The economy is fairly strong and demand for commercial space is robust. The question is, will this be enough to sustain a market that is likely to be impacted throughout 2006 by high costs of materials and labor, the ongoing saga of the city of San Diego’s fiscal demise and longer commutes for employees that will be further exacerbated by inefficient planning?
Many 2006 commercial office development projects will be “upside down” in terms of the relationship between revenue and costs. We are in a cycle in the market, to some extent unprecedented, where labor and material costs (steel, cement, etc.) are rising faster than revenue (sales prices and lease rates). Some analysts foresee costs rising from 5 percent to 15 percent over the next several years before stabilizing. If that happens, it is unlikely commercial revenue from leases and sales will be able to keep pace. Inevitably construction will slow if projects are not under construction or with signed contracts.
Will Business Benefit If Housing Prices Fall?
The residential market is in the initial stages of adjustment as demonstrated by the slowdown in sales pace. Housing prices may flatten; perhaps there will even be some downward movement throughout 2006.
If the high cost of San Diego housing has influenced the commercial markets by making it difficult for businesses to attract and retain employees, will a switch to a residential cycle with more stable prices positively affect the commercial markets? Perhaps.
There is a link between the cost of a home and the region’s ability to attract and retain new talent to fill jobs. While San Diego remains one of the nation’s superstars both in terms of economic growth as well as the type and diversity of jobs, the high cost of doing business here does push some companies to the brink, and occasionally out of town as in the case of Intel, Newgen and Aetna who moved out in 2005. Undoubtedly many factors go into these decisions, but employers do grumble when the employment retention package must include extraordinary housing dollars.
A slowdown in the housing market will help companies to rethink their considerations to move out. And they should. We are still on an economic roll. New jobs added to the San Diego region are expected to grow an average of 32,000 over the next four years. Jobs mean growth in real estate demand. And this has played out in all sectors.
The Office Market Conundrum
At the end of 2005 San Diego County office vacancy was about 10 percent. Brokers filled 2 million square feet of space in 2005, up 43 percent from 1.4 million square feet filled in 2004. About 3.3 million square feet of new office construction is under way.
The more sobering statistic is the amount of sublease space available on the market — nearly 4 million square feet. While down from the high of more than 7 million square feet available in 2002, it is still a very large number and will have the effect of holding down lease rates and dragging out the amount of time this space remains on the market.
Most of the new office construction is Downtown. The 655 Broadway building, a 454,000-square-foot, 23-story tower, opened late last year. It is the first new Class A office tower built Downtown in 14 years. Diamond View, a 15-story, 250,000-square-foot building next to Petco Park, is under construction and scheduled to open in the fall.
Rancho Bernardo and Poway markets saw the addition of more than 400,000 square feet.
Investors continue to be interested in San Diego commercial real estate. Recent sales include the Irvine Co. buying Downtown’s Wells Fargo building for $148 million and Symphony Towers for $134 million. In mid-2005 we explored other similarly large transactions, which continue to be driven by belief in future market conditions. The big numbers paid do not play out in positive cash flow in the short term. These companies are betting on San Diego’s long-term upside.
While vacancy has stabilized and/or increased in San Diego sub-markets in 2005, it can mainly be attributed to new office developments that have come online.
In the first three quarters of 2005, 34 new buildings were added to the regional market, totaling more than 1.6 million square feet.
Demand seems to be spread evenly throughout the region’s sub-markets. However, Downtown and North County office buildings have seen a surge of tenants being lured with increased amenities.
The trend of tenants in small office buildings businesses buying their buildings is evolving and will boost demand for space in “office condos.” That in turn may spur the construction of new office condos, or even conversions of existing buildings.
Industrial Demand To Continue
The industrial market added almost 2.5 million square feet in 2005, more than double the 1.2 million square feet it posted in 2004. Half of this new construction was in Otay Mesa.
The net industrial absorption in 2005 approached 2 million square feet, almost double the previous year. Industrial vacancy in 2005 was about 6.2 percent, slightly lower than 2004. The lowest vacancies are in Miramar (5.4 percent) and Kearny Mesa (3.2 percent).
While 2005 was a strong year, the brokerage community anticipates that 2006 will be stronger because there is a high demand for industrial product and few large new construction projects have been announced.
Some of the new, larger developments are really employment “campuses” rather than traditional, low density, low quality industrial. These include campuses on the new state Route 56: Santa Fe Summit (483,000 square feet) and Plaza 56 (680,000 square feet), both of which provide opportunities for either expansion or upgrades. Other interesting opportunities for larger corporate users will be in the Escondido Research & Technology Center and in Poway.
The new Highway 56 corridor, Mission Valley, Rancho Bernardo and other locations along the Interstate 15 corridor have experienced the highest demand. The South County market, mainly Otay Mesa, has the most vacancies, which will have to be burned off. Yet, there is new construction under way in this region.
About 9 million square feet of new industrial development will unfold over the next four to six years in Vista, Carlsbad and Escondido. The recent annual absorption in these submarkets has been 1 million square feet. It looks like a surplus in the making, which will impact lease rates and occupancy.
Strong Retail Evolution
The retail market was extremely healthy in 2005 and will continue to be so in 2006. The central San Diego market continues to be the strongest, and new construction has begun in South County, particularly Otay Ranch and Otay Mesa. However, much of the retail sector is trending toward recycling and upgrading of existing retail centers in this dynamic sector, which faces a scarcity of prime, developable properties.
Political Battles/Fiscal Uncertainty
Look for a political battle in the city of San Diego over whether to further regulate the placement of residential housing near employment centers. The battle is taking place on two fronts: the “conversion” of industrially zoned property, mostly in Otay Mesa, to mixed use projects, including residential, commercial office and retail; and the intrusion of housing projects in formerly exclusive industrial and commercial areas. Both phenomena theoretically reduce the inventory of purely industrial zoned property.
Although categories of incompatibility exist, the battle is likely to play out in the “gray” areas: employers arguing that the intrusion of residential housing means complaints by neighbors over noise and traffic, and residential developers arguing that “smart growth” means locating homes near jobs, and not further exacerbating the region’s transportation problems.
Underlying it all is the state of our government. The city of San Diego now stands as a textbook example of inept leadership. With the election of Jerry Sanders as mayor and the shift to a strong mayor form of government, perhaps 2006 is the year that the problems are identified, that the fiscal crisis bottoms out and that a plan of recovery is put into place.
A region cannot continue to prosper under a state of political and fiscal havoc. The year 2006 is a pivotal political year. If we come out of it with a plan and direction, the real estate markets will benefit.
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.