GlobeSt.com: How would you characterize the dynamic between the class-A and class-B office sectors in Orange County?

Fleener: First, you have to look at how you define the two product types. At our company, we say anything high-rise, that's new product and more modernized, is class A. It's priced higher and in better locations. When the market is soft, you obviously have twice the quality because things get cheaper. When the market tightens, people start to go back to class-B product—they probably shouldn't have been in class A to begin with. In 2012, for example, the market was still soft, so there was a flight to quality, and since the average lease term is five years, renewals would come into effect now.

There's also a new aspect to the different classes, as well: conversions. Some older class-B space has been converted into progressive space, and it's harder to do that in class-A buildings, especially on multiple floors. It's easier to do if you have a 50,000-square-foot building and you can redevelop the whole building. When you have conversions, some demand is created. There's maybe 5% conversion of product now, but when it adds up, it does have an effect on absorption.

There's always a price difference, too: there's a 20% to 30% price difference between class-B and class-A space, which brings me back to the original discussion point: economics does come into play with this as well. Also, it's a pretty tight market right now. Depending on which submarket you're looking at, on average there's 10% vacancy. When you get to sub-10%, that's a very tight market—you're looking at only one or two small suites available in a building. There's no room for growth for tenants. Tight numbers force some users into class-B space because it's the only thing available or close by.

Another thing to take into account is that the number of class-A properties being built is high, although Irvine Co. has built some quality two-story space that's mostly class B. Two cycles ago, we saw a huge increase in our base, which has an impact, but in this cycle, we're only building about 1.5 million square feet, so the impact isn't as great. Orange County's biggest problem is that when we build, we tend to build so much so fast that it takes time to get absorbed, but this time we're not doing that.

GlobeSt.com: What other reasons are there for direct absorption in the class-B sector to grow so much in the last year?

Fleener: We always track employment statistics as well; it's good to know where the employment is coming from. In 2013, we added between 12,000 and 13,000 office jobs; the year after that 10,000 to 12,000, and this year we're on track to add 9,000 to 10,000 office jobs. A large portion of those office jobs have been in administrative services, backfilling layoffs since many employees were doing double duty. So now we're adding users, but it's more back office, so it goes to class-B product. It's not big job push like we're opening up a lot of new law firms—those would go into class A. But that's not the case, though.

GlobeSt.com: Do you expect absorption to increase in the class-A office sector?

Fleener: It will keep increasing, I don't think it will be at the pace we've been at before, basically reaching peak pricing. We're going into new territories. Lease rates are going to keep going up. They have had a strong uptick over the last five years, and I think they are going to keep going up, for two reasons: 1. operating expenses increase no matter what—utility costs, property taxes, etc.; 2. we're seeing peak pricing on sales, and landlords have to get higher lease rates to justify the acquisition price in order to make money. We're due for another peak as well; this peak will be much higher than the last one due to those reasons.

Also, we don't have a big construction influx coming in. Our base is close to 100 million square feet, and we're putting in about 1 million square feet; it's not a huge add. And a lot of these buildings are adding a lot of things we didn't have 10 years ago: free Wi-Fi, onsite amenities, onsite gyms, yoga classes. These things have a cost, but they also have a value, and that's reflected in the lease rate.

GlobeSt.com: What do you expect to happen with rents in both classes for the rest of the year?

Fleener: We're anticipating they will go up even more next year—not at the same pace as before, but definitely will see it. Orange County is a very unique market compared to most other markets; we seem to have extreme swings in pricing: really low lows and really high highs. But if you graph it over a 20-year period, the average growth is only 3%. It looks like a huge increase, but on a historical average, it's not a huge increase. However, a very large landlord like Irvine Co. has an influence on lease rates because it owns so much of the base.

|

IRVINE, CA—With up to 30% price differentials between class-A and class-B office space and conversions and renovations being better suited to those smaller buildings, it's not surprising that absorption is greater in that space within the Orange County market, PM Realty Group's SVP Oliver Fleener tells GlobeSt.com. According to the firm, the class-B office sector has dominated with 474,804 square feet of direct absorption growth in the 12 months prior to the end of Q2.

In fact, the firm reports that limited construction deliveries and negative absorption have caused class-A direct vacancy rates to increase by 30 basis points to 12.5% since June 2016, while the class-B direct vacancy rate has experienced a year-over-year decline of 90 basis points to 9.9%. The class-B category also dominated in rental-rate growth, with class-A full-service gross asking rents increasing by 4.4% to $2.94 per square foot over the prior 12 months and class-B rents also appreciating 5.5% to $2.35 per square foot over the same time frame.

Cushman & Wakefield Q2 data concurs, with the firm reporting that the trend of tenants continuing to be priced out of class-A space likely to continue across the country as landlords make improvements to class-B space and adjust to the demands of their tenants. With the addition of the Quad, a four-building, 370,000-square-foot campus the Irvine Co. is developing in the Irvine Spectrum, development projects now top out at 2.6 million square feet for the market.

We spoke with Fleener about the dynamic between class-A and class-B office space in Orange County and what he foresees for the rest of the year.

GlobeSt.com: How would you characterize the dynamic between the class-A and class-B office sectors in Orange County?

Fleener: First, you have to look at how you define the two product types. At our company, we say anything high-rise, that's new product and more modernized, is class A. It's priced higher and in better locations. When the market is soft, you obviously have twice the quality because things get cheaper. When the market tightens, people start to go back to class-B product—they probably shouldn't have been in class A to begin with. In 2012, for example, the market was still soft, so there was a flight to quality, and since the average lease term is five years, renewals would come into effect now.

There's also a new aspect to the different classes, as well: conversions. Some older class-B space has been converted into progressive space, and it's harder to do that in class-A buildings, especially on multiple floors. It's easier to do if you have a 50,000-square-foot building and you can redevelop the whole building. When you have conversions, some demand is created. There's maybe 5% conversion of product now, but when it adds up, it does have an effect on absorption.

There's always a price difference, too: there's a 20% to 30% price difference between class-B and class-A space, which brings me back to the original discussion point: economics does come into play with this as well. Also, it's a pretty tight market right now. Depending on which submarket you're looking at, on average there's 10% vacancy. When you get to sub-10%, that's a very tight market—you're looking at only one or two small suites available in a building. There's no room for growth for tenants. Tight numbers force some users into class-B space because it's the only thing available or close by.

Another thing to take into account is that the number of class-A properties being built is high, although Irvine Co. has built some quality two-story space that's mostly class B. Two cycles ago, we saw a huge increase in our base, which has an impact, but in this cycle, we're only building about 1.5 million square feet, so the impact isn't as great. Orange County's biggest problem is that when we build, we tend to build so much so fast that it takes time to get absorbed, but this time we're not doing that.

GlobeSt.com: What other reasons are there for direct absorption in the class-B sector to grow so much in the last year?

Fleener: We always track employment statistics as well; it's good to know where the employment is coming from. In 2013, we added between 12,000 and 13,000 office jobs; the year after that 10,000 to 12,000, and this year we're on track to add 9,000 to 10,000 office jobs. A large portion of those office jobs have been in administrative services, backfilling layoffs since many employees were doing double duty. So now we're adding users, but it's more back office, so it goes to class-B product. It's not big job push like we're opening up a lot of new law firms—those would go into class A. But that's not the case, though.

GlobeSt.com: Do you expect absorption to increase in the class-A office sector?

Fleener: It will keep increasing, I don't think it will be at the pace we've been at before, basically reaching peak pricing. We're going into new territories. Lease rates are going to keep going up. They have had a strong uptick over the last five years, and I think they are going to keep going up, for two reasons: 1. operating expenses increase no matter what—utility costs, property taxes, etc.; 2. we're seeing peak pricing on sales, and landlords have to get higher lease rates to justify the acquisition price in order to make money. We're due for another peak as well; this peak will be much higher than the last one due to those reasons.

Also, we don't have a big construction influx coming in. Our base is close to 100 million square feet, and we're putting in about 1 million square feet; it's not a huge add. And a lot of these buildings are adding a lot of things we didn't have 10 years ago: free Wi-Fi, onsite amenities, onsite gyms, yoga classes. These things have a cost, but they also have a value, and that's reflected in the lease rate.

GlobeSt.com: What do you expect to happen with rents in both classes for the rest of the year?

Fleener: We're anticipating they will go up even more next year—not at the same pace as before, but definitely will see it. Orange County is a very unique market compared to most other markets; we seem to have extreme swings in pricing: really low lows and really high highs. But if you graph it over a 20-year period, the average growth is only 3%. It looks like a huge increase, but on a historical average, it's not a huge increase. However, a very large landlord like Irvine Co. has an influence on lease rates because it owns so much of the base.