Reprinted from University of California at Santa Barbara Economic Forecast 2008. Written by Greg Stafford and Steve McCarty of Stafford-McCarty Commercial Real Estate.

Issues of the Year

• Residential slowdown and bankruptcy news cloud public view of commercial markets


• All time high values for downtown San Luis Obispo commercial buildings


• Neutralizing/Reversing of loan rates (approximately 25 to 50 basis points less than end of 2006)

Notes on the Residential Market—An Indicator for Overall Market Confidence

The downward trend in the residential market projected last year has become a vivid reality. The number of home listings has increased dramatically since this time in 2006, and the number of home sales has dropped to levels not seen for over a decade. Home prices continue to decline. San Luis Obispo County average home prices fell about 9.0 percent in 2006 and it appears that an 8.0 to 9.0 percent decline is probable for 2007.

The Multiple Listing Service (MLS) continues to report staggering numbers of home price reductions on a weekly basis. Of course, no one can accurately predict when prices will stabilize, but pundits estimate anywhere from six to eighteen months.

A few words about Cal Poly and its efforts to accommodate incoming freshmen with on-campus housing are in order. Cal Poly has an incredibly large influence on the housing market and commerce in the City of San Luis Obispo. Total enrollment is about 18,500 with about 3,700 first year students. Construction of “Poly Canyon Village”, a 2,700 student housing complex, is well underway. The complex will have an Olympic size pool, retail and food service areas, study labs, two parking structures and below-market rents. The first phase of apartments is expected to be completed September 2008, and is intended for first and second year students. The actual impact of the project completion and occupancy upon the local market remains to be seen.

Commercial Markets in San Luis Obispo

SLO Vacancy Rates (October, 2007)

Industrial/Warehouse: 2.3%
Retail: 1.4%
Office: 3.5%

Downtown San Luis Obispo

As discussed last year, a new rental paradigm is emerging. Seismically retrofitted and new buildings are achieving market-high rents evincing a large spread between existing rents (under $2.00/ square foot/month/NNN) and rents for the best locations. New asking rental rates can be $4.25/square foot/month/NNN, which is about double the former rate.

Investors are continuing to pay higher prices for downtown properties ($400 to $700 per square foot), which also translates into higher rents for tenants. However, there is evidence of some price reductions as well. Downtown land values are approximately $250 per square foot. This would include properties with structures, which are destined for demolition and replacement with a denser development.

Ultimately, the net result of costs associated with mandated earthquake retrofits of downtown San Luis Obispo City’s un-reinforced buildings is raising rents. The more affordable space is invariably outside the downtown core. There are a limited number of “affordable” retail spaces in San Luis Obispo City, which means that some local retailers will have to move their operations out of the city or simply cease doing business.

Using market rate examples, say an investor purchases a downtown property. If the investor pays cash for a building at $400 per square foot and seeks an 8.0 percent return, the investor would have to receive $2.80/square foot/month/NNN. If he paid $700 per square foot he would have to charge $4.90/ square foot/month/NNN. These rents have been adjusted upward

5.0 percent to account for a vacancy factor. Given that rents are higher than local tenants have typically been paying, we are seeing a trend of more national retailers, not only in the newer centers away from downtown but downtown as well, with the Apple Store in the Copeland’s Project and Peet’s Coffee and Tea opening adjacent to the Court Street Project.

Increase Height Limitations for Downtown Buildings

Over the last year there has been a great amount of street talk and local print regarding the impact of expanding building standards to allow increased building heights. Increased height limitations were met with substantial public opposition, but not enough to alter the City Council’s eventual approval of taller buildings in the downtown core. The new ordinance went into effect October 2007. The newly adopted height ordinance allows buildings to be as tall as 75 feet. However, each project is subject to governmental scrutiny on a case-by-case basis. Buildings can have a maximum height of 50 feet without special approvals. However, in order to achieve 60 feet in height an Architectural Review Committee (ARC) approval with specific standards and objectives must be met by the applicant. To be able to get to 75 feet a project must receive Planning Commission approval with a use permit.

Retail

A very stable retail sector continues to demonstrate low vacancy rates (1.8 percent at this reporting). Presently the retail market base is approximately 3,842,000 square feet. Most visible in the non downtown markets are the recent tenants at the Irish Hills Plaza next to Home Depot and Costco. Tenants include Circuit City, Pet Smart, Linens ‘n Things, Old Navy, Bev More, Office Depot and Panda Express. Pad building rents at Irish Hills Plaza are generating approximately $42 to $45 per square foot for annual NNN rent.

Office

High construction costs are still the chief complaint from developers. This being said there are several projects which have been completed this year and some presently under construction. The typical asking rent is between $1.50 to $2.00/square foot/month/NNN. The office inventory base is approximately 2,624,000 square feet.

Westpac’s medical office project at the Airport is still on hold. At the south west corner of Tank Farm Road and Broad Street, NKT Commercial’s project of approximately 77,000 square feet is undergoing final touches with tenant improvements. The following tenants have announced occupancy: American Principle Bank, Chevron, San Luis Eye Associates, Mind Body and Coldwell Banker Vista Associates, which is moving from downtown—this is significant in that it further endorses this developing area as a business hub. Rents for this project are approximately $1.50/square foot/month/ NNN with a $30-$50/square foot tenant improvement (TI) allowance plus one year of free rent with a minimum 5 year term. The approximate 71,000 square foot mixed-use office/retail Airport Business Center on Broad Street is under construction. Frontage improvements are being made, building pads have been created and construction has started on the approximately 23,000 square foot building. Rental rates have not been established. The Tank Farm Commerce Park on Tank Farm Road is now the home to Idler’s Appliance and the Regional Transportation Authority. Further construction on the project includes 34,000 square feet along Tank Farm Road and 15,500 square feet along Suburban Road. Rental rates are approximately $1.35/square foot/month/NNN with the owner delivering a finished vanilla shell.

Existing buildings just outside or near downtown are selling for approximately $350-$650 per square foot.

Manufacturing

This market segment has traditionally been the keystone to a community’s economic vitality. In our coastal areas it is functioning less and less in that role. Pure manufacturing space is being absorbed by and/or converted into non-traditional uses-churches, service companies, warehousing and distributors with retail components and offices. Thus, the associated manufacturing job market sector is shifting into office, services, retail or simply going away. As it relates to actual vacancy, the rates for manufacturing product have been very stable, 4.3 percent reported last year (2006) and 2.2 percent this year. Not all the jobs are making the transition but the buildings are. The San Luis Obispo City industrial base inventory is approximately 3,693,000 square feet. As a note of comparison, the approximate base of the Santa Maria industrial market is a little over 7,000,000 square feet.

Of the traditional manufacturing product, the most noticeable transaction was Copeland’s former warehouse (103,000 square feet) on Suburban Road. The property was purchased by Tennis Warehouse for $6,250,000 ($61/square feet) in August 2007. In contrast, $250 per square foot was paid for four smaller, newly constructed industrial buildings on Ricardo Court. Mostly these units were sold as leasehold investments.

Investment

The Central Coast investment markets continue to soften as the number of transactions decreases compared with past years. Tax deferred driven transactions have been few as with the paucity of inquires as well. However, several have closed this year.

The following represent the majority of income property sales projected to close in 2007 within the City of San Luis Obispo:

Market sentiment has pressured capitalization rates to increase in 2008 following the upward trend that started nationally last year. However, locally we are not seeing overwhelming evidence of this, especially given the dearth of investment transactions. There is no market ubiquitous Cap Rate being established, only an expanded range. Each transaction is a case-by-case basis, with buyers having their own basis for determining value. The upper end range results when projected rents are applied to vacancies in the market, not actual income.

The following are capitalization rate ranges evinced over the last six 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
2007……….. 5 to 7

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 market Cap Rates would correspond 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
2007……….$2,000,000

Atascadero

Colony Square, the 210,000 square foot residential and commercial development has broken ground on a ten-screen movie theatre. However, the developer indicated via The Tribune that he has asked the City of Atascadero to help with funding the project to the tune of $1,000,000. In February of 2007, the developer stated he estimated the cost of construction to be about $60,000,000. The request from the city was precipitated by the current credit crunch. The developer stated that he is encountering resistance from tenants regarding his asking lease rates of plus or minus $3.00/ squar foot/month/NNN, which are necessitated by the high costs of construction.

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 space 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 the low $300,000’s to the mid $400,000’s (compared to last year’s report of $430,000 to $582,000).

Paso Robles

Paso Robles, even though small in population continues to be the county’s economic dynamo. This relatively small community on the Central Coast has been bursting with commercial activity across all market segments. Approximately 270,000 square feet of new commercial product has come on line this year. The total retail base in Paso Robles is 6,942,000 square feet. This is comprised of 4,275,000 square feet for retail, 242,000 square feet for office and 2,425,000 square feet for industrial. Included in this year’s new construction are three motel/hotels, two of which are La Quinta Inn on Buena Vista Drive and a 130-room Marriott Courtyard on South Vine Street and two national chain restaurants on Theatre Drive, Chili’s and Applebee’s. Even with the addition of these lodging facilities several Paso Robles luminaries still believe that the area is under served with available rooms.

A significant project that has received zoning approval is Matt Masia’s Black Ranch Resort at Airport Road and Highway 46. The resort will have a golf course, restaurant, health spa, conference facilities, 80 casitas and a 200 room hotel. A smaller project, an 80 room motel, has been approved for 24th Street.

The next large retail center is planned for Golden Hill Road and Dallons Drive on 11.6 acres. The center will consist of 5 major tenants, 6 pads and multi-tenant space for a total of approximately 292,300 square feet. The project owner, Regency Centers, has applied for zoning approval.

Recently completed is the Mee Memorial Medical Office Building consisting of 23,300 square feet at 416 Spring Street. As the bulk of the medical office supply resides in neighboring Templeton around Twin Cities Hospital this will become a significant asset serving the Paso Robles market.

Paso Robles Vacancy Rates (October, 2007)

Industrial/Warehouse: 2.8%
Retail: 0.3%
Office: 5.6%

Politics and Development in San Luis Obispo County, The “D” Word

Development is an extremely passionate issue to the county’s citizens. Ernie Dalidio was previously turned down by the City of San Luis Obispo in his efforts to build and bring his shopping center into the City. He took the Dalidio Marketplace shopping center project to the county electorate via Measure J, which won by a landslide, 65 percent to 35 percent, in November of 2006. The election results are now being challenged and the project timeframe is uncertain again. 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 and sports fields. As a perspective, this project has more square footage than all of downtown San Luis Obispo.

The City of Atascadero also has its political development issues. A two year process to entitle a 195,000 square foot Wall-Mart project, on land they have already purchased, has run aground as the City Council has elected not to amend the general plan to accommodate Wal-Mart. According to the local press The Rottman Group and Wal-Mart are considering taking their entitlement proposal to the ballot.

Final Words

There is a present confidence schism in the real estate markets of San Luis Obispo County. For residential purchases there is a “wait and see” attitude before jumping in, yet the commercial market continues to demonstrate strength. Vacancy rates have remained consistently low. Central Coast commercial markets continue to evince stability and demonstrate increased rents. Building sale prices set all time highs. Investment capi-talization rates have remained stable even with the perceived pressure to rise. Will there be a lack of confidence spill over to the commercial sector? Will the commercial markets follow residential? This will be our “wait and see” time.