It's an exaggeration to say that 2010 will be the year in which nobody builds anything. But it might not be much of a stretch.

The consensus found in numerous prognostications from economists, academics and analysts is that a "normal" level of development activity is still two to four years away. In the meantime, as Chuck DiRocco, director of real estate research at PricewaterhouseCoopers summed up, "Now is not the time to develop."

California is a very diverse state, and some areas are certain to see more development activity than other areas. Still, extremely tight credit markets, concerns over a new wave of residential foreclosures, potential commercial property foreclosures, the scheduled end of federal government programs, high retail and office vacancy rates, and the state's ugly unemployment rate all combine to paint a dismal picture of the year ahead.

"In essence, there are 3 confluences," said Larry Kosmont, a normally optimistic real estate and economic development advisor based in Los Angeles. "There is still a huge overhang of existing product that is yet to hit the market that everyone is waiting for. That is reinforced by the underlying lender requirements – from the few people who are willing to lend – for new products. The required ratios of capital-to-debt are so much more onerous today that the likelihood is slim and none that developers will be willing to proceed with these loans. The third is that rents are way down."

During last decade's real estate boom, the build-it-and-they-will-come approach prevailed. But that's no longer an effective recipe, said DiRocco. This appears to be especially true for nonresidential products. The annual "Emerging Trends" report prepared by PricewaterhouseCoopers and the Urban Land Institute, and which is based on industry surveys and interviews, said that commercial real estate vacancies will continue to rise and rents will decrease before the market bottoms out at some point this year. That certainly appears to be the case in ever-important Silicon Valley, where CB Richard Ellis Group identified 43 million square feet of vacant office and flex space at year's end – the most since the dot-com bust of early last decade. Asking rents are down approximately 20% and, unlike during the dot-com crash, companies are not hanging onto empty space in the hope that they will need it in the near future. Developers did put up about 4 million square feet of speculative office space in Silicon Valley during the last three years, but the speculative building appears to be over for the foreseeable future.

Shortly after the first of the year, The Wall Street Journal reported, "The pain is just beginning for commercial property markets." The Journal quoted a Deutsche Bank analyst who said nearly two-thirds of $1.4 trillion in commercial mortgages due by 2013 will be difficult to refinance. Thus, the foreclosure wave that swept through residential markets during the last two years could move to the commercial property market.

According to Kosmont, the commercial vacancy figures are artificially low because they do not reflect the fact that some leased space is underused. If you account for the underuse, commercial vacancy rates are in the 20% to 30% range, he said.

Retail vacancy rates loom in the teens for many parts of the state, and analysts predict very little construction of new space – whether in lifestyle centers, power centers or enclosed malls – because retailers have their pick of inexpensive vacancies.

As for residential development, which often drives other development in California, there is great uncertainty. Gov. Schwarzenegger has proposed allocating $200 million to provide buyers of new or existing homes a $10,000 tax credit. Unlike a 2009 program – which provided a similar tax credit to buyers of new, unoccupied homes – the proposed 2010 version would offer the tax break to buyers of either new or existing units. The California Building Industry Association (CBIA) credited last year's program with bringing buyers back to the market, and the association applauded the governor's latest proposal. However, it is not a done deal, as outgoing Assembly Speaker Karen Bass said the state, because of its $20 billion budget deficit, should not be creating additional tax breaks.

The fate of federal programs that have helped prop up the residential market appears equally uncertain. The Federal Reserve, which helped keep mortgage rates at record low levels during 2009, is scheduled to stop buying mortgages at the end of March. If that occurs, mortgage rates are almost certainly going to increase, according to analysts. An $8,000 federal tax credit for certain homebuyers is scheduled to expire in July after getting extended once for eight months. A federal government program to help underwater borrowers modify mortgages had resulted in only 31,000 loan modifications nationwide by the end of last November. The program has had little impact in California because borrowers are too deeply underwater to qualify.

Still, some trade organizations insist there is reason for mild optimism. The California Association of Realtors reported that existing home sales statewide increased in November 2009 by 4.7% compared with November 2008, and the median price jumped 5.8% – to more than $300,000 for the first time in a while. The organization also reported there is far less inventory on the market these days. New home sales increased a bit in October 2009, the last month for which figures are available, according to CBIA and Hanley Wood Market Intelligence. The numbers were still extremely low – about 2,300 new units sold in October 2009 – but there was reasonable growth in sales of condominiums, townhouses and "plexes," primarily in Los Angeles County, the Bay Area and San Diego.

Jed Kolko, a research fellow at the Public Policy Institute of California, said the residential market may have hit bottom, as prices have leveled off and inventory is no longer increasing. He also pointed to the fact that although California has led the nation in residential foreclosures, those homes typically do not sit vacant for long spells. Even during times of economic crisis, he said, "California does not have an overabundance of housing. It's one reason why we might see a quicker rebound here than elsewhere."

The CBIA's findings regarding shared-wall units may reflect the future as well as the past. The PricewaterhouseCoopers report identified San Francisco and San Jose as two of the 10 strongest real estate markets in the country. And the survey found, generally, apartments will provide the strongest market segment.

"We think apartments are pretty good performers in a recessionary period," said DiRocco. In addition, survey respondents repeatedly cited the advantages of coastal urban areas over suburban inland regions.

"San Francisco and Los Angeles stand out a little bit stronger than Sacramento or the Inland Empire. If you're on the water, people feel, you're likely going to bounce back quicker," DiRocco said. This is because the Bay Area and Los Angeles serve as important economic gateways, and because they have significant land constraints that prevent the cheap-and-easy development patterns reflected in inland areas. In addition, DiRocco said, people increasingly want to live where the opportunities and action are.

"People want to be back in infill areas and away from the suburbs. People want that 24-hour feel," DiRocco said.

Kolko agreed there is an east-west division. "Almost all of the housing indicators are better the closer you get to the coast," he observed.

Kosmont, on the other hand, sees more of an across-the-state development stagnation, but he did say that some very selective opportunities will arise in a few markets. Mostly, though, he sees few individuals or companies willing to build when they can find so many good deals already on the market.

"Right now, you can buy for less than replacement value," Kosmont said. "There really is not a lot of reason to build new product of any product type in any region."

Still, Kolko said that construction employment numbers have stopped their decline from a peak of about 950,000 jobs to a little more than 600,000. It could be that some workers who had been building homes and offices are now building government-funded infrastructure, he said. No matter, he said, "it is a positive first sign."

Larry Kosmont, Kosmont Companies, (213) 507-9000.
Jed Kolko, Public Policy Institute of California, (415) 291-4483.
PricewaterhouseCoopers "Emerging Trends" report.
California Building Industry Association:
California Association of Realtors: