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Such an incongruity of perspective tells me it’s that time again. Every 10 years or so a transitional period arises in the market. The real estate indicators are showing a flattened or declining market. Yet there are no disasters in the industry; no major devaluations; no huge oversupply of space.

But the rate of growth and development has slowed. Vacancy rates in some sectors have risen, absorption rates have cooled. Not appearing, however, is any mass exodus from commercial or industrial space.

Depending on the remaining length of the national recession that apparently officially began 10 months ago, San Diego may withstand the worst impacts.

Yet, this is a point in the economic cycle characterized by:

• Uncertainty. Because the real estate and economic numbers present a blurry picture, it is difficult to tell where things are headed or for how long.
  
  
• Denial. Five years of prosperity give rise to a kind of market dementia. People cannot bear the fact that the economy is in recession. They choose to cling to a sense of imperviousness.
  
  
• Wishful thinking. Denial then licenses people to tell themselves that nothing bad has happened.
  
  
• Boosterism: A sense of economic patriotism kicks in. There is very little room at parties to whisper the ‘r’ word.

Yet we are beginning to feel the nation’s recession. The year is not starting out with a bang. It may, however, end with one. Statistical indicators suggest the inevitability of a local downturn, leaving the main question of when true recovery will begin?

Anyone who claims to know is a charlatan. What is known is that this is a cyclical event caused by oversupply and an overheated market. This temporary condition should be cured when demand again exceeds supply. For San Diego’s amazingly diversified economy, it’s just a matter of time. This is not a structural event on the level experienced in the early 1990s. The cure for that economic downturn was to retool the basic industries making up the local economy.

In this cycle no retooling is necessary. Instead it is an economic waiting game. Demand will rise; but it may take the better part of the year or more. It is this uncertainty that many can’t accept. I advise my real estate developer, investor and lender clients to plan for a 12- to 18-month recession, but hope for a shorter one.

While my focus is commercial and industrial sectors, the residential real estate sector also has softened, particularly the move-up housing market in upper-middle and upper end communities. Prices have flattened or declined, and sales rates have slowed significantly.

The commercial real estate sectors already have softened, or are getting there.

The Office Market

Nearly 70 million square feet of office space makes up this market, up 3 million square feet from last year and having grown about 12 million square feet in the last 10 years. The official vacancy rate is 8.66 percent. Adding in the 1.7 million square feet of sublet space available pushes vacancy to 11 percent, or more than 8 million square feet. Absorption in 2001 appears to be 1 million square feet. By comparison, the year 2000 absorption was 4 million square feet. These compare to an average of 2 million square feet over the past 5 years. By any measure, the office market has slowed.

The average countywide lease rate is $1.81 per square foot per month. UTC, Del Mar Heights and Downtown are the most expensive lease markets with prime space topping $3/square foot per month for Class “A.” While UTC still hovers, on the average, just over $3, Downtown is just under. Del Mar Heights now has dropped to $2.37 on recent activity. In fact, the entire North Cities submarket has been hit hardest with an almost 15 percent vacancy rate: on a base of 19 million square feet (in Del Mar Heights, Golden Triangle, La Jolla and Miramar), 2.8 million square feet are vacant. A total of 40 percent of this vacant space was sublet.

Industrial

San Diego County is home to 124 million square feet of industrial space, up 3.5 million square feet from last year and having grown by 24 million square feet in 10 years. The current vacancy rate is about 5 percent, which only rises slightly to 6 percent if you add in the 2 million square feet of sublet space available. Absorption in 2001 was about 1.6 million square feet. By comparison, the year 2000 absorption was 5.3 million square feet. These compare to an average of 3 million square feet over the past 5 years. This market, too, has slowed.

The countywide average lease rate is 81 cents per square foot per month.

While best estimates are that as much as 1 million square feet are under construction, which is not much, the where is more interesting: it is distributed roughly 40 percent in Otay Mesa, 40 percent in Vista and 20 percent in Poway. Otay Mesa is the focal point for much of our county’s industrial activity in the coming years.

Research & Development

Research & Development is a sector of 21 million square feet, about 80 percent of which is in the North City markets surrounding UCSD. Generally this is a sleepy sector that is built to suit tenants and owners. It starts 2002 with about 11.5 percent of the space vacant, an unusually high rate for this sector. Absorption last year was negative with almost 200,000 square feet coming back on the market. This is not a big number relative to the size of this inventory, but it is definitely not the right direction. The good news is that very little inventory is under construction. R&D is a big industry in San Diego. It is not going away, it is simply a reflection of fewer dollars being thrown in this direction at this point in the economic cycle.

Retail Market

More than 73 million square feet of retail space is scattered about San Diego County in shopping centers, strip centers and freestanding buildings. The vacancy rate is about 5 percent. Unlike the other sectors, an examination of the real estate numbers is not particularly revealing. While occupancies have held, the retail sector obviously has hit a weak spot after a long economic expansion. As this year proceeds, the weakness will manifest itself in the form of a higher level of tenant turnover and perhaps the repositioning of some centers.

The areas with the biggest question marks will be smaller, strip centers and freestanding retail in older, disconnected areas. A tremendous number of these small centers already are operating on the edge. Of particular concern is retailing servicing the border. The new Las Americas outlet center has just opened there and seemed to enjoy strong business during the holiday season. At 600,000 square feet, it is the largest opening this year in the county. The long border waits have had a tremendous impact on other border area retailing, and that will remain a trouble spot.

Hotel Market

It is not especially insightful to note that the hotel market is coming off a very bad year. What is surprising is how resilient the market is as it bounces back. True, room demand is down 20 percent in the aftermath of the Sept. 11 terrorist attacks and average room rates are down 10 percent, causing a $9 million reduction in the Transient Occupancy Tax collected. Yet occupancy and the average daily rate are coming back gradually. Occupancy had fallen from 81 percent in August to 59 percent in September. But in every month since, the numbers are on the mend. The average room rate dropped from $118 to $103 in that same 60-day period, but it, too, is staging a comeback.

In fact, occupancy is now at 72.3 percent, just down from 2000’s 15-year high of 73.8 percent. This is very high by any relative measurement. ADR is now back up to $113, higher than 2000’s $109.

The Opportunities

My motto is, you make money in real estate at the time of purchase. To that end, this year may be a very good time to purchase. Here are some opportunities:

• Strip retail centers. Many are marginal in San Diego, yet occupy prime property. With the city of San Diego about to alter its land use policy to create a “City of Villages” why not take local government at its word? That would involve converting these sites into mixed use, contemporary projects including residential above retail and offices. Look at new projects in Downtown San Diego for analogues, including Village Walk in Little Italy or Crown Point in the Gaslamp Quarter. Developers can lower the scale of similar projects in less dense neighborhoods. But the opportunity is clear.
  
  
• The Condo Market. Please build condominiums, preferably as part of mixed-use commercial. The housing crisis legitimately can be blamed on the failure to build condos, normally the first rung of the housing ladder. Construction defect litigation has been the cause for the dearth. However, with the level of litigious exposure possibly lowering throughout the state, perhaps this is the time to secure properties for conversion. Many older, obsolescent commercial structures are ripe for condominium conversion. The consumer market is immense.
  
  
• Industrial to commercial. Consistent with my sense that San Diego is rapidly urbanizing and “verticalizing,” there are now many well placed, older industrial buildings ripe for upgrading and conversion to higher intensity commercial, even residential uses. Look at older areas that are well located.
  
  
• Hotels. It seems like a great year to invest in the hotel market. It is coming back, yet there will remain a window of opportunity. San Diego has historically seen the hotel and visitor industry stay strong in a down market because we convert well to an auto-accessible tourist market. Citizens of Los Angeles are very close and will come here versus, perhaps, Europe or Hawaii. And gas prices are very low for the moment.

What To Watch Out For

Watch out for overoptimism. Simply too much of it is out there right now. We are at a point in the market where agents, brokers, sellers and suppliers do not believe we will continue in a recession. This is a classic point of view in a market in transition. Yet the country is in a recession and when we will come out, no one knows. It could take a year or longer.

Here is what I do know: While we are in a classic demand slowdown in the economy, and the real estate reflects it, we will come back strong. The county will continue to grow by at least 30,000 persons this year from natural increase alone (more births than deaths). That challenges the market to supply for our housing, employment and retail needs.

Simply recognize that those needs will change. The San Diego of the immediate future may not be what we have previously experienced.

Gary H. London is president of The London Group Realty Advisors Inc., providing real estate consulting and economic analysis. Check him out on the Web at www.londongroup.com.