The inventory of class-B office space in Orange County is shrinking, which is causing a change in developer and tenant strategies, JLL executives recently told SoCal Real Estate during a roundtable discussion.
According to research by the company released in April, in the past three years, over 100 class-B office properties in Orange County have been, or are currently being converted to creative properties, totaling over 6.5 million square feet. A heavy majority of these conversions are occurring in the Airport Area submarket.
With these renovations bringing higher rents, value-oriented tenants have fewer space options, particularly in the Airport Area, says JLL. In April, the firm reported that the average asking monthly rent for the Orange County class-B market was $2.56 per square foot, full service gross, compared to creative conversion buildings which average $3.17 per square foot.
Cushman & Wakefield reports that Orange County’s class-B overall rental rates have seen a $0.32 increase year-over-year, a rise caused by class-B space becoming more attractive to cost-constrained businesses as landlords continue to add trendy building amenities. Essentially, according to JLL, class-B space is becoming class-A space, since an increasing number of office users need the class-A amenities to attract and retain talent. This leaves a dearth of class-B space for those seeking it.
So, what are tenants who need true class-B space to do? We spoke with Curtis Ellmore, SVP at JLL, about this issue and how developers and tenants are changing their strategy about office space in the Orange County market.
SoCal Real Estate: Why is the class-B office asset class shrinking in Orange County?
Ellmore:Throughout the cycle, what’s been a popular move by most investors is repositioning of assets. So, a lot of operators and investors have been buying class-B and -C assets, infusing them with capital, and making them creative office. As a result of this capital infusion and repositioning, owners feel this space is not class B but class A. There’s been a recategorizing of these properties from B to A because the owners have put money into them to recoup their investment. This all translates to higher rents.
Now, we see the gap between class-A and class-B pricing is very thin. Class B is traditionally mid- or low-rise product, and pricing for that has becoming more expensive than class-A pricing as a result of the type of companies out there: a lot of tech-based or biotech and even insurance companies and the like. They want to be in cool, creative buildings. They are retaining and recruiting talent with cool projects—we’ve even seen companies pay more now for creative class-B product than they would class-A product.
In some cases, these companies are compensating for smaller footprints. Some companies typically have open bench seating and can take less square footage. But you can only take a certain minimum of square footage. You can only get so small, and then can’t park it anymore, and ownerships won’t have a parking ratio that’s too small for the number of employees they have.
How are developers changing their strategies in light of this trend?
What everyone’s doing is trying to find value-add, older product. There’s a lot of value-add money out there, and developers are looking for these opportunities because they want to sell that story of, “We’re going to reinvest into that building, make it cool and creative, turn it into an A building with amenities and features, and charge higher rent.” It’s been the strategy of a lot of developers, so supply is going down.
Where are tenants seeking this space in Orange County turning for solutions?
They’re sucking it up. There are not a lot of solutions for tenants now in that cheaper price point. The world has just changed. As a result, companies just have to pay more, and a lot of them are seeing it in their renewals.
It’s not the beginning of the end for class B because offices have lifespans. When you walk into these new offices in 10 years, they will be outdated. Class B will come back around again. When there’s a downturn in the economy, you will start seeing a lot of B product coming back on line. In a downturn, rents are going back down and landlords are not putting money into properties.
How are investors shifting their strategies in order to find and close deals?
Investors — operators — have to find alternative money sources. A lot of funds have been raised for value add. They also have core or core-plus money, which buys value-add deals after they’ve been turned around and stabilized. Ultimately, it’s different capital chasing these deals.