Lights out for California real estate?

Real Estate Issues, Fall 2001 by Warren, Andy

California can not guarantee that it will have enough electricity to meet future demand. Since the state began experiencing rolling blackouts in January 2001, the media has extensively covered every possible cause for the power crisis and scenario as to how the solution will be paid for. Yet no one has addressed the ultimate economic impact the problem will have on California's economy-the world's seventh largest economy, larger than the entire country of Italy. Given the uncertainty surrounding the situation, determining the impact is a daunting task but one that needs to be addressed.

By comparing our third-quarter 2001 real estate forecast to a forecast showing the potential impacts of the energy emergency, we concluded that California's commercial real estate markets will be negatively impacted by the current power crisis. The forecast impounded decreasing economic activity in 2001, slower-than-expected growth in 2002, and normal growth in years 2003 to 2005. The impacts on employment, population, and income were then incorporated into our real estate models to come up with the new forecast. Eight metro areas, which represent over 90 percent of California employment, were included in this analysis. Four of the metro areas are in Northern California (San Francisco, San Jose, Oakland, and Sacramento) and four are in Southern California (Los Angeles, Orange County, Riverside, and San Diego). The results of our analysis clearly indicate that the current energy emergency will impact the commercial real estate markets in California. The impact will be painful, but not terminal.

The pain will come from decreased activity leading to slower rent growth. Decreased economic activity will lead to lower levels of absorption and this factor, combined with new space coming online, will lead to vacancy rates that are substantially higher than earlier projections. With rising vacancy rates, rent growth is likely to be slowed by two factors: 1). higher vacancy rates will give tenants more choices; and 2). landlords may have difficulty passing on rent increases to tenants who are feeling pinched by higher utility costs and who have other options available.

There are two factors at work that should help the commercial real estate markets avoid catastrophe. Primarily, most of the markets entered this situation in historically strong condition. Vacancy rates at the beginning of 2001 were at or near historical low levels and supply and demand were nearly perfectly balanced. The frenzied activity of the past two years did lead to an increase in new supply started in 2000, and the slowing economy in 2001 is leading to higher vacancy rates. Whether the addition of this new space will have severe consequences on the market will depend on how quickly the energy emergency is solved. If a solution can be found and implemented by 2002, economic activity should increase and be ready for the new space without an appreciable lag. The other factor in California's favor is that it isn't alone. It is becoming increasingly obvious that energy problems are likely to spread throughout the West and to other areas of the country. This makes a mass migration of California companies to out-of-state locations unlikely.

DEFINITION OF THE PROBLEM

A wide variety of factors have contributed to the current energy emergency in California. There has been much debate about inept deregulation, corporate greed, unrestrained consumption, extremist environmental policy, as well as many others that have been blamed for the situation.

In a nutshell, the state of California could again have problems providing enough electricity in the right places at the right time to meet its future demands. So, how will the current and potential energy emergencies impact commercial real estate markets in California?

Lease structures and who gets charged for electricity

While no one is likely to be left unscathed by rising energy prices, the type of lease in place helps identify who is directly responsible for the increased costs. The lease structures currently being utilized in California are:

Gross Lease - Under the gross lease, the landlord pays all expenses for a year up to a predetermined level, or base year stop. Any expenses above this level are the responsibility of the tenant. In this instance, the landlord is only responsible for rising energy costs up to the base year stop. The amount above this will be the responsibility of the tenant. Leases that are previously in place protect the landlord from the rising expenses. New leases going forward are going to be a little trickier. Estimating how much to expect in energy expenses over the next several years will be a dangerous business.

Gross Utilities Lease - The gross utilities lease helps protect the landlord during times of uncertainty about utilities costs. This lease operates like the gross lease described above except that the tenant pays all utility costs. The use of this lease expanded in San Diego when it began to feel the effects of deregulated electricity costs.