Emerald Plaza, which hails from the era nearly two decades ago when office construction boomed, remains a choice Class A property and was bought by The Irvine Co. for $123.5 million, or $339.32 a square foot.

The regional commercial office markets are very healthy and on track to reach their highest transaction volumes ever. Moreover, lease up (absorption) is strong and office building construction is robust, with most new construction at Class A levels. This is owed in no small part to a successfully diversified economy, growing office-oriented employment sectors and a geographic diversification of office construction.

In particular, the Downtown San Diego commercial office market is coming back. After four years of negative net absorption following a mild economic slowdown in 2000-2001 and no new office buildings, not many new tenants and stagnant lease rates, there appears to be life:

• The last two years have seen positive net absorption, with the market absorbing more than 50,000 square feet.
  
  
• Rents have been trending up due to growth in the dominant tenant sectors of law, finance and government. Average Class A monthly lease rates have increased 72 cents per square foot since 2000 and buildings now approach $2.86 per square foot (per month) although the vacancy rate is a bit high at 16 percent.
  
  
• Broadway 655 and DiamondView Tower are the first high-rise projects in more than 14 years in the Downtown market. The former is achieving rent levels of $3.42 per square foot, although it is not yet fully leased. Lease rates on existing office buildings have been slowly rebounding, as well.
  
  
• Lease transactions in 2006 have continued at a measured pace, with 50 transactions accounting for 221,251 square feet of gross absorbed space among Class A space.
  
  
• The recent sales activity reinforces San Diego’s perception as a safe harbor for institutional investors as well as private firms seeking markets with strong employment growth and low occupancy rates. Three sales in the first two quarters of 2006 have accounted for more than $330 million worth of activity.

Small Potatoes

The rising values of commercial office buildings allowed developer Rob Lankford to complete this year Broadway 655, Downtown’s first significant office building in 14 years.

As positive a story as this mostly is, Downtown is still “small potatoes” compared with the other leading office submarkets which, together, total 90 million square feet in space with more than 83 million square feet occupied and a vacancy rate of 9.5 percent. To put the commercial office market growth in perspective, there were 77 million square feet six years ago. That’s a growth of 13 million square feet, mostly in places like Carmel Valley, UTC, Mission Valley, and communities located along the northern interstates 5 and 15 corridors.

In the past two years, absorption has been well over 2 million square feet per year, a pace that appears to be continuing this year. But growth does not come without a price: About 8.7 million square feet of new office space will be completed in the county during the next two years. Based on the forecasted timing of deliverables, this future inventory is likely to increase the overall vacancy rate to 11.7 percent by the end of 2006 and 14.6 percent by 2007.

Yet lease rates countywide are now averaging about $2.47 per square foot and have been steadily rising over the past four years.

Dominant tenant types vary by market. While Downtown is mainly a repository for government, legal, finance and services, Del Mar Heights/Carmel Valley continues to attract high credit office tenants as well as companies from the biotechnology and medical sciences fields.

South County On Radar

One America Plaza set a San Diego office record when The Irvine Co. bought it for $300 million, $516.23 per square foot.

More than 200,000 square feet of new office space is under construction in Del Mar Heights/Carmel Valley and almost 200,000 square feet is under construction in UTC. Both of these markets are nearing capacity as developable land becomes increasingly scarce.

The development tide will begin shifting from these high-flying markets of the past two decades to Downtown, and then to South County, which is a sure bet as land inventory is abundant for all land uses, and many burgeoning master plans fully expect to accommodate persons who live and work in the same communities. While South County has never been on the commercial radar screen, it will no doubt show up over the next half-decade.

Activity will be bolstered Downtown because it is increasingly becoming a bona fide mixed-use environment. For some of the very same reasons that Carmel Valley and UTC exploded, proximity to large inventories of available housing, Downtown will blossom as thousands of new housing units will be built to supplement the 20,000 units already there. The only question is the pace of new development as the residential market has softened considerably.

But that is a cyclical thing. We are talking trends here. And the Downtown trend is up. If not yet convinced, consider what one company is doing to change the market. Nine Class A office buildings, totaling more than four million square feet of space have been sold in Downtown over the past three years, seven over the past year alone. Irvine Co. purchased six.

And it is apparently not the only investor that is bullish on Downtown. Of the top 10 deals over the past year, seven were in Downtown. Only Sorrento Mesa and Mission Valley posted deals outside of Downtown that made the list.

Put another way, Downtown had the highest total transaction volume, $1.6 billion!

Office Transaction Volume

In Sorrento Mesa, where telecom is king, IPERS paid $41.75 million, or $204.74 a square foot, for Center Park Plaza I & II.

Of the four major submarkets (Del Mar Heights, UTC, Sorrento Mesa and Downtown) over the past year, Downtown was by far the most active with 30 transactions (of all sizes), but not the most expensive.

UTC posted the highest transaction values. On volume of more than $200 million, the average per square foot volume was $450, although that was posted on relatively few (six) deals. Sorrento Mesa continues a torrid pace of sales, as well, posting 20 over the past year as it moves out of the technology slump of several years ago.

It also was a busy year for sales of $10 million or more, with 62 valued at $3.5 billion and totaling 12 million square feet of space.

The Top 10 deals represented barely 5 percent of transaction value. Clearly, market activity was spread around. Why?

The quarter billion dollars of office product sold in Kearny Mesa included Aero Office Park, which was bought for $19.6 million, or $192.16 a square foot, by Thomas M. Murray.

“Today’s San Diego commercial market has a lack of supply, not a lack of demand or capital,” says Dan Broderick, a broker with Eastdil Secured. He should know, having participated in brokering three of the Top 10 deals. San Diego is apparently an investor haven, although Broderick suggests that “many institutional investors are riding the market and letting their assets ‘play out,’” meaning they will hold on to them, expecting more growth in value, even though capitalization rates are at their lowest ever at less than 6 percent. This may or may not occur, but the brokerage community is suggesting that fewer buildings are selling than might normally be the case at this stage in the market.

The point is, expect more growth in lease rates throughout the county.

Growth In Employment

Growth in the kind of employment that occupies office buildings will continue in San Diego this year. We may add 20,000 new jobs in 2006. This is a relatively quiet year from the pace that has added more than 35,000 new jobs in the past, but still suggests successful economic growth in office-employment sectors. Overall, the unemployment rate is a low 4.2 percent.

The exciting part is that after years of commercial growth to the north, the market is starting to infill and shift south once again. And the region will be the better for it.

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 or e-mail him at glondon@sandiegometro.com.