Too Soon To Say…

In my fourth quarter of 2019 editorial I concluded with, “Barring a true ‘black swan’ event, 2020 should be another good year for Orange County’s economy and commercial real estate market.” Fast forward six months and… WOW! Overnight we found ourselves conducting business in an alternate reality. A remote reality, a digital reality. A reality where bedrooms and kitchens double as home offices, Zoom calls are the new norm, kids and pets are allowed to crash a “meeting,” and happy hour gets earlier by the day.

The first quarter data does not reflect a pandemic response, since there were only two weeks left in the quarter when the crisis began, and we spent most of the second quarter in lockdown as evidenced by the second quarter numbers. When “stay-at-home” orders are easing, it is important that we get back to work as quickly and safely as possible to minimize the damage.

The office sector will take a hit but it’s likely to fare better than its retail counterpart. Industrial should be least affected. Office pricing will decline but not as dramatically as some have been forecasting. In February, the underlying fundamentals were strong, demand was outpacing supply and office rent collection has remained in the 90th percentile each month since the pandemic started. That said, we expect landlords to soften their stance on up-front concessions and show more willingness to accept shorter-term leases. Sublease inventory is expected to rise, as businesses hit the hardest look to shed excess space.

In the short term, it’s all about your own “re-entry strategy.” There is no one-size-fits-all protocol and it’s important that landlords and tenants work together. As a rule of thumb, each tenant is responsible for their specific space while landlords are responsible for the building and its common areas.

The crisis has also given a boost to the split-roll property tax initiative, now known as Proposition 15, which would mandate that commercial properties be reassessed to full market value at least every three years. If passed by California voters on November 3rd, Prop 15 would raise property taxes by up to $11.5 billion per year in support of local governments and school districts. Opponents believe this would thwart the state’s economic recovery and result in more business closures, more lost jobs, lower property values and a loss in local sales tax and state income tax revenues.

It’s too soon to know the long-term impacts but one thing is for sure — this is not the end of commercial office space as we know it. Our work-from-home experience has shown that we are social beings and that the office remains relevant. In the months and years to come, we are going to see a rise in demand for “healthy” buildings, remote work will become a business strategy, technology & innovation will explode, and leadership style and company cultures will transform. These are trends that our industry has been talking about for years and the silver lining is that COVID will accelerate their widespread adoption.

Remember, disruption creates opportunity, and this is an opportunity for you as a business owner to re-examine your priorities and reset your corporate vision. Focus on building a better office with the ability to evolve and consider how your real estate can best support your employees, customers and long-term objectives.

OC Office Market Overview

In the last three months, Orange County has gone from full lockdown to a substantial economic reopening to another surge in new cases that could put the brakes on the whole process. That resulted in a mixed performance for the Orange County office market in the second quarter. Leasing activity and net absorption were well off the pace, but average asking lease  rates and vacancy held steady under very difficult conditions. Speculation about a resurgence in the popularity of Class B suburban low-rise buildings is on the rise, as business leaders review the suitability of their Class A high-rise workplaces now that employee safety has become their new priority. The premium placed on employee interaction in workspaces designed for higher density in urban cores is suddenly being challenged, but it’s still too early to predict any long-term mpact on market metrics.

Vacancy Rates

The vacancy rate for all building classes combined changed little during the second quarter, ending the period just 66 basis points higher at 11.4%. This is significant considering that COVID-19 protocols made every step of the leasing process more complex, which was expected to delay occupancies. Class A continues to see the highest vacancy with the Airport Area, Central County and South County all running in the 14% to 15% range. This has been the case for some time as new ground-up development is concentrated in these submarkets. North County vacancy is still running lowest at 8.79% and there are no new projects in the construction queue.

Lease Rates

Unexpectedly, average asking lease rates across building classes managed to increase in all five major submarkets in the second quarter, with the overall rate moving up $0.04 to $2.83 per square foot. However, concessions are on the rise, as landlords prefer to offer free rent and more generous tenant improvements in lieu of lowering their coupon rates. Some
landlords are showing a willingness to agree to shorter lease terms in order to get income from their empty space as soon as possible. Creditworthy tenants with immediate requirements now have the upper hand and stand a good chance of obtaining favorable terms on an “effective” basis.

Transaction Activity

The volume of sale and lease deals inked during the quarter fell by almost half in the second quarter. Office users operate with higher employee density than typical industrial operations, making it more of a challenge to reopen a business or plan and execute a move. Most office-based companies are running at less than full capacity, employing a variety of methods to limit close contact between employees. Sale activity fell during the quarter because buyers are reluctant to move forward on new acquisitions with so many unknowns. Moreover, commercial lenders are tightening up on their own underwriting, which is eroding borrowing power.

Employment

The unemployment rate in Orange County was 14.5% in May 2020, up from a revised 13.8% in April 2020, and above the year-ago estimate of 2.4%. This compares with an unadjusted unemployment rate of 15.9% for California and 13.0% for the nation during the same period. Professional and business services decreased by 41,200 jobs with 75% of the loss  in administrative and support services (down 31,100 jobs), which includes temporary help firms.

Construction

Total space under construction, just over 975,000 square feet, was unchanged in the second quarter. The Press, a 300,000-square-foot retrofit of the old LA Times printing facility, is underway in Costa Mesa. That creative office project is scheduled
for completion in the fourth quarter of 2020. Irvine Company’s build-to-suit for Alleryx Inc. at Spectrum Terrace 2 is set to be delivered in the fourth quarter of 2020. The company will be occupying the bulk of the 340,000-square-foot second phase. The first phase is fully leased. A headquarters campus for SchoolsFirst Federal Credit Union, including 180,000 square feet
of office and a four-level parking structure, is underway in Tustin.

Absorption

Orange County posted negative absorption in the first quarter and followed it up with an even bigger decline in the second quarter. The biggest hit this quarter was Western Digital’s vacating 152,000 square feet on Michelson Drive in Irvine. Other significant move-outs include Pacific Care’s 60,663-square-foot space on Lake Center Drive in Costa Mesa and Stern Lending’s 30,337-square-foot space at 4 Hutton Center in Santa Ana. In all, the county lost 450,000 square feet in net occupancy in the second quarter. That brought the total loss for the first half of 2020 to almost 605,000 square feet. Consecutive quarters of negative net absorption signal trouble for the office market. Current space requirements are concentrated in the lower size ranges, as smaller companies scramble to minimize the impact of the economic shock to their businesses.

FORECAST:

The office market will likely be in a state of flux until there is some kind of medical breakthrough that reduces the need for current physical distancing protocols. In fact, the industry is abuzz with speculation that the way we use office space may change forever. Low-rise office buildings in the suburbs are starting to attract attention again. If that trend materializes, the Orange County office market may be its direct beneficiary, as it has a significant stock of low-rise buildings near attractive residential areas with strong retail support. For the second half of the year, we expect rent growth to be flat, absorption slightly positive at best, and landlords will continue to offer leasing concessions to hold rental rates flat.

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 Q2 2020 OC Office Space Market Report.