Lack of subleases suggests Santa Rosa office market is steady

Over the past 12 months, the utilization of office space has likely been at the lowest point in history, as employers shifted to remote working during the pandemic. Over and over again, we have read articles about the death of the office environment and how the future of office work will forever be changed.

While it’s likely true that the future will look different as companies become more accustomed to a hybrid model of working in the office and working remotely, I do not believe for one second that the office is dead and won’t be returning. Sure, there are going to be companies that can embrace remote working and reduce their footprints, but the reality is that the office is a place of collaboration and creativity where the interactions and ideas exchanged between workers are the basis for innovation. I believe the office is a necessity for companies to continue to grow and flourish and will continue to a pivotal part of a business’ success.

Basing their evidence on a few select technology companies in the Bay Area, the media would have you believe that the office market is a bloodbath with millions upon millions of square footage available.

That’s simply not true in Sonoma County and specifically Santa Rosa. While office spaces have been underutilized since the initial shutdowns due to COVID-19, the Santa Rosa office market has continued to hold steady. The overall vacancy (including sublease space) has risen slightly, from 10.1% in the fourth quarter of 2019 to 11.9% in the fourth quarter of 2020.

However, sublease space remains a miniscule portion of this vacancy, accounting for roughly 18,000 of the total 873,000 square feet of vacancy and an overall inventory of office space at over 7.5 million square feet. In fact, space available for sublease has actually gone down, from 25,500 square feet at the end of 2019.

Since the first of January this year, tenant activity in the office market has been strong. I believe this is being driven by pent-up demand from companies that sat on the sidelines throughout 2020. I believe they are starting to see the light at the end of this very dark tunnel and are in a position where they now must make decisions.

These first tenants in the market are being welcomed by landlords who saw the market pretty much grind to a halt since March 2020. Many of these tenants are being offered lower rental rates and more incentives to attract them to a specific location.

The largest landlords have shifted their mentality from one of maximizing net income to one of maximizing occupancy and that shift is reflected in the economics of the transactions we are seeing.

We are currently seeing class A office properties in the best locations commanding monthly rents of $2–$2.35 per square foot fully serviced, with a few exceptions. Class A full-service rents outside of the most desired areas $1.75–$1.90. Office rents in older-generation properties are asking for full-service rents of $1.65-$1.75.

These rates are roughly 5%–10% below where they stood at the end of 2019.

Lease incentives such as free rent and moving allowances are making a comeback and helping landlords to try to keep long-term income stronger by providing upfront reductions in costs for companies. We are also seeing landlords more willing to invest capital into tenant improvements and providing “turn-key” improvement packages to tenants without requiring amortization of these costs into the proposed rental rates.

It should be noted that owner-user office demand has been just as strong as tenant demand. U.S. Small Business Administration loan rates continue to be at the lowest point in history, hovering around 2.5% fixed for 20 years. Also driving demand are incentives provided via the coronavirus relief packages, such as lower fees and forgiveness of upfront payments.

While we are seeing more small office buildings (1,500–3,000 square feet) available, demand is strong, and they are likely to be absorbed in the very near future. It’s difficult not to justify at least exploring a purchase opportunity, once one considers that a monthly mortgage payment would be near or below a rent payment especially after taking into account the tax incentives of ownership.

The Santa Rosa industrial market remains the strongest of the commercial property sectors in Sonoma County. This is a result of years of low rents that did not justify new construction coupled with the new market demand created by the cannabis industry throughout 2018.

We did see a bit of cooling in the demand for cannabis-related industrial properties over the last six months of 2019. However, the cannabis industry appears to be stable for the time being, as we have not witnessed many properties being put on the sublease market, which would be an indication of the industry’s retrenching.

The vacancy rate for Santa Rosa industrial stood at 6.1% at the end of 2020 versus 4.7% at the end of 2019. The overall vacancy for the county stood at 5.7% at the end of 2020, compared with 4.7% at the end of 2019. While vacancy has increased slightly, the market remains incredibly strong, and rents have been unscathed through the pandemic.

The lack of availability and the functional obsolescence of the majority of the industrial properties that are available have allowed property owners of the higher-quality properties to sustain the higher rental rates achieved over the past few years.

Monthly rental rates for the majority of industrial properties are currently ranging from 90 cents to $1.15 per square foot gross. That being said, the newest buildings like those at Billa Landing in the Sonoma County airport area are commanding rents of $1.05–$1.15 per square foot on a triple-net basis.

This pricing should hold through 2021 and beyond, resulting from our continued lack of supply coupled with demand and the barriers of entry, including the high costs of land and construction.

As with office space, ownership of industrial properties continues to be in high demand. Prices have drastically increased over the past two to three years, with many industrial buildings now commanding higher values than office buildings. Outside of the astronomical values we have seen for some cannabis transactions, there have still been a number of sales to traditional industrial users north of $200 per square foot.

Well-located properties can be priced at $200–$225 per square foot and still generate enough interest for multiple offers and bidding wars. It’s not unlikely that a property is snatched up within a few days of hitting the market, if it even gets to the market as every agent has at least a few requirements that they are searching to accommodate.

Dave Peterson is senior partner in Keegan & Coppin Co. Inc./Oncor International’s Santa Rosa office.