By MARK VAN DE KAMP
NEWS-PRESS BUSINESS EDITOR

Big sales and record prices, not big leases, distinguished the 2003 commercial real estate market in Santa Barbara County. But on the negative side, there were far more empty buildings and no takers — and lease rates declined for the third consecutive year.

Brokers believe the same will happen in 2004 — unless interest rates rise, encouraging some investors to shift dollars into the stock market.

	RAFAEL MALDONADO / NEWS-PRESS Although vacant space is near a peak, commercial real estate brokers Steve Hayes, left, and Francois DeJohn closed one of the largest deals of 2003 when they completed the signing of the lease for 614 Chapala Street in Santa Barbara with Samy's Camera.

A question mark is whether investors will keep driving up purchase prices. Cap rates (rates of return) on buildings in the South Coast and North County are lower than many investors seek. If the stock market goes up and interest rates rise, sales prices should stabilize or correct downward.

Demand is expected to remain high for all types of commercial real estate, provided that they are priced competitively, said Bob Tuler of Radius Group.

This year, many landlords will find themselves in the familiar position of keeping rents steady, brokers said at least for several months. So for now, it's a seller's market and a tenant's market.

On the South Coast and in the North County, vacancy rates and prices should improve over the year, brokers said. But there is a lot of empty sublease space and not much demand for larger spaces. Fully 40 percent of empty space on the South Coast is sublease space. Until demand rises, absorption could be weak. There is no line of big companies trying to set up shop here, yet.

"Everyone is hoping for the effects of an improving national economy to drive a turnaround here on the Central Coast," said Mark Mattingly of Pacifica Commercial Real Estate. "So far this year, the business sentiment I encounter is more positive than last year. Let's hope these hopes are proven correct."

The bright spot for landlords is retail space, which is 99 percent occupied. Asking retail rents have been steady in Santa Barbara and up in Goleta.

Overall, another positive is the vacancy rate for commercial space on the South Coast, which is low compared to many other regions. The rate of empty space for office and industrial is in the neighborhood of 6.7 percent here. In context, the rate was around 16 percent in Los Angeles, and last year in San Jose, it was around 28 percent.

Much of what brokers forecast is based on the past few years.

In 2001, the downsizing of technology firms resulted in more empty space. The commercial market in 2002 was driven by expansion needs of local companies, but it was not spectacular.

Then in 2003, there were downsizings and business relocations. Fidelity National Financial left for Florida with 450 jobs, opening space; some was filled. DuPont Displays put 149,000 square feet back on the sublease market in Goleta. Indigo Systems did the opposite, signing the biggest sublease of 2003, taking 86,000 square feet that Ericsson vacated.

In the end, Goleta's vacancy rate went up. Same with Carpinteria.

"The industrial market in Goleta faces the largest challenges in 2004, as there are currently 10 buildings larger than 10,000 square feet available with very little tenant demand," said Francois DeJohn of Blair Hayes Commercial. "The Carpinteria and Santa Barbara industrial markets will outperform all other sectors for the second year in a row and should see modest improvement."

Carpinteria has a high percentage of empty buildings. The city experienced one of its worst years in terms of vacancy and pricing due to the consolidation of Unisys, QAD Inc., Venoco Inc. and Skinmarket. The vacancy rate is about 20 percent. QAD will move into its new building in Summerland this year, creating additional vacancy in Carpinteria.

Santa Barbara, Goleta and Carpinteria office lease rates will continue to be negatively affected by the predominance of available sublease space, Mr. DeJohn said. Sublease space accounts for 40 percent of vacant buildings, he said, and rental rates have fallen for three years in every sector except for Carpinteria industrial space.

"Santa Barbara office rents fell to an an average asking rate of $1.95 per square foot last year, which is the first time since 1999 that it's been under $2," said Steve Hayes of Blair Hayes.

Some brokers think the lease rates will begin to rise later in the year.

As less expensive sublease space becomes occupied, and if the economy improves, Mr. Mattingly said, look for leases to start to rise. He said that lease rates softened in 2003 but not dramatically compared to other regions.

"We are lucky to have such low vacancy rates on the South Coast," Mr. Mattingly said.

Office lease rates will continue to decline for another six months, said Scott Glenn of Radius Group. He thinks that now is the time for businesses to expand.

"Office rates will then climb 10 percent per year and at the end of five years will surpass the prices of 2001," he forecast.

Retail rents, which have leveled, will start going up by the end of 2004 and will be up about 15 percent between now and the end of 2005, Mr. Glenn said. He thinks industrial rents will increase five percent per year.

Turning to the sales market, brokers predict that it's going to get even pricier.

"The office and industrial sales market set records in 2003, even as rental rates continued to fall in every sector except for Carpinteria industrial space," Mr. Hayes said. "This marks the third consecutive year where sale prices have increased and lease rates have decreased.

"In fact, Santa Barbara office buildings sold at an average price of $407 per square foot, crossing the $400 per square foot threshold for the first time in the history of Santa Barbara, an increase of 31 percent over 2002 prices," he said. "Santa Barbara industrial buildings also broke records, selling at an average of $258 per square foot, an increase of 43 percent over 2002 prices."

The inventory of properties for sale will increase, giving investors more opportunity to buy in Santa Barbara, said Steve Brown of Radius Group. There have been many instances when sellers chose to pay capital gains taxes because they could not find suitable exchange properties in the city, Mr. Brown said.

In other words, demand has outstripped supply.

Santa Maria leads the county with commercial and industrial development with more than 1.5 million square feet of new space approved. Last year, a record 800,000 square feet of industrial buildings was completed and this year another 500,000 square feet is under construction.

Investors went on a buying spree in Santa Maria last year, too. Purchases were driven by tax-deferred exchange money, low returns on alternative investments and favorable mortgage interest rates. Jerry Schmidt and Pat Palangi of Pacifica Commercial Realty called the sales "incredibly active."

The new FedEx building sold at completion — about $5 million for the 40,400-square-foot building, said Steve McCarty of Stafford McCarty in San Luis Obispo. A leased 30,000-square-foot building on McCoy Lane traded for more than $100 per square foot, a new high in the industrial market, Mr. Schmidt said.

"Various other sales and current escrows clearly demonstrated a seller's market with high prices, low cap rates and multiple offers," Mr. Palangi wrote in his 2004 outlook.

Among some of 2003's deals: The Santa Maria Plaza sold for about $6 million, the Santa Maria Commerce Center sold for more than $9 million, and a shopping center in Lompoc anchored by Vons sold in the neighborhood of $35 million, said Mike Hieshima of Epsteen & Associates in Carpinteria, a brokerage specializing in retail deals. Raytheon purchased a large building in Lompoc for $7.75 million and moved a few dozen engineers there, with plans to bring more employees this year.

Vacancy rates declined overall in Santa Maria, Mr. Hieshima said. Retail lease rates in Santa Maria are rising slightly, he said. But in Lompoc, rents are steady. Phil Kyle of Epsteen & Associates predicts lease rates will rise in the low single digits this year.

"North County is where the action is," Mr. Hieshima said. "With all the new homes and substantial move of very high quality demographics from Santa Barbara and San Luis Obispo to Santa Maria, the customer household income is interesting to a new level of stores and retailers."

But there are questions how much longer and higher sales prices can increase.

The expected rate of return on buildings (after expenses), known as the capitalization rate, is lower than in past years, Mr. Tuler said. Investors who in the past looked at buildings in the South Coast are now seeking opportunities in the Lompoc and Santa Maria areas and elsewhere, he said, hoping for a better return on their investment.

"But people still want to buy here," he said. "Others are considering alternatives."

Local investors are buying commercial buildings with better cap rates in other states, said broker Len Jarrott, president of Jarrott & Co. Real Estate Investment in Santa Barbara. His clients typically have $1 million to $10 million to invest.

"From my perspective, the prices are too high in Santa Barbara," he said. "I'm doing deals for them in Texas, Florida, Georgia and the Carolinas. Most of my customers are doing tax-deferred exchanges. If they're willing to invest out of this area, they can get better cap rates."

There could be a shift in interest rate momentum this year that changes the market, said longtime broker Steve Leider, partner of The Leider Group in Santa Barbara.

"Interest rates to a certain degree clearly feed the investment market here in town. I find very concerning, as interest rates rise, and lenders who have put loans on expensive new properties, that if rates fall or stay stagnant, and investments are not yielding 6 or 7 percent, that you're losing equity. That can cause problems."

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