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Surplus of commercial space will keep rental rates low

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There seems to be no clear consensus as to whether or not office rents have bottomed out in San Diego County, but one thing is certain -- major increases aren't expected soon.

In Del Mar Heights, lease rates were at or above the $4 mark in 2007. Now landlords are lucky to command $2.75 per square foot.

Del Mar Heights isn't alone. Sorrento Mesa and the University Towne Centre submarkets are among those that have seen their rents plummet by a similar amount -- with much of that drop coming within the past few months.

Jon Boland a Voit Real Estate Services vice president who believes rents have dropped enough, said UTC and Sorrento Mesa saw their rents decline from $3.50 and higher three years ago to between $2.25 and $2.50 today.

Timothy Olson, a Jones Lang LaSalle vice president, arrived at a similar conclusion.

"Class A and B buildings in the primary office markets including Downtown, Kearny Mesa, Sorrento Mesa, Governor Park, Mission Valley and UTC are seeing unweighted asking rents average about $2.35 per square foot, full service," Olson said. "This is down from $2.75 per square foot, full service, as seen during the market peak in late 2008, representing a 15 percent reduction.”

Reports vary, but a recent Colliers International survey found rates of less than $1 per square foot in some Class B and C office buildings in Mission Valley.

"Mission Valley is very competitive ..." added Voit's Boland. "I think lease values will remain low generally until employment comes back."

With unemployment at around 11 percent, "rates could be bumping along the bottom for a while," Boland said.

Some markets such as Carlsbad, which have a glut of space, are going to have to keep rates low. In Carlsbad's case, the direct vacancy is 23.88 percent in the 5.11 million square foot market, according to Cushman & Wakefield. The figure grows to 27.1 percent vacancy when sublease space is included. While the listed average rate in Carlsbad was $2.30 as of the end of 2009, for many office spaces, the rent was significantly lower than that.

Cushman & Wakefield pegged the downtown San Diego office rent average at $2.37 per square foot. While Class A spaces are pricier, they are still much less than $3 for the most expensive space.

Stacy Meronoff, a CB Richard Ellis senior associate who covers the downtown San Diego office market, said rents have declined by 25 percent to 30 percent from their peak in 2007 and haven't been improving since.

"The rates were right around $4 at their peak for Class A space. Now they are at the mid- to upper $2 range ..." Meronoff said. "That's a heck of a value for Class A space. It's a great deal."

Lynn LaChapelle, a Jones Lang LaSalle (NYSE: JLL) managing director, said office rental rates are either holding steady or dropping slightly, but she doesn't expect any more precipitous drops.

Every submarket is different, but LaChapelle estimated that office rents are off by about 30 percent from their peak in the Interstate 15 Corridor, for example. That translates to rental rates in the high $1 to low $2 per-square-foot range for excellent space in the submarket.

LaChapelle said she doesn't expect any appreciable rent growth anywhere in the county for the next 12 to 18 months, but is hopeful the market and rents will rebound in late 2011. For now, landlords may wish to keep lease terms short so as not to lock in at lower rates while trying to lure in new tenants.

"Once we get beyond 2011, some investors will be able to engineer rents over five to seven years," LaChapelle said. "That will put us back where we were a couple of years ago."

Doug Ceresia, a senior vice president with the NAI San Diego commercial brokerage firm, believes office rents have pretty much bottomed out in the county -- save for some Class B space that may have further to fall both in terms of rents and occupancy.

"I see a lot of activity with Class A buildings. Class B is still in a negative situation," Ceresia said.

LaChapelle said she is much more optimistic about the prospects for long-term office rent growth than she was a year ago.

"And a couple of hundred thousand square feet of absorption in certain markets could really turn some of these around," she continued.

As for free rent, LaChapelle and others seem to agree that one month free rent per year of the lease term is about typical these days. The concession may go higher or lower depending on variables including the location and the size of any tenant improvement allowance that comes with the lease.

A problem, noted Olson, is that San Diego County has an inventory of more than 2 million square feet of sublease space that will continue to place downward pressure on rents.

"The market must also deal with the specter of shadow space; that is, excess and unused space that companies are still paying rent on and not marketing for sublease," Olson said.

This too is expected to keep rents low. It is likely that some of this shadow space will trickle back to the market as tenants continue to restructure their leases and downsize, thereby increasing the supply inventory and further depressing rates on direct space.

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