Reprinted from University of California at Santa Barbara Economic Forecast 2006. Written by Greg Stafford and Steve McCarty of Stafford-McCarty Commercial Real Estate.

Issues of the Year

• The biggest story might be the slowdown in residential markets (inventories up and the number of sales down).
• Downtown San Luis Obispo Retail rents are skyrocketing.
• Commercial loan rates have crept up by approximately 75 basis points above rates for 2005.
• Commercial investment properties have experienced decreased demand by 1031- buyers.
• Politics and Development: Measure J was placed on the November 2006 Ballot regarding the Dalidio Marketplace.

Notes on the Residential Market – Bellwether for Overall Market Confidence

Last year (2005) we talked about the residential markets “upstaging” the commercial real estate sector. The change in market- place dynamics from a year ago is dramatic. The number of home listings has significantly increased (doubled) since this time in 2005 and the number of sales has dropped off (about half of what they were this time last year). The MLS reports staggering numbers of home price reductions. There is definitely a downward trend in home prices locally.

An interesting finding is that the average sales price per home is steadily increasing within the City of San Luis Obispo. For example, the average price in February 2006 was $619,000, $722,800 in May 2006, and $767,000 in August 2006. This indicates that fewer so-called low-end homes are selling and a greater number of higher priced homes are selling. This has been a consistent trend for the past six months.

Softness of the student housing market, which was the case in 2005, has not held through to this year. Cal Poly’s total enrollment is about 18,400 with about 3,600 incoming first year students. Even though the university added about 800 rooms last year, there remains a demand for off campus housing. However, currently there are 2700 new units under construction in Poly Canyon, which should be on-line in about a year. With these new units coming on line next year, the private sector rental housing market should be negatively impacted to a moderate degree

It’s somewhat of a mystery why buyers are remaining on the sidelines when interest rates remain relatively attractive, home prices are coming down and unemployment is minimal. Many economic pundits predict a rapid turnaround with the market fi rming up within a year or so, but others predict a protracted downturn in the housing market. Hindsight wisdom a year from now will be telling.

Commercial Markets in San Luis Obispo – Downtown San Luis Obispo

Rents in downtown San Luis Obispo are experiencing unprecedented upward pressure. Downtown lease rates historically have been fairly stable with only incremental increases over the last fifteen years; however, there is a rapidly developing new rental paradigm. Stafford-McCarty predicts that by next year $4.00/square foot/NNN rents will be commonplace in downtown San Luis Obispo in which buildings have recently traded hands, associated with new construction, or been seismically retrofitted.

Investors paying higher prices for downtown properties ($400 to $700/square foot) are translating into higher rents. If an investor pays $400/square foot and seeks an 8% return, the landlord would have to charge $2.80/ square foot/month/NNN, and if he paid $700/square foot he would have to charge $4.90/square foot/ month/NNN. (These rents have been adjusted upward 5% to account for a vacancy factor).

Costs associated with mandated earthquake retrofi t of downtown SLO un-reinforced buildings, are triggering landlords to raise rents (in some cases precipitous increases) and forcing local retailers to find more affordable space. The more affordable space is invariably outside the downtown core. There are a limited number of “affordable” retail spaces in San Luis Obispo, which means that some local retailers will have to move their operations out of San Luis Obispo or simply cease doing business. Case-in point is Meridian Furnishings at 952 Higuera. Meridian recently announced its imminent departure from their current downtown location due to a quantum leap in rental rate. The new asking rental rate is $4.25 per square foot per month NNN, which is about double the former rate. It’s our understanding that Meridian will focus on selling out of their warehouse in San Luis Obispo in the commercial service zone.Another example, which is not as extreme as Meridian’s, is Joann’s (a women’s clothing store) which has been a fixture at 1023 Morro in downtown San Luis Obispo for well over 10 years. They recently announced their departure from San Luis Obispo due to rental increases. The new asking rate is $1.85/square foot/month/NNN, which is a far cry from the $4.25 being asked just a few doors away, but enough of an increase to push the retailer out of town.

Other Issues for Downtown

Building height limitation is a hot topic for the City of San Luis Obispo. Currently, buildings have a height limitation of 35 feet. However, recently a mixed-use project was tentatively approved for the SEC of Marsh & Nipomo with a maximum height of 50 feet. There are several projects pending approval in the downtown core requesting building heights of 50 feet to 75 feet. All of these projects are mixed use, i.e. retail and office on the lower floors and apartments or condominiums on the upper floors. General concerns and fears are with increased building heights the character and feel of the town will be drastically changed wherein traffic congestion could become major plus natural sunlight could be greatly limited on the narrow downtown streets creating a cold, uninviting environment.

Retail

The retail sector continues to have very low vacancy rates (1.8 percent at this reporting). As of the writing of this article the following tenants are awaiting structures to be built in front of Home Depot and Costco by the Madonna family on Los Osos Valley Road (Irish Hills Plaza): Circuit City, Petsmart, and Linens ‘n Things, which will go head-to head with Best Buy, Petco, and Bed Bath & Beyond located about a half mile away.

Costco was under construction when we wrote our article last year. No one knew for sure how Costco would fare in this relatively small market (the entire County of San Luis Obispo has approximately 263,000 people). According to Costco officials, the SLO Costco will surpass the national sales average of Costco stores by doing a projected $121,000,000 in gross annual sales. The store is about 140,000 square feet, which translates into gross sales of $864/square foot. This is a phenomenal figure given the large square footage. Their “category killer” competitors typically generate $250 to $500 per square foot for significantly less square footage.

Pad building rents at Irish Hills Plaza are generating approximately $42 to $45 per square foot for annual NNN rent.

Office

Increasing costs to construct new office buildings remained unabated and is a continual theme of conversations with developers. As a matter of fact, WestPac Development Corporation had planned on building and selling medical office buildings ($270/ square foot shell prices) by the County Airport, but cancelled their plans when construction bids came in significantly higher than anticipated. This project remains on hold.

Several new office projects have recently been completed and are entering their occupancy phase. Sycamore Court Office Park, approximately 24,000 square feet, is advertising a 90 percent occupancy and the NKT Commercial Project, approximately 77,000 square feet, is putting on final touches. These projects are across the street from each other on the corner of Tank Farm and Broad Streets.Sycamore Court is achieving five to ten year lease terms at approximately $2.00 per square foot NNN. The owner is contributing approximately $50.00 per square foot towards the tenant improvements to compete for tenants. Some recent tenants and approximate square footages are: Wilson and Company, 4,000 square feet, Barnett and Cox, 5,700 square feet, Rick Engineering, 7,000 square feet and AG Edwards 3,035 square feet.

Manufacturing

This segment of the market has been very stable (vacancy 4.3 percent) but represents a smaller and smaller component of the market as traditional manufacturing space is being converted to office, retail, and commercial service uses. Of the traditional manufacturing product, most noticeable is the surplus warehouse space being offered for lease at the recently completed Dioptics facility of +/-114,000 square foot, up to 27,000 square foot is for lease at $0.70 per square foot gross rent, and the former San Luis Sourdough facility of 35,000 square feet being offered for $0.65 per square foot NNN. Both facilities are presently pending proposals.

Investment

The Central Coast Investment markets are softening and capitalization rates are showing signs of rising. Tax deferred driven transactions have been few and the inquiries for potential opportunities have diminished as well.

The table above shows the majority of income property sales transacted in 2006 within the City of San Luis Obispo.

It is our opinion that Cap Rates will increase in 2007, reversing the downward trend the last several years. This will be primarily due to lenders focusing on income production versus comparative sales (which has been the primary method of valuation for a great number of local banks) with an emphasis on debt coverage ratios (DCR). This will probably be a slow process, but inevitable due to the fact recent income property sales make little or no economic sense, implying negative leverage. Moreover, we are seeing higher Cap Rates in Northern Santa Barbara County.

Following are Capitalization Rate ranges evinced over the last four years for our market area:

2002 ……….. 9.0 to 9.5
2003 ……….. 7.0 to 8.0
2004 ……….. 6.5 to 7.5
2005 ……….. 5.5 to 6.5
2006 ……….. 4.5 to 6.5

To illustrate the capitalization influence on valuation, let us assume a commercial building produces a net income to the investor of $100,000 per year. The declining market Cap Rates would correlate to the approximate purchase prices according to the following years:

2002 ………. $1,100,000
2003 ………. $1,428,000
2004 ………. $1,538,000
2005 ………. $1,818,000
2006 ………. $2,222,000

Atascadero – Downtown Atascadero

Colony Square continues to be the city’s hope of creating a pedestrian friendly downtown retail/living core for Atascadero. The owners of the property are pressing ahead with this large development with plans for a 10-screen movie theater, creek restoration, and creek-walk, public art, 72 live/work units, 21,000 square feet of office space and 79,000 square feet of retail and restaurant space. Demolition of some of the existing structures has started. Completion date is projected at two years.

One of the more prominent residential developments to come on line in Atascadero is Centex’s Dove Creek at the south end of town. The project is entitled for 45,000 square feet of commercial and consists of 277 homes, parks, walking trails, and of course a creek. They have three product lines of attached and detached units ranging in approximate prices from $430,000 to $582,000.

Paso Robles

Paso Robles continues to be a hotbed of commercial activity. There is a total of 554,400 square feet of commercial either under construction or with building permits approved. Included in this are three motel/hotels, two of which are La Quinta Inn (Buena Vista Drive) and a Marriott Courtyard (South Vine).

Under construction is the Mee Memorial Medical Office Building consisting of 23,300 square feet at 416 Spring Street. This is significant as there has been very little medical office product in the Paso Robles market. The bulk of the office supply resides in Templeton near the hospital.

Presently there are dozens of projects applying for building permits.

In accordance with the most recent published Residential Activity Report dated June 2006, there are 1,298 single family recorded lots and out of this number 1,013 are either built or under construction.

Politics and Development in San Luis Obispo County

A frustrated Ernie Dalidio took his Dalidio Marketplace shopping center development approval to the county electorate via Measure J on the November 2006 ballot. Dalidio had been thwarted by the residents of the City of San Luis Obispo in his efforts to build his shopping center, so he asked County residents to approve his development. It was a landslide approval, 65 percent in favor in contrast to 35 percent against. The Dalidio Marketplace is planned to have 530,000 square feet of Retail (Target and Lowe’s are anchor tenants) plus 60 residential units, a hotel, office product, organic farm, sports fields, etc. To put this in perspective, this project has more square footage than downtown San Luis Obispo. The point regarding this section is that development is an extremely passionate issue to the county’s citizens.

The “R” Word is Showing Up Again

It is not uncommon in our daily conversations to hear owners and buyers talk about a pending recession. Whether or not economic data supports or negates the presence of a recession, it is a common conversation theme. Not being sure of how many rumors it takes to make a fact, we are seeing buyers and users taking a “wait and see” attitude until they feel more comfortable with their own business climate or see positive movement in the market. As noted above, lenders are focusing more on economic valuations than comparable sale valuation.

Final Words

Vacancy rates have remained consistently low. Building sale prices are at new high water marks. Construction costs remain high and are not concomitant with the downward adjustment of the present residential market. Investment capitalization rates have leveled near the end of this year and are showing signs of rising. Given the “wait and see” attitude created in the residential market, Central Coast commercial markets have been very stable and are experiencing increased rents.