By Tucker Hughes

The Orange County commercial real estate market remained strong through the final quarter of 2018. However, certain conditions–such as increased sublease availability and a slew of new construction–could signal that a market slowdown is looming.

Rental rates for office properties continued to increase due to strong tenant demand, with an average asking rate of $2.56 per square foot in the fourth quarter of 2018, up from $2.55 per square foot in the third quarter and representing a 2.3% annual growth rate. However, while rates were slightly higher the prior quarter, this represents the slowest annual growth rate in over six years (since January 2013).

The office vacancy rate decreased to 9.8% in the fourth quarter, down from 10.0% in the prior quarter. While decreasing vacancy rates typically signals a strengthening market, this slight dip in vacancies could be explained in part by the lack of new office product hitting the market in the final months of 2018. Only two new buildings were delivered in the fourth quarter for a total of 41,000 square feet, as compared to 365,000 square feet in the previous quarter. Approximately 1.3 million square feet of new office product is currently under construction and scheduled for delivery in the first and/or second quarters of 2019. As we have noted in prior market reports, this glut of new construction is expected to put downward pressure on rental rates as tenants begin to have more options and the decreasing vacancy rate we saw at the end of 2019 is likely to be short-lived.

Similarly, a cursory review of the Orange County industrial sector appears to indicate continued market strength but some fractures may be starting to develop. Rental rates for flex and industrial product crept slightly higher to $1.12 per square foot in the fourth quarter of 2018, up from $1.11 per square foot in the prior quarter. However, this represents a significant slowing in the rental growth rate on a year-over-year basis. At the same time, flex and industrial vacancy rates increased from 2.7% in the third quarter to 3.0% in the fourth quarter.

Overall sublease availability in the region continued to decline, ending the year at 4.1 million square feet for combined office, flex and industrial properties, down from 4.3 million square feet in the third quarter. Decreasing amounts of sublease space can indicate strong regional economic health. However, when the office market is separated out from flex and industrial, we see a different story. Vacant office sublease space increased to 1.5 million square feet at the end of 2018, up from 1.3 million square feet in the third quarter, and up by almost 500,000 square feet since the beginning of 2018. With the abundance of new office construction set to hit the market in the first half of 2019, tenants will begin to see more favorable market conditions as more options become available and landlords are pressured to reduce rental rates and make more concessions in order to remain competitive.

We will continue to keep a watchful eye on the market in hopes that developers’ recent optimism does not result in an oversupply of inventory that the market cannot bear, leading to an overall drag on the economy as we saw prior to the real estate market crash in 2007. As of now, the local economy in Orange County remains robust, with the unemployment rate at a mere 3.0% and tenant demand remains strong as local companies continue to grow and new tenants move into the area. These factors, combined with the expected reduction in rental rates mentioned above, are likely to result in a real estate market that is increasingly shifting in tenants’ favor as the year progresses, which of course is excellent news for our clients.