MARKET HIGHLIGHT, JULY 2004

SAN DIEGO: A CLIMATE FOR GROWTH

San Diego has named 2004 the “Year of the Ballpark,” with PETCO Park, the brand new 42,000-seat downtown stadium, serving as a catalyst for more than $1 billion in residential, office and hotel development in the surrounding 26-block area. Led by San Diego Padres owner John Moores and his real estate company, JMI Realty, the massive undertaking is making history as San Diego becomes the first major city in the United States to base its investment in a professional sports facility upon a commitment from the team’s owner to redevelop the surrounding neighborhood.

“The ballpark has become a symbol for the city of San Diego, and its long-awaited arrival marks just one more vital step forward for the area, which has become one of the most desirable real estate markets in the country,” says Stath Karras, president and CEO of Burnham Real Estate. “San Diego’s natural amenities — location, miles of waterfront, weather and attractions — are matched by its business strengths, including that which is found in the telecommunications, electronics, computer software, biotechnology and defense industries.”

Such natural and economic attributes contribute to a strong real estate market that is only getting stronger. The more than 126,000 new jobs projected for the next 4 years means that opportunity awaits in San Diego.

Office

Since last year, demand for San Diego County office space has continued to gain momentum, setting the stage for at least 2 million square feet of net absorption by year end — the county’s best performance in nearly 4 years.

Overall, San Diego’s first quarter leasing activity — including renewals and expansions — is up 15 to 20 percent over the same period in 2003. “This increase is being driven by stronger regional employment numbers — San Diego County gained 21,700 jobs between February and April, with 2,700 jobs accounted for by professional and business services, which need office space,” says Lynn LaChapelle, senior vice president with Burnham Real Estate.

The most recent Burnham studies show that net absorption of nearly 420,000 square feet was recorded in the first quarter, with an additional 300,000 square feet in signed leases. Coupled with build-to-suit commitments for almost 70 percent of the 960,000 square feet of new space scheduled for completion in 2004, the absorption sets the stage for a much improved office market with strong supply/demand balance. “This strong first quarter performance follows a surprising 2003, in which demand for office space exceeded supply by more than 600,000 square feet,” says LaChapelle. “This helped lower vacancy to 11.5 percent, paving the way for rising rental rates in 2005 and the first speculative office development in several years.”

Already, several new office buildings are under way. Lankford & Associates, a La Jolla, California-based development firm, just broke ground on 655 Broadway, a 23-story downtown San Diego high-rise that was already 50 percent pre-leased before construction began. Cisterra Partners recently formed a development agreement with JMI Realty to build DiamondView Tower, a 14-story office building adjacent to the ballpark that could break ground as early as the fourth quarter of this year. “These downtown office projects are being driven by the significant amount of residential development that is occurring in San Diego’s city center area,” says John Kratzer, president and CEO of JMI Realty. “DiamondView Tower is now moving forward based upon substantial pre-leasing that has ensured the project’s ability to secure financing.”

Newport National Corporation has also just begun construction on a new speculative office building in the Mission Valley area. Called Rio San Diego Plaza II, the 73,100-square-foot Class A office park will be complete in May 2005.

Given the tightening office market, many tenants are sensing that lower rental rates and concessions are coming to an end and are acting fast to lock in favorable terms to meet their future real estate needs. Rental rates for Class A office buildings are averaging between $2.60 and $2.90 per square foot. By year-end 2004, rental rates are expected to increase by another 5 to 7 percent.

Stronger office fundamentals such as increasing demand, declining vacancy and increasing rents will continue to encourage new investments. Last year, $1.3 billion was funneled into San Diego County office properties, and that strong momentum is carrying over into 2004 as well. Year-to-date, $709 million has been invested in the office market, 55 percent of which is attributed to the purchase of four downtown high-rises.

Industrial

Demand for industrial space in San Diego picked up during the first quarter with the completion of several build-to-suit projects that contributed to nearly 500,000 square feet of net absorption. Net absorption this year should total 2.7 million square feet, up 23 percent from last year and on par with the net absorption recorded in 2002. Vacancy in the industrial market stands at 8.2 percent, based upon total leasable inventory, and just 5.7 percent when owner-occupied buildings are included. “The limited availability of existing industrial space means that future absorption will be determined by new development,” says Jed Stirnkorb, senior vice president and industrial market specialist at Burnham Real Estate.

New development includes build-to-suit facilities in Oceanside for Biogen Idec (410,000 square feet) and Ashworth (196,692 square feet). Otay Mesa follows with 582,783 square feet of new construction, more than half of which is accounted for by Master Development’s One Piper Ranch, a 289,000-square-foot project with 12 buildings ranging in size from 11,500 to 32,000 square feet.

The tight San Diego industrial market is once again encouraging speculative development. This type of development accounts for 56.6 percent of the 1.8 million square feet of new space currently in the pipeline. “Most of this construction is occurring in the northern and southern regions of the county where more land is available,” says Stirnkorb.

In addition to new construction, another 1.8 million square feet of space is planned and could break ground within 6 months. Two thirds of this total is scheduled as spec space (43 buildings) with the rest specified as owner-user build-to-suits. H.G. Fenton Company will break ground at the end of the year on the 43,000-square-foot first phase of its 131-acre master-planned Fenton Technology Park, located in Sorrento Mesa. For corporate users wishing to stay in the central county area, there are only five potential campus locations exceeding 20 acres – none of which are available for sale. In the 10- to 20-acre range, there are only six sites not already controlled by users, and again none are available for sale.

The R&D market is showing signs of recovery, posting 80,000 square feet of positive net absorption in the first quarter — nearly 40 percent of the 2003 total. R&D vacancy for total leasable space is 14.9 percent and just 11.1 percent when owner-user space is included. New R&D construction — the first in 4 years — is user-driven and, unlike industrial product, is being concentrated in the mid-county area, says Mike Philbin, senior vice president with Burnham Real Estate. New R&D development includes the 350,000-square-foot first phase of Biosite’s new corporate headquarters in Fenton Technology Park.

“The county’s diminishing land supply will continue to strain future industrial and R&D development and drive rental rates up as demand for space exceeds inventory,” Philbin adds.

Retail

Demand for San Diego County retail space continues to be strong. “The retail market is in the expansion phase where vacancy is declining, rents are increasing and construction is influenced by user demand keeping supply/demand ratios in check,” says Burnham Real Estate’s Pete Bethea. “As a result, the San Diego County retail market once again leads all commercial real estate asset classes.”

During the first quarter of 2004, the retail sector experienced 1.2 million square feet of net absorption and a corresponding decline in vacancy from 1.9 to 1.6 percent –– marking one of the tightest retail markets recorded in the city’s history. Given continued positive economic indicators, there is no sign of slowing.

Rising consumer confidence and new job growth — San Diego County gained 7,200 jobs in February, 9,400 jobs in March and another 5,100 jobs in April — are driving the robust retail sales activity. “With this job growth, the retail market will benefit from a surge in consumer spending, which already accounts for two-thirds of the overall U.S. economic activity,” says Bethea.

In the first quarter, new shopping centers were responsible for most of the county’s retail net absorption — nearly 965,000 square feet. Existing community and neighborhood centers accounted for nearly 20 percent of all countywide net absorption, with 225,316 square feet of activity. Leading this year’s net absorption were new centers including Quarry Creek in Oceanside (372,000 square feet), Creekside Market Place in San Marcos (262,000 square feet) and The Forum at Carlsbad (220,000 square feet).

At 1.3 percent, neighborhood centers report the lowest retail vacancy, followed closely by community centers with 1.7 percent vacancy and strip centers with 3.7 percent vacancy. Retail vacancy is evenly distributed throughout the county, with most submarkets reporting vacancy rates of less than 2 percent. Only North City and the Highway 78 Corridor report vacancies of 3.3 percent and higher.

Year-to-date, one million square feet of new retail space has been completed in seven centers. More than 1.6 million square feet of new retail construction is under way in 15 additional shopping centers and stores. Big-box users such as The Home Depot, Costco, Kohl’s and Wal-Mart are driving most of the construction. However, a slow and calculated shift to speculative strip center development of less than 20,000 square feet has begun. Tenant demand and high occupancy rates have created new development opportunity in Class A markets.

Multifamily

The San Diego County housing market is one of the strongest in the nation, with supply falling well short of demand. Single-family homes and condominiums are being sold faster than they can be built, and at prices that are unaffordable for many. In April, the median price for a single-family resale home in San Diego rose to $485,000. A strong and diversified economy, coupled with the appeal of San Diego’s Southern California location and weather, is contributing to the record demand for housing, and this, in turn, is driving the area’s very healthy multifamily market.

“The limited availability of for-sale housing to meet demand, coupled with prices that many people simply cannot afford, continues to support the San Diego multifamily market, which currently reports vacancy of approximately 5.8 percent,” says Ed Rosen, senior vice president and apartment specialist with Burnham Real Estate.

The lack of available land and the high cost of development are causing a boom in San Diego County condominium development and conversions. Many apartment owners are recognizing that conversions fill a vital niche in a hot market. MarketPointe Realty Advisors reports that more than 2,300 converted apartments were sold in San Diego in 2003 — a greater volume than the last 7 years combined. In fact, today San Diego County is home to more than nine out of every 10 Southern California conversions.

Given these supply/demand dynamics, San Diego County continues to reign as one of the strongest apartment investment markets in the nation. Real Capital Analytics reports that nearly $1.5 billion were invested last year into local apartment acquisitions of $5 million or more, once again ranking San Diego as the second hottest apartment market in the western U.S. So far this year, another $360 million worth of multifamily properties have been purchased. Bidding wars for limited available product are driving up prices for San Diego apartment properties. The 2003 median per-unit selling price for San Diego complexes with 5 to 49 units was $105,000 — up 27 percent over 2002 — while the median price for complexes with 50 to 99 units rose 18 percent in 2003 to $94,085.

Certain segments of the market have relaxed, however — specifically, the new high-end luxury units, which are drawing rental rates in the range of $1,300 to $1,834 per month. This is particularly true in downtown San Diego where thousands of new units have been added. As a whole, rental rate growth is slowing down from its 3.6 percent pace in 2003. “As more would-be homeowners are priced out of the housing market, we will see demand rise for high-end [multifamily] units during the next 12 to 18 months, helping to lowering vacancy,” says Rosen. “In the meantime, demand for Class B and Class C units is outstripping supply in all areas of San Diego County.”

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