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San Diego office market slows, expected to pick up through 2007

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San Diego County's office market, like that of the rest of the country, is expected to continue to be quite strong in 2007, but not quite as healthy as it was during the first part of this year.

A report by Newmark Knight Frank, a New York-based real-estate brokerage, and CoStar Group (NYSE: CSGP), a Bethesda, Md.-based real-estate information service, said the surge in office activity happened virtually in all of the nation's major markets during the first six months of 2006, despite soaring energy prices and interest rate hikes.

By the second half, however, these factors, along with the rapid contraction in the housing market, seemed to weigh heavily on the economy in San Diego as well as nearly everywhere else. Employment slowed as office construction continued, leaving a lot of space to fill.

While San Diego County had a 9.4 percent office vacancy rate (about 10 percent is the industry standard for a market in balance) at of the end of the third quarter, some 3.95 million square feet of speculative office space was under construction as of Sept. 30, according to Newmark Knight Frank.

Newmark Knight said there are some markets that have significantly more developments going up. Phoenix, for example, has 7.5 million square feet of office space under construction. That may sound like too much to absorb, but Newmark Knight concluded the demand in the desert city is so great that the office vacancy should remain around its current 11.5 percent mark for the foreseeable future.

Peter Kozel, Newmark Knight managing director, suggested San Diego County's office fundamentals remain quite strong as well.

"You live in paradise," he said. "The question I have about the market is that it has done so well -- it didn't get knocked down the way it has in other areas -- is what happens now? On the flip side of your strengths, employment growth in your market has slowed to 1 to 2 percent per year.

"This is unlike the '90s, when we had a real recession."

There may not be a recession in our future, but Newmark Knight reported that while office employment in San Diego County climbed by an average of 3.64 percent annually between the fourth quarter of 1990 to the fourth quarter of 2000, it increased by an average of just 1.25 percent annually since then. This translated to a slowdown in leasing during the second half of this year in particular.

A third-quarter report by The Staubach Co. concurred the leasing activity grew weaker here as 2006 progressed.

"Buildings that were delivered in late 2005 and early 2006 are having difficulty securing new tenants. As long as the market supply continues to increase and these new buildings sit vacant, downward pressure on rents will surely follow," Staubach wrote. "Carlsbad will likely be hit the hit the worst. There are several lonely office developments in this finite area."

All told, more than 5 million square feet of office, industrial and research and development space could still be developed in Carlsbad if sufficient build-to-suit users and tenants can be found.

Carlsbad may or may not face a glut of space, but Kozel is optimistic about the near-term employment picture, both here and the rest of the country. He predicted the national year-end employment data will show impressive gains, and said this trend will carry through to San Diego as well. With regard to employment, Kozel expects sufficient people to be hired to fill the empty office buildings.

San Diego's 9.4 vacancy rate stands up well when compared with the rest of the country. The major city with the lowest vacancy in the country was Miami, with a 7.1 percent rate as of the end of the third quarter. That market had 2.75 million square feet of office space under construction as of the end of September.

By contrast, the Dallas/Ft. Worth market had a 17.2 percent office vacancy, but still had some 4.8 million square feet of space under construction, according to Newmark Knight.

Office rents have either held their own or climbed in many, if not most, areas of the country. San Diego saw its annual office rent increase by 7.7 percent to $29.80 per square foot at of the end of the third quarter from a year earlier. That average is projected to grow modestly to $31.74 per square foot annually by the end of 2007.

Phoenix posted the largest percentage increase in major market office rents, with a 12.2 percent hike to $23.40 per square foot. Like San Diego, the Phoenix rate of increase is expected to slow to $24.34 by the end of 2007.

At the other end of the spectrum, San Jose, perhaps still feeling the effects of the "tech wreck," saw its average annual rent decline by 6.8 percent to $21.43 between the third quarter of 2005 and the third quarter of 2006. That figure is expected to be about identical by the end of next year.

Columbus, Ohio, saw its third-quarter, year-to-year office rent decline by 3.8 percent to $15.55 -- the lowest rate of any major U.S. city.

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