Strong tenant demand in 2017 leads to an overall positive net absorption for the year, but a slew of new construction and continued uptick in sublease availability prompts a cautious forecast ahead.

By Tucker Hughes

The Orange County commercial real estate market continued to show its strength through the end of 2017, with a positive net absorption of 306,000 SF in Q4 and 492,000 SF for 2017 overall. While not anemic, the absorption rate slowed dramatically from the prior 12-month period, largely as a result of new construction in the region. Asking rental rates saw a modest uptick from the prior quarter, and a healthy 4.2% increase from the prior year, as landlords continued to capitalize on strong tenant demand and lack of available inventory.

Despite a generally strong market overall, certain Orange County submarkets have performed differently than others. For example, Airport Area saw rental rates increase to $2.86 full service gross (FSG), but also saw 638,000 SF of new construction deliveries and a net absorption loss of 459,000 SF (i.e., more available space was added to the market than was leased). This phenomenon is likely the result of new high-priced inventory hitting the market versus actual appreciation of all existing assets. Several outliers, like Trammel Crow’s new project, The Boardwalk, are increasing and distorting the average rental rate, yet there are still competitive deals for tenants elsewhere. South County, for example, had 1.438 million SF of new deliveries and a positive net absorption of 322,000 SF, with flat rental rates at $2.65 FSG, the result of local developer and landlord Irvine Company bridging the cost delta between existing product and their new product to entice tenants to upgrade their space. Big bets by Irvine Company are paying off in strides, as exceptionally strong tenant demand throughout Irvine Spectrum gobbles up space as fast as it can be built, often before it’s even built. Recent significant transactions in the region include Vyaire Medical pre-leasing two full buildings for 185,000 SF at The Quad, Irvine Company’s newest project in Irvine Spectrum, Pathway Capital for 65,000 SF at The Boardwalk (bringing pre-leasing activity now to 20%), and American Advisors Group (AAG) for 54,000 SF at Irvine Towers.

Generally, positive net absorption and rising rental rates are two necessary—but not sufficient—signals of market strength, and must be considered in the context of the broader market as a whole. While there was positive net absorption in Orange County overall (i.e., more space was leased than was available), there was also a significant amount of new construction in 2017, resulting in increased vacancy rates—a historical indication of a softening real estate market.

As we pointed out over the summer, the combination of strong tenant demand and lack of supply has fueled the developers’ race to bring new product to the market. Positive developer sentiment and market optimism materialized in the form of 1.1 million square feet of new construction hitting the market in Q4 2017, with an additional 1.5 million currently under construction and delivering by Q3 in 2018. This increased supply helps explain why Orange County’s vacancy rate increased quarter over quarter in 2017 to 9.7% in Q4, despite overall positive net absorption figures. These figures may reveal a potential softening in the market as we head into 2018.

Despite a relatively significant amount of new construction hitting the market right now, we’re still well below prior booming development cycles. The 1.5 million square feet currently under construction represents only 1% of the regional building inventory, whereas in 2006 (at the brink of the recession) we saw 6.3 million square feet of new construction, representing 4.4% of total inventory. Given the current numbers, Orange County could be far from overbuilt, particularly if the absorption rate continues to appreciate for the next two years, outpacing existing inventories.

As further evidence of the need for a cautious outlook in the coming year, we ended 2017 with yet another quarter of increased sublease space availability. Available office sublease space increased to 900,000 SF in Q4, representing four straight quarters of increased sublease space, and a 51% increase from Q1. Increasing amounts of sublease space can indicate a softening market if it is the result of companies downsizing or going out of business, but it can also signal a strengthening if it’s the result of growing companies needing to expand into larger space.

Is the canary in the coal mine singing louder for all to heed the warning? Or will the developers’ ‘build it and they will come’ mentality pay off? These questions will loom as 2018 progresses. We will continue to keep a close watch on the market in the coming months to see whether local developers’ recent optimism creates an oversupply of inventory.