The San Diego commercial real estate market fared better than expected last year, with office and industrial leasing activity exceeding original projections, reports Burnham Real Estate Services. Investment sales recorded all-time high prices and a near record level of activity as investors continue to be drawn to the strong fundamentals and long-term outlook for the San Diego real estate market.

"The San Diego County real estate market continues to benefit from an economy that fortunately is faring better than many other U.S. cities," said Carol Hillestad, director of research with Burnham Real Estate Services. "In 2003, San Diego will once again record positive job growth, although some sectors, like biotech, may scale back. As a result, we could see 21,000 new jobs created in 2003 compared to 23,000 in 2002. This could cause office leasing to slow a bit over the coming year, while industrial activity should remain fairly constant. Fortunately, there is little new office or industrial construction on the horizon and a fall-off in demand for space will not significantly impact vacancy rates."

In its annual real estate survey, Burnham Real Estate Services shows that San Diego County office leasing activity posted a strong fourth quarter, with 627,000 square feet of net absorption for that period alone. Total 2002 net office absorption of 1.6 million square feet exceeded that of 2001 when just 1 million square feet of net activity was recorded.

Where the San Diego County industrial/R&D market is concerned, 2.1 million square feet of net absorption in 2002 is higher than the prior year, a sign that the leasing slowdown that started in 2001 may be nearing an end. More than 1.6 million square feet, or 75 percent, of 2002 activity occurred during the second half of the year. Burnham studies show that the R&D sector also gained ground, with 420,640 square feet of net 2002 absorption.

Office

Burnham Real Estate Services attributes much of San Diego County's positive office performance in 2002 to major leases signed by several companies in the biotech, health care, high-tech and defense-related industries. During the second quarter, Pfizer (NYSE: PFE) and Vical (Nasdaq: VICL) signed 60,000-square-foot and 68,000-square-foot leases, respectively, both for facilities in Sorrento Mesa. Additionally, Pfizer and Syrrx each completed build-to-suits in the Torrey Pines Science Center: Pfizer's facility is 84,000 square feet and Syrrx's facility is 51,000 square feet.

"Biotech clearly drove the office market in 2002," said Mark Wayne, Burnham senior vice president. "In 2003, however, a decline in the amount of venture capital in the biotech sector will likely cause some companies to scale back and others to vacate. This could cause the overall net absorption in 2003 to fall short of that achieved in 2002."

During the fourth quarter, the Interstate 15 Corridor office market absorbed 436,000 square feet in several newly completed build-to-suits. BAE Systems (PNK: BAESF) completed a new 213,000-square-foot facility in Rancho Bernardo. In Scripps Ranch, Nation Smith Hermes Diamond completed a 41,000-square-foot building, and CNN First Health purchased and occupied a 55,000-square-foot building in Scripps Ranch Technology Park. Anchor General Insurance also occupied a 45,300-square-foot building in Scripps Ranch Technology Park.

The current San Diego County office vacancy rate is up slightly over last year, standing at 12.6 percent.

"While this compares favorably with many other cities in the United States, it is on par with the rates we saw in 1996 just prior to the last recovery," Wayne said. "The fact that construction is slowing as activity shows some initial signs of stabilizing should help curtail rising vacancy."

While office vacancy overall remained relatively stable during 2002, there were some class distinctions worth noting. Vacancy rates for more expensive Class A space rose to 17.4 percent, up from 13.1 percent at year-end 2001. This was due to the completion of several Class A buildings of which 577,000 square feet remains unoccupied, as well as to 24,300 square feet of net negative Class A office absorption.

Countywide, there was 2.1 million square feet of newly completed office product in 2002. Of the 1.1 million square feet of space now under way, 63 percent is preleased.

"Although 13 office projects are in various stages of planning, it is unlikely that construction will start before tenant commitments are in place," Wayne said. "Moreover, a decline in demand for space will be offset by the fact that there will be very little new inventory coming on line. This will help keep the vacancy rate relatively stable even if net absorption tapers off a bit."

New office inventory, coupled with contraction within the high-tech arena, disproportionately impacted the suburban office markets where Class A vacancy stands at 19.9 percent. Del Mar Heights and Sorrento Mesa were the hardest hit submarkets in San Diego, with vacancy rates at 24.9 percent and 29.4 percent, respectively. Burnham studies show that these areas also have the largest amount of available sublease space. Del Mar Heights alone has nearly 700,000 square feet of sublease space of which 84 percent is vacant. Available sublease space in Sorrento Mesa totals 469,000 square feet.

"Popular submarkets like Del Mar Heights and Sorrento Mesa are attracting tenant interest, not only because of space available, but also because of softer rental rates," Wayne said. "This interest may materialize into net absorption and lower vacancy rates for Del Mar Heights."

Industrial

The solid performance of San Diego's industrial and R&D markets is a very positive sign, according to Mickey Morera, also a senior vice president with Burnham.

"The industrial market is always the first to shut down during a soft economy and the first to rebound during a recovery," he said. "Most economists predict a slow but steady national recovery beginning in mid-2003. Because San Diego's industrial downturn was not as severe as other parts of the country, recovery here could begin even earlier."

In 2002 the San Diego County industrial market saw the addition of 1.6 million square feet of new inventory. Of another 1.8 million square feet that is under construction, 80 percent is already committed to either through build-to-suits or owner-users. This is well below the 14.9 million square feet of new space that was added to the market during the record years of 1997 to 1999 -- an average of 5 million square feet of space per year.

"The increasing build-to-suit activity we are seeing in the industrial sector today is reminiscent of 1996 at the start of the last real estate recovery," Morera said.

The San Diego County industrial vacancy rate of 7.4 percent is at its lowest level since 1997 when the last real estate recovery began. Vacancy for multitenant space is even lower at 4.7 percent. Warehouse product reports the highest industrial vacancy rate at 9.3 percent. "Industrial vacancy has remained stable in the 8-percent range for the past three years," Morera said. "This is due in large part to the fact that there is very little excess supply in this product sector."

R&D vacancy is holding steady at 10 percent, with little new inventory on the horizon. Burnham research shows just 294,000 square feet of space currently under construction.

Burnham Real Estate Services predicts that there will be little new industrial product added in the mid-county area of San Diego County since land prices there are just too high to support the development of this product type.

"The lack of new development will put significant upward pressure on industrial rental rates for existing space over the next 12 months," Morera said. "In the future, most new building activity will take place in the northern and southern parts of the region."

Investment sales

Institutional investors see the fundamentals of the San Diego economy and real estate market as very strong, particularly when compared to Northern California or other areas of the United States. Adding to the county's investment appeal is its limited supply of employment lands, which will prevent long-term overbuilding, as well as a diversified economy and strong population growth. Combined, these factors set the stage for strong demand with limited supply that will only increase the value of local real estate in the years to come.

Sales prices of San Diego institutional-grade office properties have risen across-the-board, driven in part by historically low interest rates and the reallocation of investment capital away from Wall Street and into real estate. Notable office sales transactions include Pacific Center I and II in Mission Valley, which sold in a single $85 million transaction; The Aventine in University Towne Center, which sold for $75 million; One America Plaza sold late in the year for $166.3 million and Seaview Corporate Center located in Sorrento Mesa, which sold for just over $65 million.

Major industrial sales included the acquisition by Harsch Investment Properties of a 13-building industrial park in Miramar for $20.45 million; the 174,413-square-foot Carroll Canyon Center, also in Miramar, for $18.9 million; and the 214,533-square-foot Cabrillo Commerce Center in Kearny Mesa for $22 million.

Additionally, Carroll Vista Center in Sorrento Mesa was purchased by Carr Development and Construction for $24.6 million, the Los Vallicitos industrial park was purchased by Triquest for $14.7 million, and Faraday Corporate Center was purchased by Equus Realty for $24 million.

Grove is president of The Grove Agency Inc.

Related Link:

Burnham Real Estate Services: www.burnhamrealestate.co