MARKET HIGHLIGHT, OCTOBER 2007

SAN DIEGO
Georgia Montague, Michael Glickstein, George Gramm and Jennifer Cornelius

Retail is still hot in San Diego, as reflected by very low vacancies, and the multifamily sector has converted away from condo conversions. While still healthy, the city’s office and industrial sectors have tempered a bit.

Retail

Space for new retail centers is tight in San Diego County, creating a bigger market for mixed-use and rehabilitated shopping centers. Some mixed-use properties have been completed in the last couple of years in the inland North County neighborhoods of San Marcos and Escondido, while longstanding Westfield Malls properties Plaza Camino Real and University Towne Center (UTC) will undergo significant facelifts in the next 3 years.

Westfield plans to add 400,000 square feet to the 1.1 million-square-foot Plaza Camino Real, Carlsbad’s only traditional mall, replacing the defunct Robinson’s May department store with Bloomingdale’s and Macy’s and adding trendy shops and boutiques for a homier atmosphere. Similarly, UTC in University City, just outside of La Jolla, will get its first remodel in its 30-year history, adding 750,000 square feet to the existing 1 million square feet. Westfield will spend $2 billion on upgrading both centers.

Despite its high barrier to entry for big boxes, Carlsbad will also be getting a Wal-Mart center at El Camino Real and College Avenue, where the retailer has recently purchased a 17-acre site. It is uncertain when the center will be built and whether or not it will be a supercenter.

Also in North County, the neighborhoods of Rancho Bernardo, 4S Ranch and San Marcos have recently opened large retail centers. Grand Plaza in San Marcos is a 355,000-square-foot center that includes Nordstrom Rack and Sports Chalet, as well as smaller shops, grocery stores and restaurants. At 4S Ranch, 4S Commons offers 265,000 square feet of retail stores, and Rancho Bernardo completed 265,000 square feet of space.

Additionally, there is a proposed total of 1.6 million square feet of retail space in North County, including the 900,000-square-foot Ocean Pavilion in Oceanside, Carlsbad’s 373,000-square-foot La Costa Town Square and 170,000-square-foot Sunny Creek Plaza, as well as 212 acres in San Marcos called Creekside.

South County has 606,000 square feet under construction with 313,000 square feet in Chula Vista, 150,000 square feet of which is at Village Walk at Eastlake and 106,000 square feet of which is at the Winding Walk. Additionally, Eastlake Design District Phase II will add 82,700 square feet of space in Chula Vista. There is a proposed total of 747,000 square feet for all projects in downtown Chula Vista, including 11 new projects under construction.

Also of note, the 361-acre Liberty Station, San Diego’s former Naval Training Center on Point Loma, has been transformed this year into a mixed-use development of retail, residential, office, education and recreation. The $850 million project, a collaboration between The City of San Diego Redevelopment Agency and developer The Corky McMillin Companies, was funded entirely without taxpayers’ dollars.

New retailers coming into the county include Tesco’s Fresh and Easy, an up-and-coming U.K.-based grocery store chain, which will open seven sites throughout the county at undetermined dates.

The county’s leasing sector remains strong with a 2.2 percent vacancy rate, even tighter than last year’s 2.5 percent overall vacancy rate. Rental rates continue to rise with few concessions being offered and lease rates at $2.40 per square foot, a 10-cent or .8 percent increase from 2006. Vacancy rates are predicted to tighten further, and development is expected to remain difficult due to the cost of construction and lack of developable land.

— Georgia Montague is an advisor at Sperry Van Ness’ San Diego office.

Multifamily

Condominium conversion activity has slowed down to an almost negligible pace in San Diego, leaving an overabundance of converted condominiums. Many of these will likely revert back to rental stock and not sell until the next condominium conversion cycle, which may not occur for another decade based on historical precedent.

Conversions weren’t as much of a factor downtown, where a significant number of condos had existed before the conversion trend. Apartments there mostly escaped conversions. The majority of conversions took place where the greatest number of apartment buildings stood, namely in the mid-city neighborhoods of Hillcrest, Normal Heights, North Park and Kensington — areas considered strong with considerable infill development and gentrification continuing. In El Cajon, an East County neighborhood with many apartment buildings, converters were initially welcomed but now face higher standards for apartment conversions due to a glut of product and concerns for maintaining affordable rental housing stock.

A hefty number of conversions are still mired in construction loans, with converters not having anticipated needing permanent financing on the properties. Many of these projects will be taken back by the bank or the loans recast permanent financing secured. One such example is a broken 280-unit condominium-conversion project in Oceanside,  River Oaks Apartments, with only 39 of its units sold. This creates an unusual challenge for holder Bank of America as well as potential buyers who will need to deal with an active homeowners’ association and 39 individual owners.

Several downtown high-rise, high-density projects that were slated for development will probably not be completed, particularly if they have not broken ground yet, and many may have their uses converted to hotel or office buildings as the downtown market is currently oversupplied with apartments and condominiums. However, there are a few apartment projects coming online in San Diego that will likely be absorbed fairly well, as the overall vacancy rate remains low at 5 percent, up recently from 2.5 percent countywide.

Properties of note being developed include DRHorton’s 135-unit Atlas project, which is just out of the ground on 4th Avenue, with condominiums ranging from the low $300,000s to the low $500,000s. La Boheme, completed by DRHorton, is another condominium project located in North Park, with prices ranging from the upper $200,000s to the upper $400,000s. La Jolla Pacific, a boutique developer, recently completed Deca, a complex of 37 flats and street-accessible townhomes in Hillcrest.

In the investment sector, prices per unit are lowering, as is overall sales volume in terms of individual complexes sold. With cap rates rising and gross rent multipliers (GRM) falling, the market continues to soften. In San Diego County, the average price per unit in 2005 was $160,500 with nearly 600 projects sold and an average cap rate of 5.1 percent; as of mid-August 2007, the average price per unit was roughly $140,000, a 13 percent decline, with less than 150 transactions and an average cap rate of 5.7 percent.

Rental rates currently range from $820 to $1,340 per month for a one-bedroom apartment and $965 to $1,450 per month for a two-bedroom/one-bath, with prices rising toward the coast. As more converted condominiums revert to housing stock, the vacancy rate may be impacted to some degree, but the San Diego rental market remains strong, with reasonable increases in rental rates of 3 percent to 5 percent per year expected, barring other mitigating factors. The long-term picture is excellent.

— Michael Glickstein is vice president of Sperry Van Ness’ San Diego office.

Office

The San Diego office market will remain moderately active through the end of 2007 and should pick up in 2008 as several projects now under construction are scheduled to come online. Heading into third quarter, the countywide vacancy rate was below 11 percent, but is expected to rise in the next 6 months as the new product becomes available. Overall, the mid-year demand for space was down, but was still close to the historic average.

As third quarter approached, approximately 7.1 million square feet were available with approximately 3.2 million square feet under construction. In the last 24 months, vacancy rates in Class A projects have remained relatively low, but will increase as a result of this additional product coming on the market. Some of the more active submarkets are seeing double-digit vacancy rates, causing a fear of overbuilding; however, San Diego County’s recent and pending completions make up only 2 to 4 percent of the overall inventory.

Rental rates on the other hand have increased nearly 20 percent in the last 5 years. Although they will remain relatively high, rental rates are expected to level off as we reach the end of the year.

Areas of active development in San Diego County include the Interstate 15 corridor as well as the UTC, Del Mar Heights, Kearny Mesa and Mission Valley submarkets. Many of the Class A projects scheduled for completion in 2007 and 2008 are located in these submarkets and include: Hines’ La Jolla Commons, a 15-story, 345,000-square-foot office tower; Cisterra’s Gateway at Torrey Hills, a two-building, 200,000-square-foot project; Sudberry Properties’ two-building, 380,000-square-foot Terraces at Copley Point in Kearny Mesa; Sunroad’s 11-story, 275,000-square-foot Sunroad Spectrum; and Kilroy’s 140,000-square foot Kilroy Sabre Springs project in Sabre Springs.

“We continue to see strong leasing activity at projects that fulfill larger requirements (50,000+ square feet), such as Gateway Torrey Hills and La Jolla Commons,” says Tony Russell, Grubb & Ellis office specialist. “Tenants actively seeking space today are typically in the defense, technology or legal industries, while those in the real estate/mortgage, financial services and insurance are scaling back.” Tenants seeking large, contiguous space, Russell added, will likely pay a premium because of the lack of availability.

Typically, it takes 6 to 18 months to lease out an office project, but developers could potentially face a few more months of lease-up time in the next year as a result of market slowing. Fewer companies are pre-leasing space, waiting instead until 2008 to make commitments. Less demand, more options due to the new product and some tenants choosing to wait until projects are closer to completion to commit are factors. However, tenants seeking larger space (50,000+ square feet) and those that need to be located in prime submarkets like Del Mar Heights and UTC continue to pre-lease space because competition for space remains high in these areas.

“As we begin fourth quarter, sublease space in San Diego stands at approximately 1 to 2 percent, which is standard for the market,” says Richard Gonor, Grubb & Ellis office specialist. “However, we anticipate a possible increase in the next year as a result of multiple real estate-related and mortgage companies closing their doors and vacating space.”

Activity in San Diego’s office market should remain steady through the end of this year and will likely increase in 2008 after credit fears have passed. A short-term rise in vacancy is anticipated as a result of product being added to the market during 2008, with overall asking rental rates leveling off due to the increased availability of space and competition for tenants. Overall, the outlook remains positive with countywide numbers hovering near historic averages.

— George Gramm and Jennifer Cornelius are vice president of research and public relations manager, respectively, for Grubb & Ellis in San Diego.

Industrial

As of mid-year 2007, the industrial absorption numbers in San Diego County were still coming in positive, showing moderate absorption at the end of June. Vacancy levels countywide remain under 10 percent, but the market has not kept pace with previous years. Todd Davis, Grubb & Ellis industrial expert, says that fundamentals are still strong and that there is activity occurring throughout the market.

During the last several years, new development in San Diego’s industrial market has been moving at an accelerated pace, especially in the far north and south areas of the county where most of the developable land was available. As of mid-year 2007, the pace had slowed considerably as the rising cost of construction and land prices caused many new developments to be put on hold until existing inventory of space is off the market or until rental rates rise high enough to support the projects.

Heading into third quarter, many of the submarkets throughout San Diego County experienced moderate activity with tenants looking for space to lease. Oceanside, Carlsbad and Kearny Mesa all experienced strong demand for industrial space through mid-year. Some submarkets did experience a slowdown in demand, much of which can be attributed to many of the buyers waiting to see which direction the overall economy will go. “There are still buyers out there, buildings are still selling, tenants are leasing,” Davis says. “It’s just not at the same pace they were in previous years.”

As the second half of 2007 started, the industrial market continued to see new construction activity, half of which was in North County. Carlsbad and Oceanside led the North County submarkets with 340,000 square feet and 232,000 square feet, respectively. Other areas of San Diego experiencing new construction are Otay Mesa and Sorrento Mesa. Notable projects include: Three Piper Ranch, a two-building, 330,000-square-foot distribution project in Otay Mesa; Opus Point and the Towers at Bressi Ranch, both large R&D/Flex projects in the Carlsbad submarket; and Gateway Spectrum Business Park, a group of manufacturing buildings in Oceanside.

While the residential mortgage industry has been struggling, it has not had much impact on the local industrial user market. SBA loans continue to be readily available for the owner-user looking to buy an industrial building. Leasing activity remains positive and rental rates remain level with slight increases as a result of the new higher-end buildings coming on the market. San Diego industrial rental rates continue to rank among the top five highest markets in the country, and some tenants that have needed inexpensive space have transitioned out of the San Diego market, opening up space for expansion of technology, defense-related and other high-end uses.

While the small owner-user has not been largely affected, the institutional investment market has seen a rather large impact as Wall Street and major lending institutions adjust their level of risk tolerance. What this has done has changed the underwriting and put upward pressure on cap rates. Investment activity is still present, but changed is the environment of lending on large assets. As a result, overall industrial cap rates are predicted to rise moderately through the end of 2007 and into 2008.

— George Gramm and Jennifer Cornelius are vice president of research and public relations manager, respectively, for Grubb & Ellis in San Diego.


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