Downtown San Diego Expected To Play A Starring Role In Office Development And Leasing

San Diego developers did not overbuild office product in the current real estate cycle or the last one. As a result, vacancy has declined and rents continue to rise, particularly in Downtown.

TSA Contracting president Terry Arnett, pictured center above with Steve Grimes and Tom Coan, said his company is staying busy now doing value-add upgrades, creative office conversions, and renovation of old warehouses to retail, “but I think there are some things in the near future that will create energy for new office product.”

He said the University of California San Diego’s recently announced plans to establish a satellite campus in Downtown will generate more office product to support the school. Arnett said JMI Realty, one of his clients, has a residential project rising in East Village and is looking for more opportunities there.

UCSD plans to acquire the 66k SF office component at Holland Partner Group’s Park & Market project for a satellite campus, a move experts believe will boost the city’s effort to create a tech/design hub in East Village, grow jobs and jump-start an innovation economy in Downtown.

Moderator Martin Togni (pictured right with Bradley Schnell), a partner at Allen Matkins San Diego, said in terms of construction in San Diego, “we’re priced pretty nicely.” He asked the panelists what they think are the biggest incentives for attracting firms to San Diego.

Cypress Office Properties principal Mark Wayne said when you look at the cost of living, occupancy and employee costs—particularly for tech companies—in the Bay Area, “San Diego, in my mind, is really a bargain, because you have the lifestyle, you have a lower cost of living—even though it’s not cheap to live here in San Diego—you’ve got lower occupancy costs. I think it’s very attractive, and I’m hopeful that we’re going to continue to see movement into San Diego from other markets, particularly from other California markets."

Google landed in Sorrento Mesa earlier this year, he said, and other companies are coming into San Diego because there is talent available, such as former Qualcomm employees and other types of engineers. “I’ve just heard a rumor that Google is taking space at the WeWork facility in Downtown,” Wayne said. “This is the kind of movement we’re hoping to see more momentum with.”

Arnett said the availability of a strong labor force for construction is another incentive for Bay Area companies to relocate to San Diego. While San Francisco has a large stock of older buildings that could be converted or replaced, there’s so much construction going on up there, he asked, “Where are you going to get the labor?” He said San Diego’s proximity to Mexico provides a labor advantage, because over the next year or two the region’s labor force is expected to expand. “We’re currently getting a good labor force out of Mexico on a daily basis.”

Wayne, pictured right with James Laverty, said rising office rents set off a “flight to value,” with companies moving to Class-B space. This, along with declining vacancy, has boosted prospects for value-add office investors. Togni suggested that might be why the 400k SF to 500k SF of Class-A space exited by Qualcomm over the last couple of years is being absorbed slowly. 

Wayne, who heads up Cypress’ acquisitions, told the audience that his company purchased five assets over the last year—two each in San Diego and Phoenix and one in Orange County—with a total of 1.4M SF and plans to invest $1M to $10M per property in upgrades.

Expecting the market to change as interest rates rise, he said, “We’re still relatively bullish, but being we're higher up in the cycle curve, we’re very focused on the highest quality and location, while still trying to find those value-add opportunities—which if you hunt hard enough, you can find them."

This year there clearly was a pause, Wayne said. "It’s been a little choppy, so we’ve seen pricing come down. We’ve been pretty aggressive on buying this year, and we’re hopeful that we’ll look back on 2016 and view it as a good time to buy, because there clearly was a dip in values as it relates to the investment arena.”

He said only a few new projects have come out of the ground in this cycle and the last and have been absorbed or sold to users. The Irvine Co built One La Jolla Center in UTC, and Kilroy Realty and American Assets Trust are building a couple of projects near Torrey Reserve.

While various suburban companies may move Downtown, Togni, who represents Illumina and other biotech firms, said life sciences/biotech companies are unlikely to be among them. “The challenge in Downtown is having space to create large floor plates for some end users, where going vertical doesn’t work.”

He said these companies require lab space, and so look for large campus-style facilities with large, open floor plates, which is one reason new industrial development and redevelopment of older office buildings and warehouses to biotech space are really hot areas right now. Wayne agreed, sharing how a biotech user recently told him that biotech/life sciences companies probably won’t locate in Downtown because it’s a cluster industry.

Wayne expects San Diego markets overall to continue to grow and create jobs in 2017, but at a slower rate than recent years. Downtown, however, may be the region’s star. “Downtown has the highest peak rents in all of San Diego,” he said. The Downtown submarket absorbed 50% of the region’s total positive net absorption over the last year, and the total may be greater by year's end. “The top buildings in Downtown have 4% vacancy, so there’s not a ton of available space in Downtown San Diego, so there will be a lot of development in the coming years.

“There is definitely much better demand in Downtown today than there ever has been, primarily from companies that aren’t your typical model like a law firm or government entity. They’re coming from the suburbs, and we’re definitely seeing tech movement, and UCSD’s announcement, that’s going to be a big shot in the arm for Downtown San Diego.

“All types of companies want to hire and retain good talent, and because the younger workforce is a big talent sector, particularly for tech-related companies, they want to be in an urban, walkable environment.” He mentioned companies opening offices in Downtown or recently signing up for space there. This includes Houzz.com; Classy, which has signed a lease for 25k SF at Diamond View Tower in East Village; Sionics Weapons Systems, which took 35k SF at One Columbia; and WeWork, which occupies 90k SF on six levels in the San Diego Union-Tribune building at 600 B St.

Wayne said while office rents will continue to grow in most markets, rents were impacted by tenant improvement costs that rose $10 to $15/SF when the state implemented changes to Title 24. The minimum wage increase will also impact rents.

Tongi asked Arnett if he thinks Downtown projects will have the types of amenities going into suburban projects. Arnett said amenities won’t be as extensive as in suburban projects, simply because of the price per square foot in Downtown.

He expects older buildings to be torn down and replaced with new product, but said it will take two years for UCSD's facility to begin generating office projects. “This is probably a good thing, because everyone on the construction side is so busy right now.” Arnett cited Cisterra’s Park & Market, which has a mix of hotel, retail, office and residential, as an example of the type of projects that will come out of the ground over the next few years.

Tongi asked the panel about other challenges or negatives for companies considering Downtown. He said while young people want a live/work/play environment, Downtown isn’t conducive to families with children in school. Arnett said the lack of for-sale housing, high rents and limited parking in Downtown were also deterrants. Wayne said the largest floor plate in a Downtown office tower is 50k SF, so a company’s growth potential is limited in terms of contiguous space.

Tong,i said San Diego has historically been viewed as a secondary market by institutional and foreign capital, but wanted to know if the panel thinks these capital sources will invest in San Diego in the near term.

“The bigger gateway markets, New York, San Francisco, LA, Boston and Seattle have priced up and cap rates have come down so far, I think that capital is still looking for returns, so it's looking in places like San Diego,” Wayne said. He said from an investment and value standpoint, there are lots of good things about San Diego. There’s been pretty good demand and rent growth, but pricing has come down because of capital markets and concerns about the debt market.

"But people have really stepped back this year and paused to see what’s happening,” he said. “The election, I think, will create some positives and some unknowns, but I do think that capital is coming. There’s still a ton of capital on the sidelines, billions of dollars in both domestic and foreign capital that needs placed in the next couple of years.”