MARKET HIGHLIGHT, MAY 2007

SAN DIEGO MARKET HIGHLIGHT
Robert Lester, East Haradin, David Onosko, Ron King, Justin Harvey, Scott Danshaw, Ron Graves, Lou Bulte and Tom Olson

Real estate has gone from a high boil to a steady simmer in this sunny, ocean-side haven. The San Diego office market is slowing, and industrial is experiencing a phase of oversupply. Meanwhile, the county’s runaway housing market appears to be undergoing a mild correction following the wild ride of condominium conversions in 2004 and 2005. Retail, meanwhile, has gone through the proverbial roof, attesting to the long-term attractiveness of San Diego.

Office

San Diego’s office space inventory is at a relative standstill, with a mere 0.3 percent increase above the previous quarter. The vacancy rate at the end of the year, while still not worrisome at 11.9 percent, represents a big increase from 9.1 percent in fourth quarter 2005. Rising vacancy has led some market observers to ask whether San Diego landlords are being too aggressive with asking rates. Those rates increased 1.4 percent since last year to $28.40 per square foot, according to the REIS Reports, while the effective rent is only up 0.7 percent from the previous quarter. For the year-to-year total, asking rents jumped 7.3 percent while effective rents rose 8 percent.

In the central business district, an unaccustomed supply of new office space is fast disappearing. The newly completed 381,043-square-foot 655 W. Broadway (soon to be renamed Advanced Equities Plaza) continues to attract tenants. Since its completion in third quarter 2005, 82 percent of the building has been leased at rates ranging from $3.41 to $3.61 per square foot full-service. The building is an acquisition target, according to the San Diego Daily Transcript, and may achieve a price in the $500 per-square-foot range. Still under construction, the other major downtown project is Diamond View Towers, which is only the second downtown high-rise to be built in the past decade. (Only half of the 300,000-square-foot building is devoted to office space, however.) Diamond View is currently 27 percent pre-leased and is achieving rents of $3.78 per square foot, which are high for the market.

The Irvine Company has invested heavily in downtown San Diego in the past 24 months with the purchase of Koll Center for $150 million ($402 per square foot) and One America Plaza for $300 million ($516 per square foot), pushing the submarket’s rents upward. Market experts expect the Orange County-based developer to further increase its stake in the downtown area.

In San Diego’s suburban markets, office vacancy hit a low of 8.6 percent in first quarter 2006, but has since worked its way back up to 10.4 percent. This rise is partly due to the high rate of construction, much of it in Central County submarkets such as Sorrento Mesa and Kearny Mesa.

The North County office submarket is also moving full-speed ahead. Economic and lifestyle factors — such as comparatively short commute times from some desirable residential communities — are making this once-overlooked area appealing to many kinds of business, notably biotech, R&D and professional services. North County, which extends northward from Del Mar Heights to Oceanside and eastward from Carmel Mountain Ranch, includes the communities of Poway, Rancho Bernardo and Escondido. Companies of all sizes are setting up shop in these areas. The attractions are an array of housing options, ranging from high-end executive estates in Bressi Ranch, Carlsbad, Rancho Bernardo and Rancho Santa Fe, to affordable, fast-growing suburbs such as Temecula in the Interstate 15 corridor.

Leasing activity is strong in the North County, with a low vacancy rate of 8 to 10 percent and lease rates growing at a modest 5 to 8 percent per year. In product type, the North County office submarket is a mix of low- and mid-rise, campus-style R&D Class A corporate headquarters, and Class B and C buildings. The market is now poised for a major influx of new for-sale and lease product in Carlsbad and Oceanside. This will likely create a temporary spike in the vacancy rate. At the current rate of leasing activity, however, this space is expected to be absorbed in the next 2 to 5 years. Rental rates mirror these trends, ranging from $2.25 to $3.50 per square foot with the highest rents in the Del Mar Heights and coastal areas.

— East Haradin is a senior associate and Robert Lester is a sales associate for Coldwell Banker Commercial Almar Group.

Industrial

The long-term outlook for San Diego’s industrial market is sunny, even if the sector seems slightly soft and overbuilt in the North County, causing the vacancy rate in that area to jump 4 percentage points above the previous quarter to 11.6 percent in fourth quarter 2007. Supply has outpaced demand in this popular market. Given the robust leasing activity in recent quarters, however, one can expect vacancies to rapidly head back to their accustomed 5 to 10 percent range, and for currently spiraling lease rates and sale prices to stabilize.

Central San Diego is supporting a healthier industrial market, with a vacancy rate less than 5 percent. Some tenants are leaving Central San Diego to find cheaper rent elsewhere, but that doesn’t seem to affect vacancy rates and the continued demand for space in multi-tenant industrial parks.

As with the residential, retail and office sectors, development and leasing trends in San Diego’s industrial market are largely being driven by the scarcity and high price of developable land. Throughout the county, land is in short supply, and the cost of land seems unlikely to fall in the near future. Land prices in North San Diego County have hit the $20 to $25 per-square-foot range, while those in South County are in the mid-teens and climbing. Central San Diego is virtually built-out with no significant parcels available and prices in the high $30s for the occasional small property that opens up. At these prices, developers inevitably turn to development types such as retail and multifamily to maximize the rental income or price per square foot.

— David Onosko and Ron King are senior vice presidents and Justin Harvey and Scott Danshaw are senior sales associates for Coldwell Banker Commercial Almar Group.

Retail

Retail is hot all over California and even hotter in San Diego, where the strongest submarkets report near-zero vacancies and national credit tenants continue standing in line for space in the most sought-after projects.

In contrast to San Diego’s troubled housing market, the retail market is marching forward in full stride, whether in exclusive enclaves such as La Jolla, the upscale suburbs of Carmel Mountain Ranch and Mission Valley or fast-growing middle-class cities such as Chula Vista and Eastlake. This growth is due to economic expansion, income growth and population growth throughout the county.

Retail lease rates range from $3 to $4.50 per square foot, although high-end markets are able to command $5 per square foot; La Jolla can command an eye-popping $10 per square foot.

Beyond the city limits of San Diego, the I-15 corridor is thriving, and land prices west of the Interstate are climbing quickly, while demand from national retailers continues to rise. Even with that demand, however, no new large-scale, single-story retail projects are currently under construction here. Rising land prices are putting the squeeze on developers, which are opting for mixed-use projects that incorporate retail with office and/or residential components.

Another high-growth area that is experiencing a development boom is the Otay Mesa/Eastlake area, located on the border with Mexico. General Growth Properties is nearing completion of Otay Ranch Town Center, San Diego County’s first new regional mall in 25 years. At 860,000 square feet, Otay Ranch Town Center promises to be a premier lifestyle center serving the communities of Chula Vista and Eastlake and boasting such high-end tenants as Coach, Anthropologie, Macy’s, The Cheesecake Factory and P. F. Chang’s China Bistro.

Throughout San Diego County, major retail tenants of all sizes are in search of new locations that will connect them with consumers, although some of the larger users are exercising caution. Even movie theater chains, despite flat or falling attendance levels, are seeking new sites. Although theaters are not as productive for retail developers as retail space, movie venues continue to draw patrons to retail centers and prolong the shopping experience.

One factor that could eventually constrain retail development is the mounting cost of construction; however, the slower pace of residential building could potentially relieve some of that upward pressure on construction costs and free up materials for retail developers.

— Ron Graves is vice president of Coldwell Banker Commercial Almar Group.

Multifamily

A sudden major drop — approximately 50 percent — in the sales volume of San Diego apartment properties, increasing interest rates and slow growth in rental rates have some observers talking about a shift to a buyers’ market. Such talk may be premature, however. Following the heated (and possibly overheated) sales activity in the condo and condo-conversion market of 2004 and 2005, which removed many apartment units from the market, the underlying demand for rental properties and support of basic investment value remains strong.

San Diego remains one of the least affordable housing markets in the country. There is a growing gap between the cost of owning versus renting due to the constrained supply for new rental stock and an onerous fee structure for any new apartment development, despite the stimulus of low interest rates. Those fortunate San Diegans who already own their own homes have enjoyed tremendous growth in both value and equity. For prospective homebuyers, however, it is often difficult to save up for a down payment.

While apartment rents are currently growing at a slower pace, vacancy rates for multifamily properties in San Diego County are some of the lowest in the country at around 3 percent. Vacancy rates will continue to remain low, even with the anticipated return to rental stock of some converted units currently being offered for sale, as well as a possible drop in proposed new construction.

Despite sub-6 percent cap rates and sale prices approaching $200,000 per unit, San Diego’s apartment market remains one of the most sought-after investment markets in the country. All market dynamics appear in place for continued upward pressure on rents, not the least of which is the sharply growing cost of new construction.

Aside from the condo conversion trend, the basics to sustain high multifamily occupancy, increasing rental rates and stable values remain strong. Although the employment growth in the area is slowing slightly, the labor market is still tight with unemployment at 3.7 percent. Unlike other parts of the country where residential prices have dropped dramatically, the median home price in San Diego has held relatively steady at around $490,000. Finally, with interest rates remaining at historical lows, low vacancy rates and continued upward pressure on rental rates, the apartment investment market remains healthy throughout San Diego County.

— Lou Bulte is a senior vice president at Coldwell Banker Commercial Almar Group.

So what does the future hold? Apartment values should plateau as the frenzied condo conversion craze of the past several years cools off. Expect to see continued low vacancies with continued upward pressure on rental rates, if not as strong as in the recent boom times. A drop in overall sales volume is also expected due to the overhang of unsold condo conversions as well as legal challenges to the conversion process. All of these trends, while calmer than in recent years, suggests that apartment investors will continue to have strong interest in San Diego, and the area will remain one of the coveted markets for both institutional and individual investors.

Some of San Diego County’s problems appear minor and short-lived, given the rate of growth in the county. Boom periods often are followed by overbuilding or a slight stagnation in activity as the market searches for the precarious balance between supply and demand. Over supply is probably a short-term phenomenon, however. In San Diego County, growth remains the big story. 

— Tom Olson is a senior vice president for Coldwell Banker Commercial Almar Group.


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