New Decade. Same Cycle.

2019 was another good year for the OC office market. A diversified, well-educated employment base continues to keep the office market on firm footing. Consistent demand has kept lease rates and sale prices on an upward trend notwithstanding the significant spike in speculative office development over the past two years.

This year technology tenants are expected to dominate leasing, which isn’t surprising because they accounted for 22% of the activity through the first half of 2019. Interest in flexible office space will continue to grow, but at a much slower pace thanks to the recently botched WeWork IPO. Political activity continues to impact the overall CRE outlook. The House has passed the USMCA (NAFTA 2.0) and it is expected to be signed into law in January. Many believe the new law will strengthen U.S. trade with Canada and Mexico. Tax incentives for energy-efficient commercial buildings have been extended, allowing owners to claim a deduction of up to $1.80 /SF for qualifying systems.

Of great concern going forward is the California Schools and Local Communities Funding Act, which will likely be on the ballot in November. This controversial initiative would remove Prop 13 protection for most commercial properties. Beginning with the 2021–22 tax year, commercial property would be subject to periodic reassessment to full market value even if it does not change hands. Tenants subject to operating expense pass-through could be forced to absorb huge tax increases, while investors who cannot pass those increases along would see a decline in property values due to lower NOI.
Looking ahead, I’m keeping an eye on these key market drivers:

#1: Interest rates will remain low. The Fed’s three rate cuts in 2019 made clear its intentions to avoid recession. We expect interest rates to remain stable going forward, which makes 2020 a good year to acquire or refinance office properties.

#2: The creative and progressive design trends that have dominated the OC office market since 2015 will continue. The latest iteration is the “outdoor” office and developers have taken note. Employees, predominantly millennials and Gen Z, expect an excellent experience at work, which means spaces with high levels of choice, variety and balance.

#3: The alternative investment sector of CRE will remain strong. Data center, self-storage and medical office activity has doubled since 2008, making up approximately 12% of all CRE activity. As this trend continues, expect to see adaptive reuse projects growing in popularity. Old factories, mills, schools, vacant retail boxes and more are being converted into flex space and residential housing. Programs like Opportunity Zones or the Low-Income Housing Tax Credit will further support those efforts. Barring a catastrophic economic disturbance, 2020 should be another solid year for Orange County’s
economy and commercial real estate market.

OC Office Market Overview

The OC office market has stabilized into a relatively strong and stable position. Vacancy remains manageable, but has ticked up slightly in the past year. Technology, Financial Services, and Health Services firms have driven a  significant amount of recent leasing activity. However, expanding companies are leveraging new workplace technologies
to save money by increasing the number of employees for each square foot of space they lease, and that has had an impact on overall absorption and transaction velocity. Tenants in Class A and B buildings who leased space early in the recovery cycle are getting sticker shock at renewal time, as rent growth, which has moderated in recent quarters, is up substantially over the past 5 years.

To mitigate higher per square foot occupancy costs, many tenants are moving down in building class and taking less space by switching to more open workspace designs. The market has seen modest levels of supply additions in recent years compared with previous development cycles, but several of the Class A projects delivered over the past two years are leasing up more slowly than expected. Net absorption, though still in positive territory, has been softening over the past several years. Capital market conditions remain solid, and while sales volume is down from its record level back in 2016 and 2017, it remains robust. Cap rates remain at or near historical lows, especially for high quality Class A and B assets.

Vacancy Rates

Nearly 1.39M SF of space has been delivered in the OC office market since Q1 2019, expanding the office base by 1.2%. This has contributed to the uptick in overall vacancy. Direct / sublease space (unoccupied) finished the quarter at 11.44%, up 48 basis point year-over-year. North Orange County posted the lowest vacancy rate at 7.17%, while the Airport Area and Central County had vacancy rates greater than 12% at the end of fourth quarter. Higher vacancy in the Airport Area is mainly
due to its concentration of new deliveries still in the initial lease-up phase.

Lease Rates

Rent growth in the OC office market leveled off in 2019. The average asking lease rate in Orange County rose by just 0.37% over the past year compared with 1.7% nationwide. The average asking FSG monthly asking lease rate lost $0.09 in the fourth quarter, ending the period at $2.74. The average quoted rental rate for Class A space was $3.10 per square foot, compared with the Class B asking rate of $2.47 per square foot.

Transaction Activity

Slow growth in the region’s labor force has resulted in hiring challenges for many firms, and that may be impacting transaction velocity. Orange County’s labor market remains historically tight, with the unemployment rate holding at 2.5%. The total square feet leased and sold in the fourth quarter was approximately 3.4M SF, a significant slowdown from
the 5.0M SF of transactions in the fourth quarter of 2018. Downsizing into more open workspace to increase headcount and appeal to younger workers is also a factor.

Employment

The unemployment rate in the OC office market was 2.5% in November 2019, unchanged from a revised 2.5% in October, and below the year-ago estimate of 2.7%. This compares with an unadjusted unemployment rate of 3.7% for California and 3.3% for the nation during the same period. Local job growth was evident across all subsectors but financial services (up 1,200 jobs) and Government (up 2,200 jobs) led the way as the year ended.

Construction

Total space under construction in the OC office market ended the year at 795,177 square feet. In Costa Mesa, construction is underway at The Press located at 1375 Sunflower Drive. This former L.A. Times printing facility is being converted into more than 300,000 square feet of creative office space to accommodate the shift in demand from businesses looking to recruit and retain a younger workforce. The Source, located in the Irvine Spectrum, offers a two-building concept with common atrium connectivity and more than 70,000 total square feet of rentable space. Irvine Company’s build-to-suit for Alteryx Inc. at Spectrum Terrace 2 is also in the works. The company will occupy the bulk of the project’s 340,000 square foot second phase. The first phase is fully leased.

Absorption

Co-working tenants like WeWork have leased millions of square over the past few years and the current slowdown in that sector is partly responsible for the recent decline in new transaction velocity. Orange County office occupancy grew by 167,588 square feet in the final quarter, bringing the year-to-date gain in occupied space up to 707,160 square feet. The Airport Area submarket accounted for 260,089 square feet of that total. By product type, Class A office led the way with a net gain of 314,790 square feet in just the fourth quarter. Notable transactions included: Avanir Pharmaceuticals (103,879  square feet in Aliso Viejo), County of Orange Assessor (69,151 square feet in Orange), and WeWork (71,076 square feet in Irvine).

FORECAST:

Lease Rates

Rent growth may pick up again as the absorption of the remaining first generation space gets leased up. With fewer attractive alternatives in the market, rent growth should return to an annualized rate of 2–3% over the course of the year.

Vacancy Rates

We anticipate that the overall vacancy rate will remain in the 11–12% range over the next three quarters, but the Class A
sector will run somewhat higher due to its higher concentration of first generation space.

Overall

Signs of a global economic slowdown, concerns over US-China trade relations and a decline in the US GDP growth rate
motivated the Fed to cut its benchmark Federal Funds Rate 3 times in 2019. That effort to stimulate consumer spending and business investment seems to be working. Equity markets responded by rising to new highs and the spread between short- and long-term US Treasuries widened again after a dangerous inversion earlier in the year. The latest estimates for domestic GDP growth for 2020 are running in the low 2% range, which should be enough to keep the current economic recovery on track.

For more information on the OC office space market and how to capitalize on real estate opportunities to grow your business, contact Stefan Rogers 949.263.5362 / srogers@voitco.com.

Click HERE to download Voit’s Q4 2019 OC Office Space Market Report.