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Oh, what a difference a few months make in the office-leasing business. It seems like only yesterday that commercial real-estate brokers filled the air with predictions of new Downtown high-rises packed with new tenants paying premium rents — and who would think otherwise with an economy that was humming along?
But that was then, and this — well, it’s no time to be waving any white flags, but the winds blowing through the landlord-tenant game are shifting. With office vacancy rates on the rise again in some key business sectors throughout San Diego County, it seems unlikely that rental rates will be rising anytime soon — and they could even drop slightly.
"The party's not over, but the band's on a break and the bartender's in the rest room," says one of the fresher minds in the tenant-representation business, Dave Marino of The Irving Hughes Group. The concern stems from the unusual confluence of several economic factors that — happening all at the same time as they did — seems to point to a cooling-off period in office high-rise construction and landlord dominance in the commercial-leasing world.
"The net effect," the executive vice president explains, "is in the last three months, the suburban office markets, which were at anywhere from 4 to 7 percent vacancy six months ago, are now double that. They went up around 15 percent in some marketplaces overnight."
Meanwhile, Downtown is awash in mergers and acquisitions, as well as some business failures, retrenchments and outright cutbacks. Hence, the residual result — affectionately called "office dumping" — troubles Marino and his cohorts, including firm partner Jason Hughes, the Boston terrier of Downtown tenant reps.
"We have more options Downtown than we had just six months ago. The market peaked back in June," Hughes says. "Now we have the suburban markets with more opportunities than there are tenants to fill them, which ultimately puts pressure on Downtown landlords.
"Don't get me wrong. The outlook for Downtown is bright. But it’s an odd time; a year ago many experts thought the REITs would own every commercial building out there and economize expenses while pushing rates through the ceiling — a Wall Street dream. But it’s not happening. It’s not necessarily a tenant's market, it’s just that everyone's taking a breather, and landlords can’t get much more aggressive than they've been without losing more tenants."
While those publicly traded REITs, or real-estate investment trusts, will still be a market force, there is some shuffling going on. "Obviously there was a lot of capital out in the market last year, both debt and equity, and there was a push for development — much of that being fueled by the REITs in town," concurs Stath Karras, executive vice president and transaction expert at John Burnham & Co.
But when the rates of return on these REITs underwhelmed investors, the flow of capital slowed and REIT stock prices stumbled badly. In October, Downtown’s largest private landlord, Southwest Value Partners, stifled rumors by announcing it would retain ownership of four of its flagship Downtown high-rises rather than pool them in a REIT.
"Wall Street has hammered (REIT) valuations," Marino says. "The REITs have had their knees cut out from under them."
But office construction continues. "There's a lot of building going on that people don’t realize," says Hughes, sounding a bit annoyed. "Landlords and their brokers think that it’s such a landlord's market, but we’ve seen prices go down probably 5 to 10 percent within the last 90 days."
That's a far cry from a year ago, when many so-called experts predicted a three-year boom in high-rise construction starting in late 1998. Instead, says Marino, "Landlords are going to scramble to get their buildings leased, because there are more buildings now than there are tenants in 1999. A year ago, it looked like the reverse was true, and everybody was pushing up their rents. I mean, who a year ago would have ever thought that Callaway Golf would lay off 700 people?"
Those layoffs — and others like them at other San Diego companies — hit like lightning as the Asian fiscal crisis came into focus. Uniden San Diego, the local arm of Tokyo's wireless giant Uniden Corp., built a $50 million, 10-story edifice in Sorrento Mesa, but now intends to sell it off — and dump all of its leased buildings as well — as it downsizes, says Marino.
Nicholas Applegate is seeking to sublease two floors in One America Plaza.
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And that’s just the tip of the office-dumping iceberg. Companies whose products have "hit the wall," industry parlance for not meeting expectations, are putting office space back on the market at a fairly healthy clip. In the North County, software developer TriTeal was ready to move into 50,000 square feet in Carlsbad until its financial wheels fell off. Optimal Integration Solutions, a Carlsbad computer network firm also hit with sharp cutbacks, built a 28,000 square-foot corporate shrine to itself that it will never inhabit.
In the UTC area, TrizecHahn Centers, having sold off its retail portfolio, is shrinking down to three floors, putting two floors back on the market. Extra space also has been returned by FPA Medical, ADC Wireless, Com-stream Corp., Phase Metrics, Cymer and LG Infocom to the north and inland. It’s office space that wasn’t anticipated to be back on the market anytime soon.
Hughes reports that Sunroad recently topped off the first phase of a 400,000 square foot speculative office complex at the south end of Eastgate Mall without a single tenant signed up to move in. "Sunroad thought they would hit the market at its peak," Hughes says. "They thought they would get $2.50 a square foot rent starting rate . . . yet they don’t have anybody lined up."
Meanwhile, Downtown is seeing its own office cutbacks.
The merger of Price Waterhouse and Coopers Lybrand put about 18,000 square feet back on the market. The law firm Brobeck Phleger & Harrison is moving out of three floors at 550 Corporate Center to new offices in Del Mar Heights, still one of the hotter office markets. Another two-floor law firm there is looking to cut its space by half.
A law firm in Symphony Towers, Shifflet Walters Kane & Konoske, is breaking up, meaning its 27,000 square feet will be available this quarter. AT&T, a major Symphony Towers tenant, will reportedly not renew its four-floor lease there in a consolidation move to cheaper office space elsewhere. Bank of America, facing thousands of layoff nationwide, is returning anywhere from 40,000 square feet to a rumored 100,000 square feet of office space in its Downtown flagship high-rise that once housed nothing but BofA employees.
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An executive suite operator in the First National Bank Center terminated its lease in the fourth quarter, putting three floors on the market. The cutbacks have even hit Downtown’s premier Class A high-rise, One America Plaza, where Nicholas Applegate is seeking to sublease two floors, a 40,000 square-foot cutback and Advanced BioResearch is trying to leave two-thirds of a floor.
Even the city of San Diego’s recent closing of a deal on 15 acres in Kearny Mesa — where some companies are now gravitating because of cheaper rents — has some Downtown observers concerned the city is fixing to move its Water Department there. The department currently occupies half of Downtown’s Comerica Bank Building. That would be a colossal office dump of about 150,000 square feet.
While some of the prime space no doubt will be backfilled by new tenants seeking primo locations, the shakeouts leave other office complexes in the lurch. "When a user goes out of the market, somebody else backfills, leaving space elsewhere," Hughes says. "There's a surprisingly large number of groups looking to give back some space. Many companies are just kind of hunkering down and looking towards the future."
John Burnham's Karras agrees that rental rates will remain relatively flat for the next year or two — an opinion not held by broker Kraig Kristofferson of CB Richard Ellis, who predicts a 10 percent rent jump this year Downtown — but believes the excess office space will be absorbed, thanks to the slowdown in development.
"If we had a higher vacancy rate and we had a lot of product being developed, we might view it differently," Karras explains. "But when your market is at 10 percent vacancy and there has been a slowdown in activity, it allows that type of product to get absorbed."
But with big lease rollovers on the horizon, the office market is likely to get even more active. "These leases are with companies that occupy multiple floors, prime candidates to anchor new buildings," Hughes speculates. "So when developers have that itchy finger, like the Padres or Catellus, who have to put up a minimum of 600,000 square feet each, they're going to sweet talk all these tenants…. It’s a perfect time to be hooking into these tenants and build them something."
Sounds like office dumping may become a way of life for the time being.
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