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More capital, but finding trophy assets elusive

While San Diego is continuing to recover from the recession, capital continues to chase more quality assets than what's available.

The state of the capital markets was the topic of a NAIOP San Diego meeting Wednesday at the Del Mar Marriott.

Tim Wright, HFF senior managing director, said investors who might have been looking for commercial buildings in places such as the Pacific Northwest and San Francisco are giving San Diego a longer look "and the capital is migrating down the coast."

There is no single source of capital to pay for commercial properties. The Commercial Mortgage-Backed Securities market, which tanked during the recession, has returned somewhat.

Wright noted, however, that it is a far cry from prior to the recession when $230 billion to $250 billion worth of CMBS annually was the norm.

"There was about $80 billion in CMBS last year. This is expected to grow about 30 percent this year," Wright said.

While CMBS funding isn't nearly what it was prior to the recession, Wright said there are other avenues for financing acquisitions.

"There are tons of mezzanine capital around," Wright said. "I think this is very disciplined capital."

Wright added that debt pricing has come down and bank financing for most asset classes remains inexpensive.

The free flow of capital isn't coming toward all types of property.

"Banks aren't lending as much on homebuilding these days," Wright said.

That may be, but Brunson Howard, a Cushman & Wakefield capital markets director, said if gross domestic product growth reaches 3 percent from last year's 2.3 percent, the economy will be well on the way to recovery.

San Diego County's office market is also recovering.

After exploding during the recession, Howard said San Diego County had 11.6 percent direct vacancy level countywide as of the end of the last quarter. That figure was almost unchanged from the 11.7 percent vacancy garnered in 2007, immediately prior to the recession.

Although the office vacancy rates are lower than they have been for a while, Rick Reeder, a Cassidy Turley capital markets specialist, said the rents generally aren't high enough to justify new construction.

Still, he said, the rents have at least begun to increase.

"San Diego has had a good recovery, but a lot of value has yet to be harvested," Reeder said.

Adam Robinson, principal co-founder of SR Commercial, said San Diego is still on the tail end of the recovery "and there hasn't been a lot a lot of rent growth, but we will see it in ’15 and ’16."

Dennis Cruzan, founding partner of the Cruzan|Monroe local development and investment firm that with Cigna co-owns DiamondView Tower, said he believes that the markets in general have recovered.

"We're beginning to see growth, albeit slower growth, but there does seem to be a lot more capital around," Cruzan said adding that high-quality assets remain in very short supply. "And whenever you have excess capital, there is an upward pressure on pricing."

Cruzan said this doesn't mean commercial property prices will rise too quickly.

"No one gets too far over the skis to overpay for an asset," Cruzan said.

Clarke Michalak, an investment banker with Prudential Real Estate Investors, whose assets include the Sorrento Towers North and the Sorrento Towers South developments in Sorrento Mesa, said the yields for such properties can vary widely depending on the asset and location.

"There are markets where you can get yield, and markets where you are buying on hope," Michalak said.

Robinson said that although he is currently underwriting about 3 percent rent growth, he is seeing higher returns when leases are renewed.

Higher rents should mean higher sales prices, but Reeder said he believes that prices may lag if for no other reason that the whole nature of offices has been changing. Not only are there more open-floor plans at the expense of corner offices, the amount of required space per employee has continued to shrink over the past decade.

Robinson further warned that despite some reports to the contrary, the flight to quality is more in force than ever. That means some older buildings will be starved for tenants.

"San Diego is generally a good deal, but a building generally needs to be new or repositioned to do well," Robinson said.

Robinson said SR Commercial has made much of its money by buying older properties and refurbishing them into higher-class spaces.

"When we look at an asset, we first look at its flaws in design and then go from there," Robinson said.

While real estate investment trusts and large national funds such as Prudential may get the lion's share of the trophy properties, Reeder said he expects to see more private investors in the mix, as well.

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