Which Office Submarkets Will Recover Next?

Part 2 of 2

SAN DIEGO—The Carlsbad and Downtown office markets are coming back to life, and Mission Valley and San Marcos have updated community plans that will change the face of commercial real estate in San Diego, Colliers International experts tell GlobeS.com. In part 2 of this exclusive overview, we spoke with the firm's Andy La Dow, Colliers' new regional managing director and downtown office expert; Chris Williams, North County office expert; and Derek Hulse, Central San Diego office expert, about which submarkets they see recovering next in San Diego and how the region compares to other Southern California markets. See part 1 for a rundown of the office trends each executive is seeing in his respective market.

GlobeSt.com: Many are saying Carlsbad is the next big office submarket to recover here. What other submarkets do you think will follow suit?

Williams: In North County, the recovery is already being seen on the I-15 corridor. Rents in class-A space have returned to near-peak levels, and this has had an elastic effect on class-B inventory. The last office lease I did for a tenant in B product in Rancho Bernardo was $2.20 per square foot. Most people don't think of Poway as an office market, but we've listed four of the five multitenant buildings there and they're full now. Pretty much everything is full, and we're marketing spaces that are not yet on the market. Carlsbad still has a 20%-vacant office market; it's whittling away at absorption and recovering, but it hasn't seen the drastic rebound we've seen on the I-15 corridor.

La Dow: Downtown is a lot like Carlsbad in that each end of the county is wagging its tail. In between, from Mission Valley up to Del Mar Heights, the class-A market is virtually full. There have been significant rental-rate increases, which is driving tenants out into lesser-quality space, which can be less efficient. Downtown has been lagging a bit on the demand side, and for the past four or five years there has been a flight to quality. So, there's a huge separation on statistics in class-A as compared to class-B or –C space. With the Irvine Co. owning more than 50% of the class-A market, they can dictate where the market goes and can handle the acceleration of Downtown rents without much risk. They've been successful in UTC, but there are not the pressures in UTC where you have a larger base of –B and –C buildings. In certain areas, spaces are being priced like Amazon in that those that have been sitting around the longest are flexible in their pricing and larger spaces are pushing those rents. Overall, most class-A buildings Downtown could get away with pushing rents.

Hulse: Moving north into Mission Valley—outside of Downtown, Mission Valley is the next live-work submarket. It has public transportation, freeway access, housing and office. Mission Valley is the number-one priority for community updates. San Diego is updating a lot of antiquated community plans, and it's a painful process. I've been part of this process in Mission Valley, where there's so much activity. There are about 22,000 residents today in Mission Valley, and they're looking to double that within the next 10 years. Right now, there are almost 4,500 apartment units coming online in this submarket, either under construction today or planned, including Civita, the Sudbury master plan; and a dense project by Dinerstein, a residential development company that is redeveloping a whole Bob Baker site; and Doug Manchester was going to build a class-A office on his site, but now that's changed to all residential.

I've seen this submarket transform in a positive way over the past few years, but it takes bodies coming in there to support residential growth. The community plan allows us to plan better for a more connected and walkable community. Anyone who lives in Mission Valley knows it's not that easy to get around, so they're opening up the river and extending the paths. There's a great natural environment running through the valley and out to the ocean. They're building new parks, and there's a river park planned. Residential is going in, and what will follow is taking some of these older office projects and repurposing them. It doesn't have to be “creative,” but it's taking what was great in the 1980s and doesn't work in 2015, and making it more contemporary and more naturally lit, with contemporary landscaping and design. This is all happening now.

GlobeSt.com: Compared to other major Southern California markets, how much to you think San Diego is embracing creative space?

Hulse: San Diego is a late adopter of a lot of trends; maybe it starts north and flows down south. If you look at other markets, you see a lot more creative space than you see here. But some people were pioneers here, like Cruzan Monroe, who was doing it before anyone. There are so many creative projects going on now; the market is embracing it and tenants are seeking it. Whether you call it boutique or creative, everyone is seeing a new, contemporary work environment. The challenge is, how do you buy a building in a market with a lot of rental growth and a lot of optimism about rents for a price that's low enough that you can invest money into that project to turn it around and sell it profitably? We have a perfect project we're working on now, but it's a challenge. It's not a fire sale, but the owners want their profit. It's more of a challenge. We are embracing it, but it has to be the right opportunity.

La Dow: It's more expensive to build out creative space in traditional office buildings, so we don't have the velocity of a lot of tech companies pushing that envelope non-stop in San Diego. Not to mention Title 24, ADA regulations, etc.—and rents are not supporting a complete gut redux. We're seeing hybrids, and it's certainly happening in second- or third-generation shell space. If the landlord is willing to demo, we're starting to see some hybrid-type office environments with partially open ceilings and progressive space—that's in high demand. But creative development is as much a cost thing as anything right now.

Williams: Ultimately, you have to differentiate between next-generation contemporary space and true creative space. There is a trend toward more contemporary, clean space. People want to come into newer, updated space, but not everyone needs that true creative environment. Some tenants want to have the pop factor in the reception area, but the workspace is still perimeter offices with open space and maybe a drop ceiling to help with noise issues. In Carlsbad in particular, there's a distinction between class-A creative space and industrial creative space, where you're repurposing a warehouse suite to be more of a fully conditioned office environment. That's significantly less of an investment—it still generates a return, but you don't have to spend as much. North County is really a tale of two cities—you have your large corporate users who are slow to adapt creative space, and you have Carlsbad, where people want to live by the beach and go surfing at lunch. You have to take into account when considering conversions what the demand is, where it's coming from and how to meet the needs of clients. You could have a modern finish but still traditional office structure. Not every company is going to a collaborative environment—it's all about flexibility and reaching the widest variety of tenants.

We work with architects closely to do an 80% build out and preserve the open areas as much as we can, but build out the reception area, a conference area, a huddle room and some private offices and reserve capital to finish out additional offices. This gives us flexibility in appealing to the widest variety of tenants we can.