MARKET HIGHLIGHT, FEBRUARY 2007

MARKET HIGHLIGHT: SAN DIEGO SHINES
Sandra Grove

San Diego County continues to support a viable and stable commercial real estate market with slowing, but still-positive job growth, a diverse economy and a limited supply of land for development that continues to keep long-term overbuilding in check and land values at all-time highs.

Office

Strong demand for San Diego office space, which fueled all-time high records in net absorption in 2004 and 2005, drove new construction to an 11-year high in 2006. The 4 million square feet of space currently under construction follows 3.1 million square feet of space completed during the year, the highest amount of new construction recorded in San Diego since 1996.

However, slowing job growth has begun to translate into cooler tenant demand, a trend that will continue through 2007 with even more downsizing in the residential real estate sector. This year, the San Diego Regional Chamber of Commerce projects 16,000 total new jobs for the county, down 15 percent from 2006. Economy.com reports that jobs that directly affect demand for office space totaled 5,649 in 2006, representing less than one third of the overall positions created during the year.

This tapering in job growth is reflected by a decline in San Diego net absorption to 2.2 million square feet in 2006, down from 2.5 million square feet the prior year. Burnham Real Estate projects that absorption will continue to slow in 2007, along with new construction as developers take a breather and allow the current supply to absorb. Fortunately, 1 million square feet or one-third of the newly finished office space in San Diego last year involved two build-to-suit-to-own facilities for Qualcomm. Companies including Broadcom and Cardinal Health have already signed significant pre-leasing commitments for space scheduled to be completed in 2007.

“Pent-up demand for space drove the San Diego office market’s momentum to robust levels of new construction and net absorption,” says Ron Miller, senior vice president and principal with Burnham Real Estate. “Now, we are seeing the market moderate with slight increases in vacancy as the new space waits to absorb. Even so, the basic supply and demand fundamentals of the San Diego region are quite strong overall with most submarkets reporting single-digit vacancy rates and the premier markets seeing notable increases in rents.”

Miller notes that in submarkets where investment activity has been heavy, such as downtown and Sorrento Mesa, asking rents in Class A buildings have increased dramatically to cover aggressive underwriting. In other markets like Del Mar Heights and UTC, where strong leasing activity has resulted in low single-digit vacancy rates, Class A rental rates are also on the upswing, reaching $4-per-square-foot plus electricity for some projects. The effect of these higher rates has been an increase in demand for Class B space, which is the immediate beneficiary of companies looking for more affordable space options. Office condos are gaining a stronger presence as a financially favorable way for small businesses to invest in their location.

“Very few new projects are being planned, and capital chasing investment opportunities have slowed,” says Miller. “This will benefit net absorption, especially in submarkets like Carlsbad which has more than a 4-year supply of new office development that will come online in 2007.”

Industrial

The limited supply and high prices of land for development in central San Diego County continues to drive industrial development to the northern and southern regions of the county where most of the county’s 1.7 million square feet of new construction is occurring. Nearly all of the activity is now being geared toward smaller-scale, for-sale product, including freestanding buildings and industrial/R&D condos.

Land prices in the North County area of San Diego County alone have more than doubled over the past 4 years, and there is a large disconnect between the rates industrial/R&D properties lease for and the rental rates and sales prices that must be achieved to offset the high land prices.

“As a result, more existing projects are being converted with condo maps and then sold to smaller users, who are typically looking for space ranging from 1,500 to 20,000 square feet, ” says Greg Lewis, an associate vice president with Burnham Real Estate. “In north San Diego County alone, approximately 2.75 million square feet of for-sale industrial/R&D projects have recently been completed or will come to market over the next 12 to 24 months.

“An abundance of SBA financing and relatively low interest rates continue to fuel moderate demand for industrial space, but whether or not the pool of buyers exists to sustain this merchant builder trend still remains to be seen,” Lewis says.

Existing industrial landlords have benefited from the sudden spike in land and construction costs since industrial users are less inclined to purchase at the current high price of ownership. “Educated users are now reverting to lease renewal and expansion options, rather than purchasing, since the price of facilities in some markets have jumped by more than $50 per square foot,” says Lewis.

Large blocks of new distribution/manufacturing space (50,000 square feet or more) are all but non-existent in central submarkets, and this is also resulting in positive renewal activity and rental growth for existing owners of industrial product. One of just a few areas where opportunities to lease large amounts of contiguous space at affordable (low $0.50 per square foot NNN) prices still exist, South Bay, which includes Otay Mesa, led the county in new construction and net absorption in 2006.

“Only a select few owners and developers still enjoy the land basis necessary to entertain build-to-suit lease requirements for larger tenants,” says Lewis. “For example, Techbilt in Carlsbad has controlled its 140-acre Carlsbad Oaks North project since the 1970s and can accommodate future large-scale industrial users. Other areas that have typically been considered secondary options for most tenants are now thriving due to the lack of industrial sites in the more expensive areas. In Oceanside, for example, owners such as Alere Proprety Group, Hamann, Cruzan/Monroe, AMB, and RREEF have made strategic decisions to develop and acquire larger distribution and manufacturing projects.”

Retail

A still strong San Diego economy continues to support tenant demand for retail space, as evidenced by the low 2.8 vacancy and limited available options for retailers seeking new or additional space. Looking ahead, the scarcity of land for new development and positive job growth ensures even stronger supply and demand fundamentals.

“With retail vacancy still ranking among the lowest of all San Diego commercial property types, any new space that becomes available is quickly absorbed,” says Pete Bethea, senior vice president and principal with Burnham Real Estate. “As a result, rental rates are on the upswing with fewer concessions being offered. On the investment side, sales are steady though higher interest rates are causing buyers to be more conservative, especially for non-institutional assets as negative leverage becomes a factor in investment decisions.”

Downtown San Diego is quickly emerging as one of Southern California’s hottest new retail markets with a 24/7 lifestyle that retailers are eager to capitalize on. Downtown’s 4 percent vacancy rate is down from 7.1 percent a year ago, reflecting the absorption of retail space completed in the last year and the pent-up demand of new retailers wanting to enter the market.

Even though new downtown high-rise residential construction has slowed, there are still many projects scheduled to be delivered this year, and most include ground-floor, pedestrian-friendly retail opportunities that are appealing to specialty and neighborhood retailers. Major retail tenants continue to move into downtown’s popular Gaslamp Quarter including Oakley, Soho Lab by Skechers, Adidas, Heritage, Helio and G-Star.

“Retailers want to be downtown to be in the center of activity,” says Bill Shrader, senior vice president and principal with Burnham’s Urban Retail Group. “Downtown San Diego has made the successful transition to a vital urban core with thousands of new residential units, new hotels and new office space. Retailers recognize that a downtown location puts them in the midst of a captive and shopping-friendly market.”

Bethea notes that limited land availability will continue to challenge retailers to look for creative, alternative sites, and San Diego County is likely to see an increased redevelopment of existing shopping centers to accommodate constantly changing tenant prototypes and to provide new space options. “Even though the record housing growth of the past several years has begun to slow, consumer demand for retail services is quite healthy and this will fuel a very healthy retail market in San Diego for the foreseeable future,” he says.

Multifamily

Sales for San Diego County apartment projects continue to slow, reflecting the difference in the expectations of sellers relative to buyer requirements. The slowing follows a 2-year condominium conversion activity, which drove prices to all-time high levels — investment dollars that converters could more than recoup through individual unit sales.

“One year ago we weren’t sure whether we were seeing the beginning of a market correction or a temporary aberration,” says George Carlson, vice president and apartment specialist with Burnham Real Estate. “Pricing for San Diego apartment properties became distorted as condominium converters paid unprecedented amounts in anticipation of profits from the sale of converted units. Now, however, a steady decline in sales is a sign that buyers are being more cautious, shying away from record-high prices that make it harder for deals to pencil out. The result is a necessary market correction toward lower prices that will transition us from a seller’s market to a buyer’s market.”

A recent Burnham Real Estate apartment report shows that the volume of apartment sales has fallen for seven consecutive quarters. In 2006, the number of apartment transactions was down 34.8 percent over the prior year, and sales are expected to slow even more in 2007.

“This slowing in sales confirms a correction as investors continue to price the units as conventional apartments,” says Carlson. “The one dynamic that could continue to suppress cap rates is the strong demand for rental units as San Diego’s population and workforce continue to increase without adequate housing.”

Carlson notes that buyers need to be patient as the apartment market runs its course. “Historically, market corrections are followed by significant decreases in selling prices, but not immediately. It’s too soon for quarterly averages to reflect a major drop in pricing, but we can expect to see this in the near future. Buyers are already picking up 6 percent cap properties and passing on 5 percent caps, which have been standard over the past few years.”

— Sandra Grove


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