MARKET HIGHLIGHT, MAY 2006

SANS SPACE IN SAN DIEGO
George Gramm and Sandra Grove

In the dizzying race for space in Southern California, can anyone afford to stop and enjoy the sunshine? One thing’s for sure — it’s good to be a commercial real estate owner in sunny San Diego.

Retail

The San Diego retail market continues to strengthen and is expected to thrive throughout 2006 as vacancy rates remain at historic lows and rental rates continue to increase. Supporting this trend are solid economic drivers, such as steady population growth, strong job growth, increasing income levels, healthy consumer confidence and a stable level of retail sales, which are all projected to continue throughout the year.

In 2005, San Diego retail saw increased levels of progress as tenants, landlords and investors had a continued strong desire to enter the already tight market, which absorbed 710,000 square feet in 2005 compared to 240,000 square feet in 2004. With such strong market activity, existing tenants that wanted to expand in the market had fewer options due to the overall low vacancy rate of 2.1 percent, compared to the national average of nearly 7 percent.

Even though 1.37 million square feet became vacant countywide during the second half of 2005, most of the available spaces were in older centers located in less desirable locations. San Diego also saw an increase in new retail space of more than 500,000 square feet, and nearly 1.5 million square feet are currently under construction. As a result of high tenant demand, it was only a short time before these spaces were leased, forcing many tenants to change their building characteristics to comply with available space. Time on the market for vacant space in prime retail areas continued to be only 2 or 3 months, compared to recent years of 6 to 8 months. In highly compacted areas, tenants are conceding their demands for certain space requirements in order to be in specific submarkets. With such high demand, tenants are paying rental rates of an average of $1.88 per square foot, up 10 cents from June 2005. Del Mar Heights continued to have the highest rental rates for retail space in a neighborhood center at nearly $5 per square foot per month NNN, while Carmel Mountain Ranch and the downtown submarket are seeing rates on average between $3.30 and $3.50 per square foot NNN.

There continues to be a high demand for land to build new retail centers, but supply is tight due to geographical impediments and the growth constraint tax implemented by the county. One key opportunity for developers will continue to be the redevelopment of urban infill sites; many of these projects are mixed-use with a residential component. Downtown San Diego will lead all areas of the county in this type of infill development. As a result of redevelopment, space is expected to increase in 2006 with the opening of centers like Grand Plaza Shopping Center in San Marcos, Riverview in Santee and Otay Ranch Town Center in Chula Vista.

Investor interest is anticipated to remain high for well-located retail centers despite the low cap rates and increasing interest rates. Institutional investors will emerge as the leading buyer type during 2006. Overall, the forecast for the San Diego retail market is one of positive expansion.

— George Gramm is the market research director for Grubb & Ellis in San Diego.

Multifamily

For the first time ever, San Diego ranks at the top of the list of residential markets to watch in the country, according to Emerging Trends® 2006, ahead of the traditionally hot markets of Los Angeles, San Francisco, the greater Washington D.C. area and New York.

“Average San Diego single-family new home prices of more than $600,000 have fueled a condo conversion frenzy with investors rushing to capitalize on the demand for more affordably priced housing,” says Cathryn Low, a vice president with Burnham Real Estate’s Multifamily Services Group. “With more than 90 percent of the local population unable to afford a median-priced home, condo conversion units are the only entrance to home ownership for first-time buyers.”

Housing affordability is an area of growing concern in San Diego, with substantial price increases noted in all for-sale sectors during the past three years. The average price of a resale home today is $555,000, up 40 percent in just 2 years, according to MarketPointe Realty Advisors. The average price of a resale condo is $375,000, a price that is still well out of reach for many.

Sales of attached homes are running at twice the volume of detached homes in San Diego, with conversions accounting for more than half of all attached sales in 2005. However, according to a year-end 2005 Burnham Real Estate report, the number of annual multifamily investment sales transactions has begun to slow. In 2005, the 975 apartment sales transactions recorded were down 27.2 percent from the 1,339 sales recorded the previous year.

Even with the slower sales volume, apartment sales prices remain at historic highs. According to MarketPointe Realty Advisors, the average per-unit price today of $156,900 is nearly quadruple the $43,000 average per-unit price in 1995. In fourth quarter 2005, the highest-priced San Diego County apartment property sold for condo conversion was Regents La Jolla, a 447-unit community in La Jolla, which sold for more than $154.5 million or $345,835 per unit. The highest priced sale of an apartment property without a condo map was 18 units at 425 Stratford Ct. in Del Mar, which sold for $5.95 million or $330,555 per unit.

“San Diego County apartment sales volume and pricing has risen steadily in the past 10 years, and the recent pause in activity is a sign that we are returning to a more balanced market,” says George Carlson, vice president and apartment specialist with Burnham Real Estate. “The slowdown in volume indicates that investors are looking for a price correction; this cooling may be beneficial to them in the long run, creating a more manageable and efficient market.”

Carlson notes that the increase in short-term interest rates, which is making adjustable rate mortgages much more expensive, will contribute to a temporary over-supply of for-sale housing. Additionally, if local municipalities impose greater restrictions on conversions, it will be more difficult to supply the affordable for-sale housing first-time buyers are looking for. “The beneficiary in both cases is rental product, which will see more demand and even higher rental rates,” Carlson says.

San Diego County rental rates, which have risen steadily during the past 10 years to their current average of $1,170 per month, are likely to go even higher, particularly given the current San Diego apartment vacancy rate of just 3 percent.

What is the future for conversions in San Diego? “As long as the housing shortage lasts, there will be demand for more affordable housing, and condo conversions are about the only point of entry for first-time homebuyers,” Low says. “However in the short term, buyers have a lot of condo conversion inventory to choose from, so the product absorption has slowed. San Diego’s growing economy and steady population growth point to projected demand for at least 20,000 units annually, still well below the amount of new housing that is expected to come on line each year. While the rapid run-up in for-sale housing prices has slowed, high demand and restricted supply over the long-term will keep the residential sector very strong, and multifamily product will benefit.”

— Sandra Grove

Office

Strong fundamentals in the San Diego economy are fueling corporate expansion, and this, in turn, is driving high net absorption of office space and a new wave of speculative and build-to-suit construction.

According to Burnham Real Estate, the San Diego office market absorbed more than 2.5 million square feet in 2005, more than double that of 2004.  With demand for space outpacing supply, vacancy is in the single digits in most area submarkets, rents are on the rise and investment activity remains hot with record-breaking prices per square foot.

“Pent-up demand in the business side of the economy will continue to increase capital expenditures for new space needs in 2006,” says Mark Wayne, senior vice president/principal with Burnham Real Estate. “New office product is being constructed for very real tenant demand, reflected by strong net absorption and declining vacancy in virtually every submarket. San Diego’s limited supply of land for new development will prevent any significant overbuilding, helping to keep the market in strong supply-and-demand balance.”

The Burnham report shows that office vacancy based on total inventory, including owner-user space, stands at a low 8.9 percent. Additionally, speculative development accounts for nearly half of the 3.7 million square feet of new office construction in San Diego County, followed by build-to-suits-to-own (37 percent) and build-to-suits-to-lease (13.6 percent).

According to Wayne, San Diego office rents are on the rise.  “Companies are acting now to lock in Class A space commitments before lease rates jump significantly,” he says. “By year-end 2006, Class A rents in premiere markets like Del Mar Heights and UTC should reach $4 per square foot.”

In 2005, downtown San Diego welcomed its first Class A high-rise in 15 years with the addition of 655 Broadway. Another 11-story tower called Diamond View Terrace is underway adjacent to the new PETCO Park and will be complete in 2007.

Kearny Mesa, an established San Diego Class B submarket, is undergoing an exciting transformation. A 232-acre site previously occupied by General Dynamics is being redeveloped into a spectacular master-planned commercial and residential development called Spectrum, and Sunroad Enterprises has just begun construction on a 1-million-square-foot Class A office campus located within the Spectrum community.

“Called Sunroad Centrum, the first phase features Kearny Mesa’s very first office high-rise, a 12-story, 300,000-square-foot tower,” says Rick Vann, president of the real estate division of Sunroad Enterprises. “Two more towers with 14 and 16 stories, respectively, are also planned. When complete, Sunroad Centrum will be the largest and only office project of this caliber in the mid-city area of San Diego.”

In the popular North City submarket of Del Mar Heights, San Diego is getting ready to welcome another Class A project.  Paseo Del Mar is a 240,000-square-foot, three-building campus being developed by Crescent Real Estate Equities Company and JMI Realty, in conjunction with Cruzan | Monroe.  “The project already has several lease announcements pending, including a commitment by a major law firm to occupy two full floors in building one when the project is complete in January 2007,” says Dennis Cruzan, principal with Cruzan | Monroe.

“What we are seeing is that the dwindling supply of developable San Diego sites is causing companies to look at their future needs given that only a 5- to 7-year supply of employment land remains,” says Wayne.  “This projected shortage of space, growing tenant demand and rising rental rates will continue to support high values and commensurate investor interest throughout 2006.”

— Sandra Grove

Industrial

San Diego’s industrial market will maintain steady levels of positive growth in 2006 driven by the strong economy. The strength within the industrial market is demonstrated by the positive job creation, continued flow of capital into commercial real estate and the healthy expansion of businesses. The industrial forecast is one of continued positive expansion during the year despite rising interest rates, limited long-term supply and increased construction costs.

The annual net absorption for 2005 in San Diego totaled approximately 3.2 million square feet of industrial space, slightly more than the net absorption recorded in 2004. Demand for all types of industrial space gained strength throughout the previous 3 years and is expected to remain at that level through the end of 2006. Positive economic forces both from a national and a regional standpoint will continue to fuel a large number of tenant expansions throughout the county, consistently increasing the levels of demand for industrial space during the year. During 2005, Otay Mesa led all submarkets in San Diego County with a positive net absorption of more than 720,000 square feet. Otay Mesa’s strong performance resulted from the relatively low cost of industrial land combined with the availability of larger buildings. In addition, the anticipated completion of State Route 125 and the improving industrial economy with Mexico have supported the demand.

The San Diego industrial market ended 2005 strong with more than 3.3 million square feet of new space under construction. The submarkets with the highest volume of construction activity were Oceanside, Sorrento Mesa, Otay Mesa and Vista. These submarkets from the south and north parts of the county will continue to experience higher levels of construction and are predicted to be the fastest growing areas in San Diego for industrial development.

In the last 3 years, the overall countywide industrial vacancy rate has remained at less than 8 percent with the fourth quarter 2005 vacancy rate at a low of 6.8 percent and with North County at an all time low of 5.8 percent. Rental rates continue to experience modest increases due to high demand for space, low vacancy rates, diminishing supply of land for new development and rising construction costs. The San Diego area remains a prime choice for investors as asking rental rates are expected to remain stable and potentially increase.

In 2006 industrial supply is anticipated to keep pace with demand as the overall vacancy rate is expected to remain under 7 percent. It is anticipated that companies will look to lock in lease or purchase commitments for space early in 2006 in an effort to avoid impending rental increases and supply shortages of affordable land for new development. New construction should slow moderately as rising construction costs and land values increase. Competition will continue to rise in 2006, primarily in Otay Mesa. Increased imports, business expansions and healthy consumer spending will keep the San Diego industrial market expanding throughout 2006.

— George Gramm is the market research director for Grubb & Ellis in San Diego.

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