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Tuesday, Sep 27, 2022
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Following the Market Forces

What a difference an economic recovery makes, when it comes to the balance of power between office tenants and landlords in San Diego County.

With 2013 well under way, it appears that the “flight to quality” trend that helped some companies find bargain-priced space in the region’s top Class A buildings is well in the rearview mirror, as the best-located properties with the latest amenities are near fully filled. Fading with the rent discounts are the free furnishings and other move-in incentives used to reel in tenants when the Class A market was in recuperation mode with the rest of the local market.

“It’s still somewhat of a tenant-advantaged market in some of the Class B suburban markets — less so in the Class A sector,” said Derek Hulse, associate vice president in the San Diego office of brokerage firm Colliers International.

Hulse noted that Class A vacancy rates have recently trended at or below 10 percent in high-demand central submarkets like Kearny Mesa, Mission Valley and Sorrento Valley, as well as some to the north including University Towne Center and Carmel Valley. That’s generally a sign that submarkets are moving toward equilibrium or in favor of landlords, with rents gradually heading upward.

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Market tightness and rising rents are also being seen among the better appointed, older Class B buildings in those submarkets, especially Mission Valley and Sorrento Valley, Hulse said. Class B in 2013 stands to be the beneficiary as the overall office market improves with the economy, which locally tends to be driven in large degree by space demand among small to midsized companies.

‘Slow Improvement’

“It’s going to slow improvement for the next couple of years, but that’s the kind of growth that is sustainable,” Hulse said.

While first-quarter 2013 figures have not been finalized, Hulse said preliminary data gathered by Colliers indicates that the quarter will reflect continued gradual improvement from where the market was a year ago.

Net absorption for the first quarter is expected to surpass the positive 275,000 square feet of 2012’s first quarter, and the region’s office vacancy is expected to come in at or under 14 percent, declining from 15 percent a year ago. The full-service per-square-foot average asking rent will also likely surpass the $2.15 posted in the first quarter of 2012.

Hulse said office demand is being driven by sectors that derive their revenue from intellectual capital — including firms involved in research and development in life-science, wireless and health care technology — as well as clean energy and education. Defense-related office demand is generally holding up well despite uncertainty generated by federal sequestration.

According to data from tenant services and brokerage firm Hughes Marino Inc. in San Diego, total available corporate space in San Diego County — office, industrial and hybrid “flex” properties — has been steadily declining for the past 10 quarters. The current total of just over 42 million square feet is down 17 percent from the peak of 50.5 million square feet seen in the second quarter of 2010.

Due in large part to the “flight to quality” trend of the post-recession period, newer Class A office space has been gobbled up at a faster pace than older Class B properties. As of mid-March 2013, Class A space availability was down 22 percent from its peak (2009 second quarter) while Class B space was down just 5 percent from its peak (2010 third quarter).

Potential Sticker Shock

Currently, the region’s Class A available space stands around 5.3 million square feet, while the Class B available inventory is approximately 9.8 million, according to Hughes Marino. In this climate, said Executive Vice President David Marino, tenants in most submarkets can still drive leasing bargains in the Class B sector, while the balance of power has shifted to the landlords’ favor in the Class A properties in popular neighborhoods.

One result, he said, is that some tenants who moved up in the market to well-located Class A spaces during the downturn could be scouting the Class B market again when their current leases expire in 2014 and 2015, largely because Class A landlords are in a better position to raise rents.

“Some of those Class A tenants are going to have their leases coming up for renewal, and they’re going to have sticker shock,” Marino said.

He said an improving leasing climate also means that landlords will be less willing to do short-term leases in some submarkets, and less generous with rent discounts and other move-in incentives. There will also be less restructuring of current leases to keep tenants in place, since the pool of replacement tenants for a given space is increasing.

Marino noted that the current sparse supply of big blocks of space will also work to landlords’ advantage in some submarkets as the supply grows even slimmer, especially with few new office construction projects in the pipeline.

Chris High, a director in the San Diego office group of brokerage firm Cushman & Wakefield, said the largest office property owners in the local region, such as Irvine Co. and Kilroy Realty Corp., have been able to push Class A rental rates upward during the past year in popular submarkets like UTC and Del Mar Heights.

That rent advantage is now spreading to owners with smaller Class A portfolios. In the long run, the landlord-slanting trends could serve to boost the supply of Class A space, as current owners pull the trigger on new construction at existing office complexes, and as more property investors seek to boost their office holdings.

“There are a lot of investors ready on the sidelines, and there’s a lot of money looking to be placed in the market,” High said.

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