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San Diego office market will see slower construction, leasing in 2008

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The remainder of the 2008 office market in San Diego County will be a transitional time with slow leasing and millions of square feet to fill, according to an international brokerage's report.

"Today, net absorption is at a 12-year low and vacancy is at a 12-year high," the report by Cushman & Wakefield (C&W) stated.

Net absorption in 2007 of 712,007 square feet is down 61 percent from 2006 -- the county's lowest level of activity since 1995.

"Considering that the years from 1996 through 2006 saw net absorption consistently well above 1 million square feet annually with spikes to 3.2 million square feet in 1998, to 4.6 million square feet in 2000 and to 2.5 million square feet in 2005, the current slowdown is a notable change of pace for the market," said Mark Wayne, a C&W senior director.

Steve Rosetta, C&W's executive director agrees, but was far from pessimistic.

"San Diego's historically strong and diverse economy that is grounded in growth areas such as biotechnology, defense, entertainment and tourism, should minimize impact from other slowing industry sectors," Rosetta said.

Not every submarket has been strong. Carlsbad, Sorrento Mesa and Rancho Bernardo each face a surplus of space that puts their vacancies between 18 to 25 percent depending on the survey and how the space is calculated.

C&W research shows the 2007 vacancy of 13.6 percent on total inventory (including owner/user space) is up 3.6 percent countywide from 2006, and the 16 percent vacancy on leasable inventory is up 3.3 percent.

Looking ahead, C&W anticipates that positive gross absorption will fall short of the additional sublease space and approximately 2 million square feet in new inventory expected to become available in the near term. This will push vacancy rates above current levels.

The report notes that the local office market has had an incredible run since 1995, with a sometimes-insatiable demand for space.

As a result, the C&W report finds that some 416 new office buildings totaling 24 million square feet have been added to the San Diego region since 1998.

"Even as large blocks of new inventory came on line, most of the county's submarkets reported single-digit vacancy as demand for space kept pace with new construction," said Wayne. "Rental rates set new records; topping $4 per square foot in premier markets like Del Mar Heights and UTC, and $2.38 per square foot average gross asking rates countywide."

C&W says the $2.38 per square foot average is beginning to soften as national and local businesses react to economic news.

Landlords who paid record prices for assets in recent years are also adjusting their expectations, as rental rates are not at the levels they expected.

However, decreasing rent levels in Class A and Class B office buildings are creating opportunities for tenants to relocate to achieve more attractive lease terms.

C&W says the news is not all bad for landlords either.

Owners who recognize the cyclical nature of the market will be able use the current situation to increase their holdings in fundamentally sound real estate.

They will likely have to reduce their rents, however.

"Instead of underwriting vacant space with the potential of higher rent-paying tenants, owners are concentrating on reducing vacancy by attracting tenants through front-end incentives and concessions, as well as evaluating starting rates," Wayne said.

Some big players are adding large amounts of space for their own use as well as the more than 3.4 million square feet of largely speculative office space that was just added to the region.

These build-to-suits and/or new lease requirements include spaces for Sony (NYSE: SNE), which recently broke ground on its new 450,000-square-foot office tower in Rancho Bernardo; Ashford University, expanding to 300,000 square feet in Sabre Springs; Leap Wireless (Nasdaq: LEAP) with local offices in Sorrento Mesa -- is seeking more than 200,000 square feet; the General Services Administration (GSA), which has a 200,000 to 300,000-square-foot requirement at an unidentified location; and defense contractor Lockheed Martin, (NYSE: LMT) seeking to consolidate into approximately 150,000 square feet at an unnamed location.

"Although the substantial requirements of these companies show their continuing need for space in San Diego, these relocations will not result in any significant net gains in leased space in the near-term," the report concluded, alluding to the shuffling of space.

Rosetta said "construction starts will continue to slow as developers hesitate to break ground on projects without tenant commitments in place and lenders hold to more rigid lending requirements. Further constraining new development is the high cost and limited supply of developable land as many San Diego submarkets approach full build-out."

That strongly suggested the market will improve, but it will not happen overnight.

"In general, tenants are taking longer to make their real estate decisions and this has been exacerbated somewhat by the upcoming election as employment sectors directly effected by government policy are taking a 'wait and see' approach," Rosetta said.

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