A rise in outpatient and medical office vacancies in San Diego in Q3 2024 is not what it seems. Instead, higher vacancy – now at its highest level since Q1 2022 — has been driven partly by building owners that have vacated office tenants to convert spaces they occupied to medical offices, according to new data from JLL.
The report found that owners planning this type of transformation are focusing on small to mid-sized blocks while also transitioning to triple net lease (NNN) rents.
“Ground-up MOB [medical office building] development is currently just 60,000 SF (one building). Modest supply relief is expected to come from a handful of pending and proposed conversion projects,” the report stated. It noted that high interest rates, inflated construction costs, lack of available land and other barriers to entry have stymied new MOB development. Indeed, new deliveries since 2014 have been on average over 81,226 square feet per year below demand.
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“With lengthy permit timelines and rising construction costs, tenants are opting to renew in place rather than incurring the expense of building out a new space,” the report said. It predicted that renewals would increase and MOB rents – that have historically risen about 3% a year – would climb by 4% to 5% because there is little vacancy in existing facilities.
Medical office sales in San Diego were active in Q3 2024, mainly for owner/user small to mid-size properties. Total sales in the quarter amounted to $183 million, averaging $316 per square foot. The average cap rate was 7.1%. In the months ahead, capital markets activity is expected to improve, while vacancies are set to drop.
Average direct asking rents in San Diego jumped 2.9% in the past year to a record high of $4.25 full-service gross per month – a trend likely to continue -- though the market also saw its third straight quarter of negative absorption. Average occupancy was 89.2%. The amount of new supply under construction is expected to remain flat.
“A broader range of office buildings, including one or two-story buildings in suburban locations, can be good candidates for full or partial conversion to medical office, so long as they are located near hospitals and areas with growing populations,” according to a 2022 national study by the Commercial Real Estate Development Association (NAIOP). It noted that developers often seek value-add opportunities since medical offices often generate higher rents and longer-term leases.
“An ideal building for conversion would be one that had wide corridors, ample ceiling heights, an appealing lobby, floor plates easy to subdivide and a robust sprinkler system,” NAIOP stated.
In the future, JLL predicted that technology will play a growing role in medical facility planning. “Health systems, providers and adjacent healthcare facilities will increasingly use AI to assist with decision making to improve efficiency and quality in care delivery, facilities management and real estate planning,” the report said.
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