Office space leasing becoming the real bargain in 2008

There's at least one New Year's resolution worthy of keeping on the part of present and future tenants in San Diego's office market: Resolve to watch and wait for the real bargains to emerge in several commercial real estate market segments.

One area in particular worthy of watching is in the office-laden North City area, off Interstate 805 and Governor Drive. The Governor Park submarket, while relatively small at about 1 million square feet, is fast becoming one of the -- if not the -- weakest leasing markets in San Diego County. That's good news for tenants who will be looking for space in the short-term.

Currently, this area has about a 33 percent vacancy rate -- and even more remarkable, a 51 percent availability rate -- almost unheard of even in today's market. Vacant space is immediately available for lease, while available space includes those spaces not presently vacant but which will become so in relatively short order as well as future space that is under construction.

The high rate of vacant and available space in the Governor Drive area is not surprising, considering that one out of three tenants up there appears to be a mortgage-related business in some stage of default. We all know what's happening in the mortgage sector. Predictably, there are no "Plan B" tenants to step in and fill the space.

The primary landlord in that area so far has not lowered rents to fill the vacant and available spaces. Such hesitancy is, in my judgment, questionable, considering the landlord is facing already closed or, soon-to-close shudders on half of his office space. Not sure what the building owner thinks will happen by waiting. Meanwhile, the office space pricing remains unrealistically high.

So, what should you do if you're a prospective tenant interested in space in that area of the city?

Wait, and keep watch.

My best guess is that pricing will start becoming more realistic in the second quarter of this year, in response to the need for building owners to survive the bleeding and hemorrhaging they've suffered to date. By then, incoming tenants will probably be able to secure space in that area by simply covering the building's operating costs -- pro rata shares of property taxes, insurance, common area maintenance, etc.

Landlords in other markets are also facing a grim 2008 and will be finding it necessary to offer handsome tenant improvement allowances, lower annual rent escalations, moving allowances and, oh yes, even multiple months of free rent. For tenants, the good old days are coming back!

At first blush, you'd think the Governor Drive landlords would have seen all of this coming and would have become more flexible much earlier in order to stave off the growing number of vacant and available office suites. Such was not the case. In some circumstances, the buildings were worth more vacant so that future buyers could "pro forma" the rents for the vacant space to justify their purchase price. Now, with the debt markets in chaos, landlords are realizing, along with the rest of us, that commercial real estate is no longer on a rocket express to the moon. Prospective office building buyers instantly disappear when push comes to even a gentle shove. The "greater fool" theory "has left the building."

The way I and other observers see it, commercial office buildings are only worth between 70 percent and 80 percent of their recent purchase prices. This also indicates that rents, predicated on those bloated prices, are artificially inflated by 20 percent to 30 percent as well. Governor Park is a prime example. Not only are the mortgages, titles and escrow office tenants evaporating overnight, so are the large homebuilders who have occupied space in that area.

The impacts from the real estate construction downtown this past year or so are staggering. Think about all the employees out of work: everybody from architects and engineers to roofers, landscapers, framers and plumbers, masons, and pool contractors. That doesn't even begin to address the impacts felt by wholesale and retail product suppliers.

Most economists don't see a short-term end to this downtown; most builders and developers have largely written off the year 2008. "Downturn" is giving way to "recession" in the industry's vocabulary and it doesn't appear that the fact that this is an election year will rescue the day, as has been the case in past economic hard times.

So, in 2008, those prospective office tenants looking for space are tightening their belts and looking for real bargains. Landlords who realize this will begin cutting competitive deals to lure tenants away from those who don't. Taking a page from Mother Nature, it's the natural selection process through and through: the survival of the fittest.

Best wishes to all for a happy and prosperous new year.

Hughes is a principal with Irving Hughes, San Diego's largest tenant representation company. E-mail: Comments may be published as Letters to the Editor.

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