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Is San Diego Heading for boom times?

Commercial real estate in San Diego County saw some lower vacancy rates and higher rents in 2015, but a new trend gained strength — increased creativity in office, retail and industrial uses and design.

The CoStar Group reported slightly higher vacancies for office and retail, and a drop for industrial properties. Annual rental rates dipped 1.9 percent for retail and rose 4.5 percent and 4.8 percent on industrial and office, respectively.

And despite a healthy increase of 37,500 jobs countywide, new commercial construction at year’s end totaled only 2.9 million square feet, less than 1 percent of the total inventory.

Commercial real estate vacancy rates, San Diego County 2010-2015

Vacancy rates, 2011-2015
Office Industrial Retail
2006 9.90% 7.40% 4.30%
2007 10.80% 7.40% 3.40%
2008 14.30% 8.50% 4.10%
2009 15.10% 11.10% 5.90%
2010 14.40% 10.70% 6.00%
2011 13.60% 10.60% 5.50%
2012 12.40% 9.20% 4.80%
2013 11.80% 8.20% 4.70%
2014 11.20% 6.80% 4.10%
2015 11.30% 5.10% 4.80%

Source: CoStar Group

But numbers aren’t everything, industry analysts and insiders say.

One need only step into the former T.R. Produce warehouse at Eighth Avenue and J Street in downtown San Diego to get a sense of the changing dynamics of the workaday world.

Underground Elephant, a digital marketing startup company with 98 employees, is pouring $3 million into the ultimate in creative office design. Basile Studio, mostly known for unique restaurant designs, has disrupted the usual office layout concept by fashioning a rural country town inside a brick facade.

When it opens this spring, the space will sport five, 100-year-old, transplanted olive trees and park benches, an old-fashioned school house for meetings, outhouse-looking restrooms and a sunken “living room” with shag carpet and plentiful power plugs and Internet connections.

“There’s a sense of demand for creative space like this,” said company spokesman Jarrod Russell. “It’s what the millennial generation aspires to work in. It’s great for talent attraction and retention, it’s great for a high-tech force. Companies, whether they’re a startup or a Fortune 500, are paying a lot more attention to culture, and you can’t build out a culture unless you have the office space to match.”

At ground level, Ralph Potter, Wells Fargo Bank’s Southern California vice president for construction equipment finance, looks out on the downtown skyline and sees 14 cranes in action, where none was evident during the recession. The bank’s construction industry “optimism quotient” dropped from a record 130 last year to a still optimistic 108 this year.

“I checked with my people today and they’re expecting this to be a very good year,” Potter said last week.

Several economic reports indicate the market might be poised for an upturn.

The American Institute of Architects said its architectural billings index in December was highest for Western states.

The latest Allen Matkins-UCLA Anderson Forecast commercial real estate survey of industry leaders declared, “California commercial real estate is booming once again and optimism about the future has not been dampened by the Fed’s interest rate policy.”

The Federal Reserve raised short-term interest rates by 0.25 percent a quarter of 1 percent at the end of 2015 — the first rate increase in a decade. The action came in response to what appeared to be a sustained and growing national economy heading toward full employment.

Jerry Nickelsburg, the Anderson Forecast’s chief economist, said San Diego is doing better in some respects than Los Angeles and Orange County in job creation.

“The highest-performing parts of the state are San Francisco and Silicon Valley,” he said. “But San Diego is not far behind.”

This far into an economic recovery, the construction industry should be running on all cylinders. But commercial development is not running at record levels. Experts point to several structural changes since the early-2000s boom:

Tougher loan underwriting standards

New zoning and building codes and environmental regulations

Less square feet required per office employee

More Internet purchasing and physical stores fighting back with “immersive” and “experiential” displays that entertain

Greater efficiency in warehousing and manufacturing as well as fewer building sites that constrain rapid industrial building growth

But with a steadily growing workforce and consumer demand, builders and employers are finding ways to use existing space more efficiently and creatively.

Top 5 commercial markets, 2015

Top 5 office submarkets Size Vacancy Annual rental rate Under construction
million sq.ft. per sq.ft. sq. ft.
Downtown 13.5 15.7% $29.01 0
Kearny Mesa 10.9 11.0% $25.25 0
Sorrento Mesa 9.7 13.9% $31.32 0
UTC 8.5 15.5% $39.27 64,832
Mission Valley 7.0 8.8% $27.66 0
County total 114.0 11.3% $29.55 623,581
Top 5 industrial submarkets Size Vacancy Annual rental rate Under construction
million sq.ft. per sq.ft. sq. ft.
Mira Mesa/Miramar 18.0 3.8% $11.90 0
Kearny Mesa 15.5 4.0% $15.41 0
Otay Mesa 15.4 6.8% $6.76 121,970
Carlsbad 13.7 11.1% $12.19 0
Vista 13.8 2.7% $8.80 17,950
County total 189.1 5.1% $8.80 1,845,708
Top 5 retail submarkets Size Vacancy Annual rental rate Under construction
million sq.ft. per sq.ft. sq. ft.
Escondido 10.2 4.8% $18.30 4,200
Chula Vista 8.9 5.3% $21.87 118,000
Oceanside 7.6 7.1% $20.71 850
San Diego-Midcity, Southeast 7.2 3.4% $16.20 0
Clairemont-Kearny Mesa 7.1 4.4% $18.49 2,310
County total 134.5 4.8% $21.82 395,013
Source: CoStar Group

Here’s a fourth-quarter 2015 look, sector by sector, at the commercial real estate market in San Diego County:

Office

Key indicators, 4th quarter 2015 (compared with 4th quarter 2014)

Vacancy rate: 11.3 percent, up from 11.2 percent

Annual rental rate: $29.55 per square foot, up $28.18

Under construction: 623,581 square feet in 12 buildings, down from 1.1 million square feet in 15 buildings

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Colliers International broker Derek Applbaum CQ said instead of building new office projects, developers are “repositioning” their existing properties to appeal to budding high-tech startup companies and downsizing legacy office users, such as lawyers, accountants and government bureaucrats.

“There’s going to be a need somewhere for that traditional use,” Applbaum said. “It’s just not as abundant as it once was.”

He said the upcoming 50,000-square-foot building in the Makers Quarter section of East Village downtown will illustrate what “collaborative” office space will look like as developers and interior designers toss out their traditional cubicle and private-office formulas.

He said the only high-rise office building that might start construction this year is Sunroad Enterprises’ second building at Kearny Villa Road and Spectrum Center Boulevard in Kearny Mesa. Projects proposed in downtown, Mission Valley and UTC have not yet reached the starting blocks.

photo
The former T.R. Produce warehouse at Eighth Avenue and J Street is being adapted to the corporate headquarters for Underground Elephant. As many at 150 employees will work there. — Peggy Peattie / San Diego Union-Tribune

Industrial

Key indicators, 4th quarter 2015 (compared with 4th quarter 2014)

Vacancy rate: 5.1 percent, down from 6.8 percent

Annual rental rate: $11.61 per square foot, up from $11.11 per square foot

Under construction: 1.8 million square feet in 15 buildings, up from 158,838 square feet in four buildings

Joe Anderson, JLL industrial broker, said 2015 marked an all-time low in vacancy rates and all-time high in rental rates.

“It’s the healthiest the industrial market has been in years,” he said. “We expect 2016 to be more of the same.”

Despite rising demand, only one major speculative industrial building, by Murphy Development in Otay Mesa, is under way. But more starts could be in the offing as other developers greenlight long-delayed plans.

But it’s not the faceless tenants that are filling up industrial spaces. Anderson said craft breweries and tasting rooms are becoming common in many industrial parks. Older industrial buildings in Sorrento Valley and Sorrento Mesa are being reconfigured and repurposed to higher and better uses, such as biomed and biotech research and development. Third-party logistics companies are searching for new space.

The impediment to meeting the demand is limited low-cost industrially zoned land in the central part of the county. Anderson said biotech companies are edging out traditional users and raising prices.

“If that slows down, we will see conversion slow down,” he said. “If it stays healthy, there’s no reason that shouldn’t continue.”

San Diego’s industrial sector, particularly along the border, stands to benefit from manufacturers “near-shoring” back to North America and specifically Tijuana now that labor costs are rising in China.

As for the general economy, further gyrations on Wall Street and international tensions could give pause to industrial developers. But Anderson said San Diego’s limited supply might benefit from a bit of a slowdown and take the pressure off rapidly growing tenants who are impatient to relocate and expand.

“As I sit here right now, I don’t see a huge problem in 2016,” he said.

Retail

Key indicators, 4th quarter 2015 (compared with 4th quarter 2014)

Vacancy rate: 4.8 percent, up from 4.7 percent

Annual rental rate: $21.82 per square foot, down from $22.25

Under construction: 395,013 square feet in 21 buildings, down from 437,619 square feet in 29 buildings

Reg Kobzi, a CBRE senior vice president specializing in retail, said the big retail trend is to catch millennials’ attention as they head toward urban centers. Owners are adapting old buildings to new, cool retail and restaurant uses.

“The more unique, sometimes, the better it is,” he said.

In the case of trendy local restaurants and nightclubs, the growing popularity of outdoor drinking and dining spaces saves money on building out interior tenant improvements.

For retail outlets, Kobzi said new concepts are having a hard time finding well-located storefronts in San Diego’s low-vacancy environment. To offer a newly built building or retail center, a developer has to cope with lengthy review processes and strict underwriter standards from lenders.

“You’ve got to get preleasing commitments (to secure financing) and the market changes in the three-to five-year entitlement time,” he said. “You start in the good (market) and end in the bad.”

As for mom-and-pop small businesses in strip centers on major boulevards, Kobzi said services, from fitness centers to nail salons, are more common than places selling physical goods.

“The public is very conscious in what they put in their bodies now and they are very health conscious,” he added.

While millennials are setting the trends, it’s the baby boomers who have the money. “They’re still the biggest piece of the pie that spends the money,” he said.

If the economy goes wobbly — economists now wonder if a recession is near — Kobzi said San Diego’s commercial real estate industry should weather the pullback relatively well.

“There’s always a flight to quality in San Diego,” he said. “From an investment standpoint, we’re safer than other markets.”