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Wednesday, Sep 28, 2022
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Focus Shifts to Rehabilitating Office Space

My firm has now completed our annual review of the real estate markets and the events and statistics that will undoubtedly catalyze or demoralize the markets and its players in the coming year.

Most auspiciously, the long, drawn out recession has exacted a phenomenal toll on our national economy, best exemplified by the loss of 8.4 million jobs during the 2007 to 2009 period. Compare this loss to the two prior recessions experienced during the past 20 years. The recession of 1990 to 1993 resulted in an overall job loss of 1.6 million people. The more recent “tech wreck” from 2001 to 2003 resulted in total job losses of 2.7 million people.

The two prior recessions combined resulted in roughly one-half the job loss of our Great Recession.

In addition to the enormous extent of actual job losses in this last downturn, one can at least double the number of people who became classically “underemployed” — the phenomenon of workers accepting a lesser job (presumably at a lower pay rate) — and on this statistic alone one could presume the damage done.

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Statistics Not a Meaningful Snapshot

The distressed and foreclosure mania has taken its toll on commercial markets nationwide. Commercial values peaked in October 2007, according to Moody’s Commercial Property Price Index, and reached their trough in August 2010. This ended a 45 percent decline in value.

Ultimately the near and long-term fate of the commercial real estate market tracks these “demand” numbers. I can take no solace in the various recent reports issued by commercial brokerage firms that are suggesting an upturn in the commercial markets. Indeed, there are better numbers being reported from the last quarter in both space absorption and lease rates (from the building owner’s perspective).

But I would advise that one exercises some restraint with this information: Last year’s bad performance means that any statistical increase in either occupancy or lease rates might look like a major jump. While it is always better to see an upturn, these numbers merely reflect the current and, ultimately, not very meaningful snapshot of the market.

There are other prevailing factors which cause us to be more sober.

The commercial office sector will be burdened for some time to come by the fact that jobs requiring office space have dropped nationally from their peak demand by 8.6 percent: In the first quarter of 2007 a total of 18.6 million people occupied office space, dropping to 17.1 million one year ago. Since then, office employment has once again been creeping upward but at a rate that will require several years just to get back to the last peak.

At this moment there are roughly as many people employed in office space in America as there were during the early to mid-1990s.

Reduced Office Demand in San Diego

In San Diego, all nonfarm employment declined in the combined years of 2007 and 2008 by approximately 100,000 jobs. Obviously, this has impacted occupancy and lease rates in the commercial office sector. Office demand is down.

Additionally, space needs — almost regardless of business type — will further compress. We are now finding that the average square feet per employee has shrunk to less than 200. This is off the peak of the prior 20 years of 250 square feet per employee. In other words, there is currently at least a 50-foot drop in per employee office space demand. We fully anticipated that this number will shrink even further in the coming years, perhaps to as low as 125 square feet per employee.

The overarching reason for this shift is due to file cabinets, or the lack thereof! Files are less and less likely to be stored on paper in cabinets that occupy space for which companies pay a lease. Think hard drives. Also, administrative jobs have been forever lost to technology (voice mail, accounting, word processing, etc.). And smaller computers have replaced bigger computers.

These business lifestyle changes add up to a lesser demand for office space. What the recession did was cause companies to think carefully about reducing overhead. The biggest overhead costs for most companies are people and space.

Thus, when projecting future occupancy, and ultimately demand for new or used office space, absorption is likely to be dramatically impacted. This becomes problematic when the local market is faced, as we are, with a current vacancy rate in excess of 15 percent throughout the region (and much more in some submarkets). It means that the first order of business is to fill that space before commercial construction might once again begin.

Rehab vs. New Construction

Another impacting factor in the commercial office delivery sector is that because lease rates (e.g. revenue) have dropped with the oversupplied market during the past few years, it is currently not economically feasible to build Class A office buildings. With at least a 30 percent drop in regional commercial lease rates the market has to first tighten, then new lease transactions will slowly reflect high rates as the next cyclical upward trajectory unfolds. Until this plays out, perhaps during the next three to five years, don’t expect to see much new commercial office construction.

It is interesting that more than 72 percent of San Diego’s inventory of 112 million square feet of office space is classified as “B” or lower. As far as the economics of this sector go it is more likely that initial absorption will go to this space, presumably in the form of rehabilitation and renewal.

So, this is the opportunity: The real action in the commercial office sector during the next few years is not likely to be new construction, except specialty construction or non-spec space. Rather, the focus will be on rehabilitating and renewing some 80 million square feet of space throughout virtually every office sector in the San Diego region. The best targets are those submarkets with the highest inventory count of sub–A, but are well-located or positioned for economic growth.

One obvious target for rehabilitation of existing structures is downtown San Diego. The problem is that this is a game that will be played only by the largest players. For instance, Hines Interests Limited Partnership purchased and rehabbed 525 B St., a “B” quality office high-rise sitting in an “A” location. Another example is the recently renovated 1620 Fifth Ave. building just outside of downtown (formerly the Driver building) by Douglas Wilson Cos.

But Class B and C office space is sprinkled over much of the region, including obsolescent buildings residing along commercial corridors from Kearny Mesa to Chula Vista. Some of these tired spaces will be candidates for implosion, representing the first time that buildings will actually be demolished in large numbers in the relatively modern San Diego region. We normally see more of that along the East Coast.

Many other buildings are certainly candidates for a change of use, such as evolving from commercial office to mixed-use projects with commercial on the ground and residential above.

Every building will have a different outcome. But it is very unlikely, given the large burden of the market — effectively the residual of the “Great Recession” — that much new construction will be built in the foreseeable future.

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