WESTERN SNAPSHOT, DECEMBER 2008

San Diego Office Market

With the financial meltdown and the current economic crisis, the San Diego office market continues to have its problems in leasing and investment sales, but positive signs can still be found in recent activity.

Recent examples include the Bridgepoint Education leases. Early in the third quarter, the company took down 147,533 square feet at the Kilroy Project in Sabre Springs, which is the location of its headquarters. Then, in October, it leased 248,000 square feet encompassing 10 of the 11 floors at the new Sunroad Building in Kearny Mesa.

Other trophy leases include Scripps Clinics’ lease of 145,998 square feet in the Innovation Corporate Center and Arrowhead General’s lease of 95,000 square feet at Arrowhead General Lot 16. The fact that all three of these companies are headquartered in San Diego signifies growth from within.

Since last year, San Diego County’s Class A and B office vacancy has increased from 11.5 to 13.5 percent. It is expected to climb to as much as 15.5 percent in the next several months before the market turns. Class A office vacancy has increased to nearly 20 percent while the Class B segment is close to the countywide average of 13.9 percent. The Class C sector is relatively stable, posting only a 6.9 percent vacancy rate.

Many companies in the financial and real estate sectors are reducing their footprint, consolidating operations into one location. For example, First American Title, which had multiple commercial escrow locations, has centralized everything into their office in the University Towne Center (UTS) submarket. The interesting thing about this adjusting market is that most of the relinquished space has been from small to medium companies; few large-scale companies have vacated large blocks of space.

Additionally, there is an increase in sublease space, which is up almost 50 percent as compared to second quarter 2008. In order to see any improvement in the office leasing market, the sublease space will have to be absorbed first as it lessens the value of the newer product. Sub-lessees have much different motivations as compared to commercial building landlords, but they also lack the flexibility in vital negotiation items to include tenant-improvement dollars and the ability to restructure lease terms. Sublease space does not impact the new product as severely as one would expect.

While vacancy has increased, rents have remained stable, climbing slowly for Class A product while remaining flat for Class B and Class C space. Currently, San Diego County average office asking prices are at approximately $3.15 per square foot for new Class A product, $2.50 per square foot for Class B and $1.83 per square foot for Class C. The trends with vacancy and rents aren’t expected to change until office employment growth becomes equal to office inventory growth. Currently, office inventory growth is outpacing office employment growth by 8 percent. Home builders, mortgage companies, escrow companies, title companies and insurance companies are probably the hardest hit as they were also the biggest benefactors of the growth that occurred from 2001 to 2007. They have the ability to enter back into the market faster than some of their counterparts so when the market does turn look to them to greatly impact office absorption.

The San Diego office market is currently in the middle of a down cycle with many expecting rents to get more affordable before it gets better. Access to capital or the lack thereof has essentially cut off the ability for deals to get done during the past few months. The institutional players are sitting on the sidelines waiting to see where the market ends up. The average entrepreneurial investor is also waiting while cash rich “vulture funds” are looking for blood. Competitively priced deals that would have brought multiple buyers a year ago are sitting on the market as most buyers feel this market will go lower. The good news is that this is a great opportunity for cash buyers who want to get a jump on the rebound. By the time one realizes the market has hit bottom it is usually too late. Cash flow versus expected appreciation has emerged as the prime reason for investment office building investments now and have to produce a real return for them to reach the buyer’s acquisition teams.

San Diego office properties are rarely selling at cap rates below 7 unless they are Class A trophy assets. Earlier this year, Metzler North America Corp. purchased Paseo Del Mar, a three-building Class A office complex in Del Mar Heights, from KBS Realty Advisors for $147.9 million in an all-cash transaction. The pro-forma cap was reported to be sub-6 percent. In another large deal, Wereldhave purchased DiamondView Tower, a 15-story, 305,255-square-foot Class A office tower in downtown San Diego from Cisterra, for $161 million in an all-cash transaction.

Looking at 2009 and beyond, cap rates will revert back to historic levels in line with debt. The San Diego office market will slog through this down cycle like many other cities, but the resilient economy and lack of overbuilding seen in the last downturn will help propel the rebound faster than most other American cities. An enormous brain trust and the best weather in the nation are drawing more and more skilled workers to the San Diego lifestyle everyday. It’s hard to get down on the economy when it’s sunny and 75 degrees year round.

Charles Currey and Steve Malley are senior vice president/sales manager and managing director, respectively, for Sperry Van Ness Real Estate Services.

©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.