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Tech Space Shakeout

Southern California's commercial real estate market has been bruised by the technology slump, particularly the Westside. The former center of gravity for many of the region's Internet-fueled businesses is becoming a ghost town of unused high-tech property. As landlords are cushioned comfortably with lines of credit, capital-drained companies are scrambling to dump or sublease prime office space--desperately offering an array of free incentives, from a fortune in furniture and technical equipment to luxurious Polynesian vacations.

"It's eerie," says Gray DeFevere of Grubb and Ellis (a major sponsor of larta), as he refers to the recent figures his research department has passed along about the amount of available square feet popping up in some of the Westside's prime spots. "You go to visit these properties and you think 'my God, here's six million dollars that this company invested in all this equipment and renovating, and it's just going away to whomever decides to rent the place for nothing.'"

Although the prime areas don't cover much territory, the amount of square feet that Westside businesses such as BizRate are trying to sublease could make up a small city. In the past nine months (a rough time frame of the economic downturn) DeFevere says that he has seen approximately 720,000 square feet become available, with 300,000 of that in the past two months. Compared to two years ago, the situation (both in terms of the rates as well as the availability of space) is startling.

"In late 1999 a space at a well-known property on the Westside was basically $3.75 to $4 a square foot, and right now it's subleasing at $1.80 including furniture and equipment," says Matthew Miller of Cresa Partners, a Westside-based brokerage. The other contrast, Miller adds, is the demand for space now compared to better times. "Eighteen months ago, a tenant on the Westside may have only had three or four choices, today they'll probably have thirty or forty."

This radical shift in the Westside's commercial space--a shift that has also affected the 101 Corridor, Pasadena and other Southern California tech sectors to varying degrees--has not left landlords in as distressed a state, because many of the leases were secured by large "letters of credit." If the tenants are in default on the rent, landlords take advtange of the letters of credit which provide them the flexibility during bad times; meanwhile, the tenants must do whatever is necessary to attract new companies to the space.

The letter of credit situation has created an interesting conundrum in the market. According to Miller, the size of letters of credit depended on multiple factors: landlord management, market timing and deal structure. Commonly, letters of credit were based upon the out-of-pocket costs of landlords, plus anywhere from three to twelve months of rent.

DeFevere of Grubb and Ellis, one of the largest commercial real estate brokers in the country, explains that landlords became savvy in their use of the letter of credit in order to insulate them from the very situation that has now developed. At the onset of the dot-com boom, landlords were loathe to depart from the conventional risk they understood well, or had become accustomed to. Suddenly, there was a huge increase in the amount of liquidity thrown at these companies, and landlords (and it may be added, the brokers themselves) had to jump in furiously to take advantage of a feeding frenzy that followed. As long as they were able to tie themselves to the financing by securing ironclad letters of credit, landlords were not paying any attention to the prospects for failure.

"Some landlords did very well in how they proactively handled their failed tenants, others were obstreperous and made stupid mistakes," says Miller. Meanwhile, despite the pain currently being felt by many players in the current market, one needs to be aware that in real terms, rents are still higher than they were five years ago. Also, tenant improvements have contributed to the potential desirability of the space (despite the current downturn). However, one reaps what one sows. Everyone agrees that memory being the scarcest commodity, landlords typically "complain about the vacancy left in the wake of the tech-wreck, but forget about their huge windfalls in 1998 and 1999 created by the identical phenomena," adds Miller.

So, many companies are now caught downwind from the great madness. During a slowdown, they slash personnel, put big plans on the back burner, and in cutting their burn rates, look to sublease excess space in order to meet their commitments on the leases they signed much earlier. The incentives can border on the outrageous--from expensive cappuccino machines, to hundred-thousand dollar server equipment, to high-priced, ergonomically correct furniture. DeFevere mentions one company trying to lease space in a brand new Westwood building, that is willing to throw in a first class trip to Tahiti as a sweetener to close a deal. This is an indicator, he says, of how the market is doing once companies start hitting these kinds of panic buttons.

"The tenant coming in can take advantage of this and leverage a lot of that infrastructure," says Richard Abbit of Lee and Associates, another Westside-based brokerage. "These are good opportunities for tenants because you can get space that is fully furnished, and the previous tenant would typically spend a lot of money enhancing the space, so there's numerous upgrades already in place."

DeFevere, who works with companies trying to sublease space, is seeking out clients within the entertainment production industry or other businesses in Southern California that could benefit from office sites which were formerly occupied by technology companies.

The existence of cheaper real estate, however, is not likely in itself to spur companies into moving into Southern California from outside of the region. This puts the lie to those economic development projects which seek to use space somewhat exclusively to market particular regions. Miller, for example, recognizes that "people start companies where they already live." However, the issue of location and relocation is a complex one. In that complex set of considerations, affordable real estate is certainly an important consideration, but other factors are as important: quality of life (an intangible collection of perceptions and facts), quality and availability of skilled labor (perhaps the most important factor other than founder drive and desire), opportunities to network with other companies in similar sectors (and to trade on their market knowledge and experience), and the proximity to customers and collaborators alike.

All of those, and history, too. Southern California has been through many real estate cycles. And while the sector has always been a barometer of the health of the region, its role is now more subtle, less clearly predictive of the future. The hope is that new development will now become less scattershot, as existing product--improved and upgraded--may fill our needs for a few years to come.

by Wendy Hall
larta Staff Writer

Rohit Shukla
larta CEO

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