Over the past 14 months, 33 commercial buildings in San Diego County sold for more than $10 million. The combined $2.3 billion in office transactions involved 7.6 million square feet of office space changing hands. Two years ago the transaction total was $1 billion sold in 35 deals involving 5.5 million square feet.

That is more than a cost of living increase.

The commercial office market is very different than residential, where value is perception. The players are hard-core, left-brained and unemotional. This game is about numbers. Investors are carefully examining revenue, comparables and capitalization rates. They are looking at “upside.” And they like what they see in San Diego’s commercial market. What is revenue measured against the comparables? It is called capitalization rate and it too is unemotional. Mostly.

“This is an overheated sellers’ market driven by historically low interest rates, exchange buyers and lack of quality properties available for sale,” says Tom Olson, a broker with Coldwell Banker Commercial.

It’s Replacement Value, Friend

David Gardner of Highland Partnership, an old hand in the construction business, says steel and cement prices have risen steeply and are approaching or exceeding $200 per square foot. So, too, has the cost of labor increased. This puts the construction cost of a new building at $300 per square foot.

This arithmetic suggests many good bargains were picked up in the form of San Diego office buildings over the past year. It is called buying for “less than replacement value.” On that measure alone, virtually every building purchased in the past year has been a bargain.

Some have been better deals. A few sales in the Downtown market were screaming bargains at less than $300 per square foot. The priciest inventory remains science space along the coast.

Office Building Sales Of $10 Million Or More
July 04 - August 05	No. of Sales	Sales Volume	Total Sq. Ft.	Avg. Price $ Per Sq. Ft.
La Jolla/Torrey Pines	2	$404,500,000	890,992	$453.99
UTC	4	$255,560,000	739,722	$345.48
Downtown	8	$688,359,250	2,345,518	$293.48
Kearny Mesa	4	$109,150,000	525,904	$207.55
I-15	2	$131,810,000	452,592	$291.23
Sorrento Mesa/Valley	5	$485,876,000	1,729,217	$280.98
Carmel Valley	2	$62,100,000	203,237	$305.55
Carlsbad	3	$57,750,000	261,215	$221.08
Mission Valley	3	$120,130,000	452,818	$265.29
Total	33	$2,315,235,250	7,601,215	$304.59

The Study’s Purpose

When we started this survey two years ago, the base cutoff value was $10 million. While that remains the theoretical base, the smallest transaction above $10 million we found was $17 million, an 88,000-square-foot building in Kearny Mesa that sold late last year. The bar has risen.

Some interesting details emerged from the research:

• Over the last two years, the average transaction value numbers increased $115 a square foot from $189 to $304 per square foot.
  
  
• Price per square foot was highest in the North Coastal trio of La Jolla/Torrey Pines, UTC and Carmel Valley, which together averaged $368 per square foot.
  
  
• The lowest transactional value market was Kearny Mesa at $207 per square foot. Those buildings are relatively small, class B structures and reflect the transition of that market from industrial to commercial.
  
  
• No large sales were reported in July. But as we went to press, an additional three Downtown deals were in escrow: Golden Eagle Plaza, SBC and the NBC buildings. So we included those in the year-to-year figures because these transactions reflect the continued attraction of Downtown San Diego from institutional investors.
  
  
• Sorrento Mesa was the weakest office market following the “tech wreck” because this market housed a disproportionate number of technology companies. Investors purchased $485 million of its assets, making it the most active market measured year to year if we subtract the $333 million in escrow Downtown.
  
  
• The biggest transactions were the Pfizer Campus office park’s 771,000 square feet at $372 million in Torrey Pines and Sorrento Mesa Corporate Center’s 601,815 square feet at $370 million.

The Market

The high level of commercial transaction activity reflects a strong and stable regional market. Overall vacancy rates remain below 12 percent, the same as last year. On a base of about 73 million square feet, less than 10 million square feet is vacant, reports Burnham Real Estate.

About 1 million square feet has been “absorbed” or leased in the past year. Another 3.5 million square feet is under construction. About half of this inventory is committed by lessees or in build-to-suit situations. With 1.4 million square feet under construction, Sorrento Mesa accounts for more than 40 percent of region’s pending offices. Qualcomm is taking two new buildings and Gen-Probe is preparing to occupy almost 300,000 square feet next year.

The remaining inventory of major construction is mostly Downtown, with two buildings adding about 600,000 square feet to the market. Those buildings, Broadway 655 and Diamond View Tower, under construction, have large-space tenant commitments, but about half of each building’s leasable space is available.

Carmel Valley is adding almost 450,000 square feet of space in significant but smaller projects, and Intuit is planning to occupy in 2007 most of a 470,000 square foot Santa Fe Summit three building complex.

The market is heating up in University Towne Centre. Equity Office, the largest public owner of office space in America, is starting Bridge Pointe Corporate Centre III, a two-building project that includes 150,000 square feet of Class A office space and represents the UTC’s first speculative office building since 2002. The development’s first and second phases were delivered in 1998 and 2000.

Monthly lease rates vary, but the top markets easily exceed $3 per square foot. Lower-than-achievable lease rates are one reason behind many of the sales. Investors are confident they can charge tenants more in the coming years.

For perspective’s sake, despite the most construction activity in five years, office vacancy rates have the potential to go into single digits by the end of the year.

Institutional Investor Hunger

While many smaller office buildings are being devoured by companies interested in their own investment portfolio, the large deals are typically the purview of nationally focused institutional buyers including pension funds, insurance companies, real estate investment trusts and asset managers.

The Hines REIT, one of the giants and the investment arm of the venerable Gerald Hines Interests development firm, recently purchased the Golden Eagle building. Hines likes the Downtown market in particular and expects it to explode in time.

Charles Hazen, president of Hines REIT, specifically targeted San Diego because “this has always been a market that we have felt is key for us long term. Southern California and San Diego have been pretty close to the top of our list of target markets because of a strong economy. During the last economic downturn, San Diego outperformed the rest of the nation. Vacancy rates did not rise much, and then quickly retracted to 10 percent to 12 percent.”

Hazen notes North City markets are “substantially built out at this point. They are premium priced and owned by institutional investors with long-term holding goals.” Hines views these as markets to be in, but with no true core assets ready to be traded and priced too high.

Hines expects to upgrade 525 B St. so that it appeals to a broader range of tenants.

Office Condos

An old but rejuvenated idea has emerged in the commercial lexicon: office condominiums. Most are targeted to boutique companies requiring smaller amounts of space, whose owners prefer to own. Two major Downtown office condo projects are proposed, Metro Works and TR Produce.

Metro Works, conceived as a nine-story 80,000-square-foot project in Little Italy, is selling space ranging between 1,188 to 2,700 square feet. Priced beyond $500 per square foot, or roughly the level of its residential brethren, the project boasts bay views, contemporary design and the benefits of ownership (tax and appreciation). Developer Howard Berkson of Berkson Realty Advisors is playing a different card than the traditional commercial office developers. “We are the first high-rise condo project conceived from the ground up,” he says. “This is an idea that began over three years ago. We are visionaries in anticipating this market when everyone else was building or converting to residential. We are changing the culture to ownership.”

Berkson says Metro Works is less about “pioneering” a concept and more about delivering a quality product to a starved, niche market. He’s right. The concept has been around but has never really been embraced in the market. Until now. He is on to something.

The Economy

So why is there so much activity in the market? Simple. It’s all about jobs and location. Our region has experienced significant employment gains (see table). In the service sector alone we have added 65,400 jobs during 2001-2004. Much of that employment growth is accommodated in office buildings.

San Diego’s Job Gains
Year	Total Employment	Annual Change
1995	989,300	989,300
1996	1,017,200	27,900
1997	1,065,000	47,800
1998	1,116,100	51,100
1999	1,164,100	48,000
2000	1,205,200	41,100
2001	1,232,600	27,400
2002	1,255,608	23,008
2003	1,270,608	15,000
2004	1,296,108	25,500
Source: California Department of Finance, EDD, The London Group Realty Advisors, Inc.

Growth will continue to be in the major office sub-markets. Investors understand the value there, but more importantly they understand the value of the entire region. This is a market that is busting loose as a prototype 21st century economic region. Adding up all of those numbers, it is a good club to be in.

Gary H. London is president of The London Group Realty Advisors Inc. For information visit londongroup.com or e-mail him at glondon@sandiegometro.com.