COVER STORY, APRIL 2006

CBDS NO LONGER MIA
Job growth and revitalization fuel downtown submarkets.
compiled by Brian A. Lee

Central business districts (CBD) in cities across the West are showing greater office activity due to job growth. Some downtown office submarkets, like those in Los Angeles and San Diego, are reaping additional benefits from massive revitalization efforts. Western Real Estate Business contacted broker experts in the region to get the lowdown downtown.

San Diego

Demand for office space in San Diego’s CBD (downtown) is on the upswing as a result of the ongoing residential and mixed-use redevelopment that has created a true urban live-work-play environment. Residential development, although now cooling, as well as hotel expansion continues to fuel the desire for businesses to locate downtown. Additionally, downtown is one of the few areas in all of San Diego where public transportation is an option, which helps tenants balance the high costs associated with parking in the area.

Cisterra Partners is hitting a home run with its DiamondView Tower development in downtown San Diego. Located in the dynamic East Village district, the office building overlooks the San Diego Padres’ ballpark.

With purchase activity now slowing, office ownership in the Class A market is now set with a single dominant landlord, further supporting rental rate appreciation. The limited future high-rise development, tightening vacancy rates, strong building ownership and downtown’s location along the waterfront will combine to make San Diego’s CBD office market one of the best in the country.

— Andy La Dow, Frank Wright and Scott Diggs are office specialists in Grubb & Ellis|BRE Commercial’s San Diego office.

Los Angeles

In 2005, the CBD continued its much-heralded revitalization and plans progressed further for the Grand Avenue Project and L.A. Live. High-rise residential development has put cranes in the skyline of downtown for the first time in many years. As the residential population grows, amenities will continue to be introduced and service both the residents and business population. The revitalized urban core will increase its attractiveness for businesses seeking office space throughout the county.

By the end of 2005, the overall vacancy rate in the CBD decreased to 14.3 percent, down from 16.9 percent at the close of the previous year. Fourth quarter 2005 marked the 11th consecutive quarter of falling overall vacancy rates in the submarket. At year’s end, few contiguous availabilities greater than 100,000 square feet remained in downtown. This number will increase slightly in the coming quarters as existing leases expire and tenants relocate. However, pent-up demand is likely to sustain current vacancy levels.

Year-to-date, more than 2.5 million square feet were leased in the downtown area, an increase of 42.7 percent versus the previous year. This higher level of activity produced 799,091 square feet of overall net absorption in 2005. Activity continues to be driven mainly by existing tenants in the CBD. Over the past several quarters, these tenants were able to “blend and extend” or relocate to nearby properties at favorable terms. The tightening of surrounding submarkets, limiting relocation opportunities elsewhere, may produce a positive effect in the CBD.

Another trend is the large increase in small and mid-sized tenants coming to Bunker Hill looking for an immediate move (30 to 60 days). This could be an initial sign of new and unplanned expansions occurring inside certain industries.

Within the CBD, direct asking rental rates averaged $2.21 per square foot per month, an increase of 4.3 percent versus 2004. Rents for Class A properties increased 4.5 percent in the same time period. Over the next 2 years, leasing demand is expected to slow slightly, but remain strong enough to maintain current vacancy levels.

In 2005, more than $2.1 billion in investment transactions were closed in Los Angeles’ CBD. The majority of trophy office buildings have sold within the past several years, some on multiple occasions. This trend is likely to continue as the burgeoning residential market and growing cultural and amenity base attract further attention to the area.

— Chris Cooper is senior managing director and branch manager of Cushman & Wakefield’s downtown Los Angeles office.

San Francisco

After years of dormancy, cranes are scheduled to appear over San Francisco’s office market again. Encouraged by the heightened leasing activity of the past 2 years, developers have proposed nearly 1.3 million square feet of new construction for delivery by 2008. While the market appears to be robust, rising construction costs and the prospect of new Class B owners repositioning their assets to secure Class A rents have many questioning whether demand in the CBD warrants new construction.

A closer look reveals an encouraging argument for development. Average Class A rental rates have continued north topping $35.60 per square foot. Additionally, 2004 and 2005 posted combined absorption gains totaling nearly 3 million square feet, with premium space commanding well over $50 per square foot. In addition, the CBD office supply experienced a net decline of 2.2 million square feet in the last 2.5 years, with residential and hospitality conversions being a significant contributing factor.

Vacancy rates continue on a downward slope. In 2005, Financial District Class A vacancy was 12.4 percent, a 4.1 percentage-point decrease from 2004. The rate is predicted to drop below 10 percent by 2007. Available space is composed mostly of mid- to small-size spaces, with a limited pool of large blocks able to accommodate leases exceeding 100,000 square feet. 

But what about the escalating cost of construction? The strain of resources from the construction boom in Asia coupled with a shortage of labor has increased construction costs 15 to 20 percent in the Bay area from last year. As a result, proposed projects must secure rental rates greater than $60 gross per square foot in order to generate conservative returns to their investors; that equates to nearly a 50 percent rental rate increase in the next 3 years. Equity Office Properties was able to secure a 335,000-square-foot lease commitment from Barclays Global Investors for $55 per square foot at Foundry Square I. The project has broken ground and is scheduled for completion in December 2007.

The reality of the market is that developers are prepared to take risks. The word “spec” has begun to be used for the first time since 2000. Examples are Tishman & Speyer’s 555 Mission and Shorenstein’s 499 Illinois Street proving that existing space and escalating construction costs will not hamper business plans. Expirations of large-block leases in the next few years and a tightening supply of existing quality space will inevitably justify the addition of cranes to San Francisco’s CBD office skyline.

— Scott Harper is the managing director for Colliers International in San Francisco.

Portland

Equity Office Properties and Gerding/Edlen Development are planning a 15-story, 350,000-square-foot Class A office building at 1st and Main streets in downtown Portland.

Several developers are poised to start new high-rise towers downtown, but most are holding off for a large pre-lease tenant, and construction will take at least 24 months. This means the CBD Class A office market will probably see vacancy dip below 5 percent before any new product hits the market. The most likely new project is Equity Office’s development at First and Main. The company has teamed up with local developer Gerding/Edlen on the planning for a new office tower, which could deliver 350,000 square feet in 2008.

In the meantime, as vacancy rates decline, there will be upward pressure on rental rates. CBD Class A rental rates will likely spike in the next 18 months. Class A asking rental rates currently average $22.66 per square foot full-service, while costs for new construction downtown would require rental rates of at least $33 to $35 per square foot. With no new construction hitting the market for at least 2.5 years, the balance of power will shift away from the tenant. Expect to see rental rates increase at least 7 to 10 percent annually in 2006 and 2007.

— David Squire is executive vice president and managing director for Grubb & Ellis Company in Portland.

Salt Lake City

Salt Lake City CBD office activity in 2006 is continuing the healthy trend set in 2005, with declining vacancy rates and increasing rental rates. The overall vacancy rate for Salt Lake’s CBD is currently hovering around 11 percent, which represents the lowest vacancy rate the submarket has seen since the steep increase in vacancy experienced in 2001.

222 South Main St., a more than $100 million joint venture between Hamilton Partners and Wasatch Development Associates, will add over 400,000 square feet of Class A office space to Salt Lake City’s CBD.

For the first time in 5 years, owners of office product in the Salt Lake CBD have successfully been able to increase asking lease rates for their properties. Currently, average asking lease rates for Class A and B office space are sitting at $22.44 and $17.10 per square foot gross. This represents an increase of roughly $1 per square foot in both classes since the close of 2005. Due to high vacancy levels in Class C space, less significant increases were achieved — only 20 cents per square foot at year-end 2005. Current asking rates in this sector are $13.95 per square foot gross. If the trend in asking lease rates continues for the duration of 2006, the Salt Lake CBD could see the most substantial rental cost increase the submarket has undergone in close to a decade.

— Casey Mills is an office leasing and sales specialist with NAI Utah Commercial Real Estate in Salt Lake City.

Albuquerque

For the first time in 4 years, the office market in Albuquerque’s CBD saw positive absorption of space greater than 50,000 square feet. The majority of this activity was the result of one tenant opening up a bilingual call center office. The fourth quarter’s vacancy rate in the downtown submarket was 18 percent, compared to 12.5 percent across the entire market.

It is still too early to say that the CBD has turned the corner, but this activity is a positive sign. When looking at areas that have the largest amount of contiguous spaces available, Albuquerque’s CBD has the most choices at the lowest rates. These spaces are the result of several large government tenants vacating the CBD over the last 2 years. Combined, these tenants vacated more than 200,000 square feet of space in the CBD and have moved into new build-to-suit projects in the popular North Interstate 25 submarket. Tenants like the North I-25 area because it offers a more centralized location relative to the growing areas of the Albuquerque metro area — Rio Rancho, West Mesa and Far Northeast Heights.

With a great selection of large contiguous spaces at very attractive rates, the CBD is poised for a turnaround by the end of 2006. The submarket has Class A spaces available at $18.40 per square foot per year, compared to new Class B buildings in the North I-25 area with asking rates of $22.00 per square foot per year. In addition, several high-end CBD condominium and niche retail projects are underway and have increased interest in the district.

— John Ransom is senior vice president and principal at Grubb & Ellis|New Mexico in Albuquerque.

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