By David Marino
The effects of the pandemic are becoming crystal clear as to how it’s affecting the commercial real estate industry
Now that we are a full two quarters deep into the global recession caused by the COVID-19 virus, the effects of the pandemic are becoming crystal clear as to how it’s affecting the commercial real estate industry. Certainly, everyone understands that the retail, hospitality, travel and leisure and entertainment industry categories are completely distressed, to the extent that tens of thousands of businesses have already been lost and the retail real estate category is in complete chaos. However, one of the bright spots of this recession is that we have not seen a significant loss of the businesses in the region that occupy industrial, research lab and office facilities. While difficult to pin the causation, companies that operate in non-retail and non-hospitality facilities tend to be surviving, and in some cases thriving.
Throughout this challenging year, life science and medical device companies have continued to raise billions of dollars of capital. Flush with capital, biotech lab and medical device companies have leased over 1,000,000 SF of space in San Diego County since March. All of this has resulted in stable demand for laboratory space, and even stronger demand for industrial space. Also fueling industrial space demand has been the transition of consumer spending from retail to e-commerce, causing distribution companies to gobble up warehouse space in the region, resulting in over 1,000,000 SF of new warehouse leases in the region since March. In prior recessions, all asset categories of commercial real estate were affected in the same way and at the same time. However, this time it’s different. Certain markets like Sorrento Mesa and Miramar have actually seen availability rates decline to the lowest point in many years, particularly for space above 20,000 SF. In many cases, we are representing tenants that literally only have one option in the market that works well for them.
The story is very different for office space in the region, and throughout the country. There are two national trends that are causing an increase in supply in the office space category. The first is that sublease inventory is spiking as we continue to go through the recession, a trend that we identified back in March. Sublease inventory at cheaper rents and shorter terms is not only the leading edge indicator of a recession, but also a landlord‘s worst nightmare. The San Diego region is now up to just under 2,500,000 SF of office space, up from 1,700,000 SF a year ago—a 50% increase. While not good news for San Diego office landlords, this pales in comparison to what’s happened in major urban markets in California like San Francisco and Los Angeles, where office sublease inventory has almost doubled and now reaches 9M and 9.5M SF respectively. With some exceptions, most of the office space tenants that we are representing in the market right now are looking exclusively at sublease spaces, and getting beautifully built out furnished space at big discounts to market, with more flexible length of terms. This is what landlords have to contend with when trying to lease out their competing vacant space.
The second factor contributing to the distress of the office market is that many office tenants that have had leases expire since the pandemic started have not renewed their leases and have elected to operate until post-COVID without any office space, essentially foregoing having any significant office space until they can reassess their needs in the post pandemic reality. Further, many office tenants with lease expirations in the next six months are also choosing not to renew their lease for the same reason. This is more common for smaller companies with 50 or fewer employees that are working fully remote and have determined that eliminating the expense of office space is to their benefit. This has caused an uptick in San Diego County office space availability, where the availability of office space in the county has gone up three percent since the pandemic began, from 15.2 percent to 18.2 percent.
The effects of the virus have been felt most strongly in Downtown, where availability rates are up 9.3% since the pandemic began. The least affected market has been Kearny Mesa, where availability has only increased by slightly less than one percentage point. Even the historically strong UTC market has seen a 3.9% increase, but all other suburban markets have seen an increase in office space availability of anywhere from 2.3% to 4.7% in the last two quarters. But if we annualize this trend, the availability rates in Mission Valley and Del Mar Heights will increase by 5%, Carlsbad the I-15 corridor and UTC will increase 7-8%, Sorrento Mesa will increase by almost 10% annually, and Downtown will increase by almost 20%. This is the thing that landlords and their defensive listing brokerage firms don’t see coming. The number of companies that choose to sublease or abandon their space, versus reoccupy it, will continue to increase over time. But what’s coming in 2021 through 2023 is likely going to negatively impact the commercial real estate office market like never seen before.
We strongly believe that most tenants will come back to the office—this is backed up by our thousands of conversations with business leaders around the country since March. Many employees are suffering from fatigue, depression and work/life imbalance, or do not have appropriate remote working infrastructure, and most employers want their teams back into the office where collaboration, teamwork and creativity can flourish. The issue is that most tenants are going to come back smaller, as a result of reductions in force and the fact that anywhere between 10% to 25% of their employees will now see full-time or part-time remote working as a significant lifestyle benefit. Employers are now talking about remote working as an employee recruitment and retention necessity for some functions and employees. Office clients that we are working with for 2021 occupancies are generally targeting 60% to 80% of the space they leased pre-COVID. One tenant at a time, companies will be downsizing over the next several years as their leases expire, putting millions of square feet of office space back onto the market. It’s a phenomenon called “negative net absorption” whereby each quarter another couple of million square feet of office space will come back to the market through the collective rightsizing of corporate America. I’ve described this as death by 1,000 slices, and the effect on commercial real estate availability will be severe. Downtown, Carlsbad, Sorrento Mesa and Del Mar Heights are all already above 20% availability, it’s likely that the remaining submarkets of I-15 corridor, Kearny Mesa and Mission Valley will all edge up to 20% availability by the end of first quarter 2021, and UTC will find itself at 15%. If the last six months are any indicator of what the next year has in store, and unfortunately this appears to be the case, many submarkets in the region will find availability rates at 25% by the end of 2021, and 30% by the end of 2022.
As we continue to march into and through this brutal recession, business owners and executive teams will look to lean down their cost structure, and this coming soft market is good news for tenants that occupy office space and have leases expiring in 2021-2023. As we head into the holiday season, it’s always a time for reflection and appreciation. We are all looking forward to getting 2020 behind us, and we are also looking forward to representing our tenant clients in the new year. Make no mistake, we are heading into the softest market in two decades, where choices have never been better, and with rents and free rent that have not been this tenant-favorable in a decade. This is not the end of office space. Great companies will always seek out great space for their teams. Better to think of it like a 30-50% off sale.
David Marino is executive vice president of Hughes Marino, an award-winning commercial real estate company with offices across the nation. One of the top commercial brokers in all of Southern California, David possesses unrivaled, comprehensive market knowledge, and writes regularly about San Diego commercial real estate on his blog, Suburban Scoop. Contact David at 1-844-662-6635 or firstname.lastname@example.org to learn more.