Walls go up at Opus West Corp.’s Opus Point in Carlsbad. More North County development is expected this year.

Capital will be big this year. The only question is where to put it. The real estate market faltered so quickly from one year ago that the capital market seemed to be caught holding large investment bags. The real estate market needs deals. Its players are not going to find satisfaction in high-rise residential real estate, not this year nor in the foreseeable future. Why? Prices are stagnant or still dropping, while construction costs seem to be peaking, particularly for the components of vertical growth like steel and concrete.

On the other hand, wood prices are dropping precipitously, suggesting that neighborhood-type density condos and apartments can be feasible if the revenue is right. This may be the year of strong rental unit construction, where diminishing vacancies will allow rents to rise to meet the perennial demand. This situation partially is caused by prospective buyers delaying their purchase of a first home. That, in turn, will make the condo market slow for the foreseeable future.

Economically, this is a curious time. Employment and population growth are still positive, but there is a big psychological cloud hanging low over this market. People are spooked, mostly by the headlines, a little by their neighbor’s resale failing to sell, and by matching incomes against housing prices and wondering “where is the correlation?” The answer is: don’t bother to look for one because there isn’t one. Residential home prices peaked a year ago, have dropped this year (although not much, outside of the new home sector) and are likely, at best, to stagnate in 2007. Interest rates remain at unbelievable lows, which has had a great impact in preventing a further slide in the residential sector.

And what about commercial? One of my confidants in the commercial sector is calling 2007 a “year of transition.” I can’t do that because I called last year the year of transition. In 2006 the markets weakened. Here are the highlights of what 2007 will bring:

Need More Space? No Problem

Over the past year total office market inventory grew by 3 million square feet in San Diego County. That is about the same level of added inventory the region experienced over the past several years combined. However, “pipeline” counts suggest that by this time next year the inventory will grow by an additional 5 million square feet, which will be the largest one-year growth increase (to 97.7 million square feet) in the past eight years. Couple that with annual absorption of 1.4 million square feet, which is almost one-half the level of the previous two years, and it is no wonder that the office vacancy rate will increase from about a 10 percent level today to 14 percent by this time next year. Average lease rates in the county have increased significantly — 20 cents per square foot per month — over the past year, by far the largest rise of the decade.

The most active office submarkets have been in the north cities and county, principally along the Interstate 15 and Interstate 5 corridors, where most of the new construction has taken place, yet vacancy levels are now the highest, as are lease rates.

Finding Space To Build It

The county’s industrial sector posted modest gains in 2006 as 2 million square feet (mostly manufacturing, warehouse, incubator, etc.) were added to push total inventory to 143.5 million square feet. Most of it was occupied, as this sector has hovered around 6 percent vacancy since 2000. Rents have only increased marginally. Next year we project more of the same, with perhaps a slight increase in vacancy.

By far the largest increase in inventory is taking place in South County, which has now added 7 million square feet since 2000, although rent levels are substantially lower than the rest of the county’s submarkets.

Commercial and industrial construction and vacancy are particularly high in Carlsbad and Rancho Bernardo. In the past these areas have served as bellwethers to the fate of the county. Watch North County closely.

Looking through the numbers, we know this will a bad year for biotech incubators as capital is no longer flocking to start-ups.

Pricey Store Spaces

The retail sector has slowed, but remains strong. On growth of 500,000 square feet (to 27.5 million square feet) vacancy has crept to 5 percent because overall net absorption was only 73,000 square feet this year. However, this sector experienced negative absorption the year prior (following the three previous years, 2002-2004, of huge net absorption), suggesting that retail is now stabilizing. Anchored shopping centers are almost 100 percent leased. But what is really happening is a reshuffling of this sector countywide as new centers have opened in South County (two new shopping malls) and other centers have rehabbed and upgraded (Fashion Valley, for instance), while others are either in need of a facelift or adaptive revitalization to new uses. Average lease rates have jumped significantly over the past year, over 20 cents per square foot per month.

Overall Economic Indicators

San Diego County added about 19,000 jobs in 2006, which is on par with 2005’s job growth. The good news is unemployment has continued to decrease from 4.3 percent in 2005 to 4.0 percent in 2006.

Population growth increased by 27,000 (to 3.1 million), but most of this was attributable to “natural increase” (births) rather than net migration, which was about flat for the year

Most would attribute this modest growth in employment and population to a national economy that has been relatively stagnant over the past year, although housing costs do play a role.

One might expect that the combination of household income growth and a slowly deflating housing market will eventually boost the San Diego County economy, which is highly dependent on the construction sector for jobs. That is a reasonable expectation — over the long term — but not in the coming year. It will take all of 2007 for the economy to sort out hanging inventory in all sectors and settle on a new equilibrium.

Investment Advice

Our county remains better off than most. In the economic world, it is better to grow than not to grow, and that is exactly what has happened over the past year, albeit only modestly. And the overdevelopment across the real estate sectors was not excessive. Both the public builders and large institutional capital investors proved to be disciplined, dramatically slowing their activities early in the year, thereby keeping our economy largely intact.

This year we should continue to see decreases in overall pricing and valuation. It is hard to gauge to what extent, and the market has not dropped much to date. But for those with capital, regardless of whether they are a small investor or a large institution, reasons are plentiful to have confidence in the future, and to purchase now for that future. But do so soberly, based on modest increases in revenue such as rental income.

Builders should be more cautious. Make sure the deal passes a financial feasibility test. Do not assume, for this year at least, dramatic decreases in construction costs, nor aggressive increases in revenue. Make sure the pro forma uses numbers in the here and now.

Looking Toward The Future

The future of San Diego County is one of continued economic diversification, scarcity of land, increase in density, rehabilitation of buildings, revitalization of aging communities and good weather. In looking around the landscape, the region is responding to the challenges of economic and population growth. This remains a very good place to live.

The problem spots continue to be high housing costs relative to income, traffic congestion and the fiscal uncertainty in the city of San Diego. Let’s add a new one this year: the unsettling feeling one gets when looking south to Mexico. While the election of a new, good president of Mexico is promising for greater Mexico, the kidnappings and killings in Tijuana, environmental problems, illegal entry and the abysmally long and unpredictable border waits coming north play out as potential catastrophes for our economy.

This deserves highlighting because most of San Diego’s remaining vacant land lies near the border. By virtue of proximity, we are becoming more economically interdependent as nations. It is incomprehensible to me how our congressional delegation, state representatives, regional Chamber of Commerce and the various interest groups do not make the resolution of the problems at our international border a greater priority. Mexicans annually expend $4 billion on retail goods in San Diego County, much of our tourist and service infrastructure (jobs in hotels and restaurants) are dependent on Mexicans and there is a growing frenzy of Americans purchasing vacation homes along the Baja Peninsula.

The interdependence between our two nations is growing. And yet one feels we are hiding our head in the sand, with only modest solutions or downright silliness (and I put the now nullified Escondido illegal alien rent ordinance in that category).

So that is my challenge to San Diego for 2007 and beyond. Time to get started on an international resolution.

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