Nothing in life is perfect, but the suburban office markets of San Diego County have little to complain about at present in spite of the tepid biotech sector, once the crown jewel of the area's economy. Starting about 20 miles north of downtown San Diego, and extending northward from La Jolla and the University of California at San Diego, the county is awash in investor capital.

Prices are pushing towards the $300 per sq. ft. mark while cap rates are inching downward. This largely coastal region of ocean bluffs, green hills and Torrey pines continues to attract build-to-suit campuses for telecom, wireless, software and defense-related firms. Only the biotech sector is showing some weakness.

With that level of investor interest, it's not surprising that San Diego is in the grips of a genuine office boom, with nearly 3 million sq. ft. completed last year and another 5 million expected to come on line by the end of 2008, a trend that is expected to push normally lean vacancy rates into the double digits.

A local economy blushing with growth industries contributes to the charm of the locale as much as the ocean breezes and avocado groves, at least to investors. “The advantage of the San Diego market is that it's very diversified,” says Tyler Rose, treasurer of Los Angeles-based Kilroy Realty. The developer's current tenants, Rose adds, include “a little bit of everything,” such as software makers, telecom, health care, biotech and professional firms.

With five office and industrial complexes in various stages of development, Kilroy claims to be the most active developer in San Diego County. Projects include the 411,000 sq. ft. headquarters for equipment maker Cardinal Health in Sorrento Mesa, the largest industrial deal of the past year at $65 million. Another is the $147 million, 466,062 sq. ft. campus complex for software maker Intuit on the Highway 56 corridor about 25 miles north of downtown San Diego.

Rob Peddicord, chief operating officer of Los Angeles-based Arden Realty, has a simpler formulation for San Diego's appeal: “It's a growth market, it's gorgeous, and people want to live there.” For its part, Arden Realty spent $162 million in December for 10 suburban office buildings totalling 533,315 sq. ft. scattered among the city's northern suburbs, including Del Mar Heights, Sorrento Mesa, Kearny Mesa, Carmel Mountain Ranch and Rancho Bernardo. The seller was DRA Advisors LLC of New York.

In a separate transaction that demonstrated the cachet of attractive, oceanfront office space, KBS Realty Advisors of Newport Beach, Calif. spent a reported $120 million for an 80% interest in Paseo Del Mar. KBS paid Crescent Real Estate Equities, a Fort Worth, Texas-based REIT, $517 per sq. ft. for the 232,330 sq. ft. office complex in Carmel Valley, the highest recorded price paid last year.

Most of the suburbs, many with romantic-sounding names evocative of the old Spanish ranchos, are strung along an N-shaped system of roads. The left side of the N is Interstate 5, linking La Jolla, Torrey Pines Road and UC San Diego — together the heaviest concentration of biotech in the region — to Del Mar Heights, Del Mar, Solana Beach, Escondido and Carlsbad to the north.

The right side of the “N” is Interstate 15, the route to Mira Mesa, Carmel Mountain Ranch and Rancho Bernardo, and a primary target for future growth in the county. The diagonal line of the “N” is State Route 805 where Kearny Mesa and Sorrento Mesa lie, a cluster of telecom and Wi-Fi related businesses.

Mixed reviews

Still, investors might be forgiven for feeling jittery about San Diego. Some of the news coming out of California's southernmost county has not all been good. The region's biotech sector, the largest in the nation after Cambridge, Mass. and the San Francisco Bay Area, has been listless, and vacancy in the highly specialized buildings is slightly higher than it has been for the past three or four years.

Local industry observers have glumly stood by as three of the area's most prominent research institutes opened satellite offices in Florida, lured by that state's $1 billion in construction incentives.

New biotech start-ups, meanwhile, may languish from the loss of venture capital and Wall Street underwriting, both of which have largely pulled up stakes from San Diego in the past year, preferring to put their money into offshore companies with products ready to market.

On the Big Pharma front, some local economic development officials are anxiously watching whether Pfizer will downsize or even close its La Jolla operations, where 1,300 people currently work, as part of the New York-based drugmaker's well-publicized belt tightening in the wake of a $4 billion loss last year.

That dual picture of troubles in paradise for the biotech industry, amid a fast-growing suburban office market, is a cell phone snapshot — accurate, if slightly fuzzy — of present-day San Diego County. On the bright side, San Diego overall has limited exposure to the ups and downs of biotech, which is a small market compared to the whole, representing little more than 6 million sq. ft. in an inventory of 51 million sq. ft.

Fast-falling cap rates

The fundamentals of San Diego's market — an affluent community with a host of technology, life sciences and defense-related tenants — has attracted many investors in the past year. Unemployment is projected to remain steady at about 4%, according to the San Diego Regional Chamber of Commerce. “For the most part, the market is adding jobs, and all the indicators are positive,” says Nathan Moeder, principal of The London Group Realty Advisors Inc. in San Diego.

The London Group reports that the number of large office transactions valued at $5 million and above in San Diego reached 62 last year, more than double the number in 2000. Cap rates, while volatile, were trending downward to an average 5.9% in the fourth quarter of 2006, compared with 6.6% a year earlier.

On a year-to-year basis, cap rates have ratcheted down from 7.3% in 2004 to 6.7% in 2005 and down to 6% last year. Correspondingly, the sale prices of office buildings on a square-foot basis averaged $290 in 2006, up from $275 the previous year and $247 in 2004. Countywide, asking rents rose to $27.62 per sq. ft. in the fourth quarter of 2006 compared with $26.40 in 2005 and $24.40 in 2004. Little wonder, then, that San Diego has caught the attention of investors.

A boom in suburbia

Moeder expects vacancies countywide to peak in the 13% to 14% range before coming down again, but is confident that the market will burn through the inventory to be built in the immediate future.

Pre-leasing is one likely reason that vacancy rates may not rise any higher. While some developers remain content to build on spec without tenants lined up, several of San Diego County's most active developers are more conservative. Kilroy is among the developers careful not to water down its portfolio with empty space. “About 80% of our space is already leased coming on line,” says Rose.

Another local developer that is careful not to err on the speculative side is Voit Development Co. of Los Angeles, which has built or bought about 1 million sq. ft. in San Diego County. “We don't hold land and wait for the market to come to us,” says Voit's vice president of development, Peter Quinn. “[Sales velocity] has remained very constant because we have been building in markets with very low vacancy.”

Among Voit's projects in San Diego are the Chula Vista Commerce Center, a six-building, 184,000 sq. ft. complex in the city of Chula Vista just south of downtown San Diego, and a 41,500 sq. ft. Class-A office building in Mission Valley, just north of downtown off Interstate 8.

Although downtown San Diego has a grove of high-rise buildings and a 15-story tower currently under construction, the area is more of an attraction for law firms and financial services than technology and biotech tenants, who prefer suburban campuses.

“[Biotech companies] are going into corporate headquarters-type buildings, typically two-story, concrete tilt-up buildings,” says Voit's Quinn. Big Pharma, on the other hand, prefer large industrial buildings, which are fitted out with research equipment.

Starting pitch

Downtown San Diego, however, hasn't been ignored by investors. The Irvine Co., best known for its holdings in Orange County, Calif., has acquired 3 million sq. ft. of downtown office space in the past year in addition to 4 million sq. ft. of suburban product in the county. And in one of the largest deals of 2006, Legacy Partners of Foster City, Calif. paid $95.5 million for the 24-story 600 B Street in downtown San Diego, located just outside of the march of development surrounding Petco Park, the local baseball stadium.

Many San Diego residents were skeptical in 1998 that John Moores, owner of the San Diego Padres and chairman of JMI Realty, would be able to deliver on his promise to develop much of the area surrounding his then-unfinished baseball stadium on the east side of the CBD.

Moores had promised local residents that new property taxes generated by development in a 10-block area around the ballpark would pay back $169 million in municipal bonds that Moores needed to help him complete the $411 million ball park. Although controversial, local voters approved the deal in a ballot measure that year.

Few skeptics remain in 2007. The ballpark district is not only bursting with high-rise development, but it is also credited with helping stimulate the condominium and loft boom that only recently peaked in downtown San Diego. Simultaneous with the opening of the Petco Park in 2004 was the Omni San Diego/The Metropolitan Condominiums, a 511-room hotel coupled with 38 luxury condo units.

Since that time, Moores and JMI have developed the 235-room Hotel Solamar, while filling in pieces of Ballpark Village, a 3.2 million sq. ft. mixed-use district. The ballpark area is also the site of the only major office building currently under construction in downtown San Diego — the $80 million, 15-story DiamondView Tower at the Ballpark, scheduled for completion early this year. The developers are JMI and Cisterra Partners San Diego.

Office condo boomlet

The most interesting trend in downtown San Diego, however, is arguably the popularity of office condominiums. This product allows small businesses to own their own commercial space or simply to invest in downtown office space. To date, about 90 units in seven separate projects have come to market.

One notable example is the $25 million, nine-story Metrowork, which offers 27 office condo suites. The condos range in size from about 1,900 sq. ft. to 2,750 sq. ft. and are listed for prices starting in the low $600,000s. The developer is Berkson Realty Advisors, which is confident that it can find buyers in a market in which 90% of tenants occupy 10,000 sq. ft. or less.

Brad Perry, a Cushman & Wakefield broker who markets Metrowork, says sales figures for office condos are not available but that the Metrowork complex has entered escrow on 18 units to date. The building is still under construction and escrows cannot close before completion.

Although developers intended the office condos for owner-users, says Perry, many of the units in the past year were sold to investors who were expecting to “flip” the units after short holds. If so, those hopes have been dashed by a slowdown in sales, which has paralleled a slowdown in residential condo sales downtown, according to Perry.

Biotech, an anomaly

Amid all this activity, the travails of biotech, however temporary, seem like an anomaly. The contraction of several firms, including Pfizer and BioGen IDEC, dumped nearly 1 million sq. ft. of extra space into a market of little more than 6 million sq. ft., where vacancies typically were little more than 2% or 3%.

At the same time, the departure in the past year of venture capital and investment-bank underwriting for small, bio-tech start-ups meant that few new companies would be able to move into space left behind by other biotech firms. “It was the perfect storm,” says Tom Mercer, chairman of the Life Sciences Group at Colliers International. Mercer hopes that local owners will be able to subdivide at least some formerly single-user buildings.

Even though the low-rise, campus-style buildings near UC San Diego are reporting some vacancies, those conditions have not prevented Hines Interests and TIAA-CREF from starting construction this fall on 347,019 sq. ft. La Jolla Commons Tower near the campus of UC San Diego, which is more likely to attract professional firms than biotech entrepreneurs. Completion is expected in the second quarter of 2008.

If there is too much empty space for the moment in Torrey Pines, CB Richard Ellis broker Chris Pascale is taking a longer view of San Diego County. Given the high rate of construction, he sees the county rapidly running out of places to build.

“We're running out of land,” says Pascale. “It's not Manhattan here, but it's getting tight.” In light of the upcoming revision of the county's general plan, Pascale wonders if California's archetypally suburban city would be ready for the density and vertical development that he believes will be necessary to sustain the growth of San Diego County.

But that is tomorrow's problem. For the time being, the gray clouds on the edges of San Diego's big sky have not blotted out the sun.

Morris Newman is a Los Angeles-based writer.

SAN DIEGO - BY THE NUMBERS

METRO POPULATION:
2.82 million

Source: 2005 U.S. Census

UNEMPLOYMENT RATE: 3.9%

Source: U.S. Bureau of Labor Statistics

LARGEST PRIVATE EMPLOYERS*:

  1. Sharp Healthcare
    13,269 employees
  2. Scripps Health
    10,313 employees
  3. Kaiser Foundation
    7,386 employees
  4. Qualcomm Inc.
    6,000 employees

* county, non-government

Source: The Daily Transcript Sourcebook

METRO AREA VITAL SIGNS

Office:

11.8% vacancy, 3Q 2006

11.5% vacancy, 3Q 2005

$28.40 rent per sq. ft., 3Q 2006

$26.47 rent per sq. ft., 3Q 2005

Source: Reis Inc.

Multifamily:

3.3% vacancy, 3Q 2006

3.4% vacancy, 3Q 2005

$1,194 avg. effective rent, 3Q 2006

$1,145 avg. effective rent, 3Q 2005

Source: Reis Inc.

Retail:

3.3% vacancy, 3Q 2006

3.3% vacancy, 3Q 2005

$23.06 rent per sq. ft., 3Q 2006

$21.50 rent per sq. ft., 3Q 2005

Source: Reis Inc.

Industrial:

16.6% vacancy, 3Q 2006

15.7% vacancy, 3Q 2005

$4.41 rent per sq. ft., 3Q 2006

$4.51 rent per sq. ft., 3Q 2005

Source: Reis Inc.

Hotel:

79.01% occupancy, 4Q 2006

77.85% occupancy, 4Q 2005

$165.79 average daily rate, 4Q 2006

$154.76 average daily rate, 4Q 2005

Source: PKF Consulting

MAJOR PROJECTS:

La Jolla Commons Tower is a 15-story, 347,019 sq. ft. tower currently under construction in the University Town Center area of San Diego, near La Jolla and the University of California's San Diego campus. The architect is Paul Danna of DMJM Design of Los Angeles.

Developer: Hines Interests and TIAA-CREF

Completion: Spring 2008

Cost: $150 million, estimated

DiamondView Tower at the Ballpark is a 306,750 sq. ft., 15-story tower currently rising directly over right field of Petco Park, the home of the San Diego Padres baseball franchise. One of several high-rise developments in the immediate area of the stadium, DiamondView is the only major office building currently under construction in downtown San Diego. The architect is Carrier Johnson.

Developer: Cisterra Partners and JMI Realty

Completion: Mid-2007

Cost: $80 million