ORANGE COUNTY
Reeling from the current economic turmoil, Orange County’s exposure to the financial service and homebuilding sectors continues to hinder any semblance of stabilization across the office market.
The countywide vacancy rate rose 460 basis points in the third quarter to 16.1%. This marks the sharpest vacancy rate increase in the past decade, as vacancy was 11.5% in the third quarter of 2007.
One bright spot has been the resiliency of a few select industry sectors. Recent activity by law firms and technology, gaming software and healthcare companies has hinted at growth; these industries appear to be weathering the current credit crisis.
The smoke needs to clear from the financial and real estate crisis before the local office market can recover.
Expect that the credit crunch and continued hardships felt within the financial system to severely limit the availability of credit for the next 12 to 18 months, which in turn will hinder the OC office market. This will create a significant barrier to many traditional office investors, who in the past 10 years put a significant amount of debt on investments.
Eventually, this barrier will create opportunities for cash buyers. The investment market will cater to low-leverage or all-cash buyers who see buy opportunities due to vacancy, declining rents and downward pressure on the cash flow. Buyers will be able to purchase investments at a discounted rate and hold the property for the next upward trend in the market.
All agree that the long-term outlook for the region is positive; however, in the near term we expect a fundamental disconnect to remain, allowing for continued stagnation in activity and pricing in sales. OC’s asking lease rates are continuing their slide, and leasing activity remains sluggish even as landlords make concessions such as tenant-improvement allowances, relocation packages and free rent. In addition, tenants who are currently shopping the market are being more conservative with their growth projections, taking less space on average than in past years and locking in today’s rents.
While space is being absorbed, it is taking longer to get leases finalized, and more deals are stalling early in the negotiation processes, while tenants gauge the economy due to the financial crisis.
Based on current economic trends and uncertainty in the financial system, the OC market will take at least 12 to 18 months to start to show signs of a meaningful and lasting turnaround. Local industry watchers’ perception is that we are near the trough and things are not likely to get significantly worse in the near future, but it will take some time for confidence and activity to return to the point where prices will increase and excess space will be absorbed. As a result, expect another 10% to 15% decrease in office rents, as well as capitalization rates to increase 50 to 100 basis points during the next 12 months. Office leasing activity will decrease some 10%. Lastly, expect one more year of negative absorption. The vacancy rate likely will hover in the 20% range through 2009.
INLAND EMPIRE
Coming off the heels of sizable negative absorption and increasing vacancy rates in the first half of 2008, the third quarter was somewhat of a cool down. Quarterly absorption was negative 24,366 square feet compared to a more dramatic loss of 281,091 square feet just three months prior. There was also a fair resurgence of tenant interest as two credit unions signed notable leases in newer developments and Riverside County’s District Attorney office announced it is in negotiations to purchase a 260,000-square-foot building in downtown Riverside.
Although asking rents on the nicest office buildings have not seen a noticeable decline, effective rents have. Factor in that 1.5 million square feet has been built in 2008 thus far and available sublease space is nearing half a million square feet,
and you have a scenario where tenants, rather than landlords, are in the driver’s seat.
A changing of the guard will help leasing activity in the months ahead, particularly in the central business districts of Ontario and Riverside,both ground zeros for new office development in the region. More tertiary submarkets, however, will endure longer lease-up times.
Though speculative construction will level off in the months ahead and developers will delay groundbreakings until 40% to 55% preleasing has been recorded, tenants who want to tap into the region’s 4.1 million population will have multiple options in the next 12 months. To date, 1.5 million square feet of new construction has been built this year, and only 14% of this total has been absorbed.
A jump in construction completions nudged the vacancy rate to 19.9%,up 240 basis points from one year earlier, while monthly asking rates were down 8 cents for class B space but steady in class A space. Quarterly absorption, while in the red with a negative 24,336 square feet, was far less than the second quarter’s 281,091-square-foot loss. Although 2008 has been a year of contraction, landlords will become more flexible with their rents, eventually luring tenants.
SAN DIEGO
The growing uncertainty about the national economy continued to adversely affect San Diego’s office market in the third quarter. Tenant activity remained low and countywide quarterly absorption was negative 630,000 square feet for the fourth consecutive quarter, due largely to Central San Diego County.
The countywide direct vacancy rate of 15% was driven up by the increase in supply of office space due to downsizing by companies affected by the economic downturn. As a result, landlords are offering more concessions and are being more flexible with their lease terms in order to attract prospective tenants.
In light of the rapidly worsening credit crunch throughout the third quarter, investment and owner-user sale activity continued to fall as owners hold on to their assets and buyers wait for prices to fall further. According to Real Capital Analytics Inc., the total volume of transactions closed in San Diego year-to-date was $590.8 million, 7.7% of the total $7.7 billion volume in the Western Region. OC held 27%.
Most likely, the intensification of financial market turmoil will exert additional strain on San Diego’s office market in the upcoming months. Overall, rent growth is not expected to occur by year-end 2008.
Analysis by Grubb & Ellis Co.
