By many measures, San Diego County's office market appears robust. Employment is increasingly diversified, office vacancies are under 10 percent, rents have risen 30 percent since 2004 and office space absorption has been strong for the past six years. These positive trends encouraged construction of millions of square feet of new office space. It appears that San Diego has managed to keep supply in check to balance with anticipated demand for office space. California's southernmost county, San Diego, encompasses more than 4,200 square miles, is the nation's sixth-largest city and enjoys a mild climate year round. It is well-located with 70 miles of Pacific Ocean coastline on the west, Orange and Riverside counties to the north, and Imperial County to the east. The area has long been recognized for its military presence with its national Marine and Naval bases. The economy was historically concentrated in the defense and manufacturing industries. San Diego County is viewed as one of the most diversified economies in the nation. Prominent biotech research institutes such as Scripps, the Salk Institute, Burnham Institute and the University of California, San Diego contribute to its recognition. In addition to biotech employment growth, San Diego's economy has diversified through growth in key industries such as communications, software, Internet and information technology. This growth has helped San Diego achieve one of the lowest unemployment rates in the nation. To discover whether economic diversification is enough to keep pace with recent office development, we analyzed employment growth by industry to evaluate the demand for office space. San Diego County's economy has steadily diversified since 1990. As a percentage of total employment, manufacturing and government comprise a smaller share of the local economy. Manufacturing's market share declined from 13 percent of total non-farm employment in 1990 to less than 8 percent in 2006, and government's share fell from 18.4 percent to 16.5 percent during the same period. Taking their place are industries that require increased office space. Between 1990 and 2006, the professional and business services sector, which includes scientific and research-and-development jobs, increased its market share from 12.8 percent to 16.4 percent. In absolute terms, this represents the addition of 85,700 jobs, or a 67 percent increase in employment. Also of note is the leisure and hospitality industry, which significantly increased its employment base by adding more than 27,000 jobs between 2000 and 2006. With a third Convention Center hotel under construction, this industry's gains are anticipated to continue growing. Additional analysis of San Diego's employment segregates historic job growth from 2000 to 2005 into its basic components: growth attributable to national employment growth, to industry groups that are growing, and to San Diego's competitive advantages in these industries derived from its amenities and institutions. The results show that 55 percent of San Diego's employment growth coincides with the nation's overall employment growth, 30 percent results from growth in major industry groups and 15 percent is from competitive advantages in growing industries. While San Diego County is somewhat insulated from national downturns by its unique attributes and diversification, it is not completely protected from economic downturns. Vacancy rates in the San Diego office market have hovered around 10 percent for most of this decade. Vacancy rates peaked in 2002, reaching an overall rate of 11.9 percent, consistent with nationwide trends following the Sept. 11, 2001 attacks and the bursting of the tech bubble. But the national slowdown did not severely impact San Diego's office economy, since an abundance of new supply also contributed to the increased vacancies. For example, in 2001 and 2002, San Diego delivered a total of 3.2 million square feet, which clearly exerted upward pressure on office vacancy rates. At the end of third quarter 2006, the vacancy rate was 9 percent, due in part to new additions in supply. As expected, rental rates have moved inversely with vacancies, since declining vacancies exert upward pressure on rents. Average asking rents for all classes increased overall from 2004 to the present. Specifically, the average asking rents increased 21 percent, from $1.92 to $2.33 per square foot per month. Between 2002 and 2005, the San Diego office market posted a healthy level of absorption, contributing to vacancy declines. In 2005, net absorption totaled nearly 1.65 million square feet, which reflects steady employment growth in the region. Also of note are companies who are locating their corporate headquarters in specific submarkets. For example, Qualcomm recently chose to locate its worldwide headquarters in Sorrento Mesa. Despite healthy levels of absorption, San Diego could be vulnerable to overbuilding. Nearly 3.3 million square feet of speculative office space is under construction, with an additional 14.7 million square feet of planned office space. Relative to the size of the San Diego office market, this translates into 6 percent of speculative office space under construction and an additional large amount of planned space. Even with significant employment growth, this is a great deal of new office space to be absorbed by the market. The expected demand for office space relies on estimates of the office space required per worker garnered from recent office and employment data for San Diego. The primary users of office space are employees in the financial, information and professional and business sectors. In the three sectors, total employment increased from 309,000 to 330,000 jobs between 2001 and 2005, or 5,300 jobs per year. By comparison, the total amount of occupied office space increased from 41.2 million square feet to 46.4 million square feet from 2001 to 2005. We estimate the average space per worker over the last few years in San Diego as 250 square feet per worker. To absorb the 3.3 million square feet of office space under construction, San Diego would need to add 13,200 new office jobs. This appears reasonable since 21,000 office jobs were created between 2001 and 2005. Of greater concern is the delivery of too much speculative space from the 14.7 million square feet of planned space. Without staging the construction, the office market could be vulnerable to increased vacancies. A simple projection shows how staging the development of planned office space can help maintain a balance between new supply and expected demand. The project is based on certain assumptions regarding the San Diego office market over the next four years. First, we assume that the housing market continues to slow down but does not create a recession or serious job losses. Second, we consider two scenarios for the growth in office employment. Scenario one assumes a moderate annual growth rate of 1.5 percent, which is somewhat less than the recent annual growth rate from 2001 to 2005. Scenario two is more optimistic, assuming an annual growth rate in office employment of 2 percent per year. We further assume that office space under construction is delivered equally in 2007 and 2008. Finally, we assume that 3.5 million of planned, speculative office space will be delivered each year in 2009 and 2010. The last assumption is rather aggressive because it exceeds recent additions of new supply and is roughly half of the planned 14.7 million square feet of office space. With the staging of planned projects, supply and demand of new office space are in balance. While San Diego County is well positioned to absorb the new supply under construction in the next two years, the market is sensitive to assumptions about the demand in the later two years. However, in both employment scenarios, expected demand roughly balances new supply, provided that the planned construction is delivered in later stages. Delores Conway is the director of the Casden Real Estate Economics Forecast. Alma Cibrian and Mark Semotiuk are master of real estate development candidates at the University of Southern California. The authors thank Robert Merkin, senior vice president with CB Richard Ellis, for providing data and assistance.
April 9, 2007