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San Diego
Wednesday, May 22, 2024
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Landlords May Gain Upper Hand This Year

By many accounts, the San Diego office market lurched into a recovery in 2004, despite signs of slowing in the second half of the year. The relative winners and losers in this year’s office market, however, might not be the same old lineup.

A flurry of sublease activity in a range of key sub-markets bodes well for the county’s landlords.

Many predict that landlords, who were forced in 2004 to offer enticing concessions and tenant improvement allowances to fill vacant space, will gain leverage in 2005.

“San Diego is turning the page on the tenant-driven market, where tenants call the shots,” said Jay Alexander, a senior vice president at the San Diego office of Colliers International, who specializes in office and industrial markets in the Interstate 15 corridor.

Office vacancy, which, by many accounts, averaged at or below 10 percent in 2004 countywide, has been diminishing for two years. According to a year-end market report from Cushman & Wakefield Alliance’s San Diego office, the direct vacancy rate for the county, once subleases are excluded, was down three basis points for the year-end quarter from the previous quarter, which is good news for San Diego’s landlords.

Peter Quinn, the vice president of development and acquisitions at Woodland Hills-based Voit Development Co., has noticed this trend develop only in the last quarter of the year.

“What’s encouraging from my standpoint and from the standpoint of the San Diego office and industrial market, is that leasing has started to pick up. And even more important, lease rates are going up, too,” he said.


Rental Rates Rising

The overall average asking rental rate in the office market ended 2004 at $2.24 per square foot, per month, on a full service basis, which is a marginal increase over the previous quarter’s $2.22, according to the report.

But with net absorption positive and vacancy rates trending downward, rental rates are expected to continue this steady increase. According to Steve Rosetta, a principal at Cushman & Wakefield Alliance, effective rental rates should increase by 3 percent to 5 percent this year.

Rents are trending up in all market types, according to Quinn. He added, “But what’s interesting is that rent differentiation is not that great.”

Some sub-markets, however, may stand to gain more than others. According to Carol Hillestad, the director of research at San Diego-based Burnham Real Estate Services, Del Mar Heights, which absorbed 338,326 square feet last year, was by far the strongest sub-market in San Diego County, followed by the University Towne Center area, which added 256,167 square feet of absorption.

Hillestad highlighted Carlsbad as one of the most improved markets, absorbing 123,885 square feet of space and effectively bringing its leasable vacancy rate to 13.6 percent.

“Carlsbad has been steadily absorbing space, making it one of our strongest markets. It was a little overbuilt in the past, but the construction pipeline fell off at the end of ’03, which helped vacancy rates come down this year,” Hillestad said.

Downtown posted good absorption as well , 255,298 for the year , and, according to Hillestad, that market is finally coming into its own.

She said that, as Downtown firms shuffle their offices, “(we) are going to see a lot of musical chairs as other Downtown firms move in to vacated space.”

Jim Munson, the managing director of brokerage services at Burnham, said the big office markets , Downtown, UTC, Mission Valley, Carmel Valley and Kearny Mesa , all experienced significant drops in vacancy and absorption and will continue to see a rise in sublease activity.


Less Space Available

The consequences of more robust office market demand in some areas, however, means there is less space available for future tenants, especially large contiguous blocks of space in Class A office buildings, Rosetta said.

“In the recent past, larger users could typically receive concessions or pay less rent, but the lack of space means this will probably end, and sooner than people might think,” he said.

“UTC and Del Mar Heights had a handful of vacant Class A office space, but, given the level of activity in the last few months, if all pending leases are signed, in 2005 we will be running out of room,” he said.

In Del Mar Heights, he said only one building of more than 20,000 square feet is left, the second of two 75,000-square-foot buildings at the Morrison & Foerster LLP High Bluff Ridge project, scheduled for completion this summer.

“Although some markets, Sorrento Mesa, for example, offer large blocks of lease space at lower rental rates, tenants who seek more than 20,000 feet of space in Del Mar, like law and tech firms, will be confronted with a lack of supply, pure and simple,” Rosetta said.

Burnham’s Munson said he sees this trend developing in some of the tighter sub-markets, but, for the most part, rents will stay constant.

This is something we have seen in the making for a number of years, Munson said. Upon losing some rent concessions this year, tenants could begin looking at other buildings to lease, but most will likely remain within their respective sub-markets.

“As leases come due, bigger tenants will try to leverage their landlords into concessions,” Munson said, but it might be harder for them to prevail this time around.

Where larger spaces do exist, it is mostly in Class B buildings, according to John Hoffman, a vice president at Colliers International.

Larger spaces that are available in North County are buildings with large floor plates, designed for an open-plan cubicle arrangement.

“There’s some large blocks of space, but the companies expanding right now, like home builders, are really in the market for private offices,” Hoffman said.

On the supply side, Rosetta also said he does not see much new office construction on the horizon for 2005, but he and Eric Northbrook, also of Cushman & Wakefield Alliance’s San Diego office, agree that two important events will play out in the next 12 months that will impact the supply side of the market: Los Angeles-based Kilroy Realty Corp. will break ground on the third building of its newly acquired Kilroy Sabre Springs, and San Diego-based Lankford & Associates, Inc. will erect a 113,000-square-foot Class A, three-story office building on Lankford’s Scripps Northridge site.

It is hard to put an exact number on the expected new construction for the year, but Munson said he forecasts the high-rise market will “stand pat.”

“While some build-to-suits might make their way onto the market and some smaller, two-story, tilt-up buildings might break ground, overall the supply will be steady,” he said.

Dave Armstrong, the vice president of San Diego-based Reno Contracting, said that increasing construction costs, most notably higher material costs, could be a hindrance on the supply side. This has really been the big driver of construction costs during the last 24 to 30 months, he said.

The critical problem is that most construction contracts have variable cost structures that make it difficult to control costs from the developers’ end.

“The dilemma for developers is deciding what value to assign to material escalation costs. We think that as warm as the economy appears to be, developers should factor in something in the range of 4.5 percent to 6.5 percent cost increases in the next few years,” Armstrong said.

Transportation impact fees are another possible constraint on the supply of new office buildings this year.

The county Board of Supervisors announced a proposal Dec. 17 to introduce traffic impact fees , single payments required to be made by developers , on a square-footage basis for residential and commercial projects, but deferred its decision Jan. 11 for 90 days. The fees would be used by the county to fund the construction of transportation facilities.

Depending on the outcome of this issue, these fees could reach up to $40 per square foot on certain commercial projects, and could thus put a damper on the amount of new office space coming onto the market, said Armstrong.

Reno Contracting has a string of large office projects it will break ground on in San Diego County this year. This includes the 240,000-square-foot JMI Realty Campus in Carmel Valley and Diamondview Tower, a Cisterra Partners building, which, according to Armstrong, will not begin until late April.

In Carlsbad, the Blackmore Co.’s Carlsbad Research Center project will begin next month, adding 60,000 square feet of high-end corporate office space to that area.

Armstrong said Kilroy has committed to building a third tower on its recently acquired Kilroy Sabre Springs property, which will add more than 150,000 square feet. The architect for the project, San Diego-based Hanna Gabriel Wells, submitted plans for the parking structure this month and Reno could break ground on the building as early as September.

The confluence of factors indicate that while 2005 will be a strong year for San Diego’s office market, there might not be enough space to accommodate large tenants.

“If you need 100,000 square feet, there is nowhere left to go,” said Rosetta.

Landlords know this and can take advantage, he said.

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