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Thursday, May 17, 2012
Feature: February 2008
The Other Shoe
What else is set to drop after the residential bust?
Story by Jeff Hudson and Douglas Curley
Mayor Heather Fargo once proudly proclaimed Sacramento “is under construction but open for business.” Now most of the pile drivers and cranes have completed their missions or been removed due to lack of interest, money or investors.
This current state of the Capital Region’s commercial real estate industry seems to echo that of the national slump of the early ’90s, caused by savings and loans. During those years, investors, brokers and bankers kept hope by telling one another to “Stay alive ’til ’95.” Today, those industry veterans may be saying the same to the 30-somethings that reaped the spillover benefits of a housing market on steroids: Ride it out.
Experts such as John Frisch, senior vice president of Cornish & Carey, say the regional commercial market — office, retail and industrial — will be slow to flat for at least the next two years.
“Leasing will remain slow, especially in the private sector,” Frisch says. “What little new construction that will occur will be driven by the state, healthcare and legal sectors.”
State government is widely recognized as the big gorilla downtown, consuming more office space than any other entity — sometimes absorbing entire buildings that were intended for the private sector. The Money Store closed in 2000, vacating the distinctive 320,000-square-foot Ziggurat in West Sacramento. The state’s Department of General Services eventually leased the building for its workers.
In hard times, the region’s economy has been bolstered by the state’s dependable demand for both workers and buildings. But that ravenous appetite for office space is slacking off, at least for the time being. In late November, the state canceled plans for a 1.4 million-square-foot office building for the California Resources Agency, which would have gone somewhere in or near downtown.
It would have been at least a $500 million project in the face of falling revenues and a $10 billion budget shortfall. Local builders, lawyers and others felt their hearts sink when the project came off the agenda. And with the governor talking about trimming expenditures by 10 percent, there’s bound to be a deeper effect on the downtown office market. But there have been some successes.
On the Sacramento side of the river, there’s the $132 million U.S. Bank Tower on Capitol Mall, a 25-story office building.
A block away, there’s another 25-story project at 500 Capitol Mall by Tsakopolous Investments, a $115 million project slated for nearly 468,000 square feet of office space and 27,000 square feet of retail.
Once builders complete these projects, most experts don’t expect any other high-rise activity in the downtown core to come on line any time soon. With the state expecting to enter into a slow-growth mode, the market could need several years to absorb the hundreds of thousands of square feet of space the new buildings will provide.
However, the market for commercial office space outside the city varies, depending on the area.
“The Highway 50 corridor is very healthy and getting healthier,” says Clyde Rawlings, senior vice president for Grubb & Ellis. “It’s driven primarily by corporate America.” National companies aren’t closely tied to the ups and downs of Sacramento’s residential market.
On the other hand, Rawlings says, “We’re seeing problems in Roseville, Rocklin and Elk Grove.” Those areas “were beneficiaries of massive growth during the homebuilding heyday,” he says. But with that industry in a slump, mortgage firms, title companies and homebuilders are vacating office space in those areas.
Frisch, speaking at a recent Urban Land Institute event, “Emerging Trends in Real Estate,” assessed the Roseville and Elk Grove markets.
“Roseville is built on sand,” he said. “A majority of the commercial activity there has — and always has — lived off the residential food chain. As those companies associated with the housing industry fold up shop — and we’ve already seen many leave town — there’s going to be a lot of vacancies.”
The challenge for city officials in Elk Grove to lure big office tenants also has become more difficult.
“There are big buildings in Elk Grove but no big tenants,” Frisch said. “And while there are thousands of state employees who commute from Elk Grove to downtown every day, there is currently no interest by the state to move department offices to the new city down Highway 99.”
Rawlings says there is also an overabundance of “small office buildings in small business parks, built to catch the demand of business owners who want to operate their own small building. Right now we’ve got a glut of that. There’s a lot of that kind of inventory on the ground.”
Still, taken as a whole, the commercial real estate picture is brighter than the residential side. “It’s a different market, a different breed of cat,” says Gary Schlossberg, senior economist with Wells Capital Management in San Francisco. Schlossberg says commercial real estate is “driven to some extent by consumers,” but also linked to “the strength or weakness in the overall [national] economy.”
Some trends affect both residential and commercial real estate — the current credit squeeze, for instance. “The cost of borrowing has gone up,” Schlossberg says. Problems stemming from the subprime mortgage fiasco have spilled over into the broader financial markets, and lenders at all levels have become more cautious.
Commercial real estate “is not as credit sensitive early on as housing,” Schlossberg says. “[It] feels the effect well after the housing market.” Although the impact is not as immediate or intense on commercial real estate, “financing is not going to provide the same tailwind for the industry during 2008,” compared to the previous five years.
Sacramento continues to enjoy its traditional advantages: proximity to the Bay Area, the quality of life and the knowledge-based work force, Schlossberg says.
“This won’t necessarily keep [Sacramento commercial real estate] out of a slump if everyone else is slumping,” he adds. “But I don’t think that the economy is going to go through a deep wringing out.”
The region’s retail market is one aspect of commercial real estate that appears neither slumping nor bounding. Several lifestyle centers have opened or are about to throughout the region. There are also a handful of big-box facilities under construction or in the planning stage.
Target, the popular alternative to Wal-Mart, has plans for at least three new or improved stores in the region, with features tailored to the area. In November, the big box announced plans to raze an existing 115,000-square-foot store on Broadway in Sacramento and replace it with a 160,000-square-foot store.
Target is also getting ready to start construction on a slightly smaller store in Woodland’s proposed Gateway Center, a project that will also include an even larger Costco store. All told, the 50-acre Gateway project — spearheaded by developer Paul Petrovich — will include a total of 550,000 square feet of commercial space. Petrovich is also talking to Woodland about an even larger project on adjacent land, involving the annexation of 153 acres for a proposed auto mall.
A third new Target could break ground this year in Davis, a town that’s previously resisted big-box retailers. Davis voters approved the Target store in 2006, after a campaign in which Target spent about $269,000 touting the store’s merits. The new store will be certified by the U.S. Green Building Council program Leadership in Energy and Environmental Design.
This big-box activity is actually skewing the region’s retail numbers, says David Brennan, senior managing director for CB Richard Ellis. The region’s unanchored centers may have a tough time retaining and attracting tenants over the next two years.
“We’re already witnessing a major slowdown in the high-end mom and pop shops. It’s very expensive to operate a shop like that, what with triple-net rents and consumer confidence heading south,” Brennan says.
While the smaller theme retail centers may suffer over the short-term, Brennan says those in prime locations will survive this difficult ride into 2009.
On the industrial front, the Capital Region has had a shortage of “modern” space for several years. This has lead major users to look elsewhere.
“Sacramento is still a great distribution market but not as good as Reno and Stockton,” Brennan says. “Because of the lack of newer properties, we’re pretty much out of the big distribution game, but we’re still a very good retail distribution point.”
Brennan predicts industrial lease rates will likely increase over the next couple years because of this supply. He says much of the supply-and-demand imbalance on this front was caused by the re-entitlement of industrial land to residential zoning over the past decade. There simply is no place to build big centers.
“Desirable industrial suites are already filled, so if you have other industrial properties, put some lipstick on those pigs so you can rent them out,” Brennan says.
While minor tenant improvements will likely attract tenants at higher lease rates, Brennan says these rents still don’t pencil out for new construction.
With the different areas of commercial real estate posing a challenge at best, Frisch, who remembers the early ’90s real estate downturn, said it isn’t all gloom and doom for the Capital Region.
“We have a much more diversified economy than we did 10 years ago. There are still pockets of activity throughout the region that will keep the building trades alive and help fuel consumer confidence,” Frisch said.
And as a message to the younger players in his industry, Frisch offered this counsel: “Hang in there. We’ll get through this, just like we did the past dips.”
