MARKET HIGHLIGHT, SEPTEMBER 2008

SAN DIEGO
Darcy Miramontes, Diane Miramontes, Mike Clark, Bryce Aberg, Rick Reeder and Brian Driscoll

The credit market may be tighter but tight vacancies in San Diego’s multifamily, retail and industrial sectors indicate a market in high demand with solid barriers to entry.

Multifamily

San Diego’s multifamily market has undergone many changes recently from the tightening of the capital markets to the death of condominium conversions. In addition, development has continued to slow due to the scarcity of developable land, high construction costs and underwriting difficulties. Tenant demographics and characteristics have also changed due to rising gas prices and the higher costs of goods and services. Tenants are now more likely to favor apartment living located closer to employment hubs, mass transit and local retail centers.

Some basic market fundamentals in San Diego have remained strong. The vacancy rate has remained level, hovering around 5 percent in most submarkets throughout the county. Rental rates also continue to remain steady and have been running generally flat. In some nicer areas where multifamily rentals have historically garnered higher rental rates, such as Carmel Valley or La Jolla, rents may slightly decrease due to competition from shadow market rentals.

San Diego multifamily investment continues though not at the aggressive pace or pricing levels seen in the past few years. Buyers, sellers, lenders and brokers are all getting more creative with deal terms due to the tightening of the capital markets and an increasing number of bank-owned properties available for sale. In particular, multifamily transactions have concentrated on distressed or bank-owned properties, as well as a few well-located multifamily development sites.

Some notable deals include the April sale of the 113-unit Parkway Plaza Apartments in La Mesa for more than $152,000 per unit to a local, well-capitalized buyer familiar with the strength of the submarket. It had been on the market for more than 250 days and was discounted to facilitate a sale. In January, Rancho Hills Apartments in Vista was sold for $144,000 per unit, the 147-unit project selling at an aggressive 5 percent CAP rate after approximately 125 days.

Affordable housing has become one of the most active sectors of the multifamily market due to the financial benefits it offers developers. Another trend includes the re-gentrification of older developments in established neighborhoods with newer construction, especially in downtown San Diego. Active developers in recent months include Pardee Homes, Garden Communities, Oliver McMillan, Fairfield and Sares Regis.

Expect to see San Diego multifamily vacancy rates continue to hover around 5 percent, which is well below the national average of approximately 12 percent. While some areas will continue to see rental rates remain flat or slightly decrease due to the shadow market, the highest quality buildings in superior locations will see slight increases. Multifamily investment deals will continue to take place, but with much less leverage, and financing contingencies will likely take longer. The strongest buyers will be those flush with cash and relying on well-established banking relationships that have survived the credit crunch. The San Diego economic marketplace has proven to be well diversified and prepared to weather an economic downturn. Similarly, the multifamily market fundamentals have remained strong and settled at more realistic capitalization rates and pricing, creating opportunities for strong multifamily investors in the near term.

— Darcy Miramontes and Diane Miramontes are investment and multifamily sales specialists at Grubb & Ellis|BRE Commercial in San Diego.

Retail

With an overall countywide vacancy rate of 3.2 percent, San Diego’s retail market is among the tightest in the nation, although that figure represents the highest vacancy rate seen in San Diego since 2004.

The lack of available land for development and expansion of the retail landscape in San Diego has prevented the area from becoming over-built, thus creating lower vacancy rates. Development has slowed down in San Diego, largely due to the land shortage caused by the area’s geographic barriers. This has helped control growth in the market, ultimately protecting San Diego’s retail sector from suffering many of the woes being felt in other places.

Retail rental rates in some lower-income areas of San Diego have decreased as those outlets struggle the most during an economic downturn. In general, however, San Diego is still considered a high-income area, and the highest income neighborhoods within San Diego, such as La Jolla, Del Mar and Encinitas, will weather the storm as tenant demand remains strong. Due to residential issues such as the highest home foreclosure rate in the market, the slowest area is South County.

San Diego’s investment sales activity remained strong in second quarter 2008 with significant sales including Bonnie Brae Shopping Center in Bonita and a retail building in La Jolla’s Girard interior design district. Bonnie Brae Shopping Center totals 50,391 square feet and was sold for $13.8 million. The 10,700-square-foot La Jolla property was sold for $6.6 million and features three antique retailers. Some tenants in San Diego that have remained active this year are the smaller grocery chains such as Fresh & Easy. Fast food is still doing well as are some sit-down restaurants, which continue to expand within San Diego County.

Wal-Mart has continued aggressive expansion plans in San Diego in recent months, with plans to open the first three supercenters in the county by 2010. New retail tenants also continue to flood downtown San Diego, including Active Ride Shop, MAC Cosmetics, Tilted Kilt restaurant, Fox Sports Grill, Donovan’s Steakhouse, Roy’s Hawaiian Fusion and Pinkberry. Retail growth downtown is expected to continue despite any ups or downs in the national economy.

With capital markets complications causing deals to take longer to complete, all participants are learning to evolve and adjust according to the new norm. Landlords are working harder to make projects more appealing, both economically and aesthetically. In the coming months expect to see the sophistication level go up as deals take longer to complete and both sides become more closely aligned with expectations that were previously disconnected.

— Mike Clark is a retail sales specialist for Grubb & Ellis|BRE Commercial in San Diego.

Industrial

Second quarter 2008 marked the fifth consecutive quarter of positive growth in San Diego County’s industrial market. There was approximately 800,000 square feet of positive net absorption.

Otay Mesa, which is located in the southern part of San Diego County, is an especially healthy submarket despite high vacancy levels due to large amounts of newly constructed product on the market. Currently, Otay Mesa is on track to surpass the 2006 record of 1.14 million square feet of positive net absorption. The second quarter experienced significant lease transactions within Otay Mesa, which included Paradigm (124,000 square feet), Hitachi Transport Systems (63,901 square feet) and GNS (24,034 square feet).

The central area of San Diego County has the highest priced square footage and one of the lowest vacancy rates in the county, which can be attributed both to the area’s convenient location and barriers to entry. Currently, central San Diego’s Kearny Mesa submarket is the largest industrial zone, with more than 16 million square feet of industrial product. However, a significant change in the central market is expected due to the price of land becoming too high for standard industrial uses. The result is property being redeveloped to its highest and best use. Thus, the central market is experiencing a transitional period of rezoning and infill projects. The net result is that the supply of industrial property will decrease, and the availability of office space will increase. Therefore, in Kearny Mesa, one can expect to see industrial property replaced by mid-rise suburban offices. This change will create a ripple effect in outside markets, resulting in an increase in positive absorption, and a decrease in the vacancy rates in markets previously considered tertiary.

At this time, San Diego County’s vacancy rate is at 7 percent, while rental rates have remained steady at $0.95 per square foot NNN. The active tenant types include both manufacturing and household supply companies. The most significant transactions have occurred in the sale-leaseback category. In June 2008, one of the largest transactions occurred when Chicago-based Reyes Company purchased Mesa Distribution. The real estate traded for a record-setting price of $25 million.

It is highly unlikely that any significant changes will occur in San Diego’s industrial market until after the presidential election. Rental and vacancy rates should remain stable, and a significant increase of activity is expected during first quarter 2009 as a result of pent-up demand. A combination of a reduction in construction and a healthy demand for space should result in the decrease in vacancy rates by the end of 2008. In addition, by remaining at their current pace, absorption rates are expected to continue outperforming the national market. 

— Bryce Aberg is an industrial landlord and tenant specialist for Grubb & Ellis|BRE Commercial in San Diego.

Office

Despite San Diego’s office development slowdown in 2008, three of the largest Class A landmark developments in recent history within the county are now simultaneously under construction and experiencing strong leasing activity — the highly visible Terraces at Copley Point by Sudberry Development Inc., a two-building, six-story project in Kearny Mesa at Interstate 805 and State Route 52 intersection; La Jolla Commons by Hines, UTC’s first high-rise development in 18 years; and Sony Corporation’s 12-story office campus expansion in the heart of Rancho Bernardo. All are slated for completion by year-end 2008. In first quarter 2008, local developer Cisterra completed construction on a 200,000-square-foot, Class A office development prominently located at Interstate 5 and Carmel Mountain in Del Mar Heights.

San Diego’s office vacancy and rental rates throughout the county posted slightly negative overall. The office leasing markets have seen the majority of negative absorption in the Class B product with a flight to quality that is historically seen in slower markets due to incentives available for tenants in the Class A projects, thus bridging the economic gap between the B product occupancy costs. 

The La Jolla Commons project signed a 10-year lease with Paul Hastings for 55,000 square feet and continues to have strong activity throughout the balance of the project. Lease negotiations are underway at Terraces at Copley Point for the entire 200,000–square-foot building or 60 percent of the project. Several large tenant requirements are currently in the market and could have a positive effect on the market through the end of 2008 and early 2009.

The investment market continues to re-price itself as more conservative underwriting and the current volatile capital market environment takes its toll. Though a gap between buyer and seller expectations still exists, it has narrowed considerably as sellers become more realistic with market conditions today. Crossroads Office Park, a 139,727-square-foot seven-story multi-tenant office building in Mission Valley recently closed escrow for $34.2 million. The building was purchased from Arden Realty by Behringer Harvard. This sale represents the trend in the investment market where creative financing or the existence of seller financing is helping close the gap on recently completed transactions. The number of office investment sales as of second quarter 2008 are down approximately 75 percent from 2007.

The balance of 2008 is expected to continue in the same direction with the investment market reevaluating price expectations and exploring creative financing solutions. The office leasing market is expected to remain aggressive in the near term with landlords competing for tenants who have several options due to the current vacancy factor.

— Rick Reeder is an owner and office sales & leasing specialist, and Brian Driscoll is an office investment specialist for Grubb & Ellis|BRE Commercial in San Diego.

Staying Power: North San Diego County’s Office/Industrial Condo Market Willingham As business owners saw their home values escalate up through 2005, the desire to create additional equity through ownership of their business real estate drove the market demand for small office and industrial owner/user condo properties. In an effort to meet the increasing demand, new developments sprung up across North San Diego County starting in early 2006. Lack of new deliveries through 2005 brought on rising prices, eclipsing $200 per square foot for industrial and $300 per square foot for shell office. Projects that were delivered early in the cycle saw a significant percentage of their units pre-sold and few left 6 months after completion. During this time, prices were moving so fast that many developers hesitated to put prices in print on marketing materials for fear they would lag the market. Looking to cash in on the new trend, developers bought land where available. Oceanside, with a healthy industrial market, and Carlsbad, with a small but rapidly growing office market in addition to a strong industrial/R&D market, had the most available land and excellent demographics. Land prices soared. Today the picture is quite different. With the lack of equity available in business owners’ residential properties and an overall level of uncertainly about the immediate future of the economy, demand for these smaller owner/user properties has slowed significantly. In the past 24 months, well in excess of 1 million square feet of industrial and office condos — with the typical unit under 5,000 square feet, including condo conversions — have been delivered in North San Diego County. Several of the condo-conversion projects and even one newly constructed project have sold in bulk to long-term holders with patient money; they are now being offered for lease only. Prices have fallen, but not substantially. Many of the developers/owners are large companies with significant staying power such as, Ryan Companies and Rockefeller Development Corporation. Rather than sell now at deep discounts, condo units are being offered for short-term leases (2 years or less), often at below market rates with fixed purchase option prices. Venture Corporation is often the most creative, offering to finance down payments, signing leases with options to purchase and even applying lease payments to the down payment when the option is exercised. Financing is still historically attractive and the owner/user market has not been as affected by the credit crunch as much as investors and developers due to the availability of government-sponsored loan programs through the U.S. Small Business Administration. These factors, including a reduced supply due to several projects being sold in bulk, have kept prices from dropping significantly. While demand remains significantly lower than the peak of 2005-2006, the transaction volume has not dried up completely. Absorption is healthy, and industrial vacancy rates across North County averaged just 7.5 percent at the end of second quarter 2008. The biggest problem is perception due to the concentration of new development where the land was available and the continued slide in housing values. San Diego County is largely made up of small entrepreneurial companies, which create a very diverse economy. While the bursting bubble in residential real estate has created significant job loss in those sectors, the biotech and defense sectors continue to grow throughout San Diego, especially in North San Diego which boarders the largest Marine Corps base on the West Coast, Camp Pendleton. The expectation is that it will take 18 to 24 months to sell or lease through the existing new inventory of industrial condos and slightly longer for office. Assuming that the economy begins to improve in the next 6 to 12 months, the market will likely see sale prices and lease rates rise quickly beginning in late 2009 with a corresponding drop in vacancy rates. Bob Willingham is vice president and partner at Coldwell Banker Commercial in Carlsbad, California.

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