Steve McCarty and Greg Stafford, Stafford-McCarty Commercial Real Estate

Highlights

1. Income producing investment properties are very difficult to find.
2. All commercial market segments of real estate show improvement over the 1st quarter of 2006.
3. Price of commercial land continues its upward climb.
4. Commercial rents are rising. Industrial vacancy is approximately 3.6%, in contrast with 5.64% for the 1st quarter of 2006.
5. Retail vacancy continues to be in the two percent range, which is a very low rate. A surge of sub-prime loan defaults creates uncertainty in the markets.

For most individuals the weather vane of real estate is the residential market and from that they tend to measure the industry as a whole. Given the latest economic news of the sub-prime fall-out and the already softening residential market, uncertainty has been created. How this will affect all markets is yet to be told. Presently the commercial markets have been performing well and commercial land prices are seeing all-time high valuations in the Santa Maria area. The following is a brief description of the various market segments.

Residential

A shift has occurred from last year in that there are now more sellers than buyers. Still, mortgage interest rates remain attractive (6+%) and asking prices of homes in the Santa Maria area are some of the most affordable for the Central Coast.

The median sales price for a home in north Santa Barbara County is currently $414,290. The median price this time last year was $469,350 which represents an 11.7% decrease in sales price from one year ago. Sales of homes are down by 23.6% from this time last year. (The median price of a home in California is $559,640, an increase of 1.9% from a year ago.)

Generally speaking, prices are basically flat with some continued downward pressure. Sellers are becoming more realistic and adjusting to the new market paradigm. Many residential experts are predicting that the pace of home sales will increase significantly as summer approaches. There are virtually no investor buyers of homes. In August 2006, 55 vacant homes sold. Buyers are not looking for fixer-uppers but looking for homes ready to move into. Tracts of entitled land are now for sale. Inland Pacific Homes, one of Santa Maria’s major builders, sold four of their entitled projects last year.

Permits for single-family dwellings significantly decreased in 2006 to 144 from 294 in 2005 and 642 in 2004. Builders of approved projects are reluctant to build new homes due to the existing soft market. As of March 14, 2007, there were 298 homes on the market in the Santa Maria area. Eighty-four (84) homes sold in February 2007 for the combined Santa Maria and Orcutt market area. As of the publishing date of this article, there are 17 listings in Orcutt, which are priced over $1,000,000. The average listing price for a home in Santa Maria is $432,000 for a 1,400 to 1,500 sq. ft. home, and the average listing price for a home in Orcutt is $604,546. Homes currently are on the market for 109 days in Santa Maria, and 138 days in Orcutt.

There is currently a mortgage industry fallout regarding sub-prime loans. These are risky loans that were made to people with serious credit issues and could not qualify for conventional loans. These sub-prime borrowers have encountered escalating monthly payments due to the adjustable nature of the interest rates and there has been a tremendous increase in the number of loan defaults. An influx of REO properties plus builders of new homes cutting prices on new homes have contributed to creating downward pressure on home prices.

Retail/Commercial

First, some general notes on the impacts of new construction costs for commercial development. There emerges a two-tier system of rental rates: one for existing inventory and the other for new construction, which can be double the rent of existing inventory. Not only has the cost of new construction driven up rental rate requirements in order to achieve reasonable ownership returns on equity, these costs have also been a windfall to existing product owners by adding value, which in turn has maintained the pressure for higher prices on older product.

Available commercial/retail space within the City of Santa Maria (as of first quarter 2006) is about 85,000 sq. ft. Since last year, most of the former Home Base building has been leased leaving 22,000 sq. ft. available at $1.35/sq. ft./mo./NNN. Club 24 has taken approximately half of the former Montgomery Ward’s building leaving approximately 30,000 sq. ft. vacant. These are the only large vacant retail spaces remaining within the city. For the purpose of this report, databank numbers include functional, non-competitive inventory (older buildings and warehouses) and excludes non-market square footage such as mini-storage, airport hangers, etc.

Retail space vacancy continues to be very low-approximately +/-2% (total retail inventory base in the City of Santa Maria is approximately 4,107,000 sq. ft.). For the most part, there has been little anchored or general retail space added to the city’s inventory in the last several years; however, the College Square development which is under construction will add approximately 55,000 sq. ft. of retail space with rents of $2.50 to $3.50/sq. ft. (As of this article, the leasing agent for College Square stated that there are 5 or 6 tenants who have submitted letters of intent to lease)

The +/-117,000 sq. ft. Santa Maria Commons shopping center at the SWC of McCoy and Broadway has recently been completed. The site consists of 10 ac. with Kohl’s as the primary retail anchor store, and World Savings, Starbucks, T Mobil as smaller users. Plans to re-develop the former Stephen’s Auto Center at the NWC of Skyway and Broadway continue to move forward to construct approximately 40,000 sq. ft. of retail and office space. The existing structures will be demolished to make way for the new commercial complex. The West-gate Marketplace (+/-120,000 sq. ft.) to be located at the NWC S. Blosser & Battles Rd. is in pre-leasing phase.

In our previous article, we stated that shopping center-sized land is very hard to find and to expect prices of $15 to $20 per sq. ft. The situation remains unchanged in regards to finding suitable shopping center land, but land prices have increased significantly. A buyer can expect to see prices ranging from $25 to $50 per sq. ft. depending upon size and location of the retail zoned parcels.

The following is a brief update on two large retail developments planned for Orcutt on which we have reported in the past:

• Orcutt Plaza (approximately 230,000 sq. ft.): Pre-leasing has been placed on hold as the property is going through an annexation process into the City of Santa Maria. The application is currently with LAFCO for processing.
• Orcutt Marketplace (approximately 295,000 sq. ft.): This center is a mixed-use development, which will consist of office, retail and hospitality. The center will be anchored by a 35,000 sq. ft. Spencer’s Fresh Market. Other tenants expressing interest include a Starbuck’s drive-thru and an ARCO service station. Another aspect of the development will be an upper end hotel-motel consisting of 105 to 125 rooms. Construction should commence the 1st quarter of next year.

Office

This market segment continues to be very tight. Office base inventory is currently approximately 1,015,000 sq. ft., which is an 8.8% increase over last year (933,000 sq. ft.). The last two years have produced healthy increases to the base inventory as opposed to prior years of limited growth (2.4% increase from 2003 to 2004).

The Parkway Medical Center medical building consisting of +/-30,000 sq. ft. on Professional Parkway has recently been completed. Two units (total of +/-7,000 sq. ft.) remain available for sale. The Shepard Medical Office/Surgery Center at 1418 E. Main Street consisting of 15,298 sq. ft. has been recently completed. Additionally, a 14,702 sq. ft. medical building (SLS Medical Clinic) at 1510 E. Main Street along with the 36,600 sq. ft. VA Clinic at 1520 E. Main Street are nearing completion.

Market rents for 2nd generation office space has increased somewhat from last year (average of +/-$1.10 to $1.15/sq. ft./mo./NNN) to an average of +/-$1.25/sq. ft./mo./NNN. Newly constructed office buildings command rents in excess of $2.00/sq. ft./mo./NNN. Slowly but surely triple net (NNN) leases are supplanting the long-standing modified gross leases, which have been prevalent in Santa Maria.

The price of appropriately zoned land allowing construction of office is similar to the discussion of land prices in the Retail segment above, as Santa Maria’s C-2 zoning allows office uses as well as retail uses. Land prices are increasing and hard-to-find smaller parcels are generally costing $25 to $50/sq. ft. (depending on location).

Industrial

Industrial vacancy is at an all time low, approximately 3.6%. Both, user/buyers and investors, continue to drive transactions in the Santa Maria industrial market segment for larger space requirements—mostly above 10,000 sq. ft. The Stafford-McCarty databank indicates that the industrial base for completed, functioning inventory in Santa Maria at the time of this article is approximately 7,200,000 sq. ft., an increase of about 295,000 sq. ft. over last year.

2006 was an active market for Industrial building sales.

Key User Expansions

For the wine industry, Central Coast Wine Services on Aviation Way has completed approximately 43,000 sq. ft., the latest in their multi-phased series of expansions bringing their facility to approximately 250,000 sq. ft. The adjacent Fess Parker’s Wine Center is preparing to a build a facility for Consilience Winery of approximately 20,000 sq. ft. on its surplus land.

Driscoll Strawberries purchased approximately 20 acres of land on Stowell Road and has completed its approximately 156,000 sq. ft. cooler and crate shed. Okonite, a long time Santa Maria manufacturer and employer, is under construction with a 76,000 sq. ft. addition. Home grown CafeFX continues with their business growth with the purchase of a 36,300 sq. ft. building. Cloud Star is expanding its operations into the former Boston Pet facilities consisting of two buildings of about 20,000 sq. ft. each on W. McCoy Lane.

Key User Shrinkage

CerOx has listed their 18,658 sq. ft. facility for sublease and has moved their enterprise to northern California. Boston Pet has placed two adjacent buildings totaling approximately 40,000 on the market, which has recently been occupied and gone into escrow with Cloud Star as noted above.

The Santa Maria market typical industrial requirement has been 4,000+/-sq. ft., which is coming from tenants looking for incubator space and other small users. Multi-tenant industrial projects offering smaller units have demonstrated good absorption and have stabilized. The tightening of the market coupled with all time high new construction costs has lead to an increase of rents. Rents for 2,500 to 4,000 sq. ft. spaces have moved up about a dime, escalating from approximately $0.75 to $0.85 per sq. ft. NNN. Asking rents for 2nd generation multi-tenant buildings have increased and range from approximately $0.45/sq. ft. to $0.75/sq. ft. NNN.

The seven -building, 139,000+/-sq. ft. FairSky Technology Park targeted larger office and R & D users, which have been noticeably absent from Santa Maria. The +/-20,000 sq. ft. buildings have been broken up into industrial condominiums for the smaller user/buyers present in the market. Valuations for these products are in the $125 per square foot range for a finished shell. As of this article, there is 28,258 sq. ft. vacant or approximately 20% of the complex.

The trend of non-manufacturing users occupying manufacturing zoned properties continues. Non-denominational churches have been moving into industrial properties, both free-standing as well as multi-tenant. Quasi retail users, such as furniture stores, and commercial services users are also back filling spaces, which were traditionally filled by manufacturing companies. Retaining manufacturing companies has been difficult in the Central Coast even though Santa Maria is one of the most affordable areas.

Meyer Asset Management has acquired land on the western side of A Street and is under construction with the first phase of a 174,973 sq. ft. development. This developer has brought to the market product meeting the needs of companies seeking ownership. What has changed this year is that additional “For Sale” buildings have come on the market, giving buyers some choices.

Industrial Land

It continues to be increasingly difficult to find finished lot product. One to seven acre sale prices can range from approximately $8.00 to $12.00/sq. ft. for CM and M1 zoned land, if they can be located. Minimal industrial transactions occurred last year. However, a noteworthy sale was a
9.22 acre PD M2 parcel on Stow-ell Road with partial infrastructure selling for $6.22 per sq. ft. M2 zoned land typically has not sold at values so near its M1 and CM zoned relatives.

The Airport District, which controls the bulk of the M-1 Light Industrial zoned land, is proposing an approximate 42-acre research park of approximately 500,000 sq. ft. A portion of the project has been approved with 15-20 lots, leasehold interest only. However, the status has remained the same for the last four years as the District awaits a non-jeopardy biological opinion in order to proceed.

Even though there is limited supply of product, there persists the higher and better use pressure for existing well-located larger inventory. Conversion of industrial land for housing and retail has come under scrutiny by the City Council. There exists sensitivity for creating an industrial preserve, specifically targeting the 56 and 120-acre sites along Betteravia Road on the westside.

The solution to the existing inventory problem is the approximately 932-acre annexation, known as Area 9, detailed in previous articles. Although these properties have come into the City, they lack infrastructure and sub-division. It may be several years, in addition to heavy infrastructure funding not yet quantified, before parcels become build-able. In the mean time owners with existing properties will see strong valuation.

Agricultural

Growers are seeking ground for organic production, which has taken two directions. First, evaluating and bringing into production previously unfarmed ground, which carries the adage, “it was unfarmed for a reason”, meaning the quality of the ground and/or resources is poor, and second, focusing on quality ground and going through costs associated with the three year certification program.

Strawberry and vegetable ground values are over $40,000 per acre. As noted in previous articles, rarely will quality land become openly available on the market. Potential buyers push the market to new highs attracting seller’s attentions.

For comparative purposes, Oxnard land valuations are in the low to mid $70,000 per acre range In the Salinas Valley, valuations are in the mid to high $50,000 per acre range. Ground lease rates in Oxnard surpass Salinas rates. Reportedly, owners are seeking $3,200 to 3,500 per acre rental rates for berries and $2,000 to $2,400 per acre for vegetable ground in Oxnard. As a comparison, Salinas Valley annual lease rates are $2,200 to $2,400 per acre for quality ground. Santa Maria Valley ranges from $1,200 to $1,800 per acre for vegetable ground and, as projected, strawberry ground leases have passed $2,000 per acre this past year.

Currently, capitalization rates for agricultural ground are approximately 4 to 5%.

Commercial Investment

Capitalization rates, termed “Cap Rates” have become less a standard number and have moved into a wider spread this last year. A Cap Rate is calculated by dividing the annual net operating income (NOI—which does not include debt service) by the purchase price, e.g. $100,000 NOI/ $1,500,000 purchase price equals 0.0667 or a 6.67 cap rate.

Buyers appear to be more sensitive to the quality of the income stream and asset location as opposed to just the return. With interest rates rising over last year, (Prime is at 8.25 at the time of this writing), properties with low capitalization rates will become less and less attractive. Buyers seeking 1031 exchanges have slowed. Many prospective 1031 reinvestment buyers are electing to pay capital gain taxes versus overpaying for property, or waiting to see if prices fall before they sell their property. That being said, it is difficult to find shopping center owners willing to sell at higher capitalization rates—in other words they still want high prices even in the light of softening valuations.

Retail, office and industrial capitalization rates have ranged between 5.6 and 7.5, with high sixes and mid sevens being the target. Cap Rates have turned upward and have moved approximately 0.5 to 1.0 point up from the previous year.

In the following table are capitalization rate ranges evinced over the last five years.

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 correlate to the approximate purchase prices for the same piece of property and income according to the following years as noted in the table.
Several market transactions between $2,000,000 and $3,500,000 for Santa Maria:

1. 3030 Industrial Parkway
   Single Tenant
   $3,285,000
   30,000 sq. ft.
   7.5 Cap Rate
   Investor
2. West Stowell*
   Mini-Storage
   $2,669,000
   53,750 sq. ft.
   9.2 Cap Rate
   Investor
3. 1846 North Broadway
   Single tenant Retail
   $3,250,000
   7,000 sq. ft.
   6.6 Cap Rate
   Investor

   *This transaction falls outside market parameters, but may foreshadow the changing market.

Ancillary issues and observations: The equity required for conventional loans and down payments has climbed in order to bridge the gap between lender debt coverage ratio requirements (DCR) and current market rental rates. In short, investors need to put more cash into the transactions. Shopping center investors/developers continue to report difficulty in adding value by renovating properties in order to attract higher rate paying tenants. This group is now looking for “ground-up opportunities”—meaning they are seeking land on which to build.

Santa Maria continues to be similar to other investment markets in that there is little availability of investment product. This condition also holds true for the balance of the Central Coast. However, we see change on the horizon.

Summary
Santa Maria is positioned to become the population center for the Central Coast. Even with the downturn in housing production, it continues to be the only city in the Central Coast producing any significant quantity of housing stock. Santa Maria is preparing for continued growth of all market segments with several large annexations and infrastructure development.

Transactions for 2006 demonstrate confidence in the region and stability for the Santa Maria market; however, housing valuations and absorption show less vigorous signs than the boom of the last few years. We are on the same path as last year in that commercial investment valuations may soften as interest rates increase and with fewer exchange buyers in the market. But, the litmus test for valuations of commercial assets remains tied to the reality of high reproduction costs.