 1991. Net absorption (the amount of office space leased minus the amount vacated) was a positive 1.65 million square feet for the year. That represents nearly a 70 percent improvement from 1990. But the increased activity was largely due to downtown landlords almost giving away space to entice tenants.

Meanwhile, Los Angeles County as a whole had positive net office space absorption of 2.554 million square feet for 1991, 40 percent less than in 1990.

The county as a whole posted an office vacancy rate of 19.2 percent at year-end 1991, not including available sublease space. That compares with 15.0 percent a year earlier.

The county's vacancy rate was actually somewhat understated, however, claimed Leventhal's Rodman, because it did not account for the tremendous amount of "gray space" now on the market.

"Gray space appears leased, but it's actually almost totally empty," he explained. "It refers to floors with hardly anyone on them, severely under-utilized space."

Office tenants are no longer attempting to sublease this space because the sublease market is so soft. So they are just waiting until the current leases expire, at which time the space will once again be put on the market.

Office sales activity in Los Angeles County during 1991 was off about 50 percent from the prior year, reported Jon Torgeson and Jerry Asher of CB Commercial Real Estate Group.

"The availability of capital has not improved at all in the past year, and that has greatly affected commercial sales, especially land sales," said Asher, an executive vice president at CB Commercial. "We don't expect that situation to improve between now and the end of the year."

Dr. Kathleen Connell, managing director of UCLA's Center for Finance and Real Estate, confirmed there is a severe capital shortage for commercial real estate financing.

"We just finished interviewing 15 major lending institutions," she said. "And we didn't find a single lender who felt the office market in L.A. would recover before 1994."

Those who do get construction loans in 1992 will be required to come up with equity equivalent to 25 to 30 percent of the loan amount, regardless of project quality, said George Smith, chairman of George Smith/Grubb & Ellis Financial Services. But interest costs on those loans will be among the lowest in years.

Preferred loan size will be $3 million to $8 million, Smith stated, with loans of more than $15 million very difficult to get.

Preferred property types are retail centers with market and drug store anchors; newer apartment buildings; single-tenant industrial buildings with 10-year leases, or longer; and multi-tenant industrial projects with staggered lease rollovers.

The sole bright spot for the local real estate industry is the residential sector, which industry observers predicted will recover in the third quarter of this year.

Demographers point out that the Southland's population has continued to outpace residential construction for many months.

Granted, affordability continues to be a problem here because many of L.A.'s new residents have low earning power. And consumer confidence remains dismal.

But interest rates are attractive. And local realtors report that open-house traffic has been picking up in recent weeks.

Financing also appears to be loosening up in the residential sector. A few months ago, the Comptroller of the Currency halved the capital reserve requirement for residential construction loans. That capital reserve requirement is now just 50 percent of the loan amount, rather than 100 percent.

Residential builders' spirits have also been noticeably buoyed by the announcement early this month that the California Public Employees Pension System (CALPERS) plans to invest some $225 million in residential real estate construction throughout the state.

Also, representatives from the Building Industry Association of Southern California were said to be on the East Coast last week, attempting to convince seven major pension funds to invest anywhere from $125 million to $250 million for residential construction in the five-county Los Angeles area.

Major demographic shifts in the Southland's population are also continuing to change the face of the retail market. Mom-and-pop stores and regional chains are disappearing. Faring only slightly better are major department stores. Meanwhile, large specialized discount retailers -- such as Home Depot, Price Club, Toys-R-Us, IKEA, Target and Wal-Mart -- are aggressively expanding.

West Los Angeles continues to be the county's strongest retail market. But rental rates there declined in 1991 and will come down a bit more in 1992, Grubb & Ellis predicted in its 1992 forecast report. The South Bay is the weakest retail market in L.A. County. But at least two South Bay submarkets, Torrance and Cerritos, have stayed relatively strong due to expanding populations with high incomes, Grubb & Ellis reports.

Los Angeles County's industrial market is also suffering a severe slump due to widespread consolidations in the aerospace, defense and other manufacturing industries.

But the industrial market is performing better than the office or retail markets because the industrial market responded more quickly to the current downturn.

"It only takes about nine months to put up an industrial building, while office buildings take two to three years," said Dennis Macheski, director of research at Big Six accounting firm Price Waterhouse. "So they were able to turn off the spigot on new industrial space much more quickly."

The 1991 year-end industrial vacancy rate for L.A. County was 10.6 percent, up from 9.5 percent a year earlier.

Probably the hardest-hit industrial market was the South Bay, where aerospace and port-related businesses have experienced drastic cutbacks. The South Bay's TABULAR DATA OMITTED industrial vacancy rate jumped to 12.7 percent at year-end 1991 from 9.8 percent year before.

Meanwhile, industrial lease rates there declined 15 to 20 percent during 1991, and concessions increased dramatically.

Overall, manufacturing buildings were hit much harder than were distribution and warehousing buildings. That is primarily because manufacturers have been leaving to escape the strict environmental standards being imposed by the South Coast Air Quality Management District.

Hayden Eaves III, president and chief executive officer of Trammell Crow Co., a major owner of industrial real estate, offered the following tips to industrial building owners: "Be pro-active in the management of your facilities. Don't let your receivables get out of hand; keep a very tight rein."

Owners of vacant manufacturing buildings might want to consider renovating them for some alternative use, added UCLA's Connell.

"Any local economist will tell you, you're not going to replace a departed manufacturing tenant with another manufacturer," she said. "Those tenants will keep moving out of the L.A. basin unless there is a radical reversal in the regulations those tenants face. It's much more likely they'll be replaced with service-oriented firms, such as suppliers and support services."