L.A. Office Ownership Shifts to Funds, REITs

Ownership of premium office buildings in downtown Los Angeles and the Westside has changed dramatically in the last 10 years as a result of a gradual pullout by foreign investors, the highly publicized buying spree of real estate investment trusts and a much less publicized return to the market by pension funds.

Pension funds and real estate investment trusts combined now own more than 70% of the premium office space on the Westside and nearly 30% of the top quality buildings in downtown Los Angeles, according to a study by the Los Angeles office of Julien J. Studley Inc.

Those numbers contrast sharply with figures from 1990, when pension funds and REITs combined owned only 10% of the office space on the Westside and 7% of the downtown space, according to the study. It showed that REITs owned no premium office space in downtown L.A. in 1990 but now own 15% of it.

The report underscores how thoroughly the tides of real estate ownership can change in just a few years, from the wave of Japanese investment in the late 1980s and early 1990s to the buying binge of real estate investment trusts in the mid-1990s to today’s increased investment by pension funds.

The study addressed only top-quality office buildings of more than 100,000 square feet--known in the industry as Class A space. It focused on downtown and West L.A. as the two largest office markets in Los Angeles County, with about 33 million square feet in downtown and about 30 million square feet in a number of submarkets known collectively as the Westside.

The survey quantifies a number of trends that real estate brokers, investment advisors and business publications have observed anecdotally for some time, including the gradual shifting of office building ownership away from private individuals to large public or private sources of capital.

“Individuals are getting out because they can’t compete with REITs and pension funds,” said Howard Sadowsky, West Los Angeles-based vice chairman of Studley. “That’s a trend not only locally but nationally.”

Individual developers and investors still own 21% of the premium Westside space and 27% of that downtown, but those figures are down from 48% on the Westside and 31% downtown in 1990, according to the report.

However, “It’s a lot harder for individual entrepreneurial developers to raise the capital to build Class A space today than it was in 1990,” said Paul Prescott, a Los Angeles-based real estate partner in the Arthur Andersen Real Estate and Hospitality Services Group. Prescott said lenders tightened their criteria after the overbuilding of office space in the late 1980s contributed to a glut of space and failed projects. Even today, he said, lenders remain wary of office projects.

One of the sharpest drops in ownership is on the Westside, where banks own only 1% of the office towers today, compared with 18% in 1990, the report said.

That’s clearly a positive shift, according to Sadowsky.

“Almost all of what the banks owned in 1990 was a result of foreclosures,” he said. “This means they’ve gotten the real estate off of their books, which is a result of the tremendous recovery in the real estate markets.”

Despite that remarkable real estate recovery, pension funds were slow to return to buying office buildings and are still a bit reticent in markets they perceive as not fully recovered--like downtown Los Angeles, said Philip Hench, managing director at CB Richard Ellis Investors in Los Angeles, the investment advisory subsidiary of CB Richard Ellis Inc.

“The pension funds were the last to jump back into the fray because they had been burned by buying at the peak of the market” and later selling at a loss, Hench said.

Hench said so-called “opportunity funds” and REITs were the first to hop back into the buying of office properties after the recession of the early 1990s, with those two groups dominating the buying roughly from 1995 through 1998.

In recent years, however, “the pension funds have gotten back into the market in a big way,” Hench said.

Hench said the pension fund activity has been much less publicized than the REIT buying spree, in part because so many REITs are publicly held companies that are required to publicize their transactions and in part because pension funds prefer to operate quietly and avoid publicity.

Pension funds were slower to return to the office market because they are generally more conservative investors and wanted to be more certain that real estate had recovered, and because office properties are usually considered slightly riskier than some other types of real estate, such as industrial and apartment buildings, Hench said.

Hench explained that pension funds typically set a goal of investing 5% to 10% of their money in real estate. Many pension funds are looking for real estate to buy because they have fallen below those goals, he said.

The changes in ownership indicated in the Studley study reflect the changing sources of real estate capital over the past 10 years, according to Frederick Chin, a real estate partner at E&Y; Kenneth Leventhal in Century City.

Institutional sources such as banks, savings and loans, insurance companies and pension funds provided much of the capital to buy office buildings before the recession of the early 1990s, Chin explained.

When the recession hit, many of these sources wound up owning office buildings through foreclosure; others owned the buildings because they had bought them as investments, Chin said. In either case, these institutional sources needed to sell their real estate. Banks and S&Ls; needed to sell to get the properties off their books, while pension funds often needed to sell because they owned the office buildings as partners in funds that had legal agreements requiring them to sell the properties by a certain date.

From about 1993 to 1995, Chin said, the so-called “opportunity funds” emerged as the main buyers of office buildings. Such funds, usually backed either by Wall Street capital or wealthy individuals, bought foreclosed or financially troubled properties at steep discounts.

This “opportunistic capital” follows an opposite track from the more conservative buyers like pension funds, Chin said. The opportunistic buyers take bigger risks, buying troubled properties with the hopes of big returns when prices recover. Pension funds, by contrast, prefer to buy buildings after a market has recovered. The result is that opportunity funds wind up buying during the “down” cycles in real estate, while pension funds are more likely to buy during the “up” part of the cycle. That explains why pension funds are more active today, he said.

What was different about the 1990s, according to Chin, was the emergence of public sources of finance--especially REITs--during the REIT buying spree around 1996 to 1998.

REITs aren’t buying much today because their generally depressed stock prices have made it much harder for them to raise capital, according to Chin, Prescott and other real estate sources.

“What we’re doing is recycling our capital by selling properties that are no longer a strategic fit for our portfolio,” said John Davenport, Southern California president for Menlo Park-based Spieker Properties REIT.

Davenport said Spieker, which owns a number of office properties on L.A.’s Westside and hopes to increase its holdings there, is also selling properties where it believes rents have peaked for the time being and using the proceeds to buy properties where it believes rents will soon grow. It’s also investing some of those proceeds into construction of new developments, which typically provide higher returns than existing buildings.

Andersen’s Prescott believes pension funds will continue as active buyers but REITs will remain relatively inactive as buyers of office buildings until their share prices rise again. But he said the ownership picture is by no means settled and stagnant.

“I don’t think the full story has been written yet on what the place of REITs is going to be in the overall real estate market,” Prescott said. “They’re still in a transitional stage, and I don’t know if anyone can predict what their ultimate place is going to be.”

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Leading Landlords

Foreign ownership of premier Los Angeles office towers has substantially dwindled during the last decade as pension funds and real estate investment trusts have taken over control of the market. Percentage of office space* owned, by category of owner:

*

*Survey includes only Class A office space (prime-quality space in good locations), in buildings of 100,000 square feet or larger.

Source: Julien J. Studley