By HEATHER BERGMAN
San Diego’s office market could be eyeing the peak this year.
With record-breaking returns produced last year for commercial real estate investors in San Diego County, some of the county’s real estate investment experts predict the first half of 2005 will be just as impressive.
Others warn that with the market as crowded as it is now, office market investors should “beware of a stampede” that may be coming later on.
Leasing fundamentals are strong, money is cheap and, despite historically low cap rates, institutional investors continue to allocate resources to the San Diego real estate market, according to panelists at the Certified Commercial Investment Member Real Estate Investment Forum earlier this month in La Jolla.
“This is an extremely interesting time in office market investment,” said panelist Steve Case, senior vice president of office leasing for the Irvine Company. “But at some point in this cycle, the herd’s going to get spooked. We’ve got to be close. It feels like the Nasdaq at 4500.”
The Irvine Co. owns Symphony Towers in downtown San Diego and was the buyer in one of the largest deals in the county last year,the purchase of downtown’s Wells Fargo Plaza for $148.3 million.
Increases in interest rates this year will create problems for leveraged investors, Case said. Although cap rates will likely remain stable in 2005, in the second half of the year, when pension funds reposition for 2006, they are expected to allocate capital away from commercial real estate, putting a damper on the commercial investment market in San Diego.
For now, San Diego commercial real estate investment is in rally mode.
Investors set a San Diego record in sales activity last year, with $5.4 billion in investment properties changing hands, versus $5.3 billion in 2003, according to Grubb & Ellis Co.
The largest deal last year was the June buy of downtown San Diego’s Emerald Plaza, Golden Eagle Plaza and Comerica Bank Tower for $247.4 million, or more than $245 per square foot.
“San Diego has experienced a dramatic recovery, with very positive net absorption, low vacancies and employment growth, supporting continued strength in the office market,” said Bert Dezzutti, regional senior vice president of Chicago-based Equity Office Properties Trust.
The office, industrial and retail markets all had solid recoveries in 2004, said Peter Quinn, vice president of development and acquisitions at Woodland Hills-based Voit Development Co.
“In general, the market was extraordinarily active on the sale of mature assets, which were selling at record low cap rates across all product types, and that was because there was more money out there looking for opportunities than there were opportunities to buy,” Quinn said.
Cap,or capitalization,rates are determined by dividing annual net operating income by the purchase price of a property. The number represents the return on real estate investment. The higher the cap rate, the better the income.
Low cap rates, which have “approached the 5s for high-end office buildings,” according to the Irvine Co.’s Case, have not yet deterred investors willing to take a short-term income hit now in exchange for big returns down the road. But he says this can’t continue forever.
“We have reached the top of the (office market) cycle,” Case said in his presentation at the real estate forum.
Case posed a pointed question: “(Is) office a good investment choice in 2005?” and offered a qualified reply.
For “hot money investors,” including 90% of commercial real estate market investors who lock up equity for three-year to seven-year holds, he said the answer is “No.”
“Yields are so low right now that if you don’t get upside on a sale, you could see your return actually go down,” Case said.
Rents in office buildings also are nowhere near the highs of 2000. Following the herd this late in the cycle isn’t the best strategy, he said, especially if the Federal Reserve Board continues to raise rates as expected. On the other hand, Case said long-term investors looking for quality office buildings to shelter income could post solid returns in the long run.
Case sees the office market in San Diego peaking in the middle of the year. He also sees cap rates approaching 4% for trophy assets, which he says “is pretty stunning given what these buildings traded for seven years back.”
San Diego’s healthy employment situation, constrained office supply and rising rents will support the market for the first half of the year, Case said. Others see these factors as justification for a strong second half of 2005, too.
“I predict continued capital market interest in San Diego across office and industrial products, and a number of new listings in the market support this hypothesis,” said Bob Prendergast, a director with San Diego-based Burnham Real Estate’s Capital Market Investment Group.
According to Case, however, “timing is everything” in San Diego’s office market.
During the holiday season, at social gatherings, he said he overheard too much discussion about the benefits of owning office buildings in San Diego.
His advice to commercial real estate investors in San Diego: “Whatever the cocktail investment conversation, do the opposite.”
Bergman is a staff reporter with the San Diego Business Journal.
