Office Prices in Subprime’s Center Leapfrog Recovery in Region

Investors are bidding up prices for top-tier office buildings in Orange County, California, even as vacancies stand at almost 20 percent after the collapse of the subprime-mortgage industry that once made the region its home.

Prices paid for offices in the area climbed 63 percent to $111 a square foot in the second quarter from recession lows of $68 in 2009, according to preliminary figures from Real Capital Analytics Inc. An 11-story building near John Wayne Airport is on the market at $225 a square foot, up 80 percent from the $125 it fetched two years ago, said Greg May, a managing director at brokerage Grubb & Ellis Co. in Newport Beach, California.

The gains come in a region where vacancies more than doubled with the 2007 collapse of subprime lenders including New Century Financial Corp. and Ameriquest Mortgage Co., both of which were based in Orange County. Second-quarter asking rents were down 31 percent from the 2007 peak, and office vacancies stood at 19.2 percent, May said. That compares with a 17.2 percent rate nationwide.

“The investment market has leapfrogged the recovery,” said Jeffrey Cole, an Irvine, California-based broker at Cushman & Wakefield Inc. “Investors are well ahead of fundamentals. Based on rents, prices paid today make a good return difficult.”

Capitalization rates, a measure of investment yield, for Orange County office buildings dropped to an average of 6.9 percent in the second quarter from 7.7 percent in all of last year and 7.9 percent in 2009, according to Cushman.

‘Premium Price’

Orange County, home to the Disneyland and Knott’s Berry Farm amusement parks, has been attractive to office buyers because of the region’s “excellent” infrastructure, school system and weather, said Doug Holte, president of the office-properties division of real estate developer Irvine Co.

“So much money is on the sidelines but so few assets are coming on line that people are paying a premium price because of lack of supply,” said Jim McFadden, a managing director at Grubb & Ellis based in Orange, California. “In some cases, on a 10-year lease, you don’t see a return until the seventh year after you factor in on all the costs in the transaction. Some of these have you scratching your head.”

The region was “a major U.S. hub” for mortgage lending, according to Duy Ngo, Irvine-based client coordinator at Cushman & Wakefield. The financial-market crisis “had a major impact on these firms and employment. It spelled the end of Orange County,” he said.

Unemployment Increase

Joblessness in the county soared to a high of 10 percent in January 2010 from 3.1 percent in December 2006, during the property boom, according to California’s Employment Development Department. In May, the latest month for which figures are available, the rate was 8.5 percent. Office vacancies rose to a high of 21.8 percent in the second quarter of last year from a low of 8.6 percent in mid-2006, Cushman said.

Office transactions of more than $5 million climbed 55 percent to $1.09 billion last year from $701.8 million in 2009, according to Cushman. That compares with about $6.33 billion in the 2007 peak. Volume so far in 2011 totals $260.6 million, the brokerage said.

Emmes Group of Cos., based in New York, in June 2009 paid $160 million, or $302 per square foot, for the 20-story 3161 Michelson Ave. in Irvine, which was 38 percent vacant at the time, according to Grubb & Ellis. The price included a parking garage, Emmes said.

The building was developed as the headquarters for New Century, the largest independent mortgage lender to subprime borrowers before it collapsed in 2007 as defaults by homeowners with poor credit soared. The company never occupied the space.

Building Dispositions

The property used to belong to MPG Office Trust Inc., the Los Angeles-based landlord formerly known as Maguire Properties. MPG has been disposing of buildings to reduce debt after paying $2.88 billion for all the real estate in downtown Los Angeles and Orange County that Blackstone Group LP (BX) purchased in its acquisition of Sam Zell’s Equity Office Properties Trust.

Vacancies at 3161 Michelson have dropped to about 24 percent, according to Edward Hernandez, an Irvine-based broker at Cushman. Tenants include Hyundai Capital, Jacobs Engineering Group Inc. (JEC) and real estate services provider Eastdil Secured LLC.

“You have to look at the underlying fundamentals,” Richard Coles, managing principal at Emmes, said in an interview. Emmes was drawn by the area’s wealth management, aerospace, finance and accounting companies, he said.

“With all these industries, we are highly confident that Irvine, Newport Beach and Orange County on a whole will continue to be on the forefront and see a recovery going forth,” Coles said.

Irvine Co. Purchase

Irvine Co. said in December that it bought Pacific Arts Plaza in Costa Mesa, an 827,000-square-foot (77,000-square meter) property with four office buildings and four restaurants, for an undisclosed amount.

“Because we think we’ll see positive returns in the future, we are comfortable with prices that have more modest initial yields on investments as we believe the recovery will outperform what most people anticipate,” said Irvine’s Holte.

Ocean West Capital Partners, founded early last year, completed the purchase of a 16-story building at 2600 Michelson for about $70 million, or $228 a square foot, this month, said Troy Miller, principal at the Santa Monica-based company. The property, previously owned by MPG and 50 percent vacant, had been under receivership for a year and a half.

Ocean West bought the building in a joint venture with New York-based Dune Real Estate Partners.

‘Reposition the Building’

“Our view is we get to step in to reposition the building and to reintroduce it to the market,” Miller said in an interview. “Our expected horizon for returns is around five years. We are already seeing some leasing activity since we acquired the building.”

While occupancies are starting to rise in Orange County, rents remain depressed. The average monthly asking rent at Class A, or the highest-quality, office buildings was $2.15 a square foot in the second quarter, down 5.7 percent from a year earlier. That compares with a record $3.13 in the third quarter of 2007, according to Cushman.

Epicor Software Corp. in February signed a 10-year lease for about 68,000 square feet at a Class A building near John Wayne Airport -- a centrally located area with a high concentration of top-tier properties -- for $1.72 a square foot, which includes such services as heat and water, according to Grubb & Ellis. In May, Access Insurance Holdings Inc. agreed to a five-year lease for 31,000 square feet at a Class A building in Orange at the same rate, the brokerage said.

No New Construction

Those actively buying, mostly local investors who understand the market, are counting on a recovery in a region where new construction was nonexistent in the first quarter, said Cole of Cushman. While Orange County will come back, some office buyers may have to wait 10 years for returns, said Stuart Gabriel, director of the Ziman Center for Real Estate at the University of California, Los Angeles.

“In some ways, these bets in Orange County will be really good bets,” he said. “It’s about the quality of life, the quality of public schools, the stable political environment. There is a low probability for a doomsday scenario.”

A broader recovery in Orange County is dependent upon a decline in unemployment, which would help boost office demand and rents, according to May of Grubb & Ellis.

Some investors aren’t deterred.

“What’s striking is how quickly the appetite has returned to such a ferocious level after such a low point,” said McFadden of Grubb & Ellis. “In 2005, 2006 and 2007, it moved so quickly. In the last 12 months, it’s moved as quickly in terms of expectations.”

To contact the reporter on this story: Nadja Brandt in Los Angeles at nbrandt@bloomberg.net

To contact the editor responsible for this story: Kara Wetzel at kwetzel@bloomberg.net

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