MARKET HIGHLIGHT, FEBRUARY 2008

SAN DIEGO
Sandra Grove 

San Diego’s commercial real estate sector is certainly in a market adjustment, but in such a desirable market with such quality fundamentals, confidence lies just below the surface.

Office

Following several years in which tenant demand drove rental rates to record highs, the San Diego County office market continues to settle into a more moderate pattern of activity with slower net absorption and slightly higher vacancy rates.

“The return to a lower and more consistent rate of annual net absorption is creating new opportunity for office tenants as landlords in many submarkets re-introduce incentives, such as rent concessions and increased allowances,” says Ron Miller, senior director with Cushman & Wakefield. “Additionally, as companies downsize in the residential debt and real estate sectors, an influx of sublease space is creating more affordable space opportunities for some office users. This leveling of market conditions is pushing landlords and their lenders to again place more emphasis on occupancy levels over higher effective rents.”

Rental rates in recent years have risen geographically across the board to a countywide average of $2.37 per square foot, a 10 percent increase from year-end 2006 alone. Rates in premier San Diego submarkets like Del Mar Heights continue to draw upwards of $4 per square foot, net of utilities, a trend that will continue as image-conscious companies continue to seek preferred locations.

“Investors have paid record prices based upon their expectation for continuing growth in rental rates,” says Mark Wayne, also a senior director with Cushman & Wakefield. “Now that the market has begun to adjust, landlords in general are holding firm on their contract rates, but some are offering incentives which lower the effective rent over any lease term. We’re seeing owners refocusing their priorities and becoming more occupancy-driven rather than pushing for every last penny in deals.”

In general, the San Diego County office market remains quite stable, and landlords and investors continue to see outstanding upside potential. One example is The Irvine Company, an owner/ developer whose investment activity and planned new development reflects the opportunity it sees in the San Diego marketplace. The company’s downtown holdings now include six high-rises as well as a planned 685,000-square-foot tower that will be built at 700 W. Broadway. In UTC, The Irvine Company has become the largest office landlord following its recent acquisition of the Maguire Properties’ 322,000-square-foot Regents portfolio for $235 million or $675 per square foot — the highest per-square-foot sales price of any San Diego office project in history.

Another sign of confidence in the outlook for the San Diego office market is the nearly 2.7 million square feet of space that is currently under construction despite the slowdown in net absorption.

“Following the exceptional run of activity we’ve enjoyed, it’s normal for the market to adjust,” Wayne says. “Vacancy rates including owner-user space stand at a still healthy 13.6 percent. The key factors in evaluating the state of the San Diego office market include job and population growth, economic diversity, and inventory to meet demand. Right now, our market enjoys all of these. When combined with a limited land supply for new development, the market is not facing an overbuilding situation.”

Industrial

The San Diego County industrial market remains in strong supply-and-demand balance with vacancy on total inventory, including owner-use space, still well in the single digits.

“The current 6.6 percent vacancy rate for San Diego County industrial space reflects the fact that there is not a lot of available product, and this limited supply continues to translate into slower absorption,” says Scott Henderson, associate director and industrial specialist with Cushman & Wakefield.

During the second half of 2007, the San Diego County industrial market recorded more than 700,000 square feet of positive net absorption, a notable improvement from the first two quarters of the year when approximately 370,000 square feet of negative activity occurred. Gross tenant activity — all transactions including leases signed, subleases and renewals as well as owner-user sales — totaled nearly 7.1 million square feet in 2007 and 2.5 million square feet in the fourth quarter.

Much of the county’s industrial activity continues to occur in the southern and northern areas where more land is available and where nearly all of the market’s new development is occurring.

“The established mid-county submarkets are tight with vacancy rates below 4 percent and no new construction on the horizon,” says Henderson.

Contributing to low industrial vacancy is the continued popularity of small, for-sale industrial buildings and condominiums.

“Industrial product is consistently one of San Diego County’s most stable commercial real estate product types, and these smaller purchase opportunities are well received by companies looking to invest in their location,” says Henderson.

Industrial construction has slowed to 780,000 square feet of space currently underway and another 1.1 million square feet planned. This compares to year-end 2006 when nearly 1.73 million square feet of new space was in progress.

“Slower construction activity will give the faster-growing south and north-county markets a chance to absorb inventory,” says James Duncan, associate director with Cushman & Wakefield. “Companies that are set on a mid-county location have little, if any, options to choose from. Coupled with high purchase prices and rents in these submarkets, we will continue to see tenant activity redirect to the northern and southern parts of the county, where there is still room for development.”

Multifamily

The San Diego County apartment market continues to see decreased sales volume, though institutional investors are still willing to pay premium prices for the anticipated upside potential of the local multifamily market.

According to a recent Cushman & Wakefield San Diego report, 2,291 units were transferred during third quarter 2007 with more than half (1,405) located in eight major complexes with 100 to 500 units. Seven of these larger transactions were to out-of-the-area institutional investors, with per-unit prices ranging from $106,000 to $293,333 and with cap rates ranging from 4 to 6 percent.

“None of these sales appear to have any condo-conversion implications,” says George Carlson, an apartment specialist with Cushman & Wakefield. “The interest by institutional investors testifies to their belief in the underlying strength of the local market. The focus now is on a return to cash flow through increased rental demand.”

The current San Diego County apartment vacancy rate is 2.58 percent, according to MarketPointe Realty Advisors, and average countywide apartment rental rates for two-bedroom units are $1,291.

The 374 San Diego County apartment sales transactions during the first 9 months of 2007 were down 24.8 percent over the same period in 2006. The 87 sales in third quarter 2007 reflect a 44.6 percent decrease from the third quarter of the prior year.

“This is the first time in 26 years that quarterly apartment sales have fallen into the two-digit range,” Carlson says. “The historically low sales of non-major properties (fewer than 100 units) is a reflection of still too-high prices for smaller investors, as well as the reluctance of owners to sell at lower prices. The result is not only fewer sales, but also very little available product to choose from.

“We anticipate that the low sales for complexes with fewer than 100 units will continue until the perception of value by both sellers and buyers is once again in balance,” he says.

Retail

The completion of 425,000 square feet of new retail space in downtown San Diego in the past 12 months, along with the postponement of several planned mixed-use redevelopment projects, has contributed to the area’s first negative absorption in 6 years.

“Available retail inventory in downtown San Diego has increased due to the near simultaneous completion of more than 400,000 square feet of new space,” says Bill Shrader, senior director of Cushman and Wakefield’s Urban Retail Group. “Additionally, the pause in the construction of several condominium projects has returned some existing retail space to the market, which is adding to the vacancy rate.”

Shrader notes that it is because retailers in general see tremendous long-term opportunity downtown that many are putting off their decision to operate downtown until new or planned projects are complete. “Retailers recognize that downtown San Diego has successfully transformed into a thriving 24/7 urban center. More importantly, they recognize that the slowdown in new residential construction is temporary and they want to be ready to move quickly once development resumes,” he says.

Adding to the stability of the downtown retail market is the nearly 2,500 new hotel rooms that are being added to the market during the next 24 months. The just completed Hard Rock Hotel has added 420 rooms to the market, and will be followed by a 1,200-room Hilton Convention Center Hotel in the Gaslamp Quarter, a 239-room Residence Inn, a 210-room Hotel Indigo in the Ballpark District and a 344-room Marriott Renaissance Hotel in the Gaslamp district. Additionally, Marriott has announced plans for an additional 1,650-room hotel just east of Petco Park.

“In essence, the downtown’s next wave of construction is new hotel development to serve San Diego’s growing tourism and convention industry,” Corinna Gattasso, director with Cushman and Wakefield’s Urban Retail Group says. “Retailers recognize the sales potential from the increased spending money visitors bring with them.”

Downtown San Diego continues to attract quality retail tenants, especially restaurants that are eager to capitalize on the thousands of new hotel rooms as well as on residents and workers in the central district areas. These include Bice Restaurant, which will be opening in Gaslamp Square.

“The residential, hotel and office growth in downtown San Diego has created the right mix of use and the synergy to support a thriving retail environment,” says Shrader. “2008 will be a year to absorb space. We fully expect the market to regain balance over the next year as existing space leases up and nowhere near as much new space is delivered. Long-term, this bodes well for retailers and investors alike.”

— Sandra Grove

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