A year ago, looking at office sales of $10 million or more for fiscal 2006, we tallied on these pages 62 deals valued at $3.5 billion and totaling 12 million square feet. Today we see a slowing and transforming office market with 52 deals valued at $2.8 billion and totaling 7.7 million square feet in the fiscal year that ended June 30. Although sales, by our count, have declined, ground still is being broken for more than 4 million square feet of new office buildings around San Diego County. Rental rates and purchase prices remain high because of the investor demand for Class A office buildings in prime locations throughout the county.

Office Transaction Volume

The slowdown in sales activity is most apparent when comparing this year to two years ago. In the first three months of 2007, 15 office properties changed hands for a combined $454.4 million. The same three months of 2005 saw 21 transactions for a combined $897.4 million.

While total sales volume is declining, many investors are purchasing buildings at extremely high prices. This is keeping the sales market alive and people wondering what these buyers see. Famed investor Sam Zell provided a hint when during a visit here several months ago he declared the world market remains awash in capital and that with a limited supply of quality assets, one should not look for a rise in capitalization rates. In other words, he expects investors will continue to pay record prices for property.

San Diego County - Major Office Buildings Sales, 06/2006 to 07/2007 (Click for Larger View)

Of the county’s four major submarkets — Del Mar Heights, UTC, Sorrento Mesa and Downtown — UTC over the last year was the most active with nine transactions. Astonishingly, all the UTC properties were purchased by a single owner, The Irvine Co., for a total of $865 million and a square footage price average of $545. Now, not everyone is Irvine, a company with immense capital reserves. Irvine mostly ignores current market circumstances in favor of the long (and usually permanent) hold. It tries to drive the market (i.e. lease rates) up. If it succeeds, that might portend more new office development as increasing rents allow new deals to pencil.

Downtown remains in the hunt for trophy sales, most recently with the $210 million June sale of Advanced Equities Plaza, formerly known as Broadway 655. One has to hand it to Rob Lankford, who took a big risk in developing this structure in an uncertain market. He built to quality and produced a winner. This transaction accounts for nearly half (42 percent) of the sales volume in Downtown over the past year, where a bit more than $500 million in office property changed hands.

Also keeping the commercial brokers happy were Del Mar Heights, where sales totaled $280 million, and Sorrento Mesa with $300 million.

For buildings valued at $20 million or more, it was a busy 12 months with sales recording for 42 valued at a combined $1.5 billion and totaling 7 million square feet. Of the top 10 deals, five were in UTC with one each in Sorrento Mesa, Downtown, Mission Valley and Del Mar/Carmel Valley.

This market is so active that everything has been shopped, regardless of size, quality or location.

Notable New Towers

Some notable 2007 deliveries into the San Diego office market include Qualcomm Towers and DiamondView Tower. Qualcomm’s 450,000 square feet was delivered in the first quarter and is 100 percent occupied by company employees.

DiamondView, which also opened in the first quarter, has 86 percent of its 300,000 square feet leased. This is a building of note because it is located adjacent to Petco Park, with great design, excellent views and a unique location overlooking a ballfield. Originally, the east-lying properties adjacent to Petco were slated to be built for commercial. With the Downtown residential market sagging, DiamondView’s success — especially if it is sold at a premium — may spur more commercial building proposals in the area.

Some larger projects that still remain under construction include La Jolla Commons Office Tower at almost 350,000 square feet and Cardinal Health with more than 300,000 square feet.

In 2006, more than 2.8 million square feet of new office space was delivered in San Diego County. A year later, 5.1 million square feet came online. By the end of 2007, the under-construction office market will include 1.3 million square feet of preleased space with 1.9 million square feet available. In 2008, 175,000 square feet of preleased office space and 600,000 square feet of unleased office space likely will be delivered. For the overall San Diego office market, net absorption by mid-year 2007 was 589,875 square feet compared to a year ago when it was 450,000 square feet.

Where To, Prices?

The San Diego County commercial market has 210 Class A office buildings offering about 26 million square feet of office space. Nearly 3 million square feet of Class A space is under construction. A year ago the Class A inventory totaled 190 office buildings with approximately 24 million square feet of office space.

Lease rates have continued to rise since they averaged $2.14 per square foot in 2003. Rates now are averaging $2.66, up 0.6 percent from the beginning of the year. Class A lease rates average $3.08 per square foot, Class B lease rates average $2.53 per square foot and Class C rates average $1.84 per square foot.

Downtown is yet to witness the commercial office renaissance that many planners anticipated. The two new Class A towers, combined with several smaller office condominiums that are being delivered, suggest a viable market. Older building renovation will upgrade some space. Yet, most of the new construction remains in the suburban submarkets, including the northern and southern submarkets of San Diego County.

Commercial developers will find land still available in areas such as Otay Mesa, Carlsbad, Oceanside and southern San Diego, where we already have seen the recent completion of projects including the Oceanview Hills Corporate Center, Opus Point and Seagate Corporate Center. Because of this movement in development, Oceanside, Kearny Mesa and Otay Mesa were the submarkets that posted the highest second quarter net absorption.

As residential development continues to expand and mature in these edge submarkets, new commercial property will be built in an effort to accommodate those employees who live and work there and nearby. The Ryan commercial office development in Santee is an example of this phenomenon in a community that has never experienced professional employment growth.

Growth In Employment

While new jobs are being created, the growth in the county’s employment numbers will slow greatly this year, probably caused by the cyclical peaking of housing prices and resulting shedding of jobs in the residential industry. As this occurs, demand for office space will slow. From a gain of 35,000 jobs in 2005 and 20,000 jobs in 2006, we will see only 13,000 jobs added in 2007. However, the unemployment rate remains low.

Our employment market is going through some changes, continuing its gradual evolution from industrial to commercial-office-based jobs. Ultimately, this is healthy, bringing higher income employees into a very diversified and expansive San Diego job market. The trend also is, of course, good for the office market.

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.