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Central San Diego office submarket sizzles with resurgent demand

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In 2005, the central suburban office submarket - particularly the commercial properties of Kearny Mesa and Mission Valley - has jumped ahead of the other submarkets in the region in terms of net absorption.

It is a dominance that commercial real estate experts Richard Gonor and Tony Russell of Grubb & Ellis|BRE Commercial believe will continue into 2006.

It is the "centrality" of the central suburban submarket that has sustained tenant interest and withstood the softer tenant market of 18 to 24 months ago, Gonor and Russell said. While some might perceive other regional submarkets as more agreeable, with glamourous addresses or bargain rental rates, no submarket comes close to central suburban in accessibility via private vehicles or public transit, and few can compete with the abundance of employee-friendly shopping, entertainment, dining, leisure, recreational and environmental amenities available just down the hill from Kearny Mesa in Mission Valley.

Among the trends and transactions fueling the resurgence of the central suburban office submarket are:Favorable response by potential tenants to the availability of two new Class A office buildings in Mission Valley - Rio Vista Plaza III and Rio San Diego Phase II;the successful sell-out of the Lennar Corporation's (NYSE: LEN) San Diego Spectrum including ResMed Inc.'s (NYSE: RMD) purchase of the last remaining parcel in the 244-acre business and residential community on the former General Dynamics (NYSE: GD) site in Kearny Mesa;the back-fill of substantial blocks of vacancy in both the Kearny Mesa and Mission Valley Class A markets;successful repositioning and retenanting of older Class B offices in Kearny Mesa;Northrup Grumman's (NYSE: NOC) occupancy of 182,000 square feet of space in Kearny Mesa in the second quarter (and the expectation that the company will exercise its option on an additional 50,000 square feet of space there in the near future); realization that there will be relatively little Class A space in Mission Valley coming back to the market due to lease expirations over the next three years, and that it could be five years or more before any significant amount of new Class A space might be added to the valley's inventory; the growing number of Mission Valley office tenants who are negotiating extensions of their existing leases and the increasing economic viability of redevelopment and replacement of aging industrial properties in Kearny Mesa for office uses.

All of these trends, transactions and issues relate back to the undeniable reality that there is little land of significant size available for further office development in the submarket. Currently, the vacancy factor for all classes of office facilities in Mission Valley and Kearny Mesa is only 9.5 percent.

Commercial real estates experts long have deemed 10-percent vacancy as the "magic number" for finding financing for new development.

Although Sunroad Enterprises will have the 300,000-square-foot first phase of its three-building Sunroad Centrum office park underway in the Spectrum by early next year, occupancy of the 12-story structure likely will not occur until 2007.

"The Kearny Mesa office market is coming into a new era since it will be the first time office rents have been above $3 per square foot," Gonor said.

"This will help the other office buildings in the area to raise their rents too," Russell said. Both believe Kearny Mesa will endure more Class A development over the next five years.

"The Kearny Mesa area is already a draw for credit tenants given its central location, and with the recent and planned Class A office development, we are seeing substantial change taking place that will result in a sharp rise in rental rates," Gonor said.

With the exception of Sunroad Centrum, and barring a major economic downturn, Gonor and Russell advise the only sure ways to accommodate the office needs of new or expanding enterprises in the region's most central submarket for at least two years will be via:infill of vacated space; improvement of second- and third-generation facilities; Rrenovation of even older office stock and Rredevelopment of obsolete properties for new office buildings.

For brokers like Gonor and Russell who specialize in the lease and sale of central suburban commercial properties, the immediate and future needs of office users have been of equal importance since the regional economy began its recovery from the impacts of the recession of 2000 and 9/11.

In the last year and a half the Grubb & Ellis|BRE duo has been instrumental in helping the owners of such Class B projects in Kearny Mesa as Seville Plaza and Square One reposition and retenant their projects, and at higher rental rates than were paid by departed tenants. Just since this summer's sale of the 83,644-square-foot Rio Vista Plaza III, they have represented the new ownership in negotiations with a variety of prospective tenants. These negotiations are expected to result in leases for more than 60 percent of the just-completed Class A structure at 9095 Rio San Diego Drive by the end of the third quarter.

They also are helping landlords and existing office users in the submarket come to agreements for lease extensions. While this tends to be a "win-win" for both parties, it does not bode well for availability of Class A office space in Mission Valley over the next three years.

Presently, Gonor and Russell said, the maximum return of Class A Mission Valley office space due to lease expirations will be about 10 percent in 2006, approximately 12 percent in 2007, and a mere 7.5 percent in 2008. Gonor and Russell recognize that Class A office availability in the valley will be exceptionally tight for the foreseeable future.

As a result, they said, rental rates have been increasing and landlords are offering fewer concessions in lease negotiations. The latter is not unexpected, they noted, as the costs associated with tenant improvements (TIs) have been increasing rapidly and for some time.

Tenants have accepted the fact that landlords are offering fewer concessions because of the lower vacancy levels and the allowances they have to provide for TIs have increased so significantly.

Since the beginning of 2005, the companies seeking to move into Mission Valley have virtually "covered the waterfront" in terms of type and size of enterprise, and the submarkets from where they were moving. Recently they have negotiated deals for as few as 800 and as many as 35,000 square feet for companies moving from Rancho Bernardo, Otay Mesa and throughout North County.

While defense contractors, insurance companies and a variety of financial service enterprises form the backbone of demand for central suburban accommodations, they are far from the only industry types moving to the submarket. Not surprisingly, the tighter the San Diego central suburban's office market, the greater the interest being shown by investors and developers in the redevelopment of industrial properties in Kearny Mesa.

In the 1950s through '80s, Kearny Mesa was among the region's most productive industrial zones. But as San Diego has evolved and its metro suburbs developed as residential and retail centers, industrial users have moved farther to the north, east and south. The evolution of the Central Suburban submarket finally has reached the point where redevelopment of the older industrial properties with new office facilities is the more viable option for obsolete and under-tenanted projects.

Perhaps surprisingly, the brokers said, companies seeking to relocate to Mission Valley from North, East and South County are not describing the extension of the San Diego Trolley as among their prime motivators. However, Gonor and Russell believe companies value the trolley as a "perk" for employees, and expect the stock of the trolley system to rise in esteem as corporate office users continue to accommodate the maximum number of employees possible in their leased premises.

Cornelius is the public relations coordinator for Grubb & Ellis|BRE Commercial

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