Page 1 of 5 In the commercial real estate market, a year of transition has closed and a year of promise has opened. The national economy probably has seen the worst, and the stock markets seem to be improving. Consumer spending has been strong enough, the housing market has continued at a dynamic pace, and there is even the promise that business expansion is inevitable during the coming year. The big unknown, of course, is the impact of a prospective war in the Middle East. Uncertainty taints markets. But assuming that the war is over during the first quarter, the remainder of the year is likely to feel much more certain. The year 2003 might very well play out as the beginning of an economic recovery period. San Diego is positioned nicely for the recovery because the region simply has not participated in the recession at the same level as most other metropolitan areas, because of: Economic diversification where a debacle in a single economic cluster (high-tech) did not excessively impact our local economy. An unemployment rate that continues to hover just above 4 percent, putting it at two percentage points below the national number. A visitor industry that now has almost fully recovered from the shock of Sept. 11, reflected in near normal hotel occupancy levels, convention bookings and relatively strong visitor counts at tourist attractions. A growing military presence, which is likely to become even more important as defense and technology support industries expand in the region. Page 2 of 5 The addition of new people (increasingly owed to natural increase) and housing starts, suggesting that economic expansion is occurring in the region. However, it is unlikely that in the coming year we will experience a continuation of the strong bid-up in housing prices. It is more likely that mortgage interest rates, which are at very low levels, will start moving up and transaction activity will quiet. These factors will contribute to a flattening of housing prices, or at least a reduction in the level of the double-digit inflationary spiral. Also, construction starts should be higher this coming year as more condominiums will be added to the market, the result of state legislation calling for a moratorium on construction defect lawsuits over the initial delivery period of new units. Condominium developers and their insurers should gradually step back into the market during the coming 18 months. Following is a brief tour of the numbers: The Office Market In the commercial office sector, this past year wasn’t much for numbers, although it was something short of a bust. Among the shining moments was Downtown’s One America Plaza selling in December for $166 million, $293 per square foot, which was just a shade below replacement cost. The Aventine, UTC’s trophy property, sold in August for $75 million, or $312 per square foot. So the question is, why would sophisticated investors compete to purchase San Diego high-rises in a lethargic commercial market? Answer: confidence in the future. Let’s cut to the chase. A lot of money is chasing very few deals, owed in part to strong real estate performance, and in part to poor stock market performance. Most owners of commercial properties and portfolios are holding on to their assets. There simply isn’t much trading in the market. So when San Diego’s premier office projects came on the market, many suitors bid the price up to a level more reflective of a commercial market going somewhere than one stuck in the mud. Yet the current performance numbers are sobering. Regional vacancies over the past year have climbed to almost 12 percent, up from 11 percent last year. But in those 113 buildings (or 5 million square feet), that have come on the market since 2001, the vacancy level is 35 percent. Most of the weakness is along the coastal Interstate 5 tech corridor, including Del Mar Heights (24 percent), Carlsbad (22 percent) and Sorrento Mesa (20 percent). The entire North Cities market is hovering just below 17 percent vacant on an inventory of almost 22 million square feet of the regional 78 million square feet. Reported regional lease rates have stabilized at $1.80 per square foot, which was roughly last year’s average. Page 3 of 5 The prognosis for 2003 is relatively positive. Very little office space is under construction (750,000 square feet), meaning that eventually the market will settle down as the national economy turns around. Look for the numbers to improve gradually throughout the year as business expansions begin later in the year. Don’t look for any significant new starts, at least not early in the year, as commercial developers will hold back until they are convinced the market is headed in the right direction. The Industrial Market The region is home to 138.9 million square feet of industrial space, where the 6.3 percent vacancy rate is up slightly from last year’s 5 percent, representing 8.7 million square feet of empty space. As in all commercial and industrial sectors this year, absorption is relatively light. While this level of vacancy suggests a somewhat strong market, this is not a particularly dynamic sector at the moment, reflecting very little activity. The countywide average lease rate is 82 cents per square foot, about the same as last year. No significant industrial project is under construction. Similar to the commercial office sector, those industrial buildings added to the market since 2001 (roughly 3.9 million square feet) are experiencing more than 31 percent vacancy. However, a good sign is that the fringe markets of Carlsbad, Vista and Otay Mesa are experiencing declining vacancy rates from the 20 percent range to the 10 percent to 15 percent range. This is positive because the industrial market is the first to plummet in a recession and the first to gain strength in a recovery/expansion. Flex Flex, also known as research and development or R&D, supports about 36.8 million square feet, mainly in Carlsbad, Sorrento Mesa, Rancho Bernardo and Miramar. These spaces are so named because they can accommodate a variety of commercial or industrial users, including startups as well as mature businesses. Vacancy is 13 percent, up from last year’s 11.5 percent, continuing an unusually high vacancy rate for this sector. Buildings that have been completed since 2001, roughly 2.4 million square feet, are over 20 percent vacant. Very little new construction activity will occur in this sector. Retail Market More than 77 million square feet of retail space is sited around San Diego County. This total includes most shopping centers and big box type retailing. The vacancy rate is about 4 percent, which is a full point below last year. Builders have added 2.3 million square feet since 2001, but most of this space has leased up, the vacancy rate for this new inventory is a relatively low 6.4 percent. Only South County and Carlsbad have plans for large retail additions, suggesting a sector that will Page 4 of 5 hold firm in terms of performance over the coming year. Few retail projects are under construction, except for rehabilitation projects. The Opportunities The commercial investment and development opportunities for the coming year should include: Mixed Use: The new strategic framework plan (e.g. City of Villages) has been passed by the San Diego City Council, albeit a watered-down version. No matter: the city has to grow up (not out) and policymakers will be warm to creative new infill proposals. The amazing success of Downtown San Diego has contributed to a sense of optimism for other urban areas, which will lead to new projects. The thorny issue of how to pay for new improvements in infrastructure and services will not be solved, but will be faced during the coming year by a new City Council that is primed with newly elected, bright, proactive people able to tackle tough problems. Rehabilitation: A lot of older inventory in San Diego County is in need of revitalization. While most entrepreneurs hesitated to invest in older structures over the past couple of years as the prospect of rehabilitation did not come with the expectation of higher lease rates, this year could be different. A strengthening economy will infuse new economic capability into the commercial markets. Uncertainty War and terrorism create uncertainty. War probably is imminent but the outcome is certain. The uncertainty is how long it will take to tame Iraq, as well as the long-term ramifications of military exposure in the Middle East. This is not an insignificant question because America is likely to protect its allegiance to Israel as well as its access to oil without equivocation. Terrorism is more problematic. As was experienced with the attack on the World Trade Center, the goal of the terrorists is to cause fear by striking at unknown times. The cost to our society has already been borne disproportionately by the travel sector. But terrorists put a pall on many aspects of our society. Last year, I warned readers to watch out for over-optimism. This year I am cautioning that too much pessimism is unnecessary. San Diego is well positioned to be very strong economically over the coming years. We probably have borne the worst of the economic downturn, and it hasn’t been so bad, unless you happen to own an office building along the I-5 coastal corridor. But even if you are badly positioned in commercial real estate, your home has gained much value over the year. And with the “big boys” buying San Diego trophy real estate at record prices, in effect banking on an upside, it would be prudent to follow their lead. Page 5 of 5 The San Diego economy and its commercial real estate market are well poised for a steady recovery. Even if events appear murky today, by the second half of the year I would expect that we will all experience renewed clarity and an optimism that will carry us forward to a very respectable year. Gary H. London is president of The London Group Realty Advisors Inc., providing real estate consulting and economic analysis. Find him on the Web at www.londongroup.com.
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