Santa Rosa office market weathers COVID decline in urban markets

Sonoma County companies are continuing to evaluate the necessity and importance of in person office interactions vs. work-from-home or hybrid policies.

It appears that most are seeing the value to having workers physically in the office and are striving to get their employees back in the office. However, employers are struggling to enforce this as historically low unemployment rates continue to give the upper hand to employees that want a more flexible schedule. The office landscape and strict in-person daily attendance policies have changed for the foreseeable future and most likely have changed permanently.

That anaylsis continues to impact the office sector as companies have downsized and consolidated their office space. However, this impact has been much lower on the Sonoma County and Santa Rosa office market thanon major metropolitan markets like San Francisco.

While San Francisco’s office vacancy jumped 10 percentage points over the pandemic, Santa Rosa office market increased just 3.7 percentage points, from 9.8% to 13.5%. Similarly,the overall Sonoma County office market increased 3.6 percentage points, from 11.9% to 15.5%.

That the Santa Rosa market has weathered the effects of the COVID pandemic better than other areas appears the result of our local service-based economy and Santa Rosa being the home of corporate satellite offices vs. major headquarters locations. While some downsizing will continue,we believe the major COVID impacts have already filtered through the market.

The remaining question is what the 2022 economy will do and how it may further impact the office sector in Santa Rosa. It appears that business confidence remains high, with historically low Sonoma County unemployment of around 2.5% vs. the historical average of 5.32%.

Furthermore, it looks like inflation is starting to get under control, but at the cost of higher interest rates that are more than double than their historic lows. The 20 year fixed SBA rates were around 2.5%–3.0%% at the end of 2021 and currently range closer to 6.5%—6.75% range.

What has had an impact on the owner–user purchase market is the increase in interest rates. Before , it was feasible to purchase a property with a 10% down payment Small Business Administration loan and have occupancy costs on an after-tax basis to be at least break even with leasing, if not cheaper.

The excellent long-term owner–user financing alternatives led to higher intrinsic pricing (cost per square foot) that enabled sellers of vacant owner–user buildings to achieve prices that most often exceeded those of leased investment properties.

But the current interest rates have increased that cost of ownership by roughly 35%-40%. Given this, the demand for owner–user office buildings has decreased dramatically, and many of the vacant owner–user properties have sat on the market for six or more months.

Prices began to be reduced coinciding with the interest-rate hikes, but buyers seem to be either sitting on the sidelines awaiting larger pricing discounts or have simply come to terms with continuing to lease their office space.

As interest rates continue to rise, we believe that vacant office buildings will continue to come down on a price-per-square-foot basis as interest rates continue to influence the economics. However, local owner–users seem to value the concept of owning their office space and tax advantages it can provide. This along with the high costs of new construction are likely to shore up the price floor keeping reductions in check.

We don’t anticipate the market heading into a situation like we saw in 2010–2012. Most likely, it will be a time period where we see some minor 10%-15% price reductions with prices leveling off until interest rates are reduced or the market accepts higher rates as the new normal.

Office rents on an asking price basis have held relatively steady for the time being. However, questions about what the near-term economy will bring are certainly impacting decisions on tenant concessions such as free rent. Owners are hedging their opportunities and being more accepting of making a deal that may not look the best today rather than waiting to hopefully land something better in the future.

Asking rents are certainly softer and more negotiable as we start 2023 than they have been over the last 12 months. Shoring up occupancy levels is currently carrying more weight than near term net income for most property owners especially those larger owners with office portfolios.

Class A office properties in the best locations are currently asking $2.05–$2.45 per square foot fully serviced. Class A rents outside of the most desired areas are $1.85–$1.95 full service. Office rents in older generation properties are $1.65-$1.85 full service. These rates are roughly in line with where they stood at the beginning of 2022.

Dave Peterson is a senior partner at Keegan & Coppin Co. Inc. (keegancoppin.com).