MARKET HIGHLIGHT, JULY 2006

SAN DIEGO MARKET HIGHLIGHT
Dan Gaston, Bo Havlik, Adam Robinson, Tyler Brook and Sandra Grove

Rising interest rates may have commercial real estate players sorting the fundamentals from the frenzy, but San Diego is still a place investors, developers and tenants want to be. Not to mention residents, business owners, tourists, surfers, golfers and the list goes on and on…

Office

The San Diego office market continued through first quarter 2006 the positive trend that began in 2005. Although rising interest rates have cooled the residential market, San Diego’s job market and overall economy have remained among the strongest in the country, with the unemployment rate hovering around 4 percent.

The consensus seems to be that San Diego is well positioned for a soft landing to what many would consider a “more normal” real estate market. Last year ended with an overall office vacancy rate in San Diego of 9.2 percent after four straight quarters of positive net absorption totaling 935,380 square feet. The end of first quarter 2006 finds the vacancy rate at 9.1 percent. There has been more activity in the sublease market, mostly due to the thinning out in the residential building and lending sectors. This has had little effect on the overall office market though, as tenants are still seeing prices rise per square foot in all sectors of the office market.

The real strength of the office market appears to be in medical/professional offices, as shown by rental rates that are higher than Class A rates in some markets. In addition, the number of proposed medical office projects currently under construction indicates developers are realizing the important demand for this product. In North San Diego County alone, there are at least a dozen new medical/professional office projects totaling approximately 270,000 square feet that have been completed or will hit the market in the next 12 to 18 months.

The downtown central business district continued its overall strong performance in sales and leasing with several trophy office properties selling at record prices. Two of the more notable sales were the NBC Building for $265 million and the San Diego Tech Center for $185 million.

The suburban markets of Sorrento Mesa, Torrey Hills, Del Mar Heights and Carlsbad continue to lead the way with large leases, including Cadence Pharmaceuticals recent signing in Del Mar. Intuit, Qualcomm, ViaSat and other large San Diego employers have also expanded in the aforementioned markets.

Sales activity should remain strong; despite low cap rates, many investors are still bullish on San Diego because of the upside on rents. The owner/user market has some pent-up demand, and interest rates are still considered low from a historical perspective. Several investors and developers have either completed or are currently building office condo projects and smaller owner/user projects to cure the demand side for the office user, who is typically more challenged in taking advantage of the benefits of ownership. With demand out-pacing supply, this should keep owner/user sales strong through 2006 barring any dramatic upward movement in interest rates.

— Dan Gaston is a principal in Lee & Associates’ Carlsbad, California, office.

Retail

Retail projects continue to spring up throughout San Diego County, with several new shopping centers opening, including developer C. W. Clark’s Los Coches Village. Located in the upscale La Costa community, the approximately 90,000-square-foot center is anchored by Henry’s Market, Petco, Prudential California Realty and a 23,000-square-foot Class A medical office building. Typical of the market throughout North County, Los Coches Village was 95 percent leased at opening with rents exceeding $3.50 per square foot NNN.

Tworoger Development has several major projects in the pipeline in Carlsbad, including La Costa Town Center, an approximately 350,000-square-foot lifestyle center anchored by a major department store, theater, restaurants, specialty shops and a medical office component; and Loker Business Center, a specialty center anchored by Staples and Starbucks Coffee with exceptional visibility on Palomar Airport Road.

With the completion of construction of the long awaited Melrose Drive link between Carlsbad and Vista, the commercial corners at Melrose Drive and Shadowridge should be busy with development this year. That connector will also enhance traffic flow along the busy Palomar Airport Road connecting San Marcos.

Four Square Properties will break ground this year on Sunnycreek Plaza, a long-awaited 20-acre commercial site, providing more than 200,000 square feet of retail space, including a market, a drug store, a service station, restaurants and stores for the airport business park employees and the rapidly growing neighborhoods in Calaveras Hills.

World Premier Investments is well under construction on Grand Plaza, a 355,000-square-foot power center on Highway 78 at the newly constructed Las Posas interchange in San Marcos. Anchored by Nordstrom Rack, Bed Bath & Beyond, Marshalls, Petco, Loehmann’s, Shoe Pavilion and Sports Chalet, Grand Plaza will also feature restaurants such as Elephant Bar and Chili’s Grill & Bar.

In south San Diego County, the Eastlake area of Chula Vista will be adding more than 1 million square feet of exciting, upscale shopping ambience to the county’s fastest growing residential community with the completion of Village Walk at Eastlake, Winding Walk at Eastlake, San Miguel Ranch and General Growth Properties’ new 850,000-square-foot Otay Ranch Mall, which is due to open before Christmas this year.

Rental rates are predicted to remain stable and even increase in certain retail use categories, with some shop space hitting the $5-per-square-foot range. At some point rents will have to stabilize in order for sales volumes to justify them, but for now developers who can build centers are experiencing some of the best absorption in the last decade.

— Bo Havlik is a principal in Lee & Associates’ Carlsbad, California, office.

Industrial

The San Diego County commercial real estate market remains strong in 2006. Increasing demand has kept industrial vacancies at approximately 7 percent, despite continued development in all sectors of the market.

North San Diego County is the place for growth in the industrial market as purchase prices have increased 60 percent in the last 2 years. Developers are buying the remaining pieces of industrial land for future speculative development.

The continued relocation and expansion of large corporations are positively influencing the inflow of smaller tenants and “feeder” industries. Ernest Paper Products just moved into 108,000 square feet in Vista, and Paolone Brothers is moving into approximately 200,000 square feet in Ocean Ranch Corporate Center.

One fundamental shift is the movement away from smaller 2,000- to 8,000-square-foot units. Options in this size range are tending to sit vacant for a longer period of time, and there are fewer buyers in the industrial condominium market than there were a year ago. Just

as the residential condo conversion market has cooled recently, so too have industrial conversion opportunities. While developers are still bringing new projects online, interest has slowed considerably.

Some of the main developers with significant projects in the pipeline are AMB Property Corporation, Opus West, Davis Partners, HG Fenton, Kelly Capital, Kilroy Realty and Slough Estates. They are building more office and R&D projects to push their returns with higher per-square-foot selling prices on completed projects because of high land prices. When dirt is $20 per square foot, pure industrial construction makes a lot less sense than it did when land was at $8 per square foot.

There are more than 3 million square feet of industrial and R&D projects to be built in the next 2 to 3 years in North San Diego County. Developers of projects such as Ocean Ranch, Bressi Ranch, Carlsbad Raceway, Palomar Forum and AMB Pacific Coast Business Park are betting on the continued popularity of North San Diego County as an alternative to more expensive and congested markets elsewhere in the county.

In truth, North County growth will have to be organic, driven by an expansion of existing tenants. Developers cannot hope all the new construction will be absorbed by tenants new to the market. If current tenants do not have the economic success necessary for growth, the market could be temporarily overbuilt.

Developments completed this year will undoubtedly be successful, but projects coming online toward the end of 2006 and beginning of 2007 could struggle with absorption. Concern for this possibility has caused developers to delay speculative projects and put their efforts into attracting larger build-to-suits to jumpstart projects and absorb initial costs.

On the investor side of the market, San Diego County cap rate compression is a reality due to the tightening of the leasing market and the expansion of national capital resources focused on real estate acquisition in Southern California. Despite these challenges, investor sentiment continues to remain bullish. If local developers manage to pace their project completion schedules to match the market’s continued growth, San Diego County will continue to be one of the hottest markets in the nation.

— Adam Robinson, principal, and Tyler Brook, associate, are based in Lee & Associates’ Carlsbad, California, office.

Multifamily

San Diego city and county apartment sales activity continues to slow, according to a Burnham Real Estate report. The 154 sales of projects with three units or more in first quarter 2006 reflect a 36.9 percent decrease from first quarter 2005 when 244 sales took place. First quarter 2005 activity was also down from the same time the prior year when 326 sales occurred, a 25.2 percent decline. The number of units sold is also slowing, from 4,763 units transferred in first quarter 2004 to 3,984 units in first quarter 2005 to 3,081 units transferred in first quarter 2006.

“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. “However, the steady decline in sales is a sign that buyers are being more cautious, shying away from record-high prices at a time when rising interest rates make it harder for deals to pencil out.”

The condominium conversion frenzy drove prices to all-time high levels — investment dollars buyers could more than recoup through individual unit sales. These high prices precluded many investors wanting to hold properties for rentals.

“Increasing government restrictions in some areas and a higher supply of converted units for sale indicate that the conversion process may have run its course, at least for the time being,” says Carlson. “The result is a necessary market correction toward lower prices that will transition us from a seller’s market to a buyer’s market.

According to Burnham Real Estate, there were four sales of projects with 100 or more units in first quarter 2006. They were:

• The Missions at Rio Vista in San Diego, a 464-unit community that sold for $135.5 million or $292,025 per unit

• Missions at Sunbow, a 336-unit complex in Chula Vista that sold for $86 million, or $255,952 per unit

• Cascade Falls, a 450-unit project in Carlsbad that sold for $77.8 million or $172,782 per unit

• Club Pacifica, a 240-unit project in El Cajon that sold for $48.3 million or $201,354 per unit

Leading San Diego County in apartment sales activity were the markets of Golden Hill/Southeast San Diego, Pacific Beach/Mission Beach and Normal Heights/Kensington, each with 16 sales transactions involving 147 units, 120 units and 103 units, respectively. Coastal North was next with 13 sales of 577 units, followed by the College Area/Del Cerro and North Park, each with 10 transactions involving 89 and 53 units, respectively.

According to MarketPointe Realty Advisors, the San Diego apartment vacancy rate is 3 percent, and the average unit rent is $1,211.

— Sandra Grove

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