If anyone in San Diego had forgotten that the region's commercial real estate sector remains in the grip of a severe economic downturn, they received a reminder when the county published its annual tax roll on July 1.

Taxable values declined for about 1,200 commercial properties, in most cases due to rising vacancies that reduced operating income. Amid the declines, institutional investors have renewed their interest in this Southern California city.

The tax assessor slashed the taxable value of the Sheraton San Diego Hotel & Marina, a local landmark, to $223.2 million, down 38% from its peak value of $362.3 million in 2006.

Even the iconic Petco Park dropped several million dollars in value to $185.6 million from $192.2 million. The six-year-old ballpark has come to symbolize the economic revival of downtown San Diego, but its value has suffered along with its neighbors in the tourist-oriented Gaslamp Quarter.

Lean times for finest city

Alan Nevin, director of economic research at San Diego-based MarketPointe Realty Advisors, says the commercial devaluations were a wake-up call. Often called America's Finest City by its residents, San Diego clearly has seen better days. Even so, there is a growing consensus that the worst is over and the commercial real estate market is poised for a rebound in 2011.

A stronger job market and a few growth industries will turn office and industrial space absorption positive this year after a three-year decline, according to Brian Driscoll, an investment specialist in the Capital Markets Group at San Diego-based Cassidy Turley BRE Commercial. “Most of the areas where we see some growth are defense-related companies, health, medical, technology and education.”

Direct industrial vacancy increased to 10.5% in the third quarter of 2010 from 7.1% in the third quarter of 2008, according to Cassidy Turley. In 2009, tenants returned more than 4.2 million sq. ft., or 2.5% of the San Diego region's industrial inventory, to the market. Countywide monthly asking rents for all industrial properties decreased 17% over the last two years to 81 cents per sq. ft. triple net in the third quarter of 2010. On the bright side, the industrial market saw an increase in leasing activity during the first three quarters of 2010.

A flight to quality in the office market has driven up occupancy in Class-A buildings in recent months, reflecting tenant expectations of economic growth and their desire to upgrade at reduced prices. Leases signed when the market was booming are difficult to renew without granting tenant concessions.

The majority of office tenants in San Diego occupy 30,000 sq. ft. or less. Recession-driven austerity is likely to spill over into the recovery, making office tenants slow to add workers or lease additional space.

With office absorption returning, capitalization rates are coming down. The average cap rate was 7.21% in the third quarter of 2010, compared with 7.6% a year earlier and 6.74% in the third quarter of 2008, reports Cassidy Turley.

The direct office vacancy rate county-wide hovered around 17% in the four quarters that ended Sept. 30, 2010. That compares with a rate of 18% in the third quarter of 2009 and 15% a year earlier.

The countywide average monthly asking rental rate for all classes was $2.27 per sq. ft. full service in the third quarter compared to $2.33 in the second quarter and $2.47 in the third quarter of 2009.

The regional vacancy rate for industrial was 10.5% in the third quarter of 2010 compared to 10.1% a year earlier and 7.1% in the third quarter of 2008.

Apartments heat up

One hot property type in San Diego is multifamily, where vacancy rates are expected to fall this year. “Apartments are sizzling because of the available financing that is out there,” says Driscoll. “A lot of people see vacancy rates dropping and that is a good combination of financing and cash flow.”

The 2010 multifamily vacancy rate through September was 4.10%, according to MarketPointe. Vacancy averaged 5.29% in 2009 and 2.25% in 2008.

Despite the increase in vacancies since the start of the recession, San Diego remains well below the national average apartment vacancy rate of 7.1%, according to Reis, a New York-based researcher. Stability in the rental market is due in part to the regional spike in home foreclosures that followed the end of the housing boom, sending many former homeowners in search of rentals.

Multifamily sales countywide totaled $550 million through the first three quarters of 2010 compared with $360 million recorded for all of 2009, reports Real Capital Analytics. Acquisitions increased to $340 million in the third quarter compared with $60 million in the second quarter and $150 million in the first quarter. Multifamily transaction volume leads the other property types and is expected to increase between 9% and 11% in 2011.

Lynn Reaser, chief economist for Point Loma Nazarene University in San Diego, estimates that commercial real estate vacancies peaked for all property types in 2010, and that 2011 will see renewed investor and tenant interest in apartments, warehouses and retail outlets.

Housing market holds the key

A gradual recovery in real estate fundamentals will parallel San Diego County's economic growth, predicts Reaser. The county's economy is diverse and will receive a lift from international trade in 2011, but housing will be the critical component of recovery.

“The housing industry was battered very hard by the recession, but it is showing signs of improvement.”

Don Ankeny, president and CEO of real estate firm Westcore Properties, notes that lenders have been reluctant to finance new commercial construction since the recession began. Some builders are moving ahead, however.

In downtown San Diego, work has begun on a 16-story, $380 million federal courthouse annex. The government project will catch the overflow of The Edward J. Schwartz U.S. Courthouse at Broadway and Front Street. The 467,000 sq. ft. tower is expected to firm up downtown's status as a regional hub for court-related activities.

Investors returning

Institutional investors have recognized that San Diego is on a recovery course, garnering renewed interest from TIAA-CREF, CalPERS, CalSTRS, TA Associates out of Boston and other public and private groups, says Driscoll.

“We meet with people three or four times a week who have, in some cases, billions of dollars to spend,” he says.

Southern California's high cost of living and the state government's ongoing budget problems haven't eroded investor confidence in the resiliency of San Diego's economy. Because of diversity, jobs come from many different sectors.

“We are not one-dimensional,” Driscoll says. “The tremendous university system is the cornerstone of the technology and research fields. There is a lot of intellectual capital in San Diego.”

Sales volume in San Diego for all property types totaled $1.6 billion during the first three quarters of 2010, an increase of 114% compared with the first three quarters of 2009, says Jolanta Campion, director of research at Cassidy Turley. Sales of multifamily and office properties led, followed by industrial and retail properties. REITs and private equity funds were the most active buyers in 2010.

Investors who expect to pick up property cheaply are likely to be disappointed, however. Jim Munson, vice president and managing director of Grub & Ellis Co.'s San Diego office, says most property owners are holding onto their commercial space in anticipation of the turnaround. Capital funds created to take advantage of struggling property owners have not been successful, he stresses. “We don't see the tremendous returns they were promising.”

Driscoll expects more distressed sales in the year ahead, however. “It will be an orderly disposal of assets over the next two to three years.”

Ever the military town, San Diego has benefited from defense spending. The city boasts one of the largest naval fleets in the world. Local facilities include Naval Base Point Loma and the Space and Naval Warfare Systems Center. Marine Corps facilities include Marine Corps Air Station Miramar and Marine Corps Recruit Depot San Diego.

In recent years, the Department of Defense has dropped more money in metropolitan San Diego than in any other region in the country, according to Cassidy Turley's 2011 commercial real estate forecast. In 2010, the department spent about $17.3 billion in San Diego County, according to a study by the nonprofit San Diego Military Advisory Council.

Retail on the rebound?

Although the worst of job cutting may be over, the labor market remains weak. After losing 106,800 jobs in the previous two years — a net decline of 8.1% — San Diego added just 8,000 jobs in the past year. Unemployment remains above 10%, although it is expected to drop to about 9% in 2011, according to a Moody's Analytics forecast that was updated on Sept. 20.

Nevin, the MarketPointe researcher, views 2011 as a comeback year for the retail sector. “Unlike places like Phoenix and Las Vegas, we are not saddled with a huge inventory of big empty boxes,” says Nevin. “There won't be much new construction because our market is in balance. We will need much more residential construction before we can justify building new shopping centers.”

Since the start of the recession, the countywide direct vacancy rate for retail has risen from 3.1% to 5.5%, reports Cassidy Turley, which tracks rentable retail centers of 50,000 sq. ft. and greater in most submarkets. Exceptions are the downtown and Uptown submarkets, where it tracks retail centers of 10,000 sq. ft. and greater.

Retail absorption languished in 2008 and 2009, and monthly asking rents had fallen to $2.06 per sq. ft. triple net as of mid-2010 from $2.21 per sq. ft. at year-end 2007. Net absorption turned positive in 2010, however, and vacancies dropped 60 basis points to 5.3% by mid-2010 from year-end 2009.

The entrepreneurial spirit is alive and well in San Diego despite recent challenges, says Eric Northbrook, an executive director with Cushman & Wakefield. The key to the recovery is putting people back to work, he adds. The pace of the recovery “comes down to employment growth and where these jobs will come from.”

Emmet Pierce is a San Diego-based writer.

SAN DIEGO: BY THE NUMBERS

POPULATION

3.08 million

Source: Moody's Analytics

UNEMPLOYMENT RATE:

10.4% (as of Dec. 17)

Source: California Employment Development Department

METRO AREA VITAL SIGNS
Office: Industrial:
17.1% vacancy 3Q 2010 10.5% vacancy 3Q 2010
18.0% vacancy 3Q 2009 10.1% vacancy 3Q 2009
$2.27 per sq. ft. 3Q 2010 $0.81 per sq. ft. 3Q 2010
$2.47 per sq. ft. 3Q 2009 $0.92 per sq. ft. 3Q 2009
Source: Cassidy Turley BRE Commercial (full-service asking rents are shown on a monthly basis)