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Current 'Spec' Building Wave Shows Restraint

Builders are again constructing office towers before finding tenants. But many are taking fewer risks than before.


A little more than two years after developers resumed the risky business of building speculative office towers in Southern California, statistics suggest that construction is proceeding slowly enough to avoid creating the kind of disastrous glut of space that was a legacy of the last real estate boom.

Ever since the current construction cycle began, real estate observers have been wondering if the industry--never known for its restraint--would overbuild office space again and drag down the local economy. Research by brokerage firms Cushman & Wakefield and Grubb & Ellis suggests that new construction and demand for new space are fairly balanced, at least for the time being.

Tenants have filled nearly 39% of the 1.7 million square feet of speculative office space that has been built in Los Angeles County since construction resumed in 1997, according to Cushman & Wakefield. In Orange County, tenants have leased 53% of the approximately 950,000 square feet of speculative buildings that have been completed.

At those rates, industry experts say, developers should be able to fill their buildings within a year to 18 months of opening their doors, the period that most allow for in their financial planning.

On the other hand, demand for office space can fluctuate dramatically from year to year, so estimating how long new space will take to fill involves a certain amount of guesswork.

For example, demand for office space in Los Angeles County grew by 3.6 million square feet in 1998 after growing by 2.2 million square feet in 1997, according to Cushman & Wakefield. But the growth rate in demand for office space in L.A. County has slowed this year to about 350,000 square feet for the first half of the year, or an annual rate of 700,000 million square feet, according to the brokerage.

A speculative or "spec" office building is one that starts construction with few or no tenants signed up, in contrast with "build-to-suit" projects that developers start with tenants already standing by.

Speculative office construction ground to a halt in Southern California in the middle of this decade. The early 1990s recession, in combination with overzealous building during the late 1980s and early 1990s, had produced a surplus of offices in both Los Angeles and Orange counties. The competition depressed rents throughout the region, driving many owners into bankruptcy and forcing lenders to write off millions of dollars worth of bad debt.

By 1997, however, developers believed it was time to build again because the region's growing economy had filled much of the empty space and even produced shortages in some business neighborhoods. But developers haven't raced to break ground at the same pace they did before.

"There are more constraints right now," said Cliff Goldstein, a partner at Los Angeles-based J.H. Snyder Co., which is building the 600,000-square-foot second phase of the Water Garden office project at Olympic Boulevard and Cloverfield Avenue in Santa Monica.

"It takes a lot more equity to build a project today, which should prevent people from leveraging too much," Goldstein said. In the last building cycle, he pointed out, developers could often borrow 100% of the value of a project, risking none of their own money. Flush lenders were eager to share in what seemed like can't-miss opportunities at the time.

"Lenders today are more prudent," said Alan Pyenson, a vice president at Transpacific Development Co., which completed one of this cycle's first speculative office buildings, a 50,000-square-foot project at Cerritos Towne Center, in November 1998.

Pyenson said Transpacific hopes to break ground on an eight-story, 165,000-square-foot speculative building at Cerritos Towne Center later this year, but that lenders probably won't fund construction until there are tenants for about a third of the space.

The market seems to be taking a breather as memories of the real estate bust linger.

"There was more talk of speculative building a year ago," Pyenson said, suggesting that the steady but not spectacular pace of leasing has made lenders and developers cautious about supporting new projects.

One of the buildings leasing fastest in the current construction cycle is not yet completed. Koll Center Irvine North, a 170,000-square-foot office tower at Main Street and MacArthur Boulevard in Irvine, is 60% rented and has leases in negotiation that might take it to 90% filled within the next 30 days, said Nader Shah, a partner at Newport Beach-based Koll Development Co. The building is scheduled to open Oct. 1.

"I wish I could tell you why we've done so well with our leasing," Shah said, "but I don't think we're doing anything differently than others who have buildings to market."

Koll plans to build an identical property later this year at a site across the street from its current project, but Shah said that will probably be the company's last traditional office tower in the area for some time to come.

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