If Downtown San Diego is such a lousy place to do business, why were there almost $400 million in commercial office building sales during the past 12 months?

The obvious answer is, Downtown is a great place to do business, especially if you are buying or selling commercial real estate. In future years, Downtown will become an increasingly important mecca for San Diego’s diverse employment base. The once and future buildings will be put to uses not yet anticipated at the scale and function of the existing business structure.

The fact that five Downtown buildings sold during the last 12 months and that Centre City’s 1,500 acres accounted for 40 percent of the big-ticket dollars invested in the region’s commercial real estate industry attests to the value and importance of the market.

Counting only those transactions totaling $10 million or greater, the San Diego region recorded $1 billion in commercial transactions in the last 12 months. About 5.5 million square feet changed hands in 35 separate deals. Mission Valley saw eight buildings sold, Kearny Mesa had six sales, while UTC and Sorrento Valley had four sales each.

The National Perspective

The investors buying these buildings are mostly big, institutional players who scour the nation for opportunities. Typically, they are looking to diversify their portfolios, both in terms of geography and asset class. The disappointment of the stock market has led investors to real estate.

But not just anywhere. While San Diego’s office vacancy rate is 12 percent, considered weak with only 1.6 million square feet of absorption (or space fill up) during 2002, the performance is not bad when compared to other markets. The San Francisco Bay Area now has 18 million square feet of empty space, nearly a quarter of its market. At a total of about 80 million square feet multi-user office space in the San Diego market our vacancy totals 9.3 million square feet, one-half of that of San Francisco at about the same total inventory level.

The promising markets around the nation are Washington, D.C., (because government is growing) and San Diego. Why us? Here are some possible explanations:

• San Diego is not overbuilt, relative to the remainder of metropolitan America. Vacancy rates may be a tad high, but not at the levels of other metropolitan areas.
  
  
• The regional employment market continues to grow as the county added 10,100 new jobs in 2002. Now that is unspectacular relative to previous years when 30,000 to 51,000 new jobs were being added annually. But it is an amazing performance when one considers most other regions experienced net job losses during the past year (Los Angeles lost 40,000 jobs).
  
  
• This is an increasingly diversified economy. This is important because it means that when one industry is down, another may be up. In fact, that is exactly what has happened during this national recession. San Diego has simply been less recessed.
  
  
• The population is rising. San Diego added another 53,000 persons last year (mostly births over deaths), about its annual average.
  
  
• Suburban land where development is allowed is in short supply. The city of San Diego only has about 10 percent of its fringe, suburban property remaining undeveloped.

The Local Perspective

Downtown San Diego is a particularly interesting example of a submarket that may benefit from these circumstances. Since 1991, the regional office market added 21 million square feet. None has been built Downtown. One has to look back to the opening of One America Plaza in 1991 for the last new building. Incidentally that is one of the buildings that changed hands last year, for $166 million, or $286 per square foot. Of the larger building sales, only Aventine in UTC sold for a higher per square foot value ($312) but at a much lower price ($75 million) for the smaller building.

Investors know that Downtown is a “sleeper” market. For one thing, it is being bombarded with new residential development. The current fear is that the high-rise residential condo market is so strong that prospective commercial office sites are being sucked up for residential. The best example has been the recent acquisition (and now development) by Bosa of former Santa Fe Railroad/Catellus properties for residential.

The thinking has to be that new employment will follow the new housing. That is how it often works in the suburbs: it largely explains the rise of Carmel Valley, home to about 3.35 million square feet of commercial space.

The alternative for Downtown is becoming largely a new residential suburb, with many of its residents commuting out. Now there is a phenomenon: Downtown as a residential enclave. That is neither practical nor consistent with the city’s avowed policy of creating communities where people live and work, linkages which improve the quality of life in a community.

At least two developers think otherwise. Rob Lankford, a commercial office developer who builds where he perceives the market is, is now within several months of breaking ground on his 655 Broadway, an anticipated 450,000-square-foot high-rise.

JMI (the ballpark neighborhood developers) have a deal to sell property to Cisterra, which has proposed an 11-story, 215,000-square-foot project in the ballpark district at J Street and Eighth Avenue. Their proposal has been highly contentious because at that height it will likely block some views of the ballpark.

While the Centre City Development Corp. now is negotiating with both sides to create an acceptable resolution of height and size, the agency also is in the midst of a new Downtown master plan. That effort has come under some fire because it is looking at office growth through 2025 of 4.4 million to 6.2 million square feet, based on Downtown’s historic market share of the region’s office market. The problem is these numbers could be severely understated. At best, this estimate suggests that less than 300,000 square feet annually would be added Downtown.

While today’s economics do not favor commercial development, they will again in the foreseeable future. That is exactly what the high transaction prices tell us: hovering around $300 per square foot, the best buildings are being sold at the level of, or above, “replacement value.” It is only a matter of time before new construction is economically justifiable.

Conclusion

A veritable “musical chairs” of office leasing now is taking place in the San Diego region. The high-tech bust has hit hardest the areas that once housed a great number of the high-tech and biotech companies, in Carmel Valley, UTC as well as the north coast corridor. Carmel Valley, for example, experienced a 24 percent vacancy rate as well as negative absorption in 2002. But brokers have been busy filling this space by companies recognizing the strong location at reduced rental rates.

The pattern of commercial office development, largely confined to northern sub markets, will change in San Diego County. Inevitably, South County will begin to see the development of new offices in conjunction with substantial increases in market share of both residential and manufacturing. East County should see a greater market share in the coming years as well.

And Downtown, with still the largest inventory of high-quality office space at more than 11 million square feet, likely will play an emerging role of importance to San Diegans. It is quite conceivable that it will begin housing more technology companies in addition to its traditional role as the repository of the legal, accounting, communication and banking community.

The San Diego region has emerged as a darling of commercial office investors, partly because most of the rest of the nation has been in a slump. But that is just the point: if San Diego appears strong relative to a weak national market, we will remain strong as the national market recovers. And that is why local buildings are achieving high sales prices, and the transaction market has been so dynamic.

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.