Industry Remains in Good Shape Although Office Tenants May Have Room to Bargain.

THE L.A. real estate landscape at the end of 2000 is substantially different than the frenzy that characterized the market at this time last year. And it won't be just because two of the city's most anticipated projects, the Cathedral of Our Lady of the Angels and the Walt Disney Concert Hall, are emerging on the downtown skyline.

Lease rollovers don't guarantee higher rents, transactions are likely to slow considerably into at least 2002, and tenants are for the first time in a long time feeling they have some room to wiggle in L.A.'s tight office market.

In marked contrast to the last time a slowdown hit the L.A. real estate market a decade ago, when fortunes were lost and development came to a screeching halt, most forecasters see the current climate as an adjustment period in an industry that is basically in good shape.

Growing demand in the hottest office markets - which were whipped into a minor frenzy thanks to tech-related expansion - coupled with restraint on the part of lenders and developers, has created an office market that at the tail end of a record-length economic expansion is still not overbuilt.

The expansion has been characterized by large amounts of capital chasing a limited range of product. In this cycle, opportunity funds have taken to buying from each other.

It's an open question as to how much demand will pull back in the face of a slowdown, tight capital markets, and the potentially catastrophic impact of unanticipated energy shortages.

Indeed, a new study by Grubb & Ellis Co. suggests that, barring an extreme economic downturn, rental and vacancy rates will remain healthy in the next year.

Slower expansion

But the slowing is obvious, said William Chadwick of Chadwick, Saylor & Co.

"Businesses are going to experience much slower earnings growth or may not experience any earnings growth at all," Chadwick said. "They are going to experience much slower expansion, or maybe no expansion at all. That clearly will have an impact on real estate, on real estate values."

Still, Chadwick said real estate investors won't experience the kind of catastrophic losses seen in the past.

"This recession won't be as broad or deep. We're not going to get the absolute re-pricing that we got last time around," he said.

Absorption has outpaced construction in recent years and in 2001 demand is expected to be robust enough to absorb slightly more than the 3.8 million square-feet of office space under construction at the end of 2000, according to Grubb & Ellis Co.

Grubb & Ellis is forecasting that even the weak downtown L.A. market (which lost a million square-feet of tenants to corporate mergers in 2000) will see vacancy rates continue to drop in the next year. Mid-Wilshire, which saw its star rise in 2000 and like downtown is fiber-rich, can expect to do better than just hold on to the ground it has gained.

In stark contrast to the last recession, when the collapse of the aerospace industry caused a hemorrhage in the job base, many of the retail, office and industrial projects set to rise against a backdrop of economic slowdown in 2001 will be on properties abandoned when the defense industry fled. Those include 100-acre projects in Burbank, Pico Rivera, and Hawthorne.

Space in Santa Monica will continue to be at a premium but the big construction spots in 2001 will reflect other cities with more room for growth that were also hot in 2000: El Segundo and Manhattan Beach, Marina Del Rey and Culver City, the Conejo Valley. The El Segundo/Manhattan Beach submarket absorbed more than 800,000-square-feet of office space in 2000, nearly twice as much as any other market, and another 500,000 is under construction or planned, according to Grubb & Ellis.

The Tri-Cities area, Burbank, Glendale and Pasadena, is seeing another million square feet proposed and 400,000 under construction. The Conejo Valley has close to one million under construction, according to Grubb & Ellis.

Miller noted that in 1981, interest rates went through the roof. In 1991 supply of office space shot past demand. But not so in 2001, where speculation has kept to the strongest markets in the Tri-Cities, Westside, and El Segundo.

"We don't have an oversupply of product," said Tom Miller, who heads up the West Coast capital markets group for Jones Lang LaSalle. "This is more of demand-based issue. You've got low unemployment, low interest, and a very attractive supply- and-demand relationship. When you look at all of the issues together, you've got a much better picture [than 10 years ago]."

Weak markets

Some feel a slowdown will only be bad news for the weakest markets, such as downtown.

"The thing that was driving it the hardest is that rents were spiking in LA and rents for comparable buildings were twice as much," said Steve Bay of Insignia/ESG.

Observers characterize a number of things likely to unfold in 2001.

* Fewer buildings will be bought or sold than in recent years.

* The hottest markets, such as the Westside, will see a softening of upward pressure on rents.

* Power to negotiate, favorable lease terms will shift slightly in favor of tenants.

Barring a major economic downturn, construction projects in the pipeline are not likely to create a glut of office space.

* Sublease space will continue to impact absorption.

Marvin Davis can rest assured that it may be years before anyone can challenge the high water mark set when he sold Fox Plaza in 2000 to Irvine CO. for about $350 million, or roughly $500 per square foot.

With stocks dropping in value, institutional investors are not going to be looking to add more real estate holdings to their portfolios, Chadwick said.

"There will be less institutional capital in the real estate market, even if the market stays stable," Chadwick said. "Acquisition and development activities should dry up. Sellers aren't seeing the prices they would like, and pulling back. Opportunity funds looking to sell aren't seeing the prices they'd like."

At the same time, many investors have already flocked to the security of real estate investments.

"People over the last six months have taken some significant losses in their equity portfolio," Miller said. "That correction can only be good for real estate. Cash flow can be a relatively important thing at the end of the day."