The recession might have taken the wind out of some landlords, but since the recovery, most office owners have gained ground. Have they gained enough ground, however, to declare Orange County a landlord’s market?
Western Real Estate Business, April 2014, written by Jeff Ingham, Senior Marketing Director, JLL, Irvine, CA
The debate over whether negotiating leverage in Orange County currently rests in the hands of office landlords or tenants is one that can be justifiably argued by either side. It’s no secret Orange County was one of the markets that struggled most with the severity and timing of the Great Recession. The mortgage industry, a staple of the office market’s tenant base, experienced one of the most severe downturns of its historically cyclical presence in Orange County, resulting in a flood of jobless workers and empty office buildings.
If the overexposure to the mortgage industry wasn’t enough, the economy inopportunely took a nosedive on the heels of Orange County’s most rapid period of new development in the county’s history. Needless to say, once the dust settled in late 2009, landlords were staring up at a steep slope to get back to the occupancy and pricing levels that were achieved at the peak.
Now that we’re four years removed from the bottom, the market is just past the halfway mark in many aspects of the recovery. The latest numbers show Orange County has regained about 60 percent of the 200,000 jobs cut during the downturn. It has also absorbed 75 percent of the 7.1 million square feet of lost occupancy. On the flipside, the office market’s vacancy rate hangs relatively high, near 14 percent. This has tempered rent growth outside of the choice assets and submarkets. Overbuilding prior to the downfall, and the efficiency in which tenants are occupying space, are just a few of the challenges landlords face today as they attempt to lease up properties. Thus, from a macro-level, it’s tough to call which side of the table has an upper hand in a lease negotiation since many facets of the market are on a steady positive climb, but at a sluggish pace and with additional challenges.
The complex market conditions have forced landlords to get creative over the past four years–both figuratively and literally. Those with the financial wherewithal have engaged in lease restructures to retain existing tenants , while offering generous concession packages like free rent and tenant improvement allowances to attract new tenancies. This aggressiveness is starting to dissipate, however, among landlords that are positioned in well-performing submarkets of Irvine, Newport Beach and select pockets in the outer regions.
Large-and mid-sized tenants looking for Class A space in these areas are finding fewer options to choose from, and landlord concessions are not as easily up for grabs as they once were only two years ago. Even though average contract rents are seeing only minimal growth (less than 3 percent over the past year), the confidence among owners is palpable enough to suggest leverage is slipping away from tenants.
Of course, these trends are being described from a very macro-level perspective. The more appropriate way to judge the current balance between landlords and tenants in this segmented state of the market is on a submarket-by-submarket, or property-by-property level. After all, there are always opportunities in the market for tenants. The key is to identify where these opportunities are and how to take advantage of the various market conditions.
For example, the Airport Area continues to be the region that drives the market’s leasing activity. The Newport Center submarket that circles the Fashion Island retail center commands a 95 percent rent premium relative to the market average. This area was identified by the national JLL research team as one of the most expensive places in the country to lease office space in 2013. Meanwhile, just 6 miles away in the Costa Mesa submarket, which offers equal, if not more retail amenities and more modern office product, there is a different story. This market is carrying an above-average vacancy rate that will spike even higher later this year when Hyundai relocates to its new headquarters in Fountain Valley.
There is also a growing disparity between individual suites in office projects as local landlords begin to dabble in speculative creative space build-outs, which have become one of the most talked-about trends in the industry as of late. Creative space has been the main appetite in recent years for the trendiest technology and media firms across the country. The demand has spread to nearly every industry today.
The Irvine Company has gained attention locally in the past year with their speculative creative suites in the Irvine Spectrum submarket. The Irvine Company intended for the suites to be a catalyst for leasing activity in the Class B campus product. So far the campaign has been a huge success. Tenants have leased the space as quickly as it has been built. They’re agreeing to terms at a nearly 30 percent rent premium relative to comparable non-creative space.
The success has encouraged others to test similar strategies, including some of the most traditional office towers where some landlords are building out full floors of creative space. Whether or not the rent premium obtained is enough to provide a solid return on the upfront capital required to develop these suites remains to be seen. Nonetheless, it is becoming a new competitive advantage for landlords in the market to attract new leasing activity. So far, it’s playing to their advantage.
The average office tenant, with minimal special requirements, still has the overall power in Orange County’s market. But just as you would expect to pay extra for add-ons like leather seats and built-in navigation when buying a new tenants should expect to lose bargaining power as they negotiate for office space in the most popular submarkets, asset classes, floor heights and unique (creative) space build-outs in the market. Given the current conditions, however, there are many instances where tenants have the opportunity to hold the upper hand on landlords in negotiating a lease. The key to success ultimately comes down to deep market intelligence to identify the most opportune time and place to strike.
Kevin Thomas is a Senior Vice President and Principal of Lee & Associates-Newport Beach, Inc. Kevin specializes in industrial and office brokerage in the Airport Area of Orange County, California.