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Bumping Along the Bottom, Region’s Office Property Market Remains Soft

San Diego County is gradually adding jobs amid a slow economic recovery. But experts say it’s still not enough to rejuvenate the region’s sagging office property market.

While overall leasing and purchase activity in the second quarter and first half of 2010 were better than what was seen a year ago, local brokers note that absorption of existing space remains sluggish, as tenants shop the market and move around for better leasing deals.

And the county’s total office vacancy rate is just over 18 percent, about a half-percentage-point lower than a year ago, but still well above pre-recession levels.

“I don’t know if it’s necessarily in a recovery,” said Steve Malley, principal in the San Diego office of brokerage firm Lee & Associates. “We have hit the bottom, but we’re not going to see a lot of improvement until we start seeing more job growth.”

Observers agree that year-to-date trends vary widely across the region’s commercial submarkets. For instance, the local office of Cushman & Wakefield notes that while downtown San Diego had negative 56,677 square feet of direct net absorption as of the end of June, Del Mar Heights had positive absorption of 64,515 square feet.

The I-15 corridor had 318,307 square feet of positive net absorption year to date. The majority of that activity occurred in the first quarter, and included Nokia moving into nearly 200,000 square feet in Rancho Bernardo and MedImpact Healthcare Systems Inc. occupying its newly built 150,000-square-foot campus in Scripps Ranch.

Increase in Transaction Activity

But there were some notable office purchases in the late second quarter, including the $40.5 million purchase of Horizon Tech Center in Scripps Ranch by KBS Realty, and the $38.3 million purchase of the Bernardo Terrace Corporate Center in Rancho Bernardo by Palomar College.

“We’re seeing a significant increase in transaction activity from this time a year ago,” said Matt Carlson, a director in the San Diego office of Cushman & Wakefield.

Much of the local leasing activity is tenants moving into new spaces or renegotiating deals with current landlords in a climate where rents overall have been declining. Carlson notes the county also has a “nagging shadow space” – space leased but not occupied by tenants due to downsizing, often not included in regional vacancy calculations – of about 5 percent.

While a few prime office locations are getting competitive offers from prospective tenants, in most markets landlords have to be flexible to keep and attract tenants. In some cases, that means offering long-range leasing terms that give businesses flexibility to downsize or expand their space as needed.

Carlson said that addresses an important psychological component in the market, as firms get leaner in their space planning – unlike a decade ago, when smaller tenants would often lease large spaces and assume they’d grow into them.

“Now they say, we’ll go for less space overall right now and people here can get by with smaller offices until things get better,” he said.

Malley said there are saving graces for the local market, including the fact that very little new office product is currently under construction. As current vacancies fill up and overall supply doesn’t grow in desirable locations, landlords could see conditions start to turn more in their favor, perhaps a year from now.

Musical Chairs

According to the local office of brokerage firm CB Richard Ellis, just 20,300 square feet of new office space was delivered in the first half of 2010, all of it in Kearny Mesa. Brokerage firm Marcus & Millichap projects that by year’s end, new office construction in the San Diego market will total 180,000 square feet. This is down from 458,000 square feet in 2009, and more than 85 percent lower than both the five- and 10-year averages for the metro area.

Also, Malley noted, investors and business owners looking to purchase smaller office properties currently have opportunities to buy at prices that are off 50 percent or more from peak levels of 2006.

Malley said he’s recently seen an uptick in lenders taking back single-owner business spaces, including office condos, where a struggling small business owner has essentially decided to walk away from the loan – similar to what has occurred with some single-family home mortgages.

“Except in this case, the person who walks away is not uprooting himself or his family from their house,” Malley said. “It’s strictly a business decision.”

The upshot is that small businesses in relatively good financial shape, and confident about their future, can purchase single-tenant office properties at a time when interest rates remain historically low for qualified borrowers. Depending on the terms they get, some may find buying more cost-effective than leasing in the long run.

Malley said the supply of such smaller properties has risen in recent months in places such as Eastlake, and elsewhere in the Eastern and Northern county markets that saw big construction run-ups prior to the recession.

As for users of larger office spaces in the county, Tony Russell, executive vice president at brokerage firm Jones Lang LaSalle in San Diego, said the most active industries include education, defense and healthcare. For instance, Bridgepoint recently leased 80,000 square feet in the Kearny Mesa area, and is now scouting for another 180,000 along the I-15 corridor. University of Phoenix and defense contractor Northrop Grumman have also been adding space in recent months.

But since much of the county’s leasing activity is “musical chairs,” with many tenants leaving vacant space behind as they move around, overall local absorption is likely to remain flat through at least the middle of 2011, said Richard Gonor, also a San Diego executive vice president at Jones Lang LaSalle.

Gonor said that so far in 2010, he’s seeing tenants commit to lease extensions of five to 10 years and beyond, when they may have committed to a two-year extension a year ago – a sign that the overall outlook of businesses has improved.

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