MARKET HIGHLIGHT, OCTOBER 2006

SUNNY SAN DIEGO REAL ESTATE
Robert Lester, East Haradin, Robert Fletcher, Ron King, David Onosko, Ron Graves and Alan Scott

With substantial development in the office market and already very low vacancies in the retail and industrial sectors, San Diego’s real estate forecast is bright and sunny.           

Office
Downtown and Central Business District

The San Diego office market has experienced a substantial increase in inventory as 1.23 million square feet of office space has been delivered in third quarter 2006. Construction starts for the quarter represent another 2.43 million square feet of future inventory. This increase in inventory has pushed vacancy rates in San Diego County back up to 10 percent after a brief dip to 9.1 percent in fourth quarter 2005. Despite the increase in available space, average rental rates continue to increase. They are up 7 percent since second quarter 2005 and are averaging $2.53 per square foot per month. Over this period, Class B buildings proved strongest with rents increasing 10 percent.

In the central business district, vacancy rates are declining as the newly completed, 381,043-square-foot high-rise located at 655 W. Broadway continues to attract tenants. Since its delivery to the market in third quarter 2005, 77 percent of the building has been leased at effective rental rates ranging from $3.41 to $3.61 per square foot, fully serviced. Diamond View Towers, the second downtown high-rise to be built in more than 10 years, is still under construction. It is currently 27 percent leased and is achieving rents as high as $3.78 per square foot.

Average rents for the downtown market are up to $2.75 per square foot from $2.46 at the end of second quarter 2005. Class A properties downtown have seen a 10 percent increase in rental rates since the end of second quarter 2005, peaking at $3 per square foot in second quarter 2006 and adjusting to an average of $2.97 per square foot currently.

The Irvine Company has invested heavily in the downtown market with the purchase of Koll Center for $150 million ($402 per square foot) and One America Plaza for $300 million ($516 per square foot), consequently pushing downtown market rents upward.

In the central San Diego suburban market, vacancy rates hit a low of 8 percent in first quarter 2006, but have since worked their way back up and are currently at 9.6 percent. This is due in part to the 937,000 square feet of new office space that have been delivered so far in this quarter alone. This represents 40 percent of the new product in San Diego County, mostly occurring in the Sorrento Mesa and Kearny Mesa submarkets. With all of this newly available office space, net absorption is at negative 76,000 square feet. Rental rates have yet to be affected by the increase in inventory and vacancies and are up 7 percent from second quarter 2005.

— Robert Lester is a sales associate for Coldwell Banker Commercial SoCal in San Diego.

North County Office

In spite of some fragility following the post-September 11th economic downturn, the North County office submarket is moving full-speed ahead and making great strides. Economic and lifestyle factors are making this once-overlooked area appealing to a diverse array of businesses including biotech, R&D and professional services.

North County extends from Del Mar Heights up to Oceanside and inland from Carmel Mountain Ranch, capturing the areas of Poway, Rancho Bernardo and Escondido. Companies of all sizes are setting up shop here because of its wide array of housing options, from high-end executive residences in Bressi Ranch, Carlsbad, Rancho Bernardo and Rancho Santa Fe, to fast-growing suburbs such as Temecula along the Interstate 15 corridor. Employees from the top down enjoy the easier, reverse commute from central San Diego.

Leasing activity is strong in the North County, with a low vacancy rate and lease rates growing at a modest 5 to 8 percent per year. The office submarket is approximately 8 to 10 percent vacant right now and comprises a mix of Class A low and mid-rise properties, campus-style R&D 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. However, at the current transaction pace, 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 and Robert Fletcher are sales associates for Coldwell Banker Commercial SoCal in Carlsbad.

Industrial

The outlook for San Diego’s industrial market sector may be almost as sunny as this coastal haven’s enviable climate. With county industrial vacancy rates at a low 5 to 10 percent and leasing activity picking up following the owner-user buying craze, San Diego’s industrial market is moving toward healthier stabilization between lease rates and sales prices.

As with the residential, retail and office sectors, development and leasing trends in San Diego’s industrial market are largely being driven by the high cost and relative scarcity of developable land. The region’s primary industrial market is the Kearney Mesa and Miramar areas, two older and more established areas in the central parts of the county. Emerging industrial submarkets with more available land can be found in North and South County, specifically Oceanside and Otay/Eastlake.

Throughout the county, land is in short, and expensive, supply: land prices in North San Diego County range from $20 to $25 per square foot, with South San Diego County in the mid-teens and climbing. Central San Diego is virtually built-out with no significant pieces of land available and the prices in the high $30s for the occasional parcel that comes on line. At these prices, developers will naturally look to other product types such as retail and multifamily that can command premium rents or sales prices per square foot.

Steep land costs have had a hand in shaping San Diego’s industrial market, which does not comprise the typical warehouse, distribution and manufacturing fare that is flourishing in other areas of Southern California such as Riverside County, the Inland Empire and Victorville. For owners and developers, conventional industrial facilities do not pencil out in an overheated land market. Instead, San Diego’s so-called “industrial market” is primarily high-end R&D “flex-tech” space utilized by defense, aerospace, technology and bio-tech companies. Like apartments, condos and retail centers, developers can extract acceptable returns for these more sophisticated flex-industrial spaces that may incorporate good-sized office components and increased parking ratios as well.

For some industrial users, it once again may make more sense to lease than to own their facilities. Historically low interest rates in 2004 and 2005 drove a temporary surge in owner-user deals, which in turn created an unusually large gap between sales prices and rental rates. During this time, “commercial condominiums” became the darling of the industry, enabling small- to mid-sized firms to reap the tax benefits, prestige and security of real estate ownership without a tremendous investment. However, in 2006, the pace and volume of sales has fallen off somewhat, while leasing has picked up. There are still firms that want to own their own real estate and view a well-located, efficiently designed building as a good long term investment, but with leasing activity increasing, the result has become a more stable and predictable market.

— Ron King and David Onosko are senior vice presidents of Coldwell Banker Commercial SoCal in Carlsbad.

Retail

If 2006 has been a nail-biter for apartment owners and new investors who jumped on the condo conversion bandwagon, it has been a much smoother ride for the retail sector. Still hot all over California, the San Diego retail market is sizzling with zero vacancy in the strongest submarkets and tenants lining up for space in the most sought-after projects.

In sharp contrast to San Diego’s housing market, which is still floundering with the implosion of the condo-conversion craze, the retail market has hit its stride. From exclusive enclaves such as La Jolla to the upscale suburbs of Carmel Mountain Ranch and Mission Valley to fast-growing, middle-class cities such as Chula Vista and Eastlake, the retail market is booming throughout San Diego County due to the region’s economic expansion, income growth and population growth.

Reflecting the market’s vitality, rental rates are hovering at about $3 to $4.50 per square foot, with the more upscale markets able to command anywhere from $5 to $10 per square foot in areas such as La Jolla.

Beyond the city limits, the I-15 corridor is thriving, with land prices west of the freeway climbing quickly and demand from retailers on the rise. However, no new large-scale, single-story retail projects are currently under construction here. Instead, rising land prices are putting the squeeze on developers, who are opting for mixed-use projects that incorporate retail with office and/or residential components.

Another high-growth region that is experiencing its own development boom is the Otay Mesa/Eastlake area, just feet from the border with Mexico, where General Growth Properties is nearing completion of Otay Ranch Town Center, San Diego County’s first mall in 25 years. Comprising more than 860,000 square feet, Otay Ranch Town Center is a premier lifestyle center in the San Diego market with retailers and restaurants such as Coach, Anthropologie, Macy’s, Cheesecake Factory and P. F. Chang’s China Bistro. The center will feature a pedestrian- and family-friendly design, connecting the communities of Chula Vista and Eastlake.

All 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, which are suffering of late because of flat or falling attendance, are seeking new sites. Although theater deals may be done at cost for the developer, movie venues continue to draw patrons to retail centers and prolong the shopping experience.

Eventually, one factor that could 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 SoCal in San Diego.

Multifamily

A precipitous drop in the sales volume of San Diego apartment properties (approximately 50 percent), an increase in interest rates and a moderation of rental rates have some observers talking about a shift to a buyers’ market. However, coming off of record-high pricing and sales activity for 2004 and 2005 driven largely by the condo conversion 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 cost-of-ownership gap versus renting due to the constrained supply for new rental stock and the onerous fee structure for any new apartment development, despite historically low interest rates. Finally, while those who are fortunate enough to own their own condo or home have seen a tremendous growth in value and equity, it is often difficult for prospective owners to save the required down payment.

While rental rates are increasing 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 of the current for-sale condo conversion inventory and a drop in proposed new construction.

San Diego, despite sub-6-percent cap rates and sale prices approaching $200,000 per unit, is one of the most sought-after investment markets in the country. With the exception of new, more expensive construction driving rental rates upward, all the market dynamics are in place for continued upward pressure on rents.

Examining the underlying apartment market separate from the price pressure created by this condo-conversion cycle, the basics to sustain high occupancy, increasing rental rates and stable values remain strong. Finally, although the employment growth in the region is slowing slightly, the labor market is tight with unemployment at 3.7 percent. San Diego continues to experience strong employment and job growth.

Like most of the country, the over-heated, for-sale residential market continues to cool. However, unlike other parts of the country where prices have dropped dramatically, the median home price in San Diego has held relatively steady at around $490,000.

After a slight run up, long-term interest rates have fallen over the last several weeks. 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.

So what does the future hold? Apartment values will plateau, moderating from the condo conversion-driven frenzied market of the last several years. Low vacancy will continue with upward pressure on rental rates, although not as strong as recent trends. Expect a drop in overall sales volume due to unsold condo conversion inventory and pending legal challenges to the conversion process. Continued strong investor interest in basic San Diego apartment market dynamics will be evident. San Diego will remain one of the most sought-after apartment investment locations for investors of all sizes, from the individual to the most sophisticated institutional investors.

— Alan Scott is a principal of Coldwell Banker Commercial SoCal in Carlsbad.

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