San Diego County direct vacancy at the end of 2011 sits at 16.0%, down from 16.9% at year-end 2010; this marks two consecutive years of positive growth after vacancy peaked in Q1 2010 at 17.3%.

Total net absorption for 2011 was positive 634,000 SF, far outpacing new inventory that came to market during the year. Significant occupancy gains in the Class A market – where 707,000 SF was absorbed – was balanced by 72,000 square feet of losses in the Class B & C office space thanks again to ‘flight to quality’ (Class B space did end 2011 in the black, with 42,000 SF of positive net absorption, Class C was -115,000 SF). Tenants eager to lock in the lowest lease rates in recent times have ‘traded up’ into superior office space while Class A pricing remains at (or even below) Class B levels.

Countywide, asking rents have stabilized and are even on the upswing in a few submarkets such as Del Mar Heights and Sorrento Mesa. These submarkets have historically enjoyed strong occupancy levels thanks to superior buildings, access, amenities, and growth within key industry clusters. Asking rents elsewhere are flat or have seen negligible changes.

Class A vacancy has dipped into single digits in a few key suburban markets such as Rancho Bernardo and Sorrento Mesa, which both sit at an astonishingly low 4.7% vacancy. Other submarkets such as Del Mar Heights and Kearny Mesa are also forecasted to join them in the single digits before year-end 2012. Other prominent submarkets like Mission Valley and UTC are poised to follow the trend of diminishing vacancy in coming quarters.

Large blocks of available contiguous space are dwindling rapidly, and, considering the 13 active tenant requirements for 100,000 SF or more in San Diego and only a handful of suitable spaces, tenants may be in for a fight if they don’t move fast and ink a lease in the near future.

There is no speculative development planned in 2012, however a few projects are being rehabbed/repositioned, such as TIAA-CRE’s new re-design and expansion of Del Mar Corporate Plaza in Del Mar Heights. Build-to-suit activity is also gathering steam given the lack of large blocks available for tenants.

According to Real Capital Analytics (tracks all building sales over $5M), total office sales volume in San Diego was up 51% year-over-year. Distressed sales have shown up in almost every submarket and pricing is trending downwards accordingly, as the average price per square foot at the end of the third quarter was 24% less than the previous quarter (encouragingly, it was only down 2% year over year).

The buyer pool saw some dramatic change in 2011 as institutional buyers exploded onto the scene making up nearly half of all buyers – after making up only 11% of the pool in 2010, and 33% in 2009. Surprisingly, REITs, who dominated in San Diego in 2010 with 55% of purchases, only deployed enough capital in 2011 to make up 12% of the buyer pool in 2011; users and private buyers were relatively unchanged while cross-border money dried up completely.

Forecast


Overall occupancy will continue to make a very modest improvement in 2012 given deal activity and current tenants in the market. Looking at the employment market, which drives office demand, job gains of 8,000 jobs in November in the PBS (Professional and Business Services) and Financial Services is very encouraging for positive growth in the next few quarters. Back-of-napkin calculations of 250 square feet per person yield 2,000,000 SF of demand from those additions alone. San Diego’s annual employment growth rate of 2.2% in 2011 is outpaced in California only by Silicon Valley (3.3%), which has the highest growth rate in the nation.

As the shrinking supply of Class A space begins to demand a scarcity premium, expect Class A effective rents to follow asking rents upward as the significant concession packages seen today diminish. The spread between Class A and B rents will begin to widen as this premium accelerates due to a lack of new construction. However, some Class B building owners may begin deep upgrade and renovation projects which will result in upward pressures on rent in those properties.

The availability of large blocks of quality office space continues to decline as the regular infusion of first-generation space seen over the last decade came to a halt in 2008. If activity levels seen in 2011 continue into 2012 and 2013 and no new projects break ground soon, there is a very real possibility that large tenants in the market will have little to no choices countywide for office space. In the most sought-after submarkets like Del Mar, Sorrento Mesa, and Rancho Bernardo, (Class A space particularly), this could potentially create a bidding war scenario.