Real Estate Southern California: Spec Office Development Is Back in Gear

Cruzan’s “make” office project at 5600 Avenida Encinas in Carlsbad, CA, was part spec development and part repurposing of an old warehouse into creative office.

After a roughly eight-year hiatus during and after the Great Recession, speculative office development is finally returning to the Southern California marketplace. While much of the construction taking place can be classified as redevelopment or adaptive reuse due to land constraints in the region, the fact that spec development is happening at all is a testament to the national and local economy and the industry’s confidence in Southern California as an attractive market for jobs. Real Estate Forum spoke with several office-development experts in Los Angeles, Orange County, San Diego and the Inland Empire to get their take on this growing trend, why now is the right time for it, the type of development taking place and where, and where they see the trend heading in the future. Today’s spec-office buildings naturally feature the modern amenities that most companies are seeking, but developers are getting creative in providing these features in unique spaces with a sense of place. “We’re in various stages of planning for campus and high-rise projects with a focus on sleek, modern architecture and coastal-California-lifestyle amenities,” Lauren Kelly, SVP and chief marketing officer for the Irvine Co., tells Forum. “Our ‘Next Gen’ campus office plans in Irvine, for example, will include floor-to-ceiling glass and aluminum curtain walls for superior natural light and energy efficiency; advanced infrastructure for technology; fitness and wellness centers offering indoor and outdoor activities, such as yoga and bike-sharing programs; and the Commons, a large, open-air space at the heart of each campus featuring Wi-Fi-enabled outdoor living rooms, sun decks and al fresco dining. Our new high-rises will also incorporate these lifestyle experiences into what we term a ‘vertical campus.’ “ Tom Bak, senior managing director of Trammell Crow Co. and overseer of TCC’s Southern California development and investment teams, tells Forum his firm has seen movement towards larger floor plates, which allows for greater connectivity and higher efficiency. “There has been a shift toward floor- to-ceiling glass and higher ceiling height, allowing for more natural light to interior areas. Tenants have higher power requirements and a demand for greater density, so developers are increasing power and providing parking ratios closer to five per thousand.” Bak adds that Southern California offers incredible year-round weather, and as a result, new projects are integrating the outdoors to provide flexible work space, relaxation areas and social environments that improve the work-life balance. “Adding outdoor amenities and ‘people places’ helps to attract and retain talent, while also facilitating greater connections for a more productive work place. Amenity offerings have expanded to include on-site gyms, wellness centers, employee lounges, retail and high-quality dining options. Office buildings have gained an increasingly important role in helping to define a company’s brand and their culture.”

“In Irvine, our building plans were accelerated because of our vacancy rate of less than 5%. We have very few blocks of space available for larger customers.”—Lauren Kelly, Irvine Co.

Like the Irvine Co., Bak says TCC is working to create and deliver the kind of next-generation office experience office users seek at the Boardwalk, a 545,000-square-foot, class-A, spec-office development in the heart of Irvine’s  CBD. “Our design includes two nine-story towers connected by enclosed bridgeways and terraced walkways, highly efficient 30,000-square-foot floor plates with the ability to bridge buildings for up to 65,000 square feet on a single floor, two acres of carefully designed outdoor space, on-site retail and a comprehensive indoor and outdoor amenity package.” In the San Diego market, Andre Childers, pre-construction lead for Pacific Building Group, tells Forum his firm has seen a lot of ground-up office activity in the UTC area. “Over the past few years, however, our firm has had the opportunity to be involved in the redevelopment of existing buildings. These exterior and interior redevelopments (common areas and spec suites) create more innovative and flexible space for new leasing opportunities. Also, we have been involved with projects such as iboss, where we have taken an existing building and redeveloped it as a build-to-suit.  The company moved its office from Sorrento Valley to San Diego’s UTC submarket and implemented a fashion-forward office design with the hope of attracting young, local talent and recent graduates.” Ben Tashakorian, first VP investments in Marcus & Millichap’s San Diego office, tells Forum the significant increase in multifamily property values has made it difficult for office developers to compete with housing developers. “As a result, we are seeing less demand for spec-office development in San Diego.” However, Stacy Meronoff, leasing director for Cruzan, which focuses on development in the San Diego market, tells Forum that while the demand for spec is lower in San Diego than in other Southern California markets, it still exists. “The Irvine Co. recently completed its One La Jolla Center project (306,000 square feet) in UTC on a speculative basis, and it has attracted significant leasing activity and interest. The thoughtful design the company implemented is important for attracting tenants in today’s market, where employers continue to emphasize creating a unique experience for their employees in order to recruit and retain top talent.” Other spec office developments under construction in San Diego are the Heights (along the 56 corridor) from Kilroy and Irvine’s Eastgate Summit in UTC and Torrey Point from American Assets, Meronoff says. “Significant projects in planning stages in central San Diego include Kilroy’s One Paseo (Del Mar Heights), Hines’ La Jolla Commons III (UTC) and Pacifica in Sorrento Mesa from Kilroy. It will be interesting to see which of these projects breaks ground on purely a speculative basis as opposed to securing an anchor tenant before kicking off construction.” Meronoff points out that San Diego’s office market is composed of more of a regional, smaller-user base rather than a lot of 100,000-square-foot tenants. As such, it can be more challenging to secure financing for a spec-office project. Gary Steinhardt, a senior director in the investment group at American Realty Advisors, tells Forum, “The lack of spec construction in San Diego may be an opportunity, but developers have to think about delivering something special and unique.”

The 21-story 200 Spectrum Center office tower is the Irvine Co.’s spec building at the center of Irvine Spectrum.

Several potential, interesting office projects in planning stages in Downtown San Diego—including IDEA1, Makers Quarter and Pacific Gateway—will probably wait to secure an anchor tenant or tenants before commencing construction, Meronoff says. Cisterra did this with its recently completed Sempra Headquarters building in East Village. “However, Downtown is highly amenitized and exploding with a well-educated Millennial population, so it seems as if it’s just a matter of time before it does support a major, speculative office development,” says Meronoff. “The growing migration and organic development of technology firms sprouting up Downtown will further support future office development. Also, the Downtown environment supports mixed-use development better than any other San Diego submarket.” Cisterra’s planned 7th & Market project will include a high-end hotel, a grocery store and residential units as well as office, “which I expect to be a fantastic addition to the fabric of East Village,” says Meronoff. “Our Carlsbad project ‘make’ was part spec development and part repurposing of an old warehouse into creative office. We did start redevelopment of the former Floral Trade Center before securing a tenant, but during construction signed GoPro for 45,000 square feet. GoPro is scheduled to occupy in the beginning of November, and this ideal anchor tenant has allowed us to be thoughtful and selective with the lease-up.” Meronoff says between the submarkets of UTC, Sorrento Mesa, Torrey Hills and Del Mar Heights, San Diego has approximately 575,000 square feet of office space under construction. Total planned development is approximately two million square feet. Additionally, the Downtown submarket has approximately one million square feet of office development planned. In Los Angeles, spec development has been strong, Martin D. Agnew, VP investments in MMI’s Encino, CA, office, tells Forum. “The bulk of development targets the metro’s core tenants. It is occurring in prime office submarkets such as Downtown Los Angeles, Mid-Wilshire and West Los Angeles. The Mid-Wilshire submarket in the Hollywood/Silver Lake area has the largest projects in the Los Angeles market. The 959 Seward campus, which has more than 200,000 square feet, and the Columbia Square site—originally the home of CBS Studios—are both spec and will have 346,000 square feet.. Of the two million square feet under construction as of October 2015, approximately 1.04 million square feet was under 50% pre-leased, often qualifying as spec.” Jerry Holdner, VP of market research for Voit Real Estate Services, tells Forum, “Over the next several years we will continue to see more adaptive-reuse office space being developed in markets that are a little later to this phenomenon, along with traditional office space. Currently there is approximately 6 million square feet under construction with another 30 million square feet planned for Southern California.” Holdner adds that the six million square feet under construction in Southern California comprises 70 office buildings, which break down as follows: Los Angeles is leading the charge with 34 buildings totaling 3.3 million square feet under construction.  Of this total, five buildings totaling 1.3 million square feet are in the Downtown submarket, five buildings totaling 890,000 square feet are in the Mid-Wilshire submarket and three buildings totaling 500,000 square feet are in the Playa Vista submarket. Orange County has 14 buildings totaling 1.9 million square feet under construction. Of that total, 11 buildings totaling 1.7 million square feet are in the Irvine Spectrum submarket. San Diego has 12 buildings totaling 625,000 square feet under construction, and the Inland Empire has five buildings under construction totaling 100,000 square feet. The vast majority of this space is spec, according to Holdner.

“The lack of speculative construction in San Diego may be an opportunity, but developers have to think about delivering something special and unique.”—Gary Steinhardt, American Realty Advisors

In Orange County, three distinct spec-office projects are in development, Michael Lawrence, SVP investments in MMI’s Newport Beach, CA, office, tells Forum. “This year, M&D Properties will complete the Source Tower, a mixed-use project that includes a seven-story 52,343-square-foot, high-tech office building located in a prime area of Buena Park. In Irvine, the Spectrum, a 21-story, 425,000-square-foot, class-A office building is scheduled to be delivered by the Irvine Co.; the building will be completed in 2016.” And, as Bak mentioned, Trammell Crow is developing the Boardwalk, an office campus on Jamboree Rd. in Irvine on 7.5 acres; completion is expected in the spring of 2017. So, why is now the right time for spec-office development to return to the various Southern California markets? Tight vacancies have helped fuel some of this construction, Kelly says. “In Irvine, our building plans were accelerated because of our vacancy rate of less than 5%. We have very few blocks of space available for larger customers. Southern California remains an attractive place to live, work and play..” Agnew says office vacancy rates in Los Angeles and westward in the Inland Empire are compressing. “While the vacancy rate for the area remains 250 basis points above its 12.7% 2007 pre-recession level, it has dropped significantly from 20.7% in 2009 at the height of the recession.” This year, Orange County’s vacancy will be down 110 basis points to 13.4% from its 2007 pre-recession rate, says Lawrence. “Absorption of office space has consistently outpaced the limited amount of new space entering the market.” Bak says in Orange County, there is a great need for contiguous class-A office space greater than 50,000 square feet, sparking the demand for spec-office space. “Year-over-year job growth of more than 3% signifies a pending need for future new space. These factors, along with year-over-year rent growth, low unemployment and diversification of industries make this a good time to develop speculative office in select submarkets.” In San Diego, vacancy will be down 120 basis points to 14.1% from its 2007 pre-recession level, Tashakorian says. “Rising demand and high absorption of new office space are encouraging builders to begin new endeavors, including more spec-development projects.” But it’s more than just shrinking vacancy that’s fueling the spec-office renaissance in Southern California. Bak says Orange County’s economy has diversified over the past cycle, seeing substantial growth from finance, technology, professional services, healthcare, consumer products, education and government groups, which are all absorbing office space. “Not only have we seen expansion by the existing tenant base, but well-known companies like Google, Vans, Ultimate Software, Houzz, Alignment Healthcare and Amazon have all entered the market over the past few years.” Holdner points out that employment gains have been positive, and employment growth is expected to keep growing in a variety of sectors throughout Southern California. “Currently, all economic indicators suggest that strong demand will continue.” He adds that decreasing vacancy in all Southern California office markets is putting upward pressure on rents, which is “the catalyst of the increase in speculative construction we’re seeing. We’ve been waiting for lease rates to get to a point where it makes economic sense to build, and we are there now in a few submarkets.” On what will make spec-office projects successful, Doug Killian, SVP of Voit Real Estate Services, tells Forum, “Timing is everything. The first projects to get completed will have less risk attached to them. The developers who have paid attention to the new workforce of Millennials will be in the driver’s seat for our fastest-growing companies within Southern California. Regarding financing, lenders for construction loans are a lot more conservative in this cycle. Therefore, spec developers are required to bring in more equity.” Steinhardt adds, “Location, speed, quality of design, and the right capital stack are paramount to success at this point in the macroeconomic cycle. Developers would be wise to seek construction loans with extension options and to partner with patient, experienced capital partners to ensure the longevity of their next project.” Meronoff says whether it’s spec or repurposing, most cutting-edge office space coming to market is amenity-rich, which is what today’s office users want. “The focus is on creating spaces and experiences that make the tenants happier, healthier and more productive.”