The Orange County office market is defying economic logic. Asking rents are rising dramatically, but demand is weakening and vacancy rates are increasing.
Overall rent jumped $2.71 in the first quarter to an average of $31.97. That was an increase of 9.3% for the quarter and 20.5% for the year.
At the same time, the overall availability rate rose to 14.2% from the fourth quarter’s rate of 12.6%. Leasing volume stood at 1.7 million square feet, the lowest level of activity in five years.
Several factors are contributing to the sky-high rental rates, including high construction costs for new development, escalated sale prices and centralization of ownership.
More than a dozen speculative office buildings were under construction in the airport and South County submarkets. Developers include The Irvine Company, Maguire Properties Inc., Hines Interests LP, Parker Properties LP and Opus West Corp.
The vast majority of space in these buildings has not been preleased. The rental rates required to compensate for the escalating construction costs are so high that these new class A buildings are not reasonable relocation options for most tenants.
The rates also directly conflict with the fact that the demand side of the market is softening. As such, leasing activity to date has been lackluster in these new developments and the market is taking notice.
The frenetic pace of office building sales activity remains remarkably robust and prices are highly inflated. Investors are aggressively competing for quality office buildings. The most significant specific market change occurred last year when the Irvine Co. bought Irvine Center Towers and Newport Gateway. By acquiring existing third-party office projects “off The Ranch,” the Irvine Co. seems to have encouraged other outside investors as to the future value of OC office buildings.
As a result, the market has recently experienced prices in excess of $375 per square foot based on capitalization rates below 6%. Such buyer confidence will likely continue to inflate rental rates until the reality and pressure of today’s declining demand require an adjustment.
Maguire’s pending buy of Blackstone Group’s former Equity Office Properties’ OC buildings will make Maguire the second largest office space landlord in the market. Maguire has already announced plans to immediately flip a portion of this portfolio.
The long-predicted collapse of the mortgage industry is now well underway. Orange County has the distinction of being the country’s capital of subprime lending businesses. This industry sector has been the dominant user of new office leasing for the last five years. Mortgage firms have been responsible for the majority of the positive absorption during this period.
Recently, several of the larger mortgage companies have announced major layoffs, bankruptcies and closures. One of the most notable examples is New Century Financial Corp., which announced it is filing for bankruptcy. This is particularly significant because New Century is the single largest tenant to have preleased one of the new developments; in fact, New Century’s 190,000-square-foot lease exceeds all of the market’s other preleasing activity combined.
The number of large contiguous blocks of space,100,000 square feet or more,has markedly increased during the past year. There were 27 such blocks, up from 23 in the fourth quarter and 13 a year ago.
Submarkets
The airport area saw the most dramatic increase in rents during the first quarter.
Class A asking rent rose from $33.68 in the fourth quarter to $36.34, and the class O rate increased from $24.35 to $28.23. The class O increase is attributable in large part to Maguire’s new building at 17885 Von Karman Ave. The 145,000-square-foot, five-story building is expected to be completed in the third quarter. Asking rent there is $30 per square foot, triple net.
However, not all of the rent increases can be attributed to new development. The highest asking rent in the county is at Plaza Tower, at 600 Anton Blvd. across from South Coast Plaza. Space on the top two floors of this building, built in 1991, is listed for $60 per square foot.
The overall availability rate in the airport area increased by 3.2 percentage points to 16.4%. The class A rate ended the first quarter up 3.4 percentage points to 19.2%.
North County class A rent increased by 17%, from $26.04 to $30.44, during the first quarter. Brea Corporate Place, at 135 S. State College Blvd., now is being marketed for $36 per square foot. The space is occupied by Capital Group Cos., but will be available in December when Capital moves to Irvine.
Overall availability in North County rose by 1.8 percentage points to 12.6%.
Looking Forward
As new developments will either be under construction or comfortably within their pro forma lease-up periods throughout 2007, reduction in their rental rates is not expected until sometime in 2008.
The balance of the market will likely remain below these rates and will take its cue as these changes take place. All indications are that the vital supply and demand statistics are going to continue to move in a tenant-friendly direction.
Analysis by Studley Inc.
