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Uptick in leases for Class B office space

There was a time, only a couple of years ago, when vast chunks of Class A office space in San Diego County were occupied during a flight to quality free for all. Now, it’s time for Class B to shine.

A Cassidy Turley first-quarter office report found that Class B outperformed Class A for a second consecutive quarter, a phenomenon not seen since the first quarter of 2010.

As a result, the Class B overall vacancy rate countywide has decreased from the peak rate of 23.1 percent recorded three years ago to 20.3 percent in the first quarter of 2013. While still high, the CT report says it likes the trend.

CT found that while the Class A market returned 16,775 square feet in the first quarter, Class B net absorption amounted to 102,707 square feet and Class C space tallied 56,220 square feet of net absorption.

During the first quarter of 2013, the San Diego office market recorded 142,152 square feet of net absorption countywide across all classes combined. The first quarter’s net absorption level was slightly below the average for the past 3 ½ years of 195,000 square feet. It was, however, positive compared to the negative net absorption recorded during the first quarters of the last two years.

Brett Ward, a Cassidy Turley senior vice president and office market specialist, said with the direct office space vacancy now between 14 and 15 percent (the overall space vacancy is still 17.8 percent).

“If the current pace continues, San Diego is poised to see another strong year for net absorption,” Ward said.

Nearly one-third of the 1,362 existing office properties tracked countywide reported activity with 17 percent reporting net absorption totaling about 1.13 million square feet, 14 percent reporting negative net absorption totaling 994,608 square feet, and 69 percent reporting no activity during the first quarter of the year.
Ward said small business is the engine driving the leasing.

“We are currently tracking 2.4 million square feet of active tenant requirements with the vast majority focused in central San Diego,” Ward said. “The most active industries are technology, financial activities, energy, and professional and business services, with 7,700 jobs created in 2012. Leasing activity will continue to strengthen due to the lack of new construction and improved hiring.”

In 2013 the office employment sectors are projected to grow by another 2.3 percent, creating 6,700 more office jobs. The three-year forecast, based on Moody’s Analytics, anticipates adding more than 26,000 new office jobs.

“If these projections hold true, look for another year of more than 1 million square feet of positive absorption and potentially 5 million square feet of positive absorption over the next three years,” Ward stated.

The 17.8 percent overall vacancy figure in the first quarter 2013 was compared to 16.8 percent in the previous quarter and 18.7 percent a year earlier.

The 17.8 percent vacancy was 380 basis points lower than the peak rate of 21.6 percent recorded as of the third quarter of 2009.

“With virtually no new speculative construction, the forecasted job growth would drop the San Diego office vacancy rate into the single digits by mid-2014,” Ward said. “The last time the local office sector saw single digit vacancy San Diego entered the development phase in which 10 million square feet was added to the market over six years. Only time will tell if history repeats itself, but based on the current trends it is feasible to see the return of speculative construction in late 2014 or early 2015.”

On the construction front, Ward noted that La Jolla Commons II in UTC, a development of Hines and JP Morgan for LPL Financial is ahead of schedule and tracking to deliver 415,000 square feet in the first quarter of 2014. Of the just under 1 million square feet of new construction under way in the county, 90 percent is comprised of build-to-suits with roughly half of the space set to complete this year and the balance to follow in 2014.

Of seven Class A projects under construction countywide, four projects or 88.6 percent are pre-leased. Four projects totaling 426,228 square feet are planned to be completed in 2013. The remaining three projects totaling 542,836 square feet are planned to be completed in 2014, all of which are in central San Diego County.

While developers are breaking ground on built-to-suit projects, the consensus is that a majority of the developers are evaluating building speculative office space, but few are considering taking the risk.

For speculative development to happen, the rents need to be high enough to justify construction. While office rents had been edging up in some submarkets, CT said the countywide first quarter average asking rent of $2.27 per square foot per month full service for all classes combined was 18.1 percent lower than the peak rate recorded in the first quarter of 2008.

“There is no doubt that landlords of older buildings located in less desirable submarkets struggling with high vacancies will not be in a position to increase rents in the short-term,” the report continued.

Tenants in the market are looking for about 2.4 million square feet over the next 24 months with 1.9 million square feet in the central and south counties combined and 511,000 square feet in North County.

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