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  As complicated as real estate is, it all boils down to a simple basic equation of supply vs. demand. Unfortunately, getting that formula right is the toughest part of any business, especially in commercial construction. A commercial real estate project takes one and a half to two years to complete. When a development breaks ground, educated guesses are made about the economy’s state when it’s completed. Slowdowns play havoc with those efforts, especially when they follow great years. “The best year we ever had was 2000,” says Tucker Hohenstein, vice president of Burnham Real Estate Services in the Carlsbad office. “The market was booming and a lot of tech and dot-com firms were moving to San Diego. Space was tight, so firms were leasing two or three floors of space and holding the third floor for expansion. But 2001 was the reverse. Firms were giving back space or subleasing it.” For many businesses in San Diego, the national recession began to affect their operations shortly after Sept. 11. For commercial builders it happened a year earlier, with the fourth quarter of 2000 proving to be the end of an era. “That’s when the market peaked,” reports David Marino, executive vice president of Irving Hughes, a commercial brokerage company. “Since then it’s been in a spiral and yes, Sept. 11th seemed to exacerbate that. Now speculative building has virtually stopped.” The numbers support that conclusion. Burnham Real Estate Services reports that several areas of San Diego are experiencing double-digit office vacancy rates. At year’s end, Sorrento Mesa had a 26.7 percent vacancy rate, while Carlsbad topped the list at 33.3 percent. Only Torrey Pines dropped from 7.6 percent to 3.8 percent, while all other areas took an upswing. At the same time new commercial/industrial construction is falling, from 3.4 million square feet completed in 2001 to 2.4 million square feet projected for completion this year. Countywide, proposed speculative projects are being canceled or put on hold. Ancient History In the 1980s, constructing office and industrial space without signed tenants was commonplace. Then the commercial market crashed, leaving San Diego with a seriously overbuilt market. “In the ’80s, savings and loans were giving away non-recourse debt loans,” explains Hohenstein. “Because there was a lot of liquidity pumped into the market, builders were borrowing money and if the project didn’t work, the bank foreclosed and took the building back.” Then the recession of the early 1990s hit San Diego particularly hard, compounding an overbuilt situation. Vacancy rates rose to an all-time high of 30 percent and commercial development effectively came to a standstill. The situation reversed itself in the late-mid 1990s as telecom, the biosciences and, to a lesser extent in San Diego, dot-coms popped up on the scene or expanded. “When demand caught up with the overbuild, there hadn’t been any new supply for five years,” says Jim Moxim, vice president of Lennar Partners, a commercial builder in the Kearny Mesa area. “Any new properties were instantly leased.” Recent History In late 2000 and the first quarter of 2001, the bottom dropped out of the high-tech industry and many of the dot-coms went bust. Since then, commercial markets with the fewest technology tenants — Downtown, Chula Vista, Kearny Mesa and Mission Valley — are faring the best in terms of occupancy levels. Hurting most these days are the markets in the UTC, Del Mar Heights, Sorrento Mesa and Carlsbad areas. “In the ’90s, Kearny Mesa builders were frustrated they weren’t winning the deals with tech companies,” recalls Marino. “In retrospect, they’re glad they didn’t.” But complicating the slowdown of high-tech and Internet-based companies is the financial squeeze created by the nation’s 2001 recession, which greatly slowed San Diego’s economic growth. Many businesses are not making a profit, and money from venture capital, IPOs or individual investors has dried up. Once again, it’s all about supply and demand. “When corporations are growing and healthy, they need more square footage,” remarks Marino. “If a corporate tenant doesn’t have the need for facilities, there’s no reason to build them.”
“When a lot of sublease space comes on the market, that depresses the lease rates,” says Chris Pascale, senior vice president of C.B. Richard Ellis. “As business slows, banks get more careful with their loans. The office market has been affected dramatically,” says Jim Pieri, president and CEO of Mountain West Real Estate. “So lenders are running scared.” Today’s Market As a result of the history of commercial building in San Diego, real estate developers are making several significant changes in the way they do business.
That’s also what attracted The Corky McMillin Cos. to its seven-building, 380,000-square foot Liberty Station project on the Naval Training Center grounds. “The office vacancy rate in the Point Loma/Sports Arena area is 0.1 percent, according to CB Richard Ellis,” says Megan Conley, director of communications for The Corky McMillin Cos. “That’s the lowest vacancy rate in any submarket in San Diego County. So we think this area will bear development.” The company plans to break ground in the second quarter on three of the commercial buildings. Lankford voices the same optimism about Downtown. “Downtown is a different animal — there’s no room to grow down there,” he says. “And with all the action in the Gaslamp Quarter and the prospects of the ballpark, plus the growing number of residents, the feeling of the whole city is being transformed.” Pieri touts Chula Vista, where his firm is constructing the 346,000-square-foot Gateway Chula Vista project across from the South County Courthouse, as the new Carmel Valley. “It’s closer to the border and the airport,” he says, adding the company already is planning Phase II. “And it doesn’t take a rocket scientist to see where the masses are moving. You just have to look at the number of homes sold.” Looking Forward If one word could sum up how commercial developers are viewing the future it would be “cautiously.” “I’ve actually seen companies out looking for space, kicking the tires, so to speak,” reports Pascale. “So I’m cautiously optimistic. San Diego is still at the top of every company’s list and we have a migration every year. Interest rates are low and so are unemployment rates, while the vacancy rates in most sub-markets are single digit. Those are positive economic markers.” Indeed, Pascale hypothesizes that 2001 wasn’t actually a bad year, unless it’s compared to 1999 and 2000. “If you take out 1999 and 2000, we probably had an average year last year,” he says. “Those years were extraordinary. I think 2001 was a typical mid-’90s year.” San Diego commerce also has more diversity than it had a decade ago. With biotech, telecom and tourism still growing, San Diego has plenty of companies looking for office space. “We’re in much better shape than the last recession and we’re a different city,” notes Hohenstein. “The vacancy rates are better, there are fewer foreclosures and there’s a shortage of buildable land in San Diego County. That’s important because real estate is a long-term business.” While brokers and developers all have different opinions on how long the market will take to recover — from four months to four years — they all agree that it will come back. “I think San Diego has a really bright year ahead of it,” says Pieri. “I think the market has just been flirting with us. There’s a slowdown, but we’re still going strong.”
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In such times, companies often minimize risk by reducing their square footage and subleasing the extra space. Hohenstein says 2.4 million square feet of sublease space is available in the county. Adding to that is space coming on the market as projects started in 2000 are completed. At the same time, some companies are coming to the end of their lease, when they can choose either to reduce the company’s square footage or find a better lease agreement in another building.