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Who will take over those Nordstroms?

Zoom's effect on San Diego's landscape

Construction starts skyrocketed after Amazon’s 2.6- million-square-foot distribution center in Otay Mesa broke ground in [the second quarter of 2020].
Construction starts skyrocketed after Amazon’s 2.6- million-square-foot distribution center in Otay Mesa broke ground in [the second quarter of 2020].

No talk of the economic fallout from the covid-19 pandemic is complete without a nod to the commercial real estate market. While residential real estate commands record prices, thanks to a shortage of supply, the commercial real estate market remains mired in uncertainty.

Since the declaration of a global pandemic in mid-March, thousands of San Diego County white-collar workers have been sent home. Will they ever be sent back to the office? Or will remote working remain commonplace as businesses rethink the need for expensive office space?

Travel is down, particularly business travel. Occupancy rates at hotels have plummeted. Areas such as downtown, where hotels rely heavily on conventions, have been hit hard. Will business travel return to pre-pandemic levels? Or has Zoom permanently replaced the airplane?

Bars which don’t serve food remain closed. Restaurants, meanwhile, have had to either shut down or contend with restrictions such as takeout only (in the first two months of the pandemic), then no indoor dining, then severely restricted indoor dining. Will a night on the town ever look like it used to? And will these restaurants be able to pay their rents?

Stath Karras, the executive director of the Burnham-Moores Center for Real Estate at the University of San Diego, says “There’s just a lot of uncertainty, and this uncertainty is more time-related as opposed to uncertainty over whether product types will continue to exist.”

Retail stores, already under attack from online merchants, endured a two-month forced shutdown and are now desperate to woo back their customers. How can they pay rent under such circumstances?

And despite the housing shortage, owners of apartment buildings are contending with missed rent payments from legions of tenants whose livelihoods have been damaged by the state’s reaction — overreaction, many say — to covid-19. State and federal eviction bans make it impossible to replace non-paying tenants. Will things ever return to normal?

“I will tell you that the best minds in real estate are struggling over these questions, with no clear consensus,” says Stath Karras, the executive director of the Burnham-Moores Center for Real Estate at the University of San Diego.

“There’s just a lot of uncertainty, and this uncertainty is more time-related as opposed to uncertainty over whether product types will continue to exist. If we had a vaccine tomorrow, if people could congregate and go to restaurants and bars again, if they could travel again, things would be a lot different, a lot clearer.”

Lanz Correia of The Correia Group Professional Real Estate Services agrees with Karras that the question will things ever return to normal, “is the toughest question to answer right now. We have volatility and insecurity today, so predicting inevitability for tomorrow is a tall order.”

Uncertainty is the last thing you would expect from Karras. Silver-haired and bushy-browed, he comes across equal parts college professor and corporate titan, an expert in real estate with a knack for explaining the intricacies of the business to students — and reporters. He is a past chair of the San Diego Regional Economic Development Corporation, and earlier this year received a lifetime achievement award at the 2020 Commercial Real Estate Awards organized by the San Diego Business Journal.

While the future of commercial real estate may be cloudy, Karras remains bullish on commercial real estate as an investment. “The analogy I use is the stock market,” he says. “If GE stock is trading at $48 a share, would you pay $52? The answer is no. But would you pay $48, or less? Most likely. Real estate is the same. Would you pay historic values? No. But is there a price at which you would buy, say, a shopping center that’s having issues? Sure. That’s why you are seeing distressed asset funds starting to build up, with the thought that in the current environment, there may be opportunities to buy. Shopping centers, hotels. Hotels are getting slaughtered, and yet there are funds to buy distressed hotels.”

Lanz Correia of the Correia Group Professional Real Estate Services agrees with Karras that the question of whether things will ever return to normal “is the toughest question to answer right now. We have volatility and insecurity today, so predicting inevitability for tomorrow is a tall order. What we are seeing now are widespread changes that may continue and evolve, and will definitely be impactful for the foreseeable future.”

Tim Lopez is a lot more optimistic about the office market’s eventual recovery. “Have you tried working at home, with kids?” he asks. “It’s absolutely going to recover. I believe a majority of people want to go back to the office, especially with so many employers offering amenities like gyms and free food.”

Commercial real estate can be broadly defined as any property that is used for business activities, or intended to generate a profit, such as large apartment buildings. Commercial real estate includes retail space, office, hospitality, industrial, and large residential. Each commercial “food group,” a veteran San Diego commercial broker says, has its own opportunities and challenges.

The office vacancy rate in San Diego County during the second quarter has only risen one-tenth of one percentage point, to 10.7 percent, according to a newly published report on the local office market by the CoStar Group, an international company which provides analytics and marketing services to the commercial property industry.

Viasat just built a huge new campus in Carlsbad. Tim Lopez says. “They’re not just going to walk away from that.”

But that’s because many leases are long-term. “I don’t think we’ve felt the effect yet,” says Tim Lopez of KW Commercial in Carlsbad, who has been dealing with commercial real estate for more than 30 years. “It’s too soon. It’s only been six months, and those leases are generally five- or ten-year leases.”

According to CoStar, “As schools, businesses, and countless other ventures transition into a new normal to combat the spread of the coronavirus, the immediate and longer-term impact on the office market is still not fully known. Leasing volume has slowed. In fact, leasing volume in the second quarter recorded its lowest stretch since the depths of the Great Recession…. The impact of the coronavirus is likely to spread across the market’s office-using employers, as workers have transitioned to telecommuting. Office size requirements may change going forward, and new leasing has slowed notably.”

A CBRE report notes that “new leasing activity in the retail sector dropped to nearly a 10-year low in the second quarter, down nearly 50 percent from the first three months of 2020.”

“The big question is, when we get past the pandemic and people will again feel good about congregating, will things look the same?” Karras asks. “And the answer is, probably not. Office is a good example. People are now used to working remotely. It’s now been proven that while it may not be as efficient or productive, it provides flexibility and positive lifestyle changes. So as an employer, you might consider a structure that provides at least some level of telecommuting, and you might decrease the amount of office space you need. A lot of companies are looking at shared desk space: if one employee works at home two days a week and the other, three, you can use the same space just by scheduling them to come in on different days.”

And yet, Karras concedes, “I don’t think anyone knows the answer to how many people are going to physically go back to the office, and in what capacity. I teach a market analysis class, with 32 students, and I asked the students what percent of the workforce they think is going to go back to a physical office. The answers were as high as 80 percent and as low as 40 percent. No one really knows, and I don’t think we’re going to know for probably a year or a year and half, at the earliest.”

Correia agrees. “Office space is probably the toughest commercial market to project because it is so reliant on the profit and losses of each individual tenant,” he says. “How to proceed with office space has a lot of businesses flummoxed. On the one hand, business are learning employees can work remotely effectively, and on the other, they may have long-term leased space they feel the need to fill. Additional considerations include cost of utilities, maintenance, and even liability for employee and consumer welfare amidst a pandemic. Much like the proposed repurposing of Horton Plaza to a tech hub, I would not be surprised if we didn’t see some repurposing of office space, for example, to multi-family. We see a long-term need for housing in San Diego and there is already a national discussion regarding converting office space to housing.”

Lopez is a lot more optimistic about the office market’s eventual recovery. “Have you tried working at home, with kids?” he asks. “It’s absolutely going to recover. I believe a majority of people want to go back to the office, especially with so many employers offering amenities like gyms and free food. People miss that. They want to have that corner office. They want to eat snacks, and go to the fridge, and turn the air conditioner to 60 without having to worry about paying for it. People are tired of staying home. The Zoom thing is boring. They want to go out and meet and look people in the eye and say, ‘We have a deal.’”

Lopez also notes that many businesses have spent big bucks over the last few years improving the workspace by adding fitness centers, game rooms, and other amenities. “Take Viasat. They just built this huge new campus in Carlsbad,” he says. “They’re not just going to walk away from that.”

The market rental rate for office space in San Diego County is $35 per square foot, according to CoStar. Rent growth is currently cooling, and CoStar predicts that “as the office environment slowly grapples with the spread of the coronavirus, rent growth is expected to turn negative,” although the decline is not expected to be as much as it was during the Great Recession. The strongest markets are Del Mar Heights/Carmel Valley, Kearny Mesa, and Mission Valley. “Demand for traditional office space among tenants and investors in Kearny Mesa and Mission Valley remains high, while Del Mar Heights/Carmel Valley’s trophy offices and demand from legal and tech firms are driving growth,” CoStar says. Areas like downtown, “where the availability rate is already above 25 percent, could feel the impact of rent losses more deeply,” CoStar says.

The market price for office buildings is nearly $340 per square foot, about $100 lower than in Los Angeles, according to CoStar. “But pricing … is forecast to pull back amid slowing rent growth and demand,” CoStar says.

Retail has been hit particularly hard by the pandemic, particularly malls. Karras notes that malls were already undergoing a transition “to more experiential” because of e-commerce. “And part of that experiential transition has been more restaurants,” he says. “If you look at University Towne Center, for example, you see a lot more restaurants, a lot more places for people to congregate. But then retailers got hammered because of covid-19, and all those restaurants that allowed socializing had to put that on hold as well….”

“We’re never going to see malls come back the way they were,” Lopez adds. He notes that one of the largest mall operators, Simon Properties, is negotiating with Amazon to turn vacant Sears and JCPenney stores into distribution centers.

While malls may be getting hit particularly hard by the pandemic, the entire retail business “is under double attack” from e-commerce and state restrictions on “non-essential” businesses.

The only safe category, Karras maintains, are neighborhood centers anchored by service businesses like grocery stores and dry cleaners. “That retail model is still working pretty well,” he says.

According to the CoStar report, “San Diego’s retailers are likely to endure a stretch of turbulence that may exceed that of other property sectors as the economy has re-opened in fits and starts…. Nordstrom in Westfield North County closed as a result of the pandemic. Leasing has slowed notably since the middle of March after the statewide shelter in place order was issued. Since mid-March, San Diego recorded its lowest level of retail leasing in more than a decade through the second quarter, and with so much uncertainty in the air, it is not expected to pick up in the near term.”

A CBRE report underscores this, noting that “new leasing activity in the retail sector dropped to nearly a 10-year low in the second quarter, down nearly 50 percent from the first three months of 2020.”

The market rent for retail space in San Diego County, CoStar says, is just over $30 per square foot. Rent growth is also expected to turn negative before the end of the year.

Due to “substantial uncertainty in the retail market surrounding the spread of the coronavirus, sales activity.... Both deal flow and sales volume cooled notably in [the second quarter of 2020]. Both reached near-decade lows after nonessential retailers had shut down for two months.”

Over the past 12 months, 448 retail properties have sold for an average of $381 per square foot, per the CoStar report. “In April 2020, a private investor from Los Angeles paid $27.7 million ($630 per square foot) for a Vons grocery store on 30th Street in North Park…. And in May, a private trust purchased the Albertson’s grocery store in downtown San Diego for $22.2 million ($516/square foot) from a local party.”

The hospitality industry has been hit even harder than retail, Karras says. Recovery is coming, but it won’t be fast. On a national level, the weekly hotel occupancy rate just hit 50 percent for the first time since mid-March, according to STR, a data research firm serving the hospitality industry. STR data shows the local hotel occupancy in San Diego rate peaked at 79 percent in 2018, then dropped to 77 percent in 2019. In May, San Diego Tourism Authority data showed that average countywide occupancy rates dropped to as low as 24 percent among hotels that had remained open. Much of the drop has been attributed to a decline in business travel.

“Businesses have found that Zoom, in particular, has been effective enough that there’s a way to decrease business travel and the associated costs of business travel,” Karras says. “So once this is over, yes, we might not see as much business travel as we have in the past, but I think people will be anxious for vacation travel, which is good for San Diego, because San Diego is a tourist destination.” The recovery period for downtown hotels may take longer, he cautions, due to the lack of conventions.

One area of commercial real estate that’s doing just fine is industrial, fueled by the growth in e-commerce and the need for “last mile” distribution centers (“last mile” is a term used in supply chain and transportation circles to describe the movement of products from a transportation hub to the consumer’s home or place of business).

The CoStar report maintains “industrial space markets may be best positioned to weather the storm from the spread of the coronavirus, given the strength of the life science and logistics sectors…. Construction starts skyrocketed after Amazon’s 2.6- million-square-foot distribution center in Otay Mesa broke ground in [the second quarter of 2020]. That was one of several new leases for the e-commerce giant in San Diego. It committed to the 530,000-square-foot speculative Vantage Point in Poway during [the second quarter of 2020] and the spec RB Vista in Rancho Bernardo in [the third quarter of this year]. In all, Amazon has leased roughly 3.5 million square feet across San Diego since 2019.”

Karras isn’t surprised. With so many consumers ordering directly from Amazon and other e-commerce providers, a centralized warehouse is no longer sufficient, he says. For one thing, he says, because items are shipped directly to consumers instead of to stores, merchandise is no longer stacked onto space-saving pallets. “Every one of those little items is now in a box,” he says, “taking up three times as much space.”

And then there’s the speed of delivery. “People want things more quickly,” he says, “so you’re seeing more warehouse space closer to suburban areas. It’s all about getting that product to the customer today, or the next day. You can’t ship it from Riverside or Ontario; you need to have it close to the population centers, and that’s why you’re seeing industrial space continue to be in high demand.”

Lopez says it’s not only e-commerce giants snapping up warehouse space, it’s Amazon resellers. “You’ve got people trying to lease 4000, 5000, 10,000 square feet of industrial space because they are distributors for Amazon and they need the space for fulfillment,” he says.

Industrial rents in San Diego, according to CoStar, are averaging around $16 per square foot, and are expected to “stall and possibly fall in the near term… amid continued disruption from the coronavirus.” Industrial rent growth tends to be strongest among tech submarkets, CoStar says, noting that “Sorrento Mesa, Sorrento Valley, and UTC were all near the top of the market for the strongest annual rent growth in the past 12 months, and companies continue to seek expansion space for lab or life science requirements in those areas.” Otay Mesa has the cheapest industrial rents, with average rents less than $12 per square foot. “Tenants commonly lease space here for less than $6/square foot and are frequently involved in the movement of products coming from Mexico,” CoStar says. “Asking rents for new space typically fall under $12/square foot. For instance, Mad Engine’s deal at the newly built Siempre Viva Business Park in 2019 had an asking rate of $9.84/square foot.”

On the sales end, Otay Mesa also has the most available land at the lowest prices, according to CoStar. Developers can often acquire land for less than $15 per square foot. The 65 acres on which Atlanta-based Seefried Properties is building Amazon’s distribution center sold for about $8 per square foot in 2019.

The multi-family residential market — apartments — is in good shape, although the pressing need for more housing is tempered by the high unemployment rate and the inability of some tenants to pay their rent. “Everyone needs a place to live,” Karras says. “The big issue here is: now that government subsidies are starting to wear off, what are collections going to look like?”

“We don’t have enough multi-family housing in San Diego,” Lopez asserts. “Look at what’s happening in Carlsbad. By 2029, to satisfy state requirements, the city needs to have 3900 additional housing units, so that’s 487 units a year over the next eight years. And of those 3900 units, 2100 have to be affordable for people with very low to moderate incomes. That means apartments.”

No surprise, then, that multi-family housing “is flying off the shelves,” Lopez says. Adding to the frenzy is the fact that some landlords are panicking because tenants aren’t paying their rents and evictions are on hold. “In a market like here, there’s blood in the water,” he says. “And that’s when sharks feed.”

Landlords may be in for a rough time. According to the CoStar report, “demand has slowed … and vacancies may rise above the level of the Great Recession. At the same time, rent growth decelerated in mid-March through April. That is the first time rent growth slowed in the spring since the Great Recession, resulting in rents falling in the first half of the year. Rent levels largely stabilized by the end of May, but that came at a time when rent growth typically surges heading into the summer. California passed a state-wide rent cap measure in October 2019 that limits annual rent increases to 5 percent plus local inflation. That figure is set at 7.2 percent for San Diego in 2020, which most assuredly will not come into play this year….”

Rents in big apartment buildings are averaging $2.20 per square foot, according to CoStar. The typical market rent for a one-bedroom apartment in San Diego is just north of $1600, with two-bedroom units going for $2000 and three bedrooms for $2500.

Over the past 12 months, CoStar says, 385 apartment buildings have sold at an average purchase price of $6.1 million, or $282,000 per unit. The average price per square foot is $416. A 16-unit apartment building in University Heights is currently listed for sale for $6.7 million. That’s $418,750 per unit, or $547 per square foot. The building is located on the 4300 block of Mississippi Street and was constructed in 1956.

A new report by the market research journal Visual Capitalist found that nationwide, the default rate among hotel and retail properties funded by commercial mortgage-backed securities debt soared 792 percent between May and June. “Ratings agencies are growing increasingly nervous about the... business side of the residential mortgage-backed securities market that touched off the 2008 global financial crisis.”

Lopez isn’t overly concerned. “People want to own commercial property in Southern California. I don’t think it’s ever going to be a bad buy. I think a lot of it is overpriced, and one reason for that is that buyers aren’t necessarily looking at cash flow, they’re looking at depreciation, where they can take a tax break.”

Karras isn’t worried either. “At the end of the day, if you think about what drives demand for almost all of this product, it’s employment. If you have good employment, if people have disposable income, people are likely to buy things, eat out at restaurants, and travel. And I think we’re pretty well positioned, from an overall standpoint. San Diego has a pretty diverse economy. Military isn’t going anywhere, so you have military and spending associated with it. You have tourism, once we get through the pandemic. And San Diego is a very robust technology center that should have pretty good employment growth. I think San Diego will fare fine over the long term.”

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Construction starts skyrocketed after Amazon’s 2.6- million-square-foot distribution center in Otay Mesa broke ground in [the second quarter of 2020].
Construction starts skyrocketed after Amazon’s 2.6- million-square-foot distribution center in Otay Mesa broke ground in [the second quarter of 2020].

No talk of the economic fallout from the covid-19 pandemic is complete without a nod to the commercial real estate market. While residential real estate commands record prices, thanks to a shortage of supply, the commercial real estate market remains mired in uncertainty.

Since the declaration of a global pandemic in mid-March, thousands of San Diego County white-collar workers have been sent home. Will they ever be sent back to the office? Or will remote working remain commonplace as businesses rethink the need for expensive office space?

Travel is down, particularly business travel. Occupancy rates at hotels have plummeted. Areas such as downtown, where hotels rely heavily on conventions, have been hit hard. Will business travel return to pre-pandemic levels? Or has Zoom permanently replaced the airplane?

Bars which don’t serve food remain closed. Restaurants, meanwhile, have had to either shut down or contend with restrictions such as takeout only (in the first two months of the pandemic), then no indoor dining, then severely restricted indoor dining. Will a night on the town ever look like it used to? And will these restaurants be able to pay their rents?

Stath Karras, the executive director of the Burnham-Moores Center for Real Estate at the University of San Diego, says “There’s just a lot of uncertainty, and this uncertainty is more time-related as opposed to uncertainty over whether product types will continue to exist.”

Retail stores, already under attack from online merchants, endured a two-month forced shutdown and are now desperate to woo back their customers. How can they pay rent under such circumstances?

And despite the housing shortage, owners of apartment buildings are contending with missed rent payments from legions of tenants whose livelihoods have been damaged by the state’s reaction — overreaction, many say — to covid-19. State and federal eviction bans make it impossible to replace non-paying tenants. Will things ever return to normal?

“I will tell you that the best minds in real estate are struggling over these questions, with no clear consensus,” says Stath Karras, the executive director of the Burnham-Moores Center for Real Estate at the University of San Diego.

“There’s just a lot of uncertainty, and this uncertainty is more time-related as opposed to uncertainty over whether product types will continue to exist. If we had a vaccine tomorrow, if people could congregate and go to restaurants and bars again, if they could travel again, things would be a lot different, a lot clearer.”

Lanz Correia of The Correia Group Professional Real Estate Services agrees with Karras that the question will things ever return to normal, “is the toughest question to answer right now. We have volatility and insecurity today, so predicting inevitability for tomorrow is a tall order.”

Uncertainty is the last thing you would expect from Karras. Silver-haired and bushy-browed, he comes across equal parts college professor and corporate titan, an expert in real estate with a knack for explaining the intricacies of the business to students — and reporters. He is a past chair of the San Diego Regional Economic Development Corporation, and earlier this year received a lifetime achievement award at the 2020 Commercial Real Estate Awards organized by the San Diego Business Journal.

While the future of commercial real estate may be cloudy, Karras remains bullish on commercial real estate as an investment. “The analogy I use is the stock market,” he says. “If GE stock is trading at $48 a share, would you pay $52? The answer is no. But would you pay $48, or less? Most likely. Real estate is the same. Would you pay historic values? No. But is there a price at which you would buy, say, a shopping center that’s having issues? Sure. That’s why you are seeing distressed asset funds starting to build up, with the thought that in the current environment, there may be opportunities to buy. Shopping centers, hotels. Hotels are getting slaughtered, and yet there are funds to buy distressed hotels.”

Lanz Correia of the Correia Group Professional Real Estate Services agrees with Karras that the question of whether things will ever return to normal “is the toughest question to answer right now. We have volatility and insecurity today, so predicting inevitability for tomorrow is a tall order. What we are seeing now are widespread changes that may continue and evolve, and will definitely be impactful for the foreseeable future.”

Tim Lopez is a lot more optimistic about the office market’s eventual recovery. “Have you tried working at home, with kids?” he asks. “It’s absolutely going to recover. I believe a majority of people want to go back to the office, especially with so many employers offering amenities like gyms and free food.”

Commercial real estate can be broadly defined as any property that is used for business activities, or intended to generate a profit, such as large apartment buildings. Commercial real estate includes retail space, office, hospitality, industrial, and large residential. Each commercial “food group,” a veteran San Diego commercial broker says, has its own opportunities and challenges.

The office vacancy rate in San Diego County during the second quarter has only risen one-tenth of one percentage point, to 10.7 percent, according to a newly published report on the local office market by the CoStar Group, an international company which provides analytics and marketing services to the commercial property industry.

Viasat just built a huge new campus in Carlsbad. Tim Lopez says. “They’re not just going to walk away from that.”

But that’s because many leases are long-term. “I don’t think we’ve felt the effect yet,” says Tim Lopez of KW Commercial in Carlsbad, who has been dealing with commercial real estate for more than 30 years. “It’s too soon. It’s only been six months, and those leases are generally five- or ten-year leases.”

According to CoStar, “As schools, businesses, and countless other ventures transition into a new normal to combat the spread of the coronavirus, the immediate and longer-term impact on the office market is still not fully known. Leasing volume has slowed. In fact, leasing volume in the second quarter recorded its lowest stretch since the depths of the Great Recession…. The impact of the coronavirus is likely to spread across the market’s office-using employers, as workers have transitioned to telecommuting. Office size requirements may change going forward, and new leasing has slowed notably.”

A CBRE report notes that “new leasing activity in the retail sector dropped to nearly a 10-year low in the second quarter, down nearly 50 percent from the first three months of 2020.”

“The big question is, when we get past the pandemic and people will again feel good about congregating, will things look the same?” Karras asks. “And the answer is, probably not. Office is a good example. People are now used to working remotely. It’s now been proven that while it may not be as efficient or productive, it provides flexibility and positive lifestyle changes. So as an employer, you might consider a structure that provides at least some level of telecommuting, and you might decrease the amount of office space you need. A lot of companies are looking at shared desk space: if one employee works at home two days a week and the other, three, you can use the same space just by scheduling them to come in on different days.”

And yet, Karras concedes, “I don’t think anyone knows the answer to how many people are going to physically go back to the office, and in what capacity. I teach a market analysis class, with 32 students, and I asked the students what percent of the workforce they think is going to go back to a physical office. The answers were as high as 80 percent and as low as 40 percent. No one really knows, and I don’t think we’re going to know for probably a year or a year and half, at the earliest.”

Correia agrees. “Office space is probably the toughest commercial market to project because it is so reliant on the profit and losses of each individual tenant,” he says. “How to proceed with office space has a lot of businesses flummoxed. On the one hand, business are learning employees can work remotely effectively, and on the other, they may have long-term leased space they feel the need to fill. Additional considerations include cost of utilities, maintenance, and even liability for employee and consumer welfare amidst a pandemic. Much like the proposed repurposing of Horton Plaza to a tech hub, I would not be surprised if we didn’t see some repurposing of office space, for example, to multi-family. We see a long-term need for housing in San Diego and there is already a national discussion regarding converting office space to housing.”

Lopez is a lot more optimistic about the office market’s eventual recovery. “Have you tried working at home, with kids?” he asks. “It’s absolutely going to recover. I believe a majority of people want to go back to the office, especially with so many employers offering amenities like gyms and free food. People miss that. They want to have that corner office. They want to eat snacks, and go to the fridge, and turn the air conditioner to 60 without having to worry about paying for it. People are tired of staying home. The Zoom thing is boring. They want to go out and meet and look people in the eye and say, ‘We have a deal.’”

Lopez also notes that many businesses have spent big bucks over the last few years improving the workspace by adding fitness centers, game rooms, and other amenities. “Take Viasat. They just built this huge new campus in Carlsbad,” he says. “They’re not just going to walk away from that.”

The market rental rate for office space in San Diego County is $35 per square foot, according to CoStar. Rent growth is currently cooling, and CoStar predicts that “as the office environment slowly grapples with the spread of the coronavirus, rent growth is expected to turn negative,” although the decline is not expected to be as much as it was during the Great Recession. The strongest markets are Del Mar Heights/Carmel Valley, Kearny Mesa, and Mission Valley. “Demand for traditional office space among tenants and investors in Kearny Mesa and Mission Valley remains high, while Del Mar Heights/Carmel Valley’s trophy offices and demand from legal and tech firms are driving growth,” CoStar says. Areas like downtown, “where the availability rate is already above 25 percent, could feel the impact of rent losses more deeply,” CoStar says.

The market price for office buildings is nearly $340 per square foot, about $100 lower than in Los Angeles, according to CoStar. “But pricing … is forecast to pull back amid slowing rent growth and demand,” CoStar says.

Retail has been hit particularly hard by the pandemic, particularly malls. Karras notes that malls were already undergoing a transition “to more experiential” because of e-commerce. “And part of that experiential transition has been more restaurants,” he says. “If you look at University Towne Center, for example, you see a lot more restaurants, a lot more places for people to congregate. But then retailers got hammered because of covid-19, and all those restaurants that allowed socializing had to put that on hold as well….”

“We’re never going to see malls come back the way they were,” Lopez adds. He notes that one of the largest mall operators, Simon Properties, is negotiating with Amazon to turn vacant Sears and JCPenney stores into distribution centers.

While malls may be getting hit particularly hard by the pandemic, the entire retail business “is under double attack” from e-commerce and state restrictions on “non-essential” businesses.

The only safe category, Karras maintains, are neighborhood centers anchored by service businesses like grocery stores and dry cleaners. “That retail model is still working pretty well,” he says.

According to the CoStar report, “San Diego’s retailers are likely to endure a stretch of turbulence that may exceed that of other property sectors as the economy has re-opened in fits and starts…. Nordstrom in Westfield North County closed as a result of the pandemic. Leasing has slowed notably since the middle of March after the statewide shelter in place order was issued. Since mid-March, San Diego recorded its lowest level of retail leasing in more than a decade through the second quarter, and with so much uncertainty in the air, it is not expected to pick up in the near term.”

A CBRE report underscores this, noting that “new leasing activity in the retail sector dropped to nearly a 10-year low in the second quarter, down nearly 50 percent from the first three months of 2020.”

The market rent for retail space in San Diego County, CoStar says, is just over $30 per square foot. Rent growth is also expected to turn negative before the end of the year.

Due to “substantial uncertainty in the retail market surrounding the spread of the coronavirus, sales activity.... Both deal flow and sales volume cooled notably in [the second quarter of 2020]. Both reached near-decade lows after nonessential retailers had shut down for two months.”

Over the past 12 months, 448 retail properties have sold for an average of $381 per square foot, per the CoStar report. “In April 2020, a private investor from Los Angeles paid $27.7 million ($630 per square foot) for a Vons grocery store on 30th Street in North Park…. And in May, a private trust purchased the Albertson’s grocery store in downtown San Diego for $22.2 million ($516/square foot) from a local party.”

The hospitality industry has been hit even harder than retail, Karras says. Recovery is coming, but it won’t be fast. On a national level, the weekly hotel occupancy rate just hit 50 percent for the first time since mid-March, according to STR, a data research firm serving the hospitality industry. STR data shows the local hotel occupancy in San Diego rate peaked at 79 percent in 2018, then dropped to 77 percent in 2019. In May, San Diego Tourism Authority data showed that average countywide occupancy rates dropped to as low as 24 percent among hotels that had remained open. Much of the drop has been attributed to a decline in business travel.

“Businesses have found that Zoom, in particular, has been effective enough that there’s a way to decrease business travel and the associated costs of business travel,” Karras says. “So once this is over, yes, we might not see as much business travel as we have in the past, but I think people will be anxious for vacation travel, which is good for San Diego, because San Diego is a tourist destination.” The recovery period for downtown hotels may take longer, he cautions, due to the lack of conventions.

One area of commercial real estate that’s doing just fine is industrial, fueled by the growth in e-commerce and the need for “last mile” distribution centers (“last mile” is a term used in supply chain and transportation circles to describe the movement of products from a transportation hub to the consumer’s home or place of business).

The CoStar report maintains “industrial space markets may be best positioned to weather the storm from the spread of the coronavirus, given the strength of the life science and logistics sectors…. Construction starts skyrocketed after Amazon’s 2.6- million-square-foot distribution center in Otay Mesa broke ground in [the second quarter of 2020]. That was one of several new leases for the e-commerce giant in San Diego. It committed to the 530,000-square-foot speculative Vantage Point in Poway during [the second quarter of 2020] and the spec RB Vista in Rancho Bernardo in [the third quarter of this year]. In all, Amazon has leased roughly 3.5 million square feet across San Diego since 2019.”

Karras isn’t surprised. With so many consumers ordering directly from Amazon and other e-commerce providers, a centralized warehouse is no longer sufficient, he says. For one thing, he says, because items are shipped directly to consumers instead of to stores, merchandise is no longer stacked onto space-saving pallets. “Every one of those little items is now in a box,” he says, “taking up three times as much space.”

And then there’s the speed of delivery. “People want things more quickly,” he says, “so you’re seeing more warehouse space closer to suburban areas. It’s all about getting that product to the customer today, or the next day. You can’t ship it from Riverside or Ontario; you need to have it close to the population centers, and that’s why you’re seeing industrial space continue to be in high demand.”

Lopez says it’s not only e-commerce giants snapping up warehouse space, it’s Amazon resellers. “You’ve got people trying to lease 4000, 5000, 10,000 square feet of industrial space because they are distributors for Amazon and they need the space for fulfillment,” he says.

Industrial rents in San Diego, according to CoStar, are averaging around $16 per square foot, and are expected to “stall and possibly fall in the near term… amid continued disruption from the coronavirus.” Industrial rent growth tends to be strongest among tech submarkets, CoStar says, noting that “Sorrento Mesa, Sorrento Valley, and UTC were all near the top of the market for the strongest annual rent growth in the past 12 months, and companies continue to seek expansion space for lab or life science requirements in those areas.” Otay Mesa has the cheapest industrial rents, with average rents less than $12 per square foot. “Tenants commonly lease space here for less than $6/square foot and are frequently involved in the movement of products coming from Mexico,” CoStar says. “Asking rents for new space typically fall under $12/square foot. For instance, Mad Engine’s deal at the newly built Siempre Viva Business Park in 2019 had an asking rate of $9.84/square foot.”

On the sales end, Otay Mesa also has the most available land at the lowest prices, according to CoStar. Developers can often acquire land for less than $15 per square foot. The 65 acres on which Atlanta-based Seefried Properties is building Amazon’s distribution center sold for about $8 per square foot in 2019.

The multi-family residential market — apartments — is in good shape, although the pressing need for more housing is tempered by the high unemployment rate and the inability of some tenants to pay their rent. “Everyone needs a place to live,” Karras says. “The big issue here is: now that government subsidies are starting to wear off, what are collections going to look like?”

“We don’t have enough multi-family housing in San Diego,” Lopez asserts. “Look at what’s happening in Carlsbad. By 2029, to satisfy state requirements, the city needs to have 3900 additional housing units, so that’s 487 units a year over the next eight years. And of those 3900 units, 2100 have to be affordable for people with very low to moderate incomes. That means apartments.”

No surprise, then, that multi-family housing “is flying off the shelves,” Lopez says. Adding to the frenzy is the fact that some landlords are panicking because tenants aren’t paying their rents and evictions are on hold. “In a market like here, there’s blood in the water,” he says. “And that’s when sharks feed.”

Landlords may be in for a rough time. According to the CoStar report, “demand has slowed … and vacancies may rise above the level of the Great Recession. At the same time, rent growth decelerated in mid-March through April. That is the first time rent growth slowed in the spring since the Great Recession, resulting in rents falling in the first half of the year. Rent levels largely stabilized by the end of May, but that came at a time when rent growth typically surges heading into the summer. California passed a state-wide rent cap measure in October 2019 that limits annual rent increases to 5 percent plus local inflation. That figure is set at 7.2 percent for San Diego in 2020, which most assuredly will not come into play this year….”

Rents in big apartment buildings are averaging $2.20 per square foot, according to CoStar. The typical market rent for a one-bedroom apartment in San Diego is just north of $1600, with two-bedroom units going for $2000 and three bedrooms for $2500.

Over the past 12 months, CoStar says, 385 apartment buildings have sold at an average purchase price of $6.1 million, or $282,000 per unit. The average price per square foot is $416. A 16-unit apartment building in University Heights is currently listed for sale for $6.7 million. That’s $418,750 per unit, or $547 per square foot. The building is located on the 4300 block of Mississippi Street and was constructed in 1956.

A new report by the market research journal Visual Capitalist found that nationwide, the default rate among hotel and retail properties funded by commercial mortgage-backed securities debt soared 792 percent between May and June. “Ratings agencies are growing increasingly nervous about the... business side of the residential mortgage-backed securities market that touched off the 2008 global financial crisis.”

Lopez isn’t overly concerned. “People want to own commercial property in Southern California. I don’t think it’s ever going to be a bad buy. I think a lot of it is overpriced, and one reason for that is that buyers aren’t necessarily looking at cash flow, they’re looking at depreciation, where they can take a tax break.”

Karras isn’t worried either. “At the end of the day, if you think about what drives demand for almost all of this product, it’s employment. If you have good employment, if people have disposable income, people are likely to buy things, eat out at restaurants, and travel. And I think we’re pretty well positioned, from an overall standpoint. San Diego has a pretty diverse economy. Military isn’t going anywhere, so you have military and spending associated with it. You have tourism, once we get through the pandemic. And San Diego is a very robust technology center that should have pretty good employment growth. I think San Diego will fare fine over the long term.”

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Mr. Arnold, this was a relevant and informative story. I'm concerned about the impacts of the pandemic on commercial real estate but I am also concerned about the impacts of passing Prop 15. If anything is going to put the screws to small business, which occupy commercial property, it will be the unintended consequences of the shock tax hikes will bring.

Sept. 23, 2020

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