Orange County Leasing Activity Flattens in Q3

The Orange County office market saw a decline in movement during the third quarter as leasing activity decreased by 14% compared to last quarter. The decline in absorption stemmed from tenant move-out's ranging in the 20,000-25,000 square foot range. As tenants seek opportunities to right size and new construction delivers to the market, absorption gains are expected to be limited in coming quarters. Investment activity jumped in the third quarter as multiple buildings traded hands, including The Atrium and the Centerpoint office campus. The third quarter marked the highest sales volume in 2018 by 42%.

Direct vacancy for the quarter was 13.0%, while sublease vacancy recorded at 1.4%. Tenants looking for spaces greater than 100,000 square feet have more options given new office construction deliveries. Tenants searching for space options under 10,000 square feet are currently in the best position. West County supplanted North County as the submarket with the tightest vacancy in Orange County at 7.3%. Net absorption recorded negative 166,600 square feet, breaking a 17 quarter streak of positive movement. Much of this negative absorption stemmed from move-out's in Airport Area (-113,000 square feet) and South County (-149,000) square feet. Large tenant move-ins during the third quarter included: Behr at 1801 Saint Andrew (236,600 square feet) and Hoag Medical at 2975 Red Hill Ave (40,300 square feet). Leasing activity decreased from last quarter's 1.9 million square feet to 1.7 million; falling within the five-year historical average. Direct asking rental rates increased $0.01 from last quarter to $2.87 PSF FSG. Much of this slowdown in growth could be an indication that asking rental rates, particularly rates of Class A product, have hit their peak. Class A rental rates decreased by $0.04 to $3.17 PSF FSG, while Class B increased by $0.06 to $2.70 PSF FSG and Class C increased by $0.04 to $1.93 PSF FSG. 

New construction in the Airport Area, Central County and South County submarkets totaled just under 1.0 million square feet. The Quad at Discovery Business Park (365,000 square feet) completed construction while The Launch (67,900 square feet) completed renovation during the third quarter. Three office projects are currently under construction, including 2722 Michelson Drive (155,000 square feet) in Irvine, The Flight at Tustin Legacy (417,300 square feet) and Spectrum Terrace Phase I (348,800 square feet) in South County. Investment activity jumped for properties greater than 25,000 square feet compared to one quarter ago, totaling $546.1 million in transaction value. Transaction value increased by 42% from the second quarter of 2018. The Airport Area witnessed an increase in investment activity during the third quarter. Lincoln Property partnered with Angelo Gordon & Co., acquiring a 8 building portfolio in Irvine/Newport Beach for $161 million (302 PSF). Kelemen Company purchased The Atrium on Von Karman for $106.8 million ($352 PSF). The Atrium was 90% leased at the time of sale and Kelemen plans to make future renovations.

Key Takeaways:

  • The Orange County office market saw negative demand in the third quarter, recording -166,600 square feet of net absorption. Move-outs in the Airport Area and Central County contributed to the fall in demand.
  • Asking rental rates growth slowed by increasing only $0.01 from last quarter to $2.87 per square foot (PSF) full service gross (FSG).
  • The construction pipeline held steady as two projects delivered to the market and one new project (Spectrum Terrace) started construction.
  • The Airport Area accounted for the majority share of leasing volume for the quarter, recording 54% of all activity.
  • Orange County job growth increased by 5,500 jobs in the month of August. Greatest annual job gains were recorded in educational and health services (+9,300) and professional and business services (+5,300). As of August 2018, the Orange County unemployment rate is still among the lowest in the nation at 3.1%.

Outlook:

Moving into the end of 2018, the Orange County market is expected to maintain positive momentum. Although Class A asking rental rates are starting to stabilized, Class B asking rentals are expected to continue to climb. New developments coming online during the following year are expected to put upward pressure on asking rental rates. Orange County will remain a highly desired market for traditional FIRE tenants as well as technology and manufacturer users.

Vacancy is expected to trend upward as new office product comes online in coming quarters. Absorption is expected to record positive at year-end from anticipated large move-in's in Airport Area and South County. Class B rental rates are expected to continue to increase, while Class A rental rates are expected to stabilize through the end of 2018. The Source in Irvine is expected to start construction by year end and The Press in Costa Mesa is expected to start construction first quarter of 2019. While interest rates continue to increase and capitalization rates slowly inch up, the investment environment has become more prudent as of late. However, Orange County remains a favorable investment market for both foreign and domestic capital.