MARKET HIGHLIGHT, FEBRUARY 2006

SAN DIEGO SHINES
Sandra Grove

Strong economic fundamentals continue to support growing demand for office, industrial and retail space throughout San Diego County as evidenced by substantial increases in net absorption over the prior year.

Industrial

Net San Diego County industrial absorption tripled to more than 3.8 million square feet in 2005 for the market's best year since 2000.

“The local industrial market is celebrating its best year since 2000 when 4.6 million square feet of space were absorbed,” says Charles Adolphe, a vice president and industrial specialist with Burnham Real Estate. “Our original projections that the industrial market would absorb 2.6 million square feet of new space in 2005 have more than been surpassed. Demand for industrial space is far outpacing new construction, with year-to-date absorption comparing to 1,928,300 square feet of new space completed during the same period.”

Adolphe attributes this robust momentum to overall improved confidence in the market and a desire by companies to lock in lease or purchase commitments for space now in light of the anticipated supply shortage due to the lack of affordable land for new development. “This shortage is already very apparent in central submarkets, such as Kearny Mesa, Miramar, Sorrento Mesa and Carlsbad, where land prices are too high to justify new industrial/warehouse construction,” he says.

San Diego County industrial vacancy based on leasable and owner-user inventory stands at a low 5.5 percent, down from 6.6 percent at year-end 2004. Adolphe predicts that vacancy will continue to decline as increasingly strong tenant demand exceeds current supply.

While the amount of speculative development has increased, demand by users to own their facilities remains as strong as ever. “Our mantra is build it and they will buy,” says Adolphe. “Lease rates have remained relatively flat while the sales price per square foot continues to increase in response to buyer demand. Still low interest rates are supporting this activity, along with the recognition that a limited supply of land for development and strong real estate fundamentals make owning very desirable for many companies.”

Office

The San Diego County office market also has reason to celebrate, with more than 2.5 million square feet of net absorption, nearly double the more than 1.35 million square feet of net absorption in 2004.

“New inventory is driving this momentum, as tenants who signed leases in 2004 and early 2005 now take occupancy,” says Mark Wayne, senior vice president and principal with Burnham Real Estate. “With demand now beginning to outpace supply, the current vacancy rate of 8.9 percent on total inventory is down from 9.8 percent in 2004.”

The Burnham Real Estate study shows that more than 2.13 million square feet of new space were completed in 2005, much of which was driven by firm tenant commitments for speculative and build-to-suit facilities. “This dynamic should continue well into 2006 and 2007 as companies recognize the impact the current land shortage for new development will have on future supply and act now to secure space for anticipated future growth,” Wayne says.

Wayne notes that over the past 2 years there has been a shift in the composition of new inventory, with speculative development now accounting for approximately 75 percent of all new supply. “The rise in speculative development is being driven by pent-up demand by companies who previously postponed expansion or relocation plans,” he says. “Build-to-suits account for the balance of this new space.”

Retail

The strength of the San Diego County economy and steady population growth continues to support a very stable retail market. Burnham Real Estate shows that mid-year 2005 vacancy stood at a low 2.6 percent based upon a total inventory of 59.2 million square feet. This excludes regional malls, which total an additional 13 million square feet of space.

“We attribute the tight San Diego retail market and continued investment into retail properties to better than expected job growth, which always translates into higher consumer expenditures,” says Pete Bethea, senior vice president/principal with Burnham Real Estate. “With economy.com forecasting an average of 29,000 new jobs annually for the next 4 years, a steady increase in net absorption is expected.”

First half net absorption of 215,917 square feet is tracking well below 2004, when 2.5 million square feet of space were absorbed. “This is due to the fact that with such a limited supply of available existing retail space, net absorption is driven solely by new construction,” Bethea says. “With no new space currently under way, all of this year's net activity occurred in existing centers.”

Limited land availability is causing retail development to look elsewhere to meet demand. Some industrial land has already been sold off for retail development in higher density areas such as Poway. Retailers are now looking to recycle older but well located facilities. Sears has already purchased five Kmart stores in the county, each of which is about 110,000 square feet in size. Factory 2-U and Toys “R” Us are both restructuring, and some of their existing stores may become available. However, these spaces won't be in the market for long given current demand and the lack of land for new centers. These sites will likely appeal to office supply and/or other outlet stores.

High demand for space coupled with limited availability is driving rental rates to new highs in nearly every San Diego retail submarket, with premier markets like Carmel Mountain Ranch and Eastlake seeing rates of $4 per square foot. These favorable supply and demand factors rank San Diego in the top seven retail investment markets in the western United States.

Multifamily

The volume of San Diego County apartment sales has hit its lowest level in 10 years following a three-quarter decline in activity.

“Three consecutive quarters of declining transaction activity clearly points to a ‘cooling off' period in which the market is undergoing a correction for sales prices that exceed a reasonable relationship to property income,” says George Carlson, vice president and apartment specialist with Burnham Real Estate.

According to the Burnham report, 2005 is the first year since 1996 that quarterly sales have numbered less than 4,000 units. The report shows that 253 sales involving 3,077 units occurred in the third quarter. This represents a 32 percent decline from the 373 sales the same time the prior year, and a 57.6 percent decline from the 7,261 units transferred during the same period a year before. Year-to-date, there have been 762 apartment transactions involving 10,619 units. This is the lowest level of activity since 1996 when there were 528 transactions transferring 10,271 units during the first 9 months of the year.

“Where income properties are concerned, this imbalance was mitigated to an extent in the recent past by low interest rates and strong demand for rental housing that supported still-rising rents,” Carlson said. “The imbalance of pricing not justified by income has been driven in large part by the wave of condo conversions. There is a substantial premium for properties that are candidates or are already mapped for conversion, and this has put strong upward pressure on prices in general.”

The Burnham apartment report shows that sales prices are at all-time record highs and more than four times higher than those of a decade ago when the San Diego region was climbing out of recession (and the Dow was at just 5,000). Average per unit sales prices of $166,000 in 2004 compare to under $40,000 per unit in 1995.

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