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Office, industrial markets on track to absorb 4 million square feet

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The San Diego County office and industrial markets are each on track to absorb 2 million square feet of space by year-end 2005, bringing their combined total net absorption to over 4 million square feet.

Burnham Real Estate/Oncor International attributes this improved performance to steadily improving corporate confidence that is being reflected in higher net absorption in most submarket areas.

A new report by Burnham Real Estate shows that the San Diego County office market absorbed 357,267 square feet in the third quarter, nearly 60 percent of which occurred in the North City in communities including Del Mar Heights and Sorrento Mesa, and an additional 20 percent of which took place in downtown San Diego.

Year-to-date, the San Diego County office market has absorbed 785,285 square feet of space, and a number of signed leases and build-to-suit commitments that will result in significant move-in activity during the fourth quarter, the report shows.

"We are seeing a definite rebound in San Diego County office leasing activity," said Mark Wayne, senior vice president with Burnham Real Estate. "Companies that began hiring again 12 to 18 months ago are now operating with as many as seven or eight people per 1,000 square feet, severely cramping their facilities. As their confidence in the long-term outlook for the economy continues to grow, these companies are making relocation and expansion decisions quickly and in response to a very real need for space for business and employees that already exist. This is a very healthy sign, and in marked contrast to the hundreds of thousands of square feet that were leased by companies in 1999 who anticipated future hiring that didn't materialize."

The Burnham Real Estate report shows that the San Diego County industrial market has absorbed 1,002,884 square feet of net absorption so far this year, and, like the office market, will experience a flurry of fourth-quarter move-ins as the result of recently signed leases.

"Although net third-quarter industrial absorption appeared to slow, with just 116,132 square feet of activity, the sector's turn-around in leasing momentum has been so quick that our statistics do not reflect actual absorption since move-outs and move-ins are occurring almost simultaneously," said Carol Hillestad, director of research with Burnham Real Estate.

"Given new industrial leases that have been signed and scheduled for occupancy by year-end, Burnham is projecting 1 million square feet of net industrial absorption in the fourth quarter alone," she added. "This puts San Diego County on track to exceed 2 million square feet of net industrial absorption for the year."

Burnham Real Estate attributes the upswing in office and industrial leasing, in part, to better than expected job growth.

"San Diego added 37,000 jobs between December 2003 and August 2004 -- a substantial increase over the 23,538 jobs added during all of 2003," Hillestad said.

Office overview

Where office space is concerned, employment growth always translates into increased demand for office space. With Economy.com forecasting 29,000 new jobs annually for the next four years, Burnham Real Estate expects to see a steady increase in net absorption followed by declining vacancy and higher rental rates.

"We will also see an increase in speculative development as developers step forward to meet demand," Wayne said.

Rental concessions for office space are already subsiding for Class A and Class B space. Burnham Real Estate's Dan Broderick notes that effective rental rates in markets like Del Mar Heights and for premier assets in North University City (UTC) are already inching upwards.

"Now that leasing momentum in general is gathering steam, landlords are starting to decrease free rent and scheduling higher asking rents," he said. "We expect that rental rates for older properties in Del Mar Heights could approach $3 per square foot range by year-end 2005."

The one variable still facing office owners and tenants is the steadily increasing cost of building materials, which is negatively impacting tenant improvement allowances.

The flow of venture capital funding into San Diego is generating increased leasing movement within the technology and life sciences sectors.

According to Burnham projections, current countywide office vacancy of 12 percent could decrease to 10 percent by year-end as expected new move-ins occur. This would be the county's lowest office vacancy rate since 2001.

Already, office construction is on the upswing with 4,026,550 square feet of new space under way.

Given San Diego's strong economic performance, high barrier to entry and market conditions, commercial properties continue to attract strong interest from both private capital/1031 exchange and institutional investors.

LaChapelle notes that investment activity will be strong for the foreseeable future as yields in equities continue to remain inconsistent and capital continues to flow into real estate.

Industrial/R&D overview

The Burnham Real Estate report shows that countywide industrial vacancy stands at a low 6.6 percent based upon total inventory of 106.6 million square feet, 30.1 million square feet of which is owner occupied.

The industrial market in San Diego's mid-county region is tight and getting tighter, according to Burnham Senior Vice President Mickey Morera.

"Vacancy in Miramar stands at just 5.4 percent, and in Kearny Mesa just 3.2 percent. As a result, rental rates are increasing -- with warehouse rates in Miramar now exceeding 60 cents per square foot for the first time in history. With virtually no existing warehouse space left in the market, expect to see the redevelopment of older industrial space in the more mature submarkets of Miramar and Kearny Mesa."

With land availability in short supply and getting smaller, most of San Diego County's new industrial construction is occurring in the northern and southern regions. Of the 2,007,565 square feet of new space that is being built countywide, 1,163,466 is located in Otay Mesa. An additional 370,000 square feet is under way in Poway, including a new facility for Toppan, and another 272,516 square feet is located along the Highway 78 Corridor.

According to Burnham Senior Vice President Joe Smith, strong interest in Otay Mesa by institutional investors, along with the affordability of its land for traditional industrial development compared to other areas of the county, has led to Otay Mesa's recognition as a primary San Diego County industrial market.

Burnham Real Estate studies show that Otay Mesa's total leasable inventory of 6,886,574 square feet accounts for just 9 percent of the countywide total of 76,503,142 square feet.

Even so, in 2003 Otay Mesa secured more than 70 percent of the county's total industrial net absorption.

Smith noted that industrial leasing activity in Tijuana has picked up notably over the last 24 months, due to the growth of the core industries that didn't move their operations to China.

These include medical, furniture, auto and upscale TV manufacturing companies. "The fact that industrial absorption is up significantly south of the border really has no bearing on the wave of new construction we are seeing in Otay Mesa today," Smith said. "Where maquiladoras are concerned, the U.S. lags Tijuana by about 24 months."

The industrial market in San Diego County is seeing an upswing in speculative development, driven by low vacancy and demand that exceeds current supply. Currently, Burnham Real Estate data shows that 61.5 percent of the 2 million square feet under construction is speculative -- a number that will grow during 2005 and 2006. Of an additional 849,487 square feet of space that is planned and could break ground in within six months, 84 percent is scheduled as speculative. The balance is specified as owner-user build-to-suits.

Although the R&D market continues to be softer than the industrial sector, it reports 369,070 square feet of new construction, nearly all of which is located in Sorrento Mesa in the Biosite Phase I project. San Diego County's R&D vacancy rate stands at 13.1 percent, down just slightly from 13.4 percent at the end of the second quarter. Negative year-to-date net absorption totals 195,604 square feet, 163,070 square feet of which occurred in the third quarter. This negative absorption is a reflection of the continued mergers and downsizing in the biotech industry.

Morera notes that San Diego County's diminishing land supply will continue to strain future industrial and R&D development. In the North County, just 130 acres in Bressi Ranch remain available, and there are just 140 acres in Carlsbad Oaks and 75 acres of contiguous land at Carlsbad Raceway. The recent completion of Ocean Ranch del Oro industrial park in Oceanside leaves few options for new space.

With demand for industrial space outpacing supply, Burnham Real Estate notes that San Diego County ranks second in the western United Sates for industrial sales volume. So far this year, the county recorded 244 sales transactions totaling $753 million and involving 7,600,000 square feet of space. "Private investors continue to be lured by the stability of the local industrial market, and users are recognizing the long-term benefit of owning their facilities -- accounting for nearly half of year-to-date industrial sales," Morera said.

Grove is president of The Grove Agency.

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