Professional Firms Getting Sticker Shock

SAN DIEGO—Proposed office lease terms in the San Diego submarkets of UTC, Carmel Valley and Sorrento Mesa are shocking tenants contemplating extending their leases, Colliers International's senior director, tenant advisory services, Ron Miller tells GlobeSt.com exclusively. Marcus & Millichap's 2015 office report states that San Diego's office market will take another step forward in 2015 as hiring remains on track and the threat of new supply is limited, and space demand began this year nearly 9% above the prior peak, with many firms scouring the market for larger footprints. In light of the improving office market here, we spoke with Miller about office rent trends he's seeing and how tenants are responding to the higher rates.

GlobeSt.com: What trends in class-A office rents are you seeing in San Diego?

Miller: Professional firms seeking new offices or contemplating extending their lease are shocked at the lease terms being proposed by landlords in areas like UTC, Carmel Valley and Sorrento Mesa as compared to their existing terms. Landlords are enjoying the rewards of the improving economy, low vacancies and limited supply of class-A office space.

Case in point: A consulting firm that leased office space in the Aventine (UTC) in mid-2012 for $2.85 per square foot per month and desiring to extend its lease was notified that its new “market rate” would be $4.25 per square foot. This is almost 41% higher than their scheduled monthly rate in the last year of their existing lease—an astonishing 14.5% annual compounded increase where the market has generally been in the 3% to 4.5% annual compounded range.

GlobeSt.com: How are office tenants responding to these unexpected higher rates?

Miller: For most firms, these rates are hard to stomach. However, for some firms that may have signed longer (seven-to-10-year) leases back in 2008-2009, their rental rate in the last year of their lease may be competitive with the new market rents.

Law firms that had signed long-term leases several years ago when “free rent” helped subsidize their relocation and significant tenant improvements are more in line with the current market rents that are accelerating as their leases mature. There are currently four law firms exploring full-floor lease options in Carmel Valley that should not be shocked by the asking rents at Kilroy's the Heights Del Mar ($4.90+ E asking rate) or American Assets' Torrey Reserve $4 triple-net (equivalent to a $4.90 + E asking rate) because it provides an opportunity to build-out new offices in a first-generation building while incorporating a customized workplace where they can accommodate more bodies in less space.

Rents are soaring in the North City West submarkets where $4-per-square-foot rents are becoming the norm in the class-A office sector. In UTC, with a 4.8% direct vacancy factor, there are six buildings with asking rents above $4 per square foot. In Carmel Valley, with a 7.4% direct vacancy factor, there are more than 10 buildings and counting.

GlobeSt.com: Which developers are leading the next wave of development?

Miller: The Irvine Co., which controls more than 65% of the UTC class-A office market, is nearing completion of One La Jolla Center with asking rents in the mid-$4-per-square-foot range. As of March, Neustar has committed to the entire 4^th floor of the 305,000-square-foot, 15-story tower. Neustar, which will be relocating from Carmel Valley in June, is already accustomed to paying $4-per-square-foot rents at its current Gateway at Torrey Hills office building.

Kilroy, which controls about 40% of the Carmel Valley class-A office market, is also well underway with the Heights Del Mar, comprising 73,000 square feet, with an expected delivery date of Q4 2015. Furthermore, Kilroy has plans for another approximate 480,000 square feet at One Paseo once that approval process has been settled.

Those who delay securing their new office lease risk valuable time to thoroughly identify opportunities that work within their price range. With landlords achieving higher rents and corresponding longer lease terms, it bodes well for the next wave of speculative office developments in North City West.

GlobeSt.com: What alternatives do companies have in this improving office market?

Miller: While effective rental rates are soaring, there are opportunities for tenants. There is a widening delta between the newer class-A office buildings and older class-A/class-B office buildings where the rent difference can be up to 50%. Furthermore, there are a number of great sublease opportunities where you will find significant discounted rent vs. leasing directly with landlords. Recent examples include Brain Corp. subleasing a full floor from Santarus and Acadia Pharmaceuticals subleasing two floors from Trion Worlds, both occurring in Kilroy Centre Del Mar. These subleases included free high-quality FF&E and a 33% rent discount as compared to a direct lease with Kilroy.