Panel Says Demand Making Good Deals Harder to Find.

THE Business Journal asked some of the top people in the field to address the current state of real estate investing in L.A., and provide their outlook on where they think the market is going in the future.

The participants were Kevin Dretzka, managing director of Eastdil Realty; Bill Chadwick, managing director of Chadwick, Saylor & Co.; George Smith, chairman and CEO of George Smith Partners; Bleecker Seaman, executive vice president with Lowe Investment Management; and Michael Zietsman, managing director at Lehman Bros.

LABJ: How does the Los Angeles-area property market size up compared to other U.S. markets and foreign markets? Are L.A. properties still a good buy, or are they relatively unattractive and overpriced at this point?

Dretzka: L.A. and West L.A. in particular are still really among the top markets nationally. Midtown Manhattan; Washington, D.C.; San Francisco and the (Bay Area) Peninsula; Los Angeles and part of West L.A. -- these are the top markets for investors in terms of relative attractiveness. Southern California, being the last to recover of those most-attractive markets, perhaps by definition might still be the best relative play.

Chadwick: For, say, the first decade of the millennium, what we call the Southern California basin may very well be the strongest market in terms of population growth, household formation, job growth and spending. There's a tremendous movement toward Southern California and away from some of the other strong markets. The axis really is shifting from what might have been (the axis) years ago -- New York, London, Paris -- to a Pacific Rim orientation. That movement spells all sorts of good things for real estate in this area.

LABJ: We've been hearing about this emergence of Los Angeles as a Pacific Rim megalopolis for decades. Is Asia ever going to truly become a force driving L.A. property values higher?

Seaman: We like the long-term demand picture for L.A. and I think Asia is a part of that. The port has been a big driver, and as you see Asia continue to come back, that will be reflected in increased activity. I think there are a number of markets on the West Coast that are trying to be big players in Asia trade and commerce. L.A., as one of those large markets, is going to be a player there. It only adds to what we see as a strong domestic-demand positive for L.A.

Smith: I think a clear problem you're dealing with is not what the demand is, but where you're going to find or get entitled land to meet the demand. You look on the Westside right now, there's no place to build. It's gone. If somebody can figure out a way to do an assemblage, they're sitting on gold right now. We know the demand is there, the question is, where is that demand gonna' go to?

Chadwick: The alternative is redevelopment. There's a lot of talk downtown about infill locations, because other than Playa Vista, there aren't a lot of sites sitting around. For the first time, you have to take existing structures and do either extensive rehabilitation or redevelopment, or just tear things down and start over. I think we're going to see quite a bit of that over the next five years.

Dretzka: We have yet to experience the San Francisco south of Market effect downtown. (The once-downtrodden area of San Francisco south of Market Street is today thriving with dot-com tenants.) Not that the dot-coms are going to be the demand saviors of the L.A. tenant base, but there's a whole lot of inventory there in the markets that may be out of favor at the moment. West L.A. is great -- we have one pad left on Constellation (Boulevard in Century City), and after that? Game over. We have some chunks in Burbank, the Valley, but Warner Center is done. If you go up and down the 101 between here and Westlake Village, there's just not that much left. There's a great expanse of class-A inventory with great infrastructure downtown. I think (downtown) can handle some of the demand, but people will have to reorient themselves a bit.

LABJ: What types of tenants do you see driving the demand for downtown space?

Dretzka: I think the next tier of users are going to be forced out of the (Westside) market. Second-tier law firms, architecture, lower-margin service professionals and service providers will need to look elsewhere, for instance to Mid-Wilshire. But what you see there in the Miracle Mile is that everything is full. The wave is rebounding back to downtown.

Zietsman: As the Westside gets more and more expensive, the tech firms are going to be forced to go downtown. The landlords there are probably going to accept their credit, whereas the landlords on the Westside are getting extremely picky these days. And the other area of demand for downtown is just tenant expansion. Some of the law firms are expanding.

Chadwick: I think because of our backgrounds, we're focusing (this discussion) on office, but there's very strong retail demand anywhere you look in the downtown area. There's also a demand for multifamily loft apartments and industrial, if you could get the space, which you can't. And there's tremendous demand for hotels. We're one of the few major cities in the world that has a convention center with no hotel-motel infrastructure.

LABJ: So everybody agrees that demand is strong and will remain so, and that supply is constrained. But rents are already up dramatically and the economy is showing signs of slowing. Aren't we peaking?

Zietsman: Everyone believes in our shop that rents have got a fair way to go in this economy. Southern California has got a good three, four, five years of growth left in it. We just talked about the lack of development supply on the Westside, and that's certainly going to fuel continued rent growth.

Dretzka: And we're still a lagger on the national scale.

Zietsman: We're way behind Northern California. You could argue that capital values are going to exceed $400 per foot on the Westside in the next three years.

LABJ: So who will be the most active investors in the months ahead?

Chadwick: There are four sources of capital that are behind acquisitions, rehab, and development. We're starting to see the return of retail capital from the individual investor that is seeking either cash flow or stability.

There's the high-net-worth person living in Silicon Valley who will fill out high-net-worth syndications in a matter of hours, because they've just made $100 million (on tech ventures) and they're very happy to take 25 percent of it off the table.

Then there's domestic-based institutional capital -- pension funds, university endowments, private foundations. Then I look at the non-U.S. sources of capital -- mainly the Swedish, the Dutch and the Germans.

Each capital source is a little different in terms of what they want to do, which means you can basically find capital for just about any project.

Zietsman: The markets are pretty segmented at the moment. The pension funds are the major segment driving the market today. All the state pension funds have got big allocations for real estate this year. That's across the country. CalPERS just announced they're going to raise their allocation by 2 percent, which is huge -- that's billions of dollars flowing into the real estate market. Then you've got the opportunity funds, and they're all looking for high-return deals.

What we're finding is that anything that falls in between those two requirements (top-quality buildings and high-return properties) has not seen a lot of play. We're finding it very tough to sell a B-quality office building in an OK suburban location. It's going to change. The players in that market all want extremely high returns. So we've seen values drop, I'd say 10 or 15 percent, because there just aren't enough buyers chasing that sort of deal.

LABJ: Does it concern you that some opportunistic investors are cashing in their chips? Is this a signal of a peak on the Westside?

Chadwick: Everything is very asset-specific. When you buy an asset you usually have a time horizon for what you want to do with it. If you look at the investment as value-added and you've taken the property from 65 percent to 95 percent occupied and you've gotten your rent bumped, you've probably optimized your return on that asset. And so you sell it. That doesn't mean that everything ought to be sold. Not everything has the same capital structure or the same time horizon, and not everything leases up at the same pace.

Zietsman: What is going to be interesting is that all the investment banks and opportunity funds have put a significant amount of money into the market over the last three or four years. It's billions, $70-80 billion nationwide. The issue is that this is impatient money, short-term money. These guys are going to be wanting to sell, so there's going to be quite a bit of pressure on the selling side.

Seaman: We've been hearing that, but we haven't seen it yet.

Dretzka: It's been a little bit slow. All the pressure to sell -- we heard that with the REITs in late 1998 and early 1999. Some of them got rid of some non-core assets, but that's about it. It's the same thing with the opportunity funds. They're very much in their four- or five-year horizons on the early funds and it's been a little more than a trickle, but certainly not a stream.

Chadwick: There are a lot of opportunity funds that missed the window to sell. They have assets they want to sell, but people aren't offering them the price that they want. The REITs went through a period where they really needed capital and they wanted to recapitalize existing ventures and do joint ventures, and do staff like that. The capital was smart enough to know that the lamb was wounded, and so the prices were coming in. Then the REIT market started to rebound a little in the first half of this year and so now they're saying, "Well, maybe we'll be a little more arrogant tomorrow."

LABJ: So are we going to see the sellers come down in asking prices and take the money and run? Or are property values going to bounce up to the point where the sellers are getting what they want?

Chadwick: You can see sellers come down because the REIT market, for example, doesn't rebound enough to enable them to issue equity. Or you can see capital get more aggressive in their pricing. CalPERS is a great example -- to go from 6 to an 8 percent allocation, that's $4 billion more that they're going to put out in real estate (investments). They want to put it out sooner rather than later, so maybe they get more aggressive on how they price things. So it could happen either way.

Smith: When I got into the business, we put together limited partnerships for tax shelters, we'd buy or build something, and the intent was to hold forever. Then all the opportunistic money came in, and a whole new vocabulary came in as well. No one had ever talked "exit strategy" before. We have a much more disciplined market now, where people go into the market with very specific plans for what they're going to do to the asset, how long they're going to hold it, and what their goals are. Once I meet that goal, I take my money off the table and I look for the next one. I don't hold for two or three cycles.

Chadwick: You're more disciplined because your capital demands it. They didn't demand a plan before, and then, uh oh, it was too late, it was 1989 (and the market sank into recession).

Seaman: The pension fund money, which is viewed as long-term money, is exactly as George (Smith) said. They want a plan, they want a four- and five-year hold, and when they reach that point, you know there's a lot of pressure to sell -- even if there's some more upside. They want to take those chips off and re-deploy that capital somewhere else.

LABJ: Say you each had $100 million to invest in L.A. real estate. What would you buy, and where, to maximize your return?

Dretzka: Someone once said, "Go where the others aren't." The retail and hotel sectors are oversold, so one could maybe take a look at that. This is a market where there's no liquidity, so maybe one would make the case to look at mid- to upper-tier hotels and selected retail opportunities. On the office side, perhaps some selected downtown properties -- downtown might be a little bit oversold at the moment.

Chadwick: I'd be putting my money in retail, grocery and drug-anchored, neighborhood centers in infill locations, which really means downtown. Because of the population density there, say within five miles of Staples Center, downtown has greater buying power than anywhere in the U.S. except maybe Manhattan. We have a fund called Metropolitan Development Partners, which is designed to do just that. And I'd be doing multifamily residential lofts. I think the demand for living space near where the jobs are is very high -- people are driving these ridiculous distances to work in order to have a nice place to live for their family.

Smith: I could leverage $25 million into about $100 million worth of small apartments, spread the risk, and that's the biggest market in terms of ability, to resell to individual investors. I would speculate part of the money with guys who are very good at land entitlement plays, whether it's residential or commercial. I'd look for single-tenant buildings where the rents are substantially below market but you may have as long as five years before the rent rolls. Finally, I'd keep my eyes open and see what shows up.

Seaman: It's fairly well picked-over, but I think there are opportunities still in looking at class-B buildings that have near-term (rent) roll, where you can pretty the building up with some paint. You redo the lobby and corridors, and then as the tenants roll, bring the rent up to-market.

But a lot of people are looking for that stuff now, so we're looking to stray to other markets. We will look downtown. You get a better quality there because, you have buildings that have had the same owners for a long time and they're looking to get, out. I like the urban residential and apartment play as well. People don't want to sit on the freeways all day long.

Zietsman: I've always been a believer in going for location. I think downtown has got a lot of locational advantages, but it's really an artificially created center. It's not where people want to live and work yet. Once people really start living in downtown Los Angeles, which you're starting to now see, that will change the whole picture. So I'd take $25 million and put it into downtown because there is room for rents to grow and value to be created.

But the majority I'd take and stick on the Westside and go with location. If you buy in the best locations, your values will grow more than if you buy in a secondary market. I would look in Beverly Hills I would also look at Westwood retail. Even Rodeo Drive I like because there's an extremely limited market there -- there's only three blocks on the street.

LABJ: Sounds like you'd all invest in L.A.'s largely developed urban areas. No interest in the outlying suburban areas?

Smith: Well, some of those outlying areas are having the same problems we're having in the urban core, which is land availability. I look at what's happening out in Calabasas, Westlake Village, Camarillo, it's just as hard finding investments along the 101 corridor as it is finding good investments in town right now. All have very well-established; high-end residential bases, and people want to work near where they live. There are a lot of smaller but prospering companies and there are the same kinds of supply constraints.

Chadwick: The Southern California basin is 16-17 million people. It's huge, and very diverse. And the investor base and capital base is not homogeneous. You could make a case for anything -- light industrial distribution center in Santa Clarita, whatever. I'll have lunch with anybody about anything, because you never know. Get me the "it," and we'll find somebody that can do it. This area is a hotbed of activity. Don't rule anything out, because there are a lot of good stories out there.